NEW BUSINESS TAX SYSTEM (CONSOLIDATION, VALUE SHIFTING, DEMERGERS AND OTHER MEASURES) BILL 2002 Explanatory Memorandum

NEW BUSINESS TAX SYSTEM (CONSOLIDATION, VALUE SHIFTING, DEMERGERS AND OTHER MEASURES) BILL 2002

The following abbreviations and acronyms are used throughout this explanatory memorandum.

*Abbreviation*	*Definition*
A Platform for Consultation	Review of Business Taxation: A Platform for Consultation
A Tax System Redesigned	Review of Business Taxation: A Tax System Redesigned
ATO	Australian Taxation Office
AVM	adjustable value method
CFC	controlled foreign company
CGT	capital gains tax
Commissioner	Commissioner of Taxation
Consolidation Bill	New Business Tax System (Consolidation) Bill (No. 1) 2002
DVS	direct value shifting
FDT	franking deficit tax
FIF	foreign investment fund
FLP	foreign life assurance policy
GST	goods and services tax
GVSR	general value shifting regime
Imputation Bill	New Business Tax System (Imputation) Bill 2002
IT(TP) Act 1997	Income Tax (Transitional Provisions) Act 1997
ITAA 1936	Income Tax Assessment Act 1936
ITAA 1997	Income Tax Assessment Act 1997
IVS	indirect value shifting
MEC	multiple entry consolidated
SAP	substituted accounting period
STS	simplified tax system
TAA 1953	Taxation Administration Act 1953

Consolidated groups

The consolidation measure represents a significant change to the taxation of corporate groups. Due to its magnitude, the measure is being enacted progressively via a series of bills. Schedule 1 of the Consolidation Bill introduced on 16 May 2002 contained most of the key elements of the measure. Those key elements are supplemented by the amendments to the consolidation measure contained in this bill which include:

• modifications to the general cost setting rules where an existing group forms a consolidated group;

• the treatment of attribution accounts held in relation to interests in foreign entities;

• a number of technical amendments and refinements to the Consolidation Bill introduced on 16 May 2002 to address issues raised through consultation.

Date of effect: The consolidation measure will allow wholly-owned entity groups to choose to consolidate under this regime from 1 July 2002. The existing grouping provisions will continue to operate in parallel with the consolidation regime until 1 July 2003, subject to special rules applying to consolidated groups with a head company that has a SAP. In general, such SAP groups will retain access to grouping provisions until the date of consolidation, provided that the head company chooses to consolidate from the first day of their next income year, commencing after 1 July 2003.

Proposal announced: The proposals were announced in Treasurer’s Press Release No. 58 of 21 September 1999. The consolidation elements in this bill were foreshadowed in Minister for Revenue and Assistant Treasurer’s Press Release No. C59/02 of 16 May 2002.

Financial impact: The consolidation measure is expected to cost approximately $1 billion over the forward estimate period as follows:

Further explanation of this impact was provided in the explanatory memorandum to the Consolidation Bill introduced on 16 May 2002.

Compliance cost impact: The amendments in this bill are integral to the consolidation measure which is expected to reduce ongoing compliance costs by ensuring that:

• intra-group transactions are ignored for taxation purposes, so that taxation and accounting treatments are more closely aligned;

• administrative requirements, such as multiple tax returns and multiple franking account, losses, foreign tax credit and PAYG obligations are reduced; and

• integrity measures aimed at preventing loss duplication, value shifting or the avoidance or deferral of capital gains within groups do not apply within a consolidated group.

The consolidation regime will necessitate some initial up-front costs for groups as they familiarise themselves with the new law, update software and notify the ATO of a choice to consolidate. Large corporate groups may incur greater start-up costs in determining the market values of group assets. These costs will be alleviated by a transitional measure under which the group can elect (prior to 1 July 2003) to bring assets into the group at their existing cost bases. Groups that form after the transitional period may use the market value guidelines developed by the ATO to minimise compliance costs.

Summary of regulation impact statement

Regulation impact on business

• The consolidation provisions included in this bill supplement those contained in the Consolidation Bill introduced on 16 May 2002. Further provisions are scheduled for introduction later this year.

• The impacts of the consolidation measure, which will allow wholly-owned entity groups to choose to consolidate from 1 July 2002, were fully explained in Chapter 14 of the explanatory memorandum to the Consolidation Bill introduced on 16 May 2002.

Imputation treatment of exempting entities

This bill also provides consequential amendments to the provisions currently referred to in the taxation laws as the ‘exempting and former exempting company provisions’. The Imputation Bill introduced into Parliament core rules for the new simplified imputation system. As a result of the introduction of that bill, certain consequential amendments are required to other areas of the imputation system not covered by those rules, including the exempting and former exempting company provisions. This bill makes those amendments.

Proposal announced: The amendments are consequential to the Government’s decision to implement the simplified dividend imputation proposal. This proposal was announced in Treasurer’s Press Release No. 58 of 21 September 1999 as a component of the unified entity regime. On 14 May 2002, the Minister for Revenue and Assistant Treasurer announced in Press Release No. C57/02, the Government’s program for delivering the next stage of business tax reform measures. In that press release, the Minister confirmed that the simplified imputation system will commence on 1 July 2002.

Compliance cost impact: The new imputation system is designed to reduce compliance costs incurred by business by providing for simpler processes and increased flexibility.

General value shifting regime

This bill introduces a general value shifting regime (GVSR). The regime applies mainly to interests in companies and trusts that are not consolidated, but meet control or common ownership tests. The GVSR replaces the share value shifting and asset stripping rules currently in the income tax law.

Entities dealing at arm’s length or on market value terms are generally excluded from the GVSR.

This bill also makes amendments to the loss integrity measure to allow the optional use of global asset valuations for calculating unrealised gains and unrealised losses in Subdivisions 165-CC and 165-CD.

A special value shifting rule is introduced into Subdivision 165-CD to maintain its integrity where global valuations are used.

Date of effect: The GVSR applies to value shifts that happen on or after 1 July 2002, unless they happen under an arrangement or scheme entered into before 27 June 2002.

The loss integrity change to allow global asset valuation applies to calculations for changeover times and alteration times from 11 November 1999. The global valuation approach is optional and will not disadvantage taxpayers in terms of the current law. A transitional rule will ensure that the new value shifting rule in Subdivision 165-CD cannot disadvantage taxpayers in respect of alteration times that happen before Royal Assent.

Proposal announced: The GVSR proposal was announced in Treasurer’s Press Release No. 58 of 21 September 1999 (Attachment K), with further details announced in Treasurer’s Press Release No. 16 of 22 March 2001. The proposal in this bill was further foreshadowed in the Minister for Revenue and Assistant Treasurer’s Press Release No. C57/02 of 14 May 2002.

The loss integrity change to allow global asset valuation has not been previously announced.

The loss integrity change to allow global asset valuation is not expected to have any significant impact on revenue.

Compliance cost impact: A small to moderate increase in compliance costs for the GVSR is expected for most taxpayers affected by the measure, at least initially. In general, the de minimis rules and safe-harbours will assist in keeping compliance costs down.

In some instances the low value transaction exclusions and safe-harbours in the new law will mean a reduction in compliance costs for some taxpayers as compared with the existing law. Also, those entities that consolidate will not be subject to the GVSR.

In particular cases, the loss integrity changes to allow global asset valuation are expected to result in a significant reduction in compliance costs.

Summary of regulation impact statement

Regulation impact on business

Impact: The GVSR implements a generalised regime to replace the current value shifting rules which are deficient in many respects. The GVSR will apply to a wider range of entities, as well as to a wider range of transactions. In some instances the exclusions for low value transactions and safe-harbours will mean that taxpayers affected by the current rules will not be affected by the GVSR.

The loss integrity change to allow global asset valuation is expected to have a significant impact in reducing compliance costs in particular cases as the savings in valuation costs if assets are valued together rather than individually. The special value shifting rule required to preserve the integrity of Subdivision 165-CD may result in a small increase in compliance costs. This is because of the need to identify the removal of value from the company by particular means (e.g. certain distributions or transfers of assets to associates at undervalue). The net reduction in compliance costs is expected to be significant. The global valuation approach will also assist cost setting under the consolidation rules where affected entities have been subject to the loss integrity measures.

General value shifting regime

There are taxpayers not subject to the current value shifting rules that will be subject to the GVSR:

• Controllers and associates that hold equity or loan interests in controlled trusts will be subject to the direct value shifting rules – however the ‘interests’ of mere objects in discretionary trusts are not subject to value shifting adjustments.

• Controllers and associates that hold equity or loan interests in controlled companies or trusts that are not covered by the asset stripping rules in the current law.

• Common owners that hold interests in closely-held companies or trusts that satisfy common ownership tests with other closely held companies or trusts.

• In some cases involving closely-held entities, persons with interests in entities who do not form part of a control or common ownership framework that actively participate in a value shifting scheme.

• Taxpayers who create rights over assets at less than market value in favour of their associates, and then sell the assets (or replacement assets) at reduced values for losses.

Taxpayers affected by the rules will need to make appropriate adjustments to account for the effect of value shifting transactions on the values of their assets to ensure that inappropriate gains and losses do not arise on the realisation of those assets. There may be some changes in the behaviour of entities subject to the GVSR who may choose to deal at arm’s length, at market value, or within safe-harbours provided, to avoid the need to make adjustments.

Some taxpayers affected by the current value shifting rules will not be subject to the GVSR:

• Interest holders affected by an indirect value shift that can satisfy the CGT small business taxpayer $5 million net asset test or that are eligible to participate in the STS.

• Entities with interests in consolidated group members whose values for tax purposes are reconstructed under consolidation rules.

• No adjustments will be required for interest holders affected by small value shifts.

• On a practical level, many of the new rules are loss-focused and adjustments will only be required if an interest is realised at a loss.

Loss integrity

• A choice will be available to use global asset valuations for calculating unrealised losses in Subdivision 165-CD. This will enable compliance costs, especially valuation costs, to be lowered in circumstances where individual asset valuations are difficult or costly to perform. The approach will be optional and individual asset valuations may continue to be done if required.

• The choice will be available for alteration times happening from 11 November 1999, thereby allowing maximum compliance cost savings vis-à-vis the individual asset approach contained in the current law.

• A specific value shifting rule will, on an ongoing basis, preserve the integrity of Subdivision 165-CD even though some unrealised gain in value may be included in a global asset valuation at an alteration time. There will be some compliance costs involved in determining whether an adjustment is required if an interest in the company is later sold at a loss. However, in net terms, the reduction in valuation is expected to exceed by a considerable margin, in most cases, any additional costs of the value shifting rule.

• The value shifting rule will have a transitional application for alteration times that happen before this bill receives Royal Assent. Broadly, there will be no requirement specifically to examine whether value has been removed from the company after the alteration time. Any method by which a reasonable conclusion may be drawn that the later realised loss on the interest does not, or could not, duplicate an unrealised loss on an asset at the alteration time, will be sufficient to avoid an adjustment.

Demerger relief

• a CGT roll-over and a dividend exemption for owners in the head entity of a demerger group; and

where a demerger group divests itself of at least 80% of its interests in a demerger subsidiary to the interest owners of the head entity.

Proposal announced: Treasurer’s Press Release No. 16 of 22 March 2001. Further details were announced in Minister for Revenue and Assistant Treasurer’s Press Release No. C40/02 of 6 May 2002.

Financial impact: Unquantifiable. Details of the financial impacts are included in the table (under Revenue costs) in the regulation impact statement which appears in Chapter 16.

Compliance cost impact: Details of the compliance cost impacts are included in the regulation impact statement which appears in Chapter 16.

Amendments to this measure are required to deal with its interaction with other tax regimes and to address issues raised during consultation. These amendments are planned to be introduced at the earliest opportunity.

Summary of regulation impact statement

Regulation impact on business

• The initial and ongoing compliance costs that may be incurred depend on the structure of the demerger group.

• The measure has the support of industry who have been consulted on the detail of the measure.

• The net benefit of this measure is to remove the taxation impediments to business reorganisations by way of a demerger and to ensure that the taxation consequences for owners does not unnecessarily drive the choice of structure in which business should operate.

Outline of chapter

1.1 This chapter explains the modifications and changes to the cost setting rules that were introduced in the Consolidation Bill introduced on 16 May 2002. Those rules were explained in Chapters 2 and 5 of the accompanying explanatory memorandum. The amendments explained in this chapter are contained in Schedules 2 to 4 and 7 to this bill.

1.2 The cost setting rules deal with the alignment of the cost of the assets of an entity that becomes a subsidiary member of a consolidated group with the group’s cost for acquiring the entity. In addition, when an entity ceases to be a subsidiary member of a consolidated group, the group is recognised as having a cost for membership interests in the subsidiary that is equal to its tax cost for the net assets of that entity.

• changes to the cost setting rules that were introduced in the Consolidation Bill introduced on 16 May 2002;

All references to sections and divisions are references to sections and Divisions of the ITAA 1997 unless otherwise stated.

Context of reform

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

1.5 This model dispenses entirely with income tax recognition of separate entities within a consolidated group. It treats a consolidated group’s cost of acquiring a subsidiary entity as the cost to the group of acquiring the assets of that entity. A group’s cost of acquiring an entity includes the liabilities of the entity that become liabilities of the group. This cost also includes the liabilities that the acquired entity owes to existing members of the acquiring consolidated group.

1.6 A consolidated group’s cost for membership interests in a subsidiary member when it leaves a consolidated group is determined based on the cost to the group for the net assets of the subsidiary.

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

1.8 On formation of a consolidated group it is recognised that modifications are required to the rules for the basic case of a single entity joining an existing consolidated group. These modifications take into account that there may be more than one entity becoming a subsidiary member at the same time.

1.9 The asset-based model discussed in A Platform for Consultation and recommended by A Tax System Redesigned also recognised the need for special rules to apply on transition to the consolidation rules. In particular, a transitional option should be available for a group consolidating during the transitional period to elect in relation to certain subsidiary members to retain the existing asset tax costs (rather than applying the cost setting rules). This transitional option thereby removes the need for consolidated groups to re-value assets as required under the ongoing tax cost setting rules.

1.10 Transitional rules are also required to ensure that the transitional provisions of the uniform capital allowance system continue to apply to consolidated groups.

Summary of new law

1.11 The new law explained in this chapter is discussed under the following topics:

• changes to the cost setting rules that were introduced in the Consolidation Bill introduced on 16 May 2002; and

Changes to cost setting rules

1.12 The changes to the cost setting rules in the Consolidation Bill introduced on 16 May 2002 relate to technical refinements and enhancements to the core rules (relating to cost setting), rules for a single entity joining and rules for an entity leaving a consolidated group.

Formation rules

1.13 The formation rules operate by modifying the basic case of a single entity joining a consolidated group. In general, when a consolidated group is formed, no changes are made in relation to the assets of the head company of the group. Intra-group debt and intra-group membership interests held by the head company are exceptions. These are not recognised for income tax purposes after the group is formed.

Transitional rules

1.14 The transitional provisions are primarily required in order to reduce the compliance costs associated with forming a consolidated group.

1.15 Division 701 of the IT(TP) Act 1997 provides for a modified application of the ITAA 1997 for certain consolidated groups formed in the 2002-2003 and 2003-2004 financial years. Where a consolidated group is formed, with effect, before 1 July 2004, the head company may choose that assets of certain subsidiary members retain their ‘costs’ for tax purposes (e.g. adjustable values). This choice enables existing groups to consolidate without valuing the assets of, or calculating allocable cost amounts for, subsidiary members. There are also transitional provisions that apply to groups formed within the transitional period where they do not elect to retain their existing tax costs.

1.16 Division 702 of the IT(TP) Act 1997 provides for a modified application of the other transitional provisions (e.g. capital allowance provisions) in relation to assets that an entity brings into a consolidated group. These rules ensure that the transitional provisions of the uniform capital allowances system continue to apply to consolidated groups.

Comparison of key features of new law and current law

*New law*	*Current law*
Technical corrections and refinements are made to the rules contained in the Consolidation Bill introduced on 16 May 2002	The Consolidation Bill introduced on 16 May 2002 contains the cost setting rules for a single entity joining and leaving a consolidated group.
Rules for formation enable groups to apply the cost setting rules when forming a consolidated group.	The cost setting rules contained in the Consolidation Bill introduced on 16 May 2002 did not contain rules for group formation.
Transitional rules reduce the compliance costs associated with forming a consolidated group.	The cost setting rules contained in the Consolidation Bill introduced on 16 May 2002 did not provide for the transitional operation of the rules.

Detailed explanation of new law

1.17 The new law explained in this chapter is discussed under the following topics:

• changes to the cost setting rules that were introduced in the Consolidation Bill introduced on 16 May 2002 (see paragraphs 1.18 to 1.47);

• rules for the formation of a consolidated group (see paragraphs 1.48 to 1.74); and

− consolidated groups that form, with effect, before 1 July 2004 (see paragraphs 1.77 to 1.114); and

Changes to cost setting rules

1.18 The changes to the cost setting rules in the Consolidation Bill introduced on 16 May 2002 relate to amendments to the following areas:

• rules dealing with an entity joining an existing consolidated group contained in Subdivision 705-A (see paragraphs 1.27 to 1.45); and

• rules dealing with entities leaving a consolidated group contained in Division 711 (see paragraphs 1.46 to 1.47).

Amendments to the core rules

Trading stock

1.19 The reference in the heading for subsections 701-25(4) and 701-35(4) is amended so that it more correctly refers to value of trading stock rather than the cost of trading stock. [Schedule 2, notes to items 1 and 2]

1.20 The cost setting rules provide that where assets of an entity that becomes a subsidiary member of a consolidated group constitutes trading stock the entity is taken to have disposed of the closing trading stock for a specified value in order for there to be neither a gain nor a loss in respect of the closing trading stock in the tax return for the joining entity in the period ending at the joining time. Similarly where an entity leaves a consolidated group and takes with it trading stock the head company is taken to have disposed of the trading stock for a tax-neutral value. As a consequence the joining entity and head company are not able to utilise the choice that is generally available to an entity to revalue its trading stock at the end of an income year under section 70-45. [Schedule 2, items 1 and 3, notes to subsections 701-25(4) and 701–35(4)]

1.21 To allow an entity to revalue its trading stock immediately prior to joining a consolidated group would be inappropriate where the cost of trading stock is reset on entry into the consolidated group. However, where a transitional consolidated group elects to retain the existing costs of assets for tax purposes this option would be available (see paragraph 1.88). The exit of an entity from a consolidated group (as distinct from the disposal of membership interests in a leaving entity) should also result in a tax-neutral consequence for the head company of the consolidated group.

Pre-existing arrangements between entities that merge or re-emerge

1.22 The rule for adjustments to taxable income where identities of parties to an arrangement merge on an entity becoming a subsidiary member of a consolidated group (section 701-70) is amended to ensure that the adjustment to the taxable income of the head company is made in the same income year as the adjustment to the taxable income of the entity. This ensures that there is symmetry as to the timing of the adjustments. [Schedule 2, item 5, paragraph 701-70(3)(a)]

1.23 The rules for adjustments to taxable income where identities of parties to an arrangement merge (or re-emerge) on joining (or leaving) a group (sections 701-70 and 701-75) are amended to ensure that where they apply in respect of part year periods the operation is consistent with the part-year rule in section 701-30. Section 701-30 provides that where an entity is not a subsidiary member of a consolidated group for the whole of an income year for the period that it is not a subsidiary member its taxable income for the period is worked out as if the start and end of the period were the start and end of an income year.

1.24 The amendments to sections 701-70 and 701-75 ensure that the rules which apply in respect of the end of an income year (or start of an income year) also apply in the same way to an income year that is taken to end (or start) as a consequence of an entity not being a subsidiary member of a consolidated group for the whole of an income year. [Schedule 2, items 5 to 11]

Other changes

1.25 A minor amendment is made to subsection 701-55(6) to ensure that it relates to where a provision is to apply in relation to an asset. [Schedule 2, item 4, subsection 701-55(6)]

1.26 An amendment is also made to subsection 701-35(4) to ensure that the reference to the end of the income year is expanded to also cover where the income year is taken to end as a consequence of an entity not being a subsidiary member of a consolidated group for the whole of an income year. [Schedule 2, item 2, subsection 701-35(4)]

Amendments to the rules for an entity joining an existing consolidated group

Depreciating assets

1.27 References to depreciating assets in the cost setting rules applying where an entity becomes a member of a consolidated group are amended to ensure that those provisions only apply to depreciating assets to which Division 40 applies. Consequently, the cost setting rules which provide for a specific outcome in respect of depreciating assets will not apply where the depreciating asset is one which is excluded from the operation of Division 40. Section 40-45 provides that Division 40 does not apply to capital works, certain indefeasible rights to use international telecommunications cables and films. [Schedule 2, items 12 to 14 and 17]

Revenue assets

1.28 As discussed in paragraph 9.22, the definition of ‘revenue asset’ is amended as part of the proposals for the general value-shifting regime. Under the new definition, an asset is a revenue asset if:

• the profit or loss arising when an entity disposes of, ceases to own, or otherwise realises the asset would be taken into account in calculating the entity’s assessable income or tax loss, otherwise than as a capital gain or capital loss; and

1.29 As a consequence, the tax cost setting limit rule in section 705-40 is amended by adopting the new definition, but adding trading stock and depreciating assets, so as to preserve the class of assets presently covered by that rule. Under the rule, the assets affected by the tax cost setting amount limit are therefore:

1.30 Consequential changes ensure that any reduction in the tax cost setting amount arising because of an application of the limit rule is allocated appropriately across the other reset cost base assets, including other trading stock, depreciating assets and revenue assets. [Schedule 4, item 1, subsections 705-40(2) and (3)]

Trading stock

1.31 An amendment is made to the rule for reducing the cost for tax purposes of over depreciated assets (section 705-50) so that subsection 705-50(2) does not apply in relation to an entity that becomes a subsidiary member and was previously a subsidiary member of a consolidated group where subsection 705–50(5) applies. This amendment ensures that section 705–50 only applies in relation to an entity that becomes a subsidiary member and was previously a subsidiary member of a consolidated group where the special rule in subsection 705-50(5) applies. [Schedule 2, item 15, paragraph 705-50(2)(a)]

Over-depreciated assets

1.32 The operation of section 705–50 is also modified to prevent a duplicated reduction to a joined consolidated group’s cost for its assets because of an unfranked dividend paid by a joining entity to a member of the joined group before the joining time. This could arise because the same unfranked dividend could cause a reduction to the allocable cost amount under step 4 in working out the allocable cost amount and a reduction in the amount allocated to the cost of an over-depreciated asset. [Schedule 2, item 16, paragraph 705-50(3)(a)]

Interaction with loss integrity rules

1.33 Amendments are made to section 705-65 (dealing with costs of membership interests – step 1 in working out the allocable cost amount) to ensure that the provision appropriately interacts with Subdivision 165-CD which deals with adjustments for certain equity and debt interests in a loss company where there has been an alteration in ownership or control of the company.

1.34 Subsection 705-65(3) is modified to ensure that it does not have the unintended effect of triggering an alteration time (i.e. change of ownership and control) for the purposes of Subdivision 165-CD. It will also ensure it does not inadvertently trigger a changeover time for Subdivision 165-CC. This is achieved by referring to a CGT event rather than a disposal. The reference to a CGT event is sufficient to trigger the outstanding CGT adjustments. [Schedule 2, item 18, subsection 705-65(3)]

1.35 As discussed in paragraph 13.56, section 165-115ZD or section 165-115ZD of the IT(TP) Act 1997 may result in an adjustment (or further adjustment) to the reduced cost base for a membership interest that is realised at a loss after the global method has been used. Subsection 705-65(3A) requires that in relation to the joining time there be a testing in terms of section 165-115ZD on the assumption that:

• just before the joining time, a membership interest in the entity becoming a subsidiary member was disposed of; and

• members of the consolidated group received consideration equal to the market value of the membership interest at that time.

1.36 Where an adjustment would have been made as a result of section 165-115ZD applying on those assumptions (the adjustments would have been made under section 165-115ZA based on amounts calculated under section 165-115ZB) then the reduced cost base of the membership interest in the entity becoming a subsidiary members is reduced by the amount of that adjustment for the purposes of working out step 1 of the allocable cost amount. This subsection is needed, in addition to subsection (3), to trigger section 165-115ZD and determine a specific amount of adjustment, without also inadvertently triggering a new alteration time. [Schedule 2, item 20, subsection 705-65(3A)]

1.37 Consequential amendments are also made to subsection 705-65(4) to ensure that where Subdivision 165-CD applied in respect of an alteration time that happened before the joining time it does not have an effect in respect of a CGT event that happens after the joining time. [Schedule 2, items 21 and 22, subsection 705-65(4)]

1.38 In order to ensure that a reduction to the reduced cost base of a membership interest that has been made under subsection 165-115ZA(3) does not double count a subtraction for an amount of loss taken into account under step 5 or step 6 of working out the allocable cost amount, subsection 705-65(5A) ensures that the reduction under Subdivision 165-CD is added back. [Schedule 2, item 23, subsection 705-65(5A)]

1.39 A similar issue arises in respect of the reduced cost bases of debts owned by members of the consolidated group that have been subject to reductions under Subdivision 165-CD in respect of losses taken into account under step 5 or step 6 of working out the allocable cost amount. Subsection 705-75(5) ensures that there is no double counting where subsection 165-115ZA(3) has applied in respect of a debt owned by members of the consolidated group. [Schedule 2, item 27, subsection 705-75(5)]

1.40 The provisions dealing with the interaction of Subdivision 165-CC and the cost setting rules (both on entry into a consolidated group and where an entity leaves) are repealed in response to concerns over the workability of the provisions. Revised rules are to be included in a later bill. [Schedule 2, items 37 to 40, 43 and 44]

Intra-group liabilities

1.41 An amendment is made to the operation of section 705-75 to ensure that in working out the step 2 amount of the allocable cost amount the reduction for intra-group liabilities is determined having regard to the modified operation of subsections 705–65(2) to 705-65(4) (which deal with value shifting, loss transfer, and section 165-115ZD adjustments). [Schedule 2, items 26 and 27]

1.42 In working out the amount of liabilities to be added under step 2 in working out the allocable cost amount, it is the value of the liability to the joined group and not the value of the liability to the entity becoming a subsidiary member that is the relevant amount [Schedule 2, item 25, subsection 705–70(1A)]. This ensures that the liabilities are correctly valued in working out the cost to the consolidated group of acquiring the entity.

Amounts accruing to membership interests

1.43 Amendments are also made to the cost setting rules dealing with working out the allocable cost amount where membership interests are held in an entity becoming a subsidiary member prior to the time it becomes a subsidiary member. The amendments ensure that steps 3, 5, 6 and 7 in working out the allocable cost amount use the concept of accrued rather than earned, so that amounts that are taken into account are by reference to the amount accruing over a period in which membership interests are held not just when the amount is realised. The amendments to step 3 are incorporated in a revised section 705–90 (see paragraph 1.45). [Schedule 2, items 28 and 34]

1.44 In determining the amount of a profit that ‘accrued’ between 2 points in time it would not be correct to assume a constant rate of appreciation of an asset through time where there are grounds for believing that the appreciation of the asset would have departed from constancy in a specific way. For example, the entity may be aware of circumstances (e.g. a change in operations) which would lead it to conclude that a profit accrued faster over an earlier period of time than a later point in time.

Calculating step 3 of the allocable cost amount

1.45 The rule for adding to the allocable cost amount, the undistributed frankable profits that accrued to the joined consolidated group’s membership interests before the entity joined (step 3) has been revised to incorporate the following changes:

• the undistributed profits comprise those retained profits calculated under the accounting standards that could be recognised in the entity’s statement of financial position if that statement was prepared as at the joining time [Schedule 2, item 28, subsection 705–90(2)];

• the extent to which dividends paid out of the undistributed profits would be frankable is determined by working out the amount the entity would be able to frank after its income tax is settled in respect of all income years up to the joining time (but not any period prior to leaving another consolidated group) [Schedule 2, item 28, subsections 705–90(3) to (5)]; and

• amounts that are taken into account are by reference to the amount of undistributed profit accruing over a period in which membership interests are held not just when the amount is realised [Schedule 2, item 28, subsections 705-90(6) to (8)].

Consequential amendments are also made to provisions which refer to step 3. [Schedule 2, items 29 to 33, 35 and 36]

Headco acquired 100% of the shares in Subco on 1 July 2001 for $94. Subco, at this time, held one asset with a cost base of $80 and a market value of $100. Headco paid $94 for the entity as it recognised a deferred tax liability in respect of the asset of $6.

The asset was disposed of on 1 January 2002 for $140 realising an after tax profit of $42 ($140 less $80 less tax liability of $18).

The amount of undistributed profit to be added at step 3 when working out the group’s allocable cost amount for Subco is $28 ($140 less $100 less tax liability of $12) being the amount of undistributed after tax profit that accrued to the membership interests of Headco.

Amendments to the rules for entities leaving a consolidated group

1.46 An amendment is made to correct the typographical error in the general company tax rate in the formula in subsection 711-35(1). [Schedule 2, item 41, subsection 711-35(1)]

1.47 An amendment is also made to replace the incorrect reference to joined group in subsection 711-45(5) with old group. [Schedule 2, item 42, subsection 711-45(5)]

Rules for the formation of a consolidated group

1.48 Subdivision 705-B contains the cost setting rules for the formation of a consolidated group. Each entity that becomes a subsidiary member of a consolidated group at the time it is formed (the formation time) is treated in the same way, subject to certain modifications, as an entity joining an existing consolidated group. [Schedule 3, item 2, section 705-130]

1.49 The Subdivision applies where one or more entities become subsidiary members of a consolidated group at the time it comes into existence as a consolidated group. It applies by modifying the basic case rules of a single entity joining a consolidated group. [Schedule 3, item 2, sections 705-135 and 705-140]

1.50 The modifications to the case of a single entity joining a consolidated group are:

• order in which tax cost setting amounts are worked out (see paragraphs 1.52 to 1.55);

• allocable cost amount adjustments where there have been roll-overs from the head company to subsidiaries before the formation time (see paragraphs 1.56 to 1.66);

• adjustments for successive distributions of profits (see paragraphs 1.67 and 1.68);

• allocation of allocable cost amount to membership interests in subsidiary entities with certain losses (see paragraphs 1.69 to 1.71); and

• determining pre-CGT factors for assets of subsidiaries (see paragraphs 1.72 and 1.73).

1.51 Where a consolidated group forms before 1 July 2004 there are transitional options available that may alter the treatment under the formation cost setting rules. Those transitional options are explained in paragraphs 1.77 to 1.114.

Order in which tax cost setting amounts are worked out

1.52 Where a subsidiary member of the group (the first subsidiary) holds membership interests in another subsidiary member of the group (the second subsidiary), it is necessary to first apply the tax cost setting rules to the first subsidiary. This will set the tax cost of the assets of the first subsidiary, including a cost for the membership interests in the second subsidiary. [Schedule 3, item 2, subsections 705-145(1) and (2)]

1.53 The amount set for the membership interests in the second subsidiary will then determine the cost base of those membership interests for the purposes of determining the joined group’s allocable cost amount in relation to the second subsidiary [Schedule 3, item 2, subsection 705-145(3)]. This amount replaces the amount that would be worked out under subsection 705-65(1) in relation to these membership interests. As such, subsections 705-65(2) to (4) do not apply in relation to this amount. However, the prevention of the later operation of the value shifting rules in relation to these membership interests is preserved [Schedule 3, item 2, subsection 705-145(4)].

1.54 This tax cost setting amount for the membership interests is not used for the purposes of working out the terminating value of assets consisting of those membership interests. Rather, the terminating value of membership interests is calculated by reference to the assets the leaving entity takes with it when it leaves the consolidated group.

1.55 In the basic case of a single entity joining a consolidated group, rights and options to acquire membership interests are treated as if they were membership interests. Similarly, in the formation case, rights and options to acquire membership interests are treated as if they were membership interests. [Schedule 3, item 2, subsection 705-145(5)]

Head Co owns all the membership interests in T Co. T Co owns all the membership interests in X Co. On 1 July 2002, Head Co forms a consolidated group with the other companies.

First, work out the tax cost setting amounts for T Co’s assets according to the rules for an entity joining a consolidated group. T Co’s assets will include the membership interests T Co holds in X Co.

Then work out the tax cost setting amounts for X Co’s assets according to the same rules. For this purpose, the cost base of the membership interests in X Co (step 1 in working out the allocable cost amount) is determined by the reset costs of those membership interests, the costs for these membership interests having been reset along with the rest of T Co’s assets.

Allocable cost amount adjustments where there have been roll-overs from the head company before the formation time

1.56 In certain circumstances, where there has been a roll-over from the head company, adjustments need to be made in working out the allocable cost amounts for subsidiary members.

1.57 One effect of a roll-over within a wholly-owned group (under Subdivision 126-B or section 160ZZO of the ITAA 1936) is to defer the gain that would otherwise be brought to account as a result of the disposal. The gain is deferred until the asset leaves the group – either because it is disposed of directly, or it leaves the group via the disposal of an entity. The deferral takes place by allowing the recipient company to retain the originating company’s cost base for the asset. Another effect that can occur where the originator in a roll-over is the head company, is that the group’s aggregate cost for its assets following consolidation would be different from what it would have been if the roll-over had not occurred. The purpose of this provision is to offset any effect that a roll-over would otherwise have in altering a consolidated group’s aggregate cost for its assets. [Schedule 3, item 2, subsection 705-150(1)]

1.58 An adjustment is not required under the basic case of a single entity joining a consolidated group as the relevant roll-over can only occur within a wholly-owned group. An adjustment is also not required where the roll-over does not involve the head company. This is because:

• Division 138 applies to adjust cost bases for membership interests where roll-overs shift value between ‘sister’ companies or from a wholly-owned subsidiary to its parent; and

• a roll-over from a parent to its wholly-owned subsidiary will only alter the aggregate cost for assets in a subsequently formed consolidated group where the originating company in a roll-over within a wholly-owned group is the head company.

1.59 Allocable cost amount adjustments will need to be considered where all of the following conditions are met:

• before the formation time, there is a roll-over under Subdivision 126-B or section 160ZZO of the ITAA 1936 (the head company roll-over event) in relation to a CGT asset (the head company roll-over asset);

• a member of the consolidated group was the recipient company (the head company roll-over recipient), and the entity that becomes the head company of the consolidated group was the originating company, in relation to the roll-over;

• after the first roll-over but before the formation time there was not a further roll-over from the head company to a member of the consolidated group (this can only occur if after the first roll-over the same asset was rolled back to the head company and then rolled-over by the head company again – either to the same entity as the first roll-over, or to another member of the consolidated group);

− if there was a CGT event, then there must have been a roll-over under Subdivision 126-B or section 160ZZO of the ITAA 1936;

• the CGT asset that was the subject of the roll-over is not a pre-CGT asset at the formation time; and

• the sum of the head company’s cost bases of all of its CGT assets just before the head company roll-over event was different to the sum of the head company’s cost bases of all of its CGT assets just after the head company roll-over event.

1.60 The amount of any adjustment is worked out by reference to the head company roll-over adjustment amount. The head company roll-over adjustment amount is the difference between the head company’s cost bases of CGT assets immediately before the roll-over and the sum of its cost bases of CGT assets just after the roll-over event.

1.61 If the specified conditions are met (listed in paragraph 1.59), the result from step 3 in working out the group’s allocable cost amount for the recipient company is adjusted. The result from step 3 is reduced (if the amount worked out for the purposes of this rule is positive) or increased (if the amount is negative) by the amount worked out as follows:

1.62 The components of the formula are such that, where the sum of the head company’s cost bases for CGT assets does not change as a result of the roll-over event, no adjustments are required. No correction is required because the roll-over would not alter the group’s aggregate cost for its assets after applying the cost setting rules for consolidation from what that aggregate cost would have been if the roll-over had not occurred.

Prior to consolidation the head company of a consolidated group (HC) rolls over an asset with a cost base of $10 and market value of $100 to a subsidiary company (SC) for consideration consisting only of the shares issued in SC. HC’s cost base for the consideration shares is the market value of the roll-over asset (i.e. $100). This has the effect of increasing HC’s aggregate cost bases for its CGT assets, which include the membership interests in SC, by $90. (Before the roll-over it had a CGT asset with a cost base of $10, after the roll-over it had a CGT asset with a cost base of $100).

If HC and SC were then to form a consolidated group, HC’s allocable cost amount for SC would be $100 at step 1, for HC’s cost base for membership interests in SC. This amount is reduced under section 705-150 by $90 (the head company roll-over adjustment amount). Assuming the asset is the only asset held by SC, upon consolidation, the reduced allocable cost amount of $10 will be pushed down onto the rolled over asset.

Without a rule to reduce the allocable cost amount, after consolidation the roll-over would have increased the group’s cost base for its assets by $90.

1.63 Where the head company holds membership interests in a company interposed between it and the recipient company, adjustments must be made to the step 3 result in working out the group’s allocable cost amount for the interposed entity.

1.64 The step 3 result is reduced (if the amount worked out for the purposes of this rule is positive) or increased (if the amount is negative) by the amount worked out as follows:

1.65 If an adjusted step 3 result after applying these provisions would be negative, the step 3 result is taken to be nil and the head company makes a capital gain equal to that negative amount. Rules to provide a CGT event under which the capital gain will arise are to be included in a later bill.

1.66 In applying step 4, the adjusted step 3 result is the amount to be taken into account.

Adjustments for successive distributions of profits

1.67 A modification to step 4 of the allocable cost amount calculation is required on formation of a group to prevent duplication of reductions in the allocable cost amount for distributions that are effectively a return of the cost of acquiring membership interests. This duplication can occur if reductions are made separately for the distribution of the same profits through a chain of 2 or more entities. [Schedule 3, item 2, subsection 705-155(1)]

1.68 The basic case rules are altered on formation so that if a reduction to the allocable cost amount for a subsidiary member at the formation time is required because of step 4 in respect of a distribution, there is no further reduction of the allocable cost amount of a second entity that becomes a subsidiary member of the group at that time if step 4 would otherwise require a reduction for the successive distribution of that amount. [Schedule 3, item 2, sections 705-155(2) and (3)]

Suppose Sub Co 2 makes a distribution of pre-acquisition profits (i.e. a distribution of profits that accrued to membership interests before those membership interests came to be directly or indirectly owned by the head company and which, therefore, would require an amount to be deducted at step 4 in working out the allocable cost amount for an entity joining a consolidated group) to Sub Co 1 and Sub Co 1 also makes a distribution of those same profits to Head Co. In this case, without modification step 4 would reduce the group’s allocable cost amount for Sub Co 1 and also reduce the group’s allocable cost amount for Sub Co 2. This would result in a duplicated reduction in allocable cost amounts as a result of the distribution of the same profits.

Therefore, the reduction is only taken into account in relation to the distribution by Sub Co 2, as the distribution by Sub Co 1 is a successive distribution of the same amount.

Allocation of the allocable cost amount to membership interests in subsidiary entities with certain losses

1.69 The rule for the allocation of the allocable cost amount to reset cost base assets is modified on formation where a reset cost base asset is a membership interest in a group entity and that group entity has an amount of losses that will be deducted under step 5 of the allocable cost amount calculation. For the purpose of allocating the allocable cost amount, the value to be used for that membership interest is its market value plus the amount of that membership interest’s pro-rata share of the losses. [Schedule 3, item 2, subsections 705-160(1) and (2)]

1.70 The amount of that membership interest’s share of the losses is calculated under the following formula (where the loss subtraction amount is the amount that is required to be deducted under step 5 of the allocable cost amount calculation):

1.71 The purpose of the adjustment is to prevent a distortion in the allocation of the allocable cost amount. In the absence of section 705-160, the losses of a subsidiary member would reduce both:

• the amount of the allocable cost amount that is allocated to membership interests, which represent direct or indirect interests in the subsidiary member with the losses (the unintended effect); and

• the allocable cost amount for the subsidiary member with the losses (the intended effect of step 5 in working out the allocable cost amount).

Example 1.5: Allocation to subsidiaries with membership interests in other subsidiaries with certain losses

Head Company forms a consolidated group with subsidiary members S1 and S2. Assuming that S2 has an amount of tax losses that will be deducted under step 5, when allocating the consolidated group’s allocable cost amount to the membership interests that S1 has in S2, the market value of those interests will reflect the losses that S2 has, and will be therefore lower than if S2 did not have losses. The lower market value of these membership interests will distort the amount of allocable cost amount allocated to those membership interests and is an unintended consequence.

Therefore, when working out the market value of the membership interests that S1 has in S2, an amount must be added to that market value to take into account S1’s share of S2’s losses.

Determining a pre-CGT factor for assets of subsidiaries

1.72 Where a head company’s directly held and indirectly held membership interests in a joining subsidiary entity are pre-CGT assets, the pre-CGT status of those interests is preserved by attaching a pre-CGT factor to the assets, other than current assets, of the subsidiary. This treatment also applies upon the formation of a consolidated group. The pre-CGT membership interests to be preserved, by attaching a pre-CGT factor to underlying assets, are the pre-CGT membership interests held by the head company only. [Schedule 3, item 2, subsection 705-165(1)]

1.73 If, when a consolidated group is formed, subsidiary members of the group hold membership interests in another subsidiary member of the group, a pre-CGT factor must first be worked out for the assets of those members before any pre-CGT factor can be worked out for the assets of the other subsidiary member. The actual pre-CGT membership interest that the subsidiary member holds in the other subsidiary member is ignored. [Schedule 3, item 2, subsection 705-165(2)]

Head Co owns all the membership interests in T Co. T Co owns all the membership interests in X Co. On 1 July 2002, Head Co forms a consolidated group with the other companies.

First, work out the pre-CGT factor for T Co’s assets, including for the membership interests T Co holds in X Co.

Then work out the pre-CGT factor for X Co’s assets. For this purpose, the number of pre-CGT membership interests in X Co is determined from the pre-CGT factor for those membership interests worked out in determining the pre-CGT factor for all of T Co’s assets.

Membership interests to which Subdivisions 165-CC and 165-CD apply

1.74 Rules dealing with the interaction between Subdivisions 165-CC and 165-CD and the cost setting rules on formation of a consolidated group will be included in a later bill.

Application and transitional provisions

1.75 The rules dealing with the changes to the cost setting rules that were included in the Consolidation Bill introduced on 16 May 2002 and the rules for forming a consolidated group have effect from 1 July 2002. [Schedule 7, item 1, section 700-1]

• modify the application of rules for transitional groups (see paragraphs 1.77 to 1.114); and

• modify the capital allowance provisions in the IT(TP) Act 1997 (see paragraphs 1.115 to 1.117).

Modified application of rules for transitional groups

1.77 There are certain transitional rules that are only applicable to a consolidated group if it comes into existence during the period from 1 July 2002 to 30 June 2004 (the transitional period).

• forming a consolidated group during the transitional period (see paragraphs 1.79 to 1.85);

− tax cost and trading stock value not set for assets of chosen transitional entities (see paragraph 1.88);

• working out the allocable cost amount on formation for subsidiary members other than chosen transitional entities (see paragraphs 1.89 to 1.97);

• no operation of value shifting and loss transfer provisions to membership interests in chosen transitional entities (see paragraphs 1.98 to 1.99);

• undistributed, unfrankable pre-formation profits of non-chosen transitional entities – adjustment to allocable cost amount and tax cost setting amount reduction for over-depreciated assets (see paragraphs 1.100 to 1.103);

• CGT event for pre-formation roll-over after 16 May 2000 to be disregarded if cost base, etc. would be different (see paragraphs 1.104 to 1.107);

• when an entity leaves the consolidated group, the head company may choose, for the purposes of a transitional group’s allocable cost amount, to increase the terminating values of over-depreciated assets (see paragraphs 1.108 to 1.111); and

• when an entity leaves the consolidated group, the head company may choose, for the purposes of transitional group’s allocable cost amount, to use formation time market values, instead of terminating values, for certain pre-CGT assets (see paragraphs 1.112 to 1.114).

Forming a consolidated group during the transitional period

1.79 The rules separate the transition period into 3 categories. Groups can be formed:

Group formed on 1 July 2002

1.80 Where a consolidated group comes into existence on 1 July 2002, the group is a transitional group and each entity that becomes a subsidiary member of the group on that day is a transitional entity. [Schedule 7, item 2, subsection 701-1(1)]

Group formed after 1 July 2002 but before 1 July 2003

1.81 Where a consolidated group comes into existence after 1 July 2002 but before 1 July 2003, the group is a transitional group if at least one entity that becomes a subsidiary member of the group on that day is a transitional entity. [Schedule 7, item 2, paragraph 701-1(2)(a)]

1.82 For those groups, an entity will be a transitional entity if at some time after 1 July 2002 and before the group came into existence, it was a wholly-owned subsidiary of the head company of the group and remained a wholly-owned subsidiary from that time until the consolidated group came into existence. [Schedule 7, item 2, subparagraph 701-1(2)(b)(ii)]

1.83 For these groups, an entity will also be a transitional entity if it is a subsidiary member of the group on the formation day, and became a wholly-owned subsidiary of the head company on that day, and had not at any time after 1 July 2002 and before formation day previously been a wholly-owned subsidiary. This will cover entities that become wholly-owned subsidiaries on the day of formation, provided they had not previously been wholly-owned and had stopped being a wholly-owned subsidiary during the period after 1 July 2002 and before formation. [Schedule 7, item 2, subparagraph 701-1(2)(b)(i)]

Group formed during financial year starting on 1 July 2003

1.84 Where a consolidated group comes into existence during the year starting on 1 July 2003, the group is a transitional group if at least one entity that becomes a subsidiary member of the group on the day of formation is a transitional entity. [Schedule 7, item 2, paragraph 701-1(3)(a)]

1.85 For these an entity will be a transitional entity if just before 1 July 2003 it was a wholly-owned subsidiary of the head company and it remained wholly-owned from 1 July 2002 or the earliest time after 1 July 2002 when it became a wholly-owned subsidiary until the consolidated group came into existence. [Schedule 7, item 2, paragraph 701-1(3)(b)]

Chosen transitional entity

1.86 Some transitional provisions are only available to transitional entities where a choice has been made by the head company of a transitional group in relation to those entities. Where a head company makes such a choice, the entity is a chosen transitional entity, or if there is more than one the entities are chosen transitional entities. The choice must be made by the end of the period for notifying the Commissioner of the decision to consolidate. Once this choice has been made, it cannot be revoked. [Schedule 7, item 2, section 701-5]

1.87 However, the rules for determining a pre-CGT factor for the assets of a subsidiary member are unchanged for chosen transitional entities. For this purpose, limited valuations will be required (i.e. valuation of the subsidiary entity itself and valuation of the aggregate of the assets to which a pre-CGT factor is attached).

Tax cost and trading stock value not set for assets of chosen transitional entities

1.88 Where a consolidated group is a transitional group, the head company may choose that the tax cost is not set for assets of chosen transitional entities. Instead, the head company will inherit the existing tax costs of the assets. This choice provides an option for groups to consolidate during the transitional period without having to undertake market valuations of all of the assets of subsidiary members of the group, or undertake allocable cost amount calculations for subsidiary members. Where the consolidated group elects that the tax cost of assets is not set, subsection 701-35(4) does not apply, and an entity is able to revalue its trading stock in accordance with the trading stock provisions immediately prior to joining a consolidated group. [Schedule 7, item 2, section 701-15]

Working out the allocable cost amount on formation for subsidiary members other than chosen transitional entities

1.89 Where the head company of a transitional group elects that a transitional entity is to be a chosen transitional entity, it is necessary to modify the core rules for working out the allocable cost amount of each entity that is not a chosen transitional entity at the formation time. This is because the chosen transitional entity is like a head company in relation to any membership interests it holds in other entities. [Schedule 7, item 2, subsections 701-20(1) and (2)]

1.90 The allocable cost amount for each non-chosen subsidiary, will be affected if a chosen transitional entity has any membership interests in it, held either directly or indirectly. Where a chosen transitional entity holds membership interests in non-chosen subsidiary, either directly or indirectly through one or more other non-chosen subsidiaries, the chosen transitional entity and each interposed non-chosen subsidiary comprise a sub-group in relation to the non-chosen subsidiary. [Schedule 7, item 2, paragraph 701-20(6)(a)]

1.91 The sub group membership interests in relation to the sub group comprise the membership interests that the chosen transitional entity holds directly in the non-chosen subsidiary and any of the interposed non-chosen subsidiaries, and the membership interests that each interposed non-chosen subsidiary holds directly in the non-chosen subsidiary or in any of the other interposed non-chosen subsidiaries. [Schedule 7, item 2, paragraph 701-20(6)(b)]

1.92 If a chosen transitional entity holds any membership interests in another chosen transitional entity, these membership interests are disregarded.

1.93 In relation to each sub-group, it is necessary to work out the subgroup’s notional allocable cost amount for each non-chosen subsidiary. This is the amount that would be the allocable cost amount if the sub group was treated as a consolidated group, formed at the same time as the transitional group, with the chosen transitional entity as the head company. [Schedule 7, item 2, subsection 701-20(5)]

1.94 In applying steps 2 to 7 to work out the sub group’s notional allocable cost amount, only a portion of the amount that is calculated in relation to those steps is taken into account. The portion represents the proportion of those sub group membership interests in the amounts. [Schedule 7, item 2, paragraph 701-20(5)(d)]

1.95 The head company’s adjusted allocable amount for the non-chosen subsidiary is the amount that would be the transitional group’s allocable cost amount for that entity if the sub group membership interests were disregarded. That is, only the membership interests held by the head company directly or via any interposed non-chosen transitional entities are taken into account at step 1. [Schedule 7, item 2, paragraph 701-20(4)(a)]

1.96 In applying steps 2 to 7 to work out the head company adjusted allocable amount, only a portion of the amount that is calculated in relation to those steps is taken into account. The portion represents the proportion of those sub group membership interests in the amounts. [Schedule 7, item 2, paragraph 701-20(4)(b)]

1.97 The allocable cost amount for each non-chosen transitional entity is the sum of the head company adjusted allocable amount and each sub group’s notional allocable cost amount for the non-chosen subsidiary. [Schedule 7, item 2, subsection 701-20(3)]

Suppose that this group is a transitional group, and that all the subsidiaries are transitional entities. Head Company makes the choice under the transitional measures to retain the existing cost bases of Sub 1 and Sub 3, making them chosen transitional entities. Sub 2, Sub 4 and Sub 5 are all non-chosen transitional entities.

There are 2 sub-groups in relation to Sub 5 as a result of the elections. Sub 3 forms a sub group in relation to its membership interests in Sub 5. Sub 1 and Sub 4 are also a sub group in relation to their direct and indirect membership interests in Sub 5. The sub group’s calculate their notional allocable cost amount in relation to Sub 5. The Head company’s adjusted allocable amount is calculated ignoring its membership interests in the 2 sub-groups. The head company’s adjusted allocable amount is added to the 2 sub group’s notional allocable cost amounts to arrive at the allocable cost amount for Sub 5. This means that membership interests that Head company holds in Sub 1 and the membership interests that Sub 1 holds in Sub 3 are disregarded in working out the allocable cost amount for Sub 5.

No operation of value shifting and loss transfer provisions to membership interests in chosen transitional entities

1.98 Where the head company of a consolidated group elects that an entity is a chosen transitional entity and therefore inherits the ‘tax costs’ for its assets, then any outstanding cost base adjustments for value shifting or loss transfers will not apply to membership interests in that subsidiary member in relation to events that happened before the consolidated group comes into existence. [Schedule 7, item 2, section 701-25]

1.99 The cost base adjustments do not need to be made because the cost base of the membership interests is not allocated to the entities assets, so the effect of the value shift or loss transfer on the membership interests has not been transferred to the tax cost of the assets of the entity. Furthermore, intra-group membership interests within a consolidated group are ignored for income tax purposes. This means, for example, that the potential for losses to be duplicated or created in relation to those membership interests no longer exists.

Undistributed, unfrankable pre-formation profits of non-chosen transitional entities – adjustment to allocable cost amount and tax cost setting amount reduction for over-depreciated assets

1.100 The requirement that undistributed profits be frankable to be included in step 3 when working out the allocable cost amount is not required for a non-chosen transitional entity. For a non-chosen transitional entity the amount to be added at step 3 of the allocable cost amount calculation is the undistributed profits of the entity that accrued to the joined consolidated group’s membership interests and if distributed to the head company, the head company and every other transitional entity interposed between the non-chosen entity and the head company would be entitled to a rebate of income tax under section 46 or 46A of the ITAA 1936. [Schedule 7, item 2, subsection 701-30(1)]

1.101 This is achieved by increasing the step 3 amount (the step 3 unfrankable profits increase) by disregarding subsections 705-90(3) and (4) and paragraph 705-90(6)(b)when working out the step 3 amount. This has the effect of ignoring the unfrankable undistributed and not excluding those profits that recouped a tax loss. [Schedule 7, item 2, subsection 701-30(2)]

1.102 As a consequence of the change in step 3 when working out the allocable cost amount for non-chosen transitional entities, the tax deferral amount for the purpose of applying section 705-50 (reduction in tax cost setting amount for over-depreciated assets) may be increased. [Schedule 7, item 2, subsection 701-30(3)]

1.103 The increase, if any, is equal to the amount that would have been the step 3 unfrankable profits increase, provided that the profits that gave rise to that increase also meet the following requirements:

• they were not subject to income tax because of deductions for the asset’s decline in value;

• the deductions for the decline in value do not form part of a tax loss covered by the step 5 amount.

Pre-formation asset transfers with roll-over after 16 May 2002 disregarded

1.104 Where, following the formation of a transitional group, the cost base or reduced cost base of an asset of the group would be different from what it would otherwise have been because the asset was rolled over under Subdivision 126-B after 16 May 2002, the transfer of the asset is disregarded in applying the consolidation provisions. The transfer is also disregarded in applying the consolidation provisions where there was not a roll-over under Subdivision 126-B but there was roll-over relief under section 40-340. [Schedule 7, item 2, section 701-35]

1.105 Section 701-35 applies to disregard the asset transfer where the transfer would have altered the cost base or reduced cost base of any asset within the group after group formation. Consequently, any effect the transfer would have had in altering the tax value of any asset within the group for any purpose (i.e. for CGT, capital allowances or trading stock purposes) does not occur.

In June 2002, Subco A transfers Asset X to Subco B and there is a roll-over under Subdivision 126-B in connection with the transfer. On 1 July 2002 a consolidated group is formed with Subco A and Subco B as subsidiary members. The tax values of the assets of the group within consolidation will be those that they would have been if the asset transfer had not occurred – that is, as though Asset X were an asset of Subco A at the formation time and any consideration that Subco B gave for the transfer were still an asset of Subco B.

1.106 Section 701-35 is not confined in its application to tax values of assets immediately involved in an asset transfer. If the tax value of any other asset within a consolidated group would be different because of an asset transfer with roll-over (for CGT or capital allowances purposes) within the relevant time period, the tax value of that asset will be what it would have been had the asset transfer not occurred.

1.107 Where an affected asset is subsequently disposed of or becomes an asset of an entity that leaves the group, this provision operates to the extent that it affects the tax value of the asset or the head company’s terminating value for the asset. It does not, for example, preclude the asset from being an asset of a leaving entity because the pre-consolidation transfer is disregarded in applying the consolidation provisions.

When an entity leaves, the head company may choose, for the purposes of the transitional group’s allocable cost amount, to increase the terminating values of over-depreciated assets

1.108 As a transitional concession, the head company is able to choose in certain circumstances that, where a subsidiary holding an over-depreciated asset leaves the consolidated group, the cost base of the equity in the subsidiary is not reduced because of the over-depreciated asset adjustment. [Schedule 7, item 2, subsection 701-40(1)]

• the leaving subsidiary must hold an asset at the leaving time [Schedule 7, item 2, subsection 701-40(2)];

• the asset became an asset of the head company of the transitional group because of the single entity rule [Schedule 7, item 2, paragraph 701-40(3)(a)];

• section 705-50 applied to the asset on formation to reduce the tax cost setting amount of the asset [Schedule 7, item 2, paragraph 701-40(3)(b)]; and

• the asset must have been continuously held by the group at all times from formation until the entity ceases to be a subsidiary member of the transitional group [Schedule 7, item 2, subsection 701-40(4)].

1.110 The effect of the choice is that if the leaving subsidiary joins another consolidated group, section 705-50 may again apply to the asset. Because of this, the head company must advise the leaving subsidiary of the amount by which the head company increases the terminating value. [Schedule 7, item 2, subsection 701-40(5)]

1.111 If all the requirements are satisfied, the head company may increase the terminating value for the asset by so much of the reduction amount (under section 705-50) as the head company chooses. This will have the effect of increasing the cost base of the head company’s equity in the leaving subsidiary. [Schedule 7, item 2, subsection 701-40(6)]

When an entity leaves, head company may choose, for purposes of transitional group’s allocable cost amount, to use formation time market values, instead of terminating values, for certain pre-CGT assets

1.112 A head company that holds pre-CGT assets immediately prior to consolidation may be at a disadvantage when compared to a head company that transfers their pre-CGT assets (with roll-over) to a wholly-owned subsidiary. This is because the pre-CGT assets that come into the consolidated group via a subsidiary will have a reset cost base whereas the pre-CGT assets that the head company holds will not have their cost base changed.

1.113 Therefore, a transitional concession is provided to a head company that holds pre-CGT assets just before the consolidated group comes into existence, allowing it to choose to use the market value of the assets at formation time as the terminating value in determining its cost for membership interests in a leaving entity. This will enable the group to put itself in the same position as that of a group where pre-CGT assets have been transferred with roll-over relief to a subsidiary member, whilst avoiding the costs associated with rolling over assets. [Schedule 7, item 2, subsection 701-45(2)]

1.114 The concession does not apply if the head company only holds the pre-CGT asset because of a roll-over under Subdivision 126-B that happened after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999 (announcement in the Government’s response to A Tax System Redesigned). This will prevent groups from transferring assets from subsidiaries to their head companies with roll-over relief to increase their cost base for membership interests in a leaving entity to take advantage of the choice that is available under this section. [Schedule 7, item 2, subsection 701-45(1)]

Modifications to the capital allowances provisions in the Income Tax (Transitional Provisions) Act 1997

1.115 In setting the tax cost of a depreciating asset to which the capital allowance provisions in Subdivisions 40-A to 40-D and sections 40-425 to 40-445 apply, the cost for tax purposes is set on the basis that the asset was acquired by the head company at the time the entity became a subsidiary member of the consolidated group. As such, modifications are required to section 40-77 and subsection 40-285(6) of the IT(TP) Act 1997 to ensure the continued application of the capital allowances transitional provisions.

• ensure that a mining, quarrying and prospecting right that a subsidiary member held before 1 July 2001, but now because of the single entity rule is held by the head company, will remain subject to the CGT provisions in the ITAA 1997 instead of being subject to the balancing adjustments in the uniform capital allowance system. This will mean that the uniform capital allowance system will not apply to a mining, quarrying or prospecting right that the subsidiary member held before 1 July 2001 and the head company will not be able to claim deductions for costs incurred on those rights after the subsidiary member becomes a member of the consolidated group. These amounts can only be used in the calculation of the head company’s gain or loss under the CGT provisions. This result will also be achieved in an entity that leaves the consolidated group with the right;

• ensure that if the head company disposes of a mining, quarrying or prospecting right, that a subsidiary member held prior to 1 July 2001, to an associate, or enters into arrangements where in-substance ownership or use is retained, the cost of the asset to the purchaser is capped at the amount that would have been deductible under the former Division 330 if the cost of the asset was instead the tax cost setting amount of the asset. This result will also be achieved if an entity that leaves the consolidated group with the right disposes of the right in the same manner; and

• ensure that when working out the amount to be included in the assessable income of the head company under section 15-40 or subsection 40-285(1) in respect of mining, quarrying or prospecting information that the cost of the asset is instead the tax cost setting amount of the asset. This result should also apply when working out the amount to be included in the assessable income of an entity that leaves the consolidated group with the information.

1.117 The modified application of subsection 40-285(6) will apply where the head company has balancing adjustment events under Division 40 occur to certain depreciating assets acquired by the subsidiary member before 21 September 1999 or, in the case of certain other assets, before 1 July 2001. Where the balancing adjustment includes an amount in assessable income the amount must be reduced, taking into account the tax cost setting amount for the asset, to preserve various CGT exemptions and applicable pre-CGT asset rules. The relevant CGT exemptions are for cars, collectables, personal use assets and plant used to produce exempt income. [Schedule 7, item 2, section 702-5]

Consequential amendments

Outline of chapter

2.1 This chapter explains the rules for dealing with attribution accounts and attributed tax accounts maintained for the purposes of the CFC and FIF measures, for entities that form, join or leave a consolidated group.

2.2 This chapter also explains the rules for calculating the appropriate amount of FIF income that should be assessed to an entity that joins or leaves a consolidated group with an interest in a FIF. The amendments explained in this chapter are contained in Schedule 6 to this bill

Context of reform

2.3 Under the current law there is little need to transfer attribution and attributed tax account surpluses. However, under consolidation the taxpayer that receives a distribution of profits that have been subject to accruals taxation may well be different from the taxpayer that was subject to accruals taxation prior to consolidation.

2.4 The ability to transfer attribution and attributed tax account surpluses will ensure the policy behind the requirement for those accounts is maintained. That is, the possibility of double Australian taxation of profits subject to accruals taxation will continue to be avoided.

Summary of new law

2.5 In accordance with the single entity principle, only the head company will be able to operate attribution accounts and attributed tax accounts for the purposes of the CFC and FIF provisions during the period of consolidation. The pre-consolidation balances of these accounts will be transferred to the head company to facilitate the use of any pre-consolidation surpluses during consolidation. In this chapter, references to attribution accounts will include FIF attribution accounts, attributed tax accounts will include FIF attributed tax accounts and attribution account entities will include FIF attribution account entities.

2.6 Subsidiary members of a consolidated group will have inoperative attribution and attributed tax accounts during the period of consolidation once the balances in those accounts have been transferred to the head company.

2.7 When a company with an interest in a CFC or FIF leaves a group, it may need to maintain attribution and attributed tax accounts for each attribution account entity in which it has an interest. A proportion of the attribution account and attributed tax account surpluses the head company has in relation to the interests in the CFC or FIF that leave the group will be transferred to the leaving company.

2.8 The notional accounting period of a FIF will be taken to end at the joining or leaving time if it does not actually end at that time. This will ensure the normal operation of Part XI of the ITAA 1936 will result in the correct amount of FIF income being included in the assessable income of the company for the period that it is not a member of the consolidated group.

Comparison of key features of new law and current law

*New law*	*Current law*
Attribution and attributed tax account surpluses of a joining company are transferred to the head company.	The taxpayer which has the CFC or FIF interest is entitled to the benefit of the attribution or attributed tax account. There is no transfer of benefits within a group.
Credits may arise in the FIF attribution and FIF attributed tax accounts at the time a company with a FIF interest joins a consolidated group because the notional accounting period of the FIF will be taken to end at the joining time.	Credits arise in the FIF attribution and FIF attributed tax accounts at the end of the notional accounting period of the FIF for amounts of FIF income included in the taxpayer’s assessable income.
The head company is to maintain the attribution and attributed tax accounts for each attribution account entity in which it has an interest as the head company (despite the legal interest in the CFC or FIF being held by a subsidiary member of the group).	Attribution and attributed tax accounts are kept by a taxpayer for each attribution account entity in which the taxpayer has an interest.
A company that leaves a consolidated group taking with it an interest in a CFC or FIF will be able to take a proportion of any attribution or attributed tax account surpluses the head company has in relation to those interests.	There is no parallel.

Detailed explanation of new law

2.9 Parts X and XI of the ITAA 1936 provide rules for maintaining attribution and attributed tax accounts in order to prevent double Australian taxation of the profits of CFCs/FIFs when those profits are distributed. They also contain rules as to when credits and debits are made to these accounts. A surplus in the attribution or attributed tax account at any point in time occurs when the credits in the account exceed the debits.

2.10 These provisions will continue to operate in relation to attribution and attributed tax accounts maintained by a head company of a consolidated group.

Transfer of attribution account and attributed tax account surpluses

On formation or joining a consolidated group

2.11 Where a company becomes a subsidiary member of a consolidated group, it will transfer to the head company at the joining time any attribution and attributed tax account surpluses it has in relation to attribution account entities (e.g. CFC, FIF or FLP) at that time. The joining company must also have an interest in the CFC, FIF or FLP at the time it joins the group. Although entities other than companies can become subsidiary members of a consolidated group only companies will have attribution or attributed tax account surpluses to transfer to the head company. These rules apply at the time a consolidated group comes into existence as well as for companies joining an existing consolidated group. [Schedule 6, item 2, sections 717-210, 717-215, 717-220 and 717-225]

2.12 The attribution and attributed tax account surpluses are transferred to the head company so that future distributions of income received from an attribution account entity are not assessed to the head company to the extent the income was previously attributed to the joining company.

2.13 The transfer of attribution account surpluses of a joining company is effected by an attribution account credit arising in the accounts of the head company. The credit arises at the joining time (or formation time) and is equal to the attribution account surplus calculated immediately before the joining time for each attribution account entity of the joining company. [Schedule 6, item 2, subsection 717-210(2)]

2.14 Subsection 717-210(2) can also mean a credit can arise in relation to a surplus in an attributed tax account, FIF attribution account and FIF attributed tax account. [Schedule 6, item 2, sections 717-215, 717-220 and 717-225]

2.15 A corresponding and equal attribution account debit will arise in the relevant accounts of the joining company at the same time [Schedule 6, item 2, subsection 717-210(3)]. This ensures that there is no net creation of the surpluses, but rather a transfer from one entity to another. The attribution and attributed tax accounts of the joining company will have a nil balance after joining a consolidated group and will be inoperative during consolidation.

2.16 Subsection 717-210(3) can also mean a debit can arise in relation to a surplus in an attributed tax account, FIF attribution account and FIF attributed tax account. [Schedule 6, item 2, sections 717-215, 717-220 and 717-225]

2.17 Any attribution account debits or credits that would have arisen in a subsidiary member’s attribution or attributed tax accounts during the time it is a member of a consolidated group will arise instead in the head company’s accounts as the head company will be the only entity that can operate the relevant accounts.

• Companies A, B and C form a consolidated group at the beginning of company A’s income year. All the companies have the same income year which is from 1 July to 30 June. Company A is the head company;

• Company A holds an interest in FIF 1 and has a FIF attribution surplus in the FIF attribution account for FIF 1 of $100 at the time it forms the consolidated group. The notional accounting period of FIF 1 is company A’s income year;

• Company B also holds an interest in FIF 1 and has a FIF attribution surplus in the FIF attribution account for FIF 1 of $250 immediately before it becomes a subsidiary member of the consolidated group. The notional accounting period of FIF 1 is company B’s income year; and

• Company C holds an interest in CFC 1 and has an attribution surplus in the attribution account for CFC 1 of $300 immediately before it becomes a subsidiary member of the consolidated group.

At the time the group consolidates, a $250 credit will arise in the FIF attribution account for FIF 1 that company A holds and a $250 debit will arise in the FIF attribution account for FIF 1 that company B holds. The FIF attribution account for FIF 1 that company B holds will be inoperative during consolidation (after the $250 debit entry is made to the account at the joining time) as company B is no longer the taxpayer in relation to the FIF income of FIF 1. Company A’s FIF attribution account surplus for FIF 1 is $350 immediately after consolidation.

At the time the group consolidates, a $300 credit will arise in a new attribution account for CFC 1 in company A’s books. A $300 debit will arise in the attribution account for CFC 1 that company C holds. The attribution account for CFC 1 that company C holds will be inoperative during consolidation (after the $300 debit entry is made to the account at the joining time) as company C is no longer the attributable taxpayer in relation to CFC 1. Company A’s attribution surplus for CFC 1 is $300 immediately after consolidation.

For subsidiary members that leave a consolidated group

2.18 Where a company leaves a consolidated group, taking with it an interest in a CFC, FIF or FLP, the head company will transfer to the leaving company at that time a proportion of the attribution surplus and attributed tax account surplus (if any) the head company has in relation to that CFC, FIF or FLP. [Schedule 6, item 2, sections 717-245, 717-250, 717-255 and 717-260]

2.19 The attribution and attributed tax account surpluses are transferred to the leaving company so that future distributions of income received from the CFC, FIF or FLP are not assessed to the leaving company to the extent the income was previously attributed to the head company or to another company before it joined the group.

2.20 The transfer of an attribution account surplus from the head company is effected by an attribution account credit arising in the new attribution account of the leaving company. The credit arises at the leaving time and is equal to a proportion of the surplus calculated immediately before the leaving time for each attribution account entity. [Schedule 6, item 2, subsection 717-245(2)]

2.21 Subsection 717-245(2) can also mean a credit can arise for a leaving company in relation to a surplus in an attributed tax account, FIF attribution account and FIF attributed tax account. [Schedule 6, item 2, sections 717-250, 717-255 and 717-260]

2.22 The proportion of the surplus the leaving company is entitled to is the percentage of the group’s attribution account percentage in relation to the attribution account entity at the leaving time that is taken by the leaving company. [Schedule 6, item 2, subsection 717-245(4)]

2.23 A corresponding and equal attribution account debit will arise in the relevant accounts of the head company at the leaving time. [Schedule 6, item 2, subsection 717-245(3)]

2.24 Subsection 717-245(3) can also mean a debit can arise in relation to a surplus in an attributed tax account, FIF attribution account and FIF attributed tax account. [Schedule 6, item 2, sections 717-250, 717-255 and 717-260]

• Companies A, B and C are a consolidated group. Company A is the head company;

• Company A has a FIF attribution surplus in the FIF attribution account for FIF 1 of $500 at the end of its income year 2010, after the determination of FIF income that will be included in company A’s assessable income. The notional accounting period of FIF 1 is company A’s income year. Company A also has an attribution surplus in the attribution account for CFC 1 of $600 at the end of its income year 2010, after the determination of attributable income included in its assessable income for that income year; and

• Company B leaves the group at the end of the income year 2010 with half the interests in FIF 1 held by the consolidated group and one third of the interests in CFC 1.

At the time company B leaves the group, a $250 credit (50% of $500) will arise in a new FIF attribution account for FIF 1 that company B will start to hold and a $250 debit will arise in the FIF attribution account for FIF 1 that company A holds. Immediately after company B leaves the group, company A’s FIF attribution surplus for FIF 1 will be $250. Company B’s FIF attribution surplus will also be $250.

Further, at the time that company B leaves the group, a $200 credit (one third of $600) will arise in a new attribution account for CFC 1 in company B’s books. A $200 debit will arise in the attribution account for CFC 1 that company A holds. Immediately after company B leaves the group, company A’s attribution surplus for CFC 1 will be $400. Company B’s attribution surplus will be $200.

Calculation of FIF income before the joining or leaving time

2.25 With the introduction of the new consolidation regime it is necessary to ensure that attributable income calculated under Part X of the ITAA 1936 and FIF income calculated under Part XI of the ITAA 1936 is included for all periods in the assessable income of the correct taxpayers. Special considerations arise where:

This will ensure that the attribution account and attributed tax account surpluses that are transferred to the head company or to a leaving company are correct at the relevant time.

2.26 When these events occur during the notional accounting period of a FIF (either the year of income of the taxpayer or, where the taxpayer elects, the accounting period of the FIF), special rules are needed to ensure that Part XI can operate appropriately. These rules are required principally because the amount of FIF income included in the taxpayer’s assessable income depends on how much of the notional accounting period for which the taxpayer held an interest in the FIF. In some cases, they are also needed because Part XI only applies to a taxpayer that has an interest in a FIF at the end of the income year. Therefore, the notional accounting period of the FIF will be taken to end at the formation, joining or leaving time. If the notional accounting period actually ends at the formation, joining or leaving time, Part XI would operate in an appropriate way without new rules. The rules are discussed in more detail in paragraphs 2.28 to 2.44.

2.27 Similar problems do not arise under Part X as the attributable taxpayer at the end of a statutory accounting period of a CFC includes in its assessable income for an income year its share of the attributable income of the CFC for the whole statutory accounting period that ends in the income year. If the head company is the attributable taxpayer because an entity with an interest in a CFC has joined the group during the statutory accounting period of the CFC, the head company will include in its assessable income for the income year in which that statutory accounting period ends its share of the attributable income of the CFC for the whole of that statutory accounting period. If the statutory accounting period had ended in the year of income of the joining entity before it joined the group, the joining entity would include all the attributable income for the whole of the statutory accounting period in its assessable income for that income year.

On formation or joining a consolidated group

2.28 If the notional accounting period of a FIF in which a company holds an interest ends immediately before that company becomes a subsidiary member of a consolidated group, the joining company will calculate the FIF income relating to the notional accounting period [Schedule 6, item 2, section 717-230]. The surplus held by the joining company at the joining time, after any credit or debit arising from the calculation of the FIF income, will be transferred to the head company.

2.29 Where the notional accounting period of the FIF does not ordinarily end at the joining time, the notional accounting period of the FIF will be taken to end immediately before the joining time [Schedule 6, item 2, subsection 717-230(2)]. This has the effect that a notional accounting period of the FIF ends in the income year of the company that joined the group, the period in respect of which FIF income may be attributed to the company.

2.30 The joining company can then determine the FIF income for the part of the notional accounting period up to the joining time according to the rules in Part XI. That amount would then be included in the joining company’s assessable income for the income year in which the company joined the group (or it may have an allowable deduction for that income year). [Schedule 6, item 2, subsection 717-230(3)]

2.31 To the extent that FIF income is included in the assessable income of the joining company for that income year, an attribution credit will arise in its FIF attribution account immediately before the joining time. All credits and debits to the FIF attribution account should arise before the calculation of the FIF attribution surplus that will be transferred to the head company.

2.32 If the calculation of the FIF income results in a FIF loss, and the joining company otherwise has a surplus in the FIF attribution account at the joining time, the joining company will be able to deduct (some or all of) the loss from its assessable income. A debit will arise in its FIF attribution account just before the joining time.

2.33 The head company will include FIF income in its assessable income from the joining time onwards according to Part XI. Part XI will operate as if the head company had the FIF interests brought into the consolidated group only from the joining time.

2.34 Where the notional accounting period of the FIF is taken to end immediately before the joining time, the head company is taken to acquire the FIF interest at the joining time for a deemed consideration, to prevent the double taxation of FIF income. If the head company chooses to use the market value method to determine FIF income in the joining year, the consideration taken to be given at the joining time for the FIF interest will be the market value of the FIF interest for the joining company on the last day of the notional accounting period of the FIF taken to end at the joining time. [Schedule 6, item 2, subsection 717-230(4)]

• Companies A, B and C are a consolidated group. Company A is the head company and has an income year from
1 July to 30 June;

• Company A purchases the shares in company D at 1 September 2005. Company D holds an interest in FIF 1. The notional accounting period of FIF 1 is 1 January to 31 December. Company D’s income year is 1 July to 30 June; and

• Company D has a FIF attribution surplus at the beginning of its 2006 income year of $200. There have been no debits or credits to the FIF attribution account prior to company D calculating the FIF income at 1 September 2005.

At the time company A purchases company D the notional accounting period of FIF 1 will end. The FIF income for the period 1 January to 31 August 2005 is calculated to be $350 at that time. That FIF income will be included in company D’s assessable income for the year ended 30 June 2006.

A FIF attribution credit will arise in the FIF attribution account of company D immediately before the joining time. The surplus in the FIF attribution account for FIF 1 is now $550. A credit will arise in the FIF attribution account for FIF 1 in the accounts of company A and a corresponding FIF attribution account debit will arise in the FIF attribution account for FIF 1 that company D holds. The FIF attribution account for FIF 1 that company D holds will be inoperative as company D is no longer the taxpayer in relation to the FIF income of FIF 1. Immediately after the joining time company A’s FIF attribution account surplus for FIF 1 is $550.

Company A includes any FIF income of FIF 1 for the period 1 September to 31 December 2005 in its assessable income for 2005-2006 if it still has an interest in FIF 1 at 30 June 2006.

For subsidiary members that leave a consolidated group

2.35 The head company of a consolidated group will calculate the FIF attribution and FIF attributed tax account credits and debits according to the rules in Part XI for any interests in FIFs the head company holds.

2.36 For the same reasons as explained in paragraphs 2.28 to 2.31, where a company leaves a consolidated group with an interest in a FIF, the head company will be required to calculate the FIF income at the leaving time. Under the normal operation of Part XI, if the company leaves the group at the end of the head company’s income year, the head company would determine the FIF income of a notional accounting period that ends in that year.

2.37 If the company leaves the group before the end of the notional accounting period, the notional accounting period of the FIF will be taken to end at the time immediately before the company left the group [Schedule 6, item 2, subsection 717-265(2)]. This has the effect that this notional accounting period of the FIF ends in the income year of the head company (in addition to any other notional accounting period that actually ends in the income year).

2.38 The head company will determine the FIF income and the FIF attribution and attributed tax account surpluses at the leaving time, according to the rules in Part XI, as though an interest in a FIF held by the leaving company (at the leaving time) was held by the head company at the end of the head company’s income year [Schedule 6, item 2, subsection 717-265(4)]. This will enable the FIF income to be calculated at the leaving time for the period from the beginning of the notional accounting period of the FIF to immediately before the leaving time.

2.39 The FIF income calculated immediately before the leaving time will be included in the head company’s assessable income in the year the company leaves the group. The head company will include the FIF income in its assessable income for that part of the notional accounting period, despite the fact that it no longer holds (some or all of) the interests in the FIF at the end of its income year.

2.40 To the extent FIF income is included in the assessable income of the head company for that income year, a FIF attribution credit will arise in the FIF attribution account immediately before the leaving time. All credits and debits to the FIF attribution account arise before the calculation of a FIF attribution surplus that will be transferred to the leaving company.

2.41 If the calculation of the FIF income results in a FIF loss and the head company otherwise has a FIF attribution surplus at the leaving time, the head company will be able to deduct (some or all of) the loss from its assessable income. A debit will arise in the FIF attribution account at the leaving time despite the loss not being deducted from the head company’s assessable income until the normal end of the year of income of the head company.

2.42 The determination of the FIF income at the leaving time, on the basis that the notional accounting period of the FIF ended at that time, is solely for the purpose of determining the correct FIF attribution account and attributed tax account surpluses at the leaving time. The head company will continue to determine the FIF income in relation to the FIF interests remaining in the group from the leaving time until the end of the notional accounting period of the FIF, unless the remaining FIF interests leave before that time or the head company otherwise disposes of the group’s interests in the FIF before the end of its income year. [Schedule 6, item 2, subsection 717-265(3)]

2.43 The leaving company will have FIF income included in its assessable income from the leaving time onwards according to Part XI. Part XI will operate in relation to the leaving company as if the leaving company had those FIF interests only from the leaving time.

2.44 Where the notional accounting period of the FIF is taken to end immediately before the leaving time, the leaving company is taken to acquire the FIF interest at the leaving time for a deemed consideration, to prevent the double taxation of FIF income. To calculate the FIF income under the market value method for the leaving year, the consideration taken to be given by the leaving company for the FIF interest it takes with it will be the market value of the FIF interest for the head company on the last day of the notional accounting period of the FIF taken to end at the leaving time. [Schedule 6, item 2, subsection 717-265(5)]

• Companies A, B and C are a consolidated group. Company A is the head company and has an income year from 1 July to 30 June;

• Company A has a FIF attribution surplus in the FIF attribution account for FIF 1 of $500 at the end of its 2010 income year. There have been no debits or credits to the FIF attribution account since then;

• The notional accounting period of FIF 1 is company A’s income year (i.e. 1 July to 30 June); and

• Company B leaves the group on 1 January 2011 with half the interests in FIF 1 that were held by the consolidated group at the leaving time. Company B’s income year is also from 1 July to 30 June. Both company A and company B still have an interest in FIF 1 on 30 June 2011.

At the time that company B leaves the group the notional accounting period of FIF 1 will end. The FIF income for the period 1 July to immediately before the leaving time is $200. That FIF income will be included in company A’s assessable income for the year ended 30 June 2011. A $200 credit will arise in company A’s FIF attribution account just before the leaving time. The FIF attribution surplus is now $700.

A FIF attribution credit of $350 ($700 × 50%) will arise in a new FIF attribution account for FIF 1 that company B will start to hold in relation to FIF 1. A $350 debit will arise in the FIF attribution account for FIF 1 that company A holds. Immediately after company B leaves the group Company A’s FIF attribution surplus for FIF 1 will be $350. Company B’s FIF attribution surplus will also be $350.

Company A will calculate any FIF income in relation to FIF 1 for the period 1 January 2011 until the actual end of the notional accounting period of FIF 1 but will only include in its assessable income the amount of FIF income that relates to the attribution account percentage in FIF 1 that it continues to hold. This amount will be added to the amount that was calculated at the time company B left the group.

Company B will include in its assessable income at 30 June 2011 any FIF income calculated from the leaving time until the time the actual notional accounting period of FIF 1 ends (i.e. 1 January to 30 June 2011).

Application and transitional provisions

2.45 These provisions will come into effect on 1 July 2002, along with the other aspects of the consolidation measures.

Consequential amendments

2.46 Amendments consequential to the measures in this chapter will be included in subsequent legislation.

Outline of chapter

3.1 This chapter explains the rules that provide for the transfer of excess foreign tax credits from an entity that becomes a subsidiary member of a consolidated group to the head company of the group to enable the head company to use those excess credits. An entity that leaves the group will not have access to any excess foreign tax credits, including those it may have brought into the group at an earlier time.

3.2 This chapter also explains the rules that ensure a head company will be taken to have paid and been personally liable for the foreign tax paid by a subsidiary member of the group where the foreign income on which the foreign tax was paid is included in the head company’s assessable income. The amendments explained in this chapter are contained in Schedules 6, 9 and 10 to this bill.

3.3 All references to sections and divisions are references to sections and Divisions of the ITAA 1936 unless otherwise stated.

Context of reform

3.4 Under the current law, Australian resident taxpayers can claim credits against the Australian tax payable for foreign taxes paid on foreign income included in their assessable income. Where a taxpayer is a company in a wholly-owned group the excess foreign tax credits of that company can be transferred to another company with insufficient foreign tax credits, provided both companies are members of the same group for the whole of the income year in which the credits are transferred.

3.5 The new consolidation regime will ensure the current foreign tax credit provisions operate appropriately for the head company of a consolidated group and that the consolidated group is not subject to international double taxation.

Summary of new law

3.6 Only the head company of a consolidated group will include foreign income in its assessable income under consolidation. Therefore, only the head company will need to use foreign tax credits to reduce its Australian tax liabilities.

3.7 Subsidiary members will transfer their excess credits to the head company when they become members of the group to enable the head company to use the excess credits. Special rules will ensure the head company can only use those excess credits at the end of the income year after the year the entity joined the group unless the transitional rule applies.

3.8 During the period that an entity is a member of the consolidated group, where it pays foreign tax on foreign income, the head company will be assessed on the foreign income and will be taken to have paid and been personally liable for the foreign tax paid by the subsidiary member.

3.9 When an entity leaves a consolidated group it will not take with it any excess foreign tax credits and it will only include foreign income in its assessable income for the period it is not a member of any consolidated group.

Comparison of key features of new law and current law

*New law*	*Current law*
The head company will be deemed to have paid and been personally liable for any foreign tax paid by subsidiary members of the group in relation to foreign income included in the head company’s assessable income.	Currently, Australian resident taxpayers are able to claim credits only for foreign tax paid against the Australian tax payable on foreign income included in their own assessable income.
Excess foreign tax credits of an entity that becomes a subsidiary member of a consolidated group will become available to the head company if the head company has a foreign tax shortfall.	A credit company can transfer excess foreign tax credits to a company with a foreign tax shortfall if both companies have been members of the same group for the whole of the income year in which the transfer is made.
A head company cannot use excess foreign tax credits of a subsidiary member at the end of the head company’s income year that is the year the entity became a subsidiary member of the consolidated group unless the transitional rule applies.	Excess foreign tax credit balances can only be transferred between companies that are group companies if both companies have been members of the group for the whole of the year of income.
The new section 160AFE will continue to allow the carry-forward and use of excess foreign tax credits for all taxpayers.	Section 160AFE contains rules to deal with the transfer, carry forward and utilisation of excess foreign tax credits.

Detailed explanation of new law

3.10 In order to prevent international double taxation, the foreign tax credit provisions (Divisions 18, 18A and 18B of Part III) provide for the calculation of credits for foreign tax that can be used to reduce the Australian tax liability on foreign income included in the assessable income of an Australian taxpayer. To ensure the policy behind these provisions is maintained under the consolidation regime, additional rules have been inserted to:

• ensure Divisions 18, 18A and 18B continue to operate for the head company of a consolidated group; and

• allow the excess foreign tax credits (calculated under Division 18) of entities that become subsidiary members to be used by the head company.

3.11 Section 160AFE is amended to prevent members of wholly-owned groups from transferring excess foreign tax credits. The new section 160AFE will apply according to special rules explained in paragraphs 3.49 to 3.55.

Application of foreign tax credit provisions

3.12 The head company will be assessed on the foreign income derived by the consolidated group under the single entity principle (section 701-1 of the Consolidation Bill introduced on 16 May 2002). The head company will be deemed to have paid and been personally liable for the foreign tax paid by a subsidiary member on foreign income that is included in the head company’s assessable income. [Schedule 6, item 2, section 717-10]

3.13 Section 717-10 of this bill ensures the head company will be held to have paid and been personally liable for the foreign tax paid by subsidiary members on foreign income that is included in the head company’s assessable income. All the conditions contained in section 160AF will have been satisfied. Therefore the ordinary operation of section 160AF will allow a credit to the head company for the foreign tax that was paid.

3.14 The operation of section 717-10 will also ensure the head company of a consolidated group will be able to claim credits for foreign tax in respect of certain overseas film income under Division 18A and certain shipping income under Division 18B that is included in its assessable income.

3.15 Under the new provisions there is no requirement that companies that effectively transfer foreign tax credits must be members of a wholly-owned group for the whole of an income year. The head company is entitled to a credit for any foreign tax paid in relation to the foreign income included in its assessable income, even if the entity that paid the foreign tax is not a member of the group at the end of the head company’s income year. This enables the head company to claim the credit without having to determine whether the subsidiary member that paid the foreign tax remains in the group at the end of the income year.

3.16 The head company is also entitled to a credit for any foreign tax that was paid in relation to the foreign income included in its assessable income where an entity that left the group paid the foreign tax in relation to the foreign income after it left the group. However, the head company would be required to keep sufficient records to show how much foreign tax was paid on the foreign income included in the head company’s assessable income.

3.17 Similarly, where an entity includes foreign income in its assessable income for a period before it becomes a subsidiary member of a consolidated group but where it pays foreign tax on that foreign income after it joins the group, the entity and not the head company will be entitled to the credit in relation to the foreign tax.

• A Co, B Co, C Co and D Co formed a consolidated group on 1 July 2002. A Co is the head company with an income year from 1 July to 30 June;

− A Co received passive foreign income of $1,000 and pays foreign tax of $100;

− B Co and C Co also receive passive foreign income of $600 and $300 respectively. B Co pays $90 foreign tax and C Co doesn’t pay any foreign tax; and

− D Co leaves the consolidated group on 31 March 2005 but receives foreign, other income of $500 before it leaves. D Co pays $200 foreign tax in relation to the foreign income of $500 on 14 April 2005; and

• the group receives no other income and the group does not have excess foreign tax credits for earlier years.

Under the consolidation single entity rule, A Co will include all the foreign income it actually received as well as the foreign income from B Co, C Co and D Co in its assessable income ($2,400).

Section 717-10 will deem A Co to have paid and been personally liable for the foreign tax paid by B Co and D Co ($290). The total foreign tax paid by A Co is $390.

Under the ordinary operation of section 160AF, A Co will be entitled to a credit of $190 for foreign tax in relation to the passive income. The Australian tax payable on the passive foreign income is $570. A Co will also be entitled to a credit for foreign tax in relation to other income of $150 (some of the foreign tax paid by D Co) as A Co has the necessary records to show that the $200 foreign tax relates only to the $500 of foreign income included in its assessable income. A Co can carry-forward the other $50 of foreign tax to offset against Australian tax payable on future foreign income of that class.

No transfers to an entity leaving a group

3.18 Where a subsidiary member leaves a consolidated group, excess foreign tax credits from earlier years that have not been used by the head company during the leaving entity’s membership of the group will not be available to the leaving entity. This is in accordance with the general treatment of a consolidated group. That is, where a subsidiary member of the group derives foreign income and pays foreign tax in respect of that income, the head company will be considered to have the foreign income and to have made the payment of tax.

New section 160AFE

3.19 The current section 160AFE provides the rules for carry-forward and transfer of excess credits for particular classes of foreign income. This section is repealed from 1 July 2003 except in special circumstances that are discussed in paragraphs 3.48 to 3.55. Section 160AFE has been repealed to prevent groups that do not form a consolidated group from transferring excess credits between credit and income companies within the group. However, a new section 160AFE will operate from 1 July 2003 that ensures excess foreign tax credits can continue to be carried forward for 5 years for all taxpayers.

3.20 Where an amount of foreign tax paid on foreign income included in assessable income of a taxpayer is less than the amount of Australian tax payable in respect of that foreign income (i.e. there is a shortfall), the taxpayer may increase the foreign tax amount under section 160AFE [Schedule 10, item 1, subsection 160AFE(1)]. Section 160AFE provides the rules to determine whether a taxpayer can access excess foreign tax credits from earlier years when they have a foreign tax shortfall for a particular class of foreign income in the current year. The excess foreign tax credits must relate to that same class of foreign income for which there is a foreign tax shortfall [Schedule 10, item 1, subsection 160AFE(5)].

3.21 A taxpayer has excess foreign tax credits from an earlier year if the amount of foreign tax paid on foreign income of a particular class that is included in assessable income in that year exceeds the Australian tax payable on that foreign income. The excess foreign tax credit amount is the difference between the foreign tax paid and the Australian tax payable. [Schedule 10, item 1, subsection 160AFE(4)]

3.22 A taxpayer can only use excess foreign tax credits up to the amount of the foreign tax shortfall in the current year for the particular class of foreign income. The excess foreign tax credits from the previous 5 years ending before the current year in which the shortfall occurred may be used. However, the excess foreign tax credits that occurred in the earliest years of the 5 year period and that relate to the particular class of foreign income must be used first (i.e. on a first-in, first-out basis). [Schedule 10, item 1, subsection 160AFE(3)]

Use of excess foreign tax credits by a head company

3.23 Where a head company of a consolidated group has a foreign tax shortfall for a particular class of foreign income in an income year, the head company can use excess foreign tax credits from earlier years of subsidiary members of the group [Schedule 6, item 2, section 717-15], as well as its own excess foreign tax credits. Any excess foreign tax credits used must relate to the particular class of foreign income.

3.24 A head company can only use excess foreign tax credits from earlier years of a subsidiary member if the current year of income is not the year in which the entity became a subsidiary member (i.e. it is not the joining year of the subsidiary member). Rules for joining years are discussed in paragraphs 3.28 to 3.40. The excess foreign tax credits of a subsidiary member are calculated under the rules contained in the new section 160AFE and become transfer credits for the head company in the income year after the joining year. [Schedule 6, item 2, subsection 717-15(2)]

3.25 Section 717-15 of this bill operates to transfer excess foreign tax credits of subsidiary members to the head company whether or not the head company ever has a foreign tax shortfall. Section 717-15 also ensures that subsidiary members no longer have their excess foreign tax credits from earlier years should they leave the consolidated group [Schedule 6, item 2, paragraph 717-15(2)(b)]. A subsidiary member will also not be able to access its own excess foreign tax credits from earlier years where it leaves the consolidated group in the year it joined the group. This is discussed in detail in paragraphs 3.32 to 3.35.

3.26 The transfer credits of earlier years from all the subsidiary members will be pooled with the head company’s own excess foreign tax credits from earlier years [Schedule 6, item 2, paragraph 717-15(2)(c)]. The transfer credits will increase the amount of the excess foreign tax credits for a particular earlier year and will be subject to the same 5 year restriction as contained in the rules in section 160AFE. The pooled excess foreign tax credits will also only be available to reduce a foreign tax shortfall for a particular class of foreign income [Schedule 6, item 2, subsection 717-15(4)].

• A Co, B Co, C Co and D Co formed a consolidated group on 1 July 2002. A Co is the head company with an income year from 1 July to 30 June;

− A Co receives passive foreign income of $1,000 and pays foreign tax of $150. A Co has excess foreign tax credits in relation to passive income for 2003 and 2004 of $20 and $25 respectively;

− B Co also receives passive foreign income of $600 and pays $90 foreign tax. B Co has excess foreign tax credits for the 2001 and 2002 income years of $50 and $15 respectively, for that class of income;

− before C Co left the group it received passive foreign income of $400 but didn’t pay any foreign tax;

− D Co received foreign, other income of $500 on which it pays $200 foreign tax. D Co has an excess foreign tax credit for this class of income for the 2002 income year of $30; and

− from 1 April 2005 to 30 June 2005 E Co receives $200 of passive foreign income on which it pays $20 foreign tax and $300 of foreign, other income on which it pays $24 foreign tax. E Co has an excess foreign tax credit for the 2004 income year in relation to passive income of $10; and

Under the consolidation single entity rule A Co will include all the foreign income it actually derived as well as the foreign income from B Co, C Co, D Co and E Co in its assessable income ($3,000).

Section 717-10 will deem A Co to have paid and been personally liable for the foreign tax paid by B Co, D Co and E Co ($334). The total foreign tax A Co has paid is $484.

Under the ordinary operation of section 160AF, A Co will be entitled to a credit for foreign tax in relation to the passive income of $260. The Australian tax payable on the passive foreign income is $660. A Co will also be entitled to a credit for foreign tax in relation to other income of $224. The Australian tax payable on the foreign other income is $240.

A Co has a foreign tax shortfall in relation to passive income of $400 and $16 in relation to other income. Under the combined operation of section 160AFE and section 717-15, A Co can access the excess foreign tax credits of B Co and D Co but not the excess foreign tax credits of E Co.

A Co uses all of B Co’s earlier year excess foreign tax credits to reduce the Australian tax payable starting with the credits that relate to the 2001 income year. A Co then uses its own excess foreign tax credits that relate to the 2003 and 2004 income year. A Co must still pay Australian tax of $290 on the passive income. A Co will use $16 of D Co’s excess foreign tax credits that relate to the 2002 income year to reduce the Australian tax payable to nil on the other income. The remaining excess foreign tax credits will become A Co’s excess foreign tax credits in relation to the 2002 income year.

At the end of the 2005-2006 income year, A Co will be able to access the excess foreign tax credits that E Co brought into the group if A Co has a foreign tax shortfall in relation to passive income.

3.27 Unlike the credits for foreign tax arising under Division 18, any credits for foreign tax held by an entity under Division 18A or Division 18B (before it becomes a subsidiary member of a consolidated group) will not be utilised by the head company. The new provisions preserve the policy that these credits cannot be transferred within a group. Further, Division 18A and Division 18B credits cannot be carried forward to a future year. Therefore, rules that have been developed for Division 18 to allow for the transfer of any excess credits held by a subsidiary member to a head company are not required for Divisions 18A and 18B.

Where an entity joins a consolidated group during an income year

Rules for the joining entity

3.28 Special rules are required where an entity (a joining entity) joins a consolidated group during the income year to ensure sections 160AF and 160AFE apply appropriately to the joining entity.

3.29 Section 717-20 operates where an entity joins a consolidated group in an income year and there is a period in that year in which the entity is not a member of any consolidated group. [Schedule 6, item 2, subsection 717-20(1)]

3.30 Where an entity joins a consolidated group for the first time and the time it joins is not at the beginning of an income year, the period from the beginning of the income year until the time it joins a group is a non-membership period. The start and end of a non-membership period are treated as though they were the start and end of an income year. [Schedule 1, item 2, subsection 701-30(3) of the Consolidation Bill introduced on 16 May 2002]

3.31 The joining entity will calculate its assessable income at the joining time as though it was the end of an income year. If foreign income is included in the assessable income for the non-membership period and foreign tax was paid on that income, section 160AF applies to determine the amount of any credit for the foreign tax for that period.

3.32 Where the joining entity has a foreign tax shortfall for the non-membership period that starts at the beginning of the income year, the joining entity can use excess foreign tax credits from earlier years as calculated under the new section 160AFE [Schedule 6, item 2, subparagraph 717-20(3)(a)(i)]. The entity will not be able to use those excess foreign tax credits for earlier years if it has another, later non-membership period in the joining year [Schedule 6, item 2, subparagraph 717-20(3)(a)(ii)]. The head company of the consolidated group which it joined and left will be treated as having the excess foreign tax credits for earlier years [Schedule 6, item 2, paragraph 717-15(2)(a)].

3.33 An entity will also not be able to use excess credits from a non-membership period that occurs at an earlier time than the current non-membership period by applying the new section 160AFE [Schedule 6, item 2, subparagraph 717-20(3)(a)(ii)]. The head company of the consolidated group that it joined and left will be treated as having the excess credits for the earlier non-membership period under section 717-15 [Schedule 6, item 2, paragraph 717-15(2)(a)]. For the head company these credits for a non-membership period will be treated as excess foreign tax credits for earlier years.

3.34 A joining entity will have an excess foreign tax credit for a non-membership period according to the new subsection 160AFE(4). That will be the case where the joining entity has paid foreign tax on foreign income in a non-membership period that exceeds the Australian tax payable in respect of the foreign income. The excess foreign tax credit amount will be the difference between the foreign tax paid and the Australian tax payable.

3.35 Where an entity is a subsidiary member of a consolidated group at the start of an income year and then leaves the group before the end of the income year, the entity will not have access to any excess foreign tax credits from earlier years, that it may have had before joining the consolidated group. [Schedule 6, item 2, subparagraph 717-20(3)(b)]

Rules for the head company

3.36 Generally, the head company of a consolidated group will not be able to use excess credits for a non-membership period of a joining entity at the end of the head company’s income year in which the non-membership period occurs [Schedule 6, item 2, section 717-15]. However, in the year after a joining year the head company can use the excess credits for the non-membership period that accrued to the entity that joined the group the previous year [Schedule 6, item 2, section 717-15].

3.37 Transfer credits under section 717-20 will include the joining entity’s excess foreign tax credits for a non-membership period that occurs in the joining year provided the non-membership period did not end at the end of the income year that was the year the entity joined the group [Schedule 6, item 2, subsection 717-20(5)]. For the purpose of section 717-15, credits for a non-membership period in the joining year will be transfer credits for the head company in the following year of income [Schedule 6, item 2, subsection 717-20(4)].

3.38 If an entity has been a subsidiary member of 2 or more consolidated groups in an income year, the head company of the first consolidated group will access all the excess foreign tax credits for earlier years and any credits for non-membership periods before the entity joined the first group.

3.39 The head companies of subsequently joined groups will only have access to excess credits for a non-membership period that occurs immediately before the entity joined the relevant consolidated group. The subsequent head companies will not have access to any excess foreign tax credits for earlier years in relation to the joining entity. [Schedule 6, item 2, paragraph 717-15(2)(b)]

3.40 If a non-membership period for a joining entity ended at the end of an income year that was a joining year for the entity, the head company of the last consolidated group the entity left will not be able to access excess credits for that non-membership period. [Schedule 6, item 2, subsection 717-20(5)]

Where a wholly-owned group consolidates in the transitional period

3.41 Generally, the head company of a consolidated group cannot access the excess foreign tax credits of subsidiary members until the income year after the year in which the subsidiary member joined the group. This would mean that wholly-owned groups that formed a consolidated group before the end of the transitional period (i.e. before 1 July 2004) would be denied use of the excess foreign tax credits of the subsidiary members for more than 12 months.

3.42 Under the current rules in section 160AFE for transferring excess foreign tax credits, group members have to be part of a wholly-owned group for the whole of an income year. However, special rules have been developed for the transitional period to ensure that wholly-owned groups can continue to use excess foreign tax credits of group members at the end of the income year in which the consolidated group is formed. These rules will be contained in the IT(TP) Act 1997.

3.43 Where a wholly-owned group forms a consolidated group in the transitional period, for example, between 1 July 2003 and 30 June 2004, the head company will be able to use excess foreign tax credits of subsidiary members at the end of the 2004 income year. [Schedule 9, item 2, section 717-15]

3.44 The subsidiary members and the head company of the consolidated group must be part of the same wholly-owned group from the start of the head company’s income year until the time the consolidated group is formed. Where a subsidiary member comes into existence after the start of the income year, the entity must be a member of the wholly-owned group for the whole period from the time it comes into existence until the time the consolidated group is formed. [Schedule 9, item 2, subsection 717-15(2)]

3.45 Section 717-20 also operates where the consolidated group comes into existence during an income year that is in the transitional period. The head company has access to excess credits for the non-membership period that occurs from the start of the income year until the time the consolidated group forms. The head company will be able to use those excess credits of subsidiary members at the end of the income year in which the group came into existence. [Schedule 9, item 2, section 717-20]

3.46 The head company of a consolidated group must use the excess credits that relate to that non-membership period prior to using the excess credits from earlier years. [Schedule 9, item 2, paragraph 717-20(3)(b)]

3.47 These transitional period rules will also apply appropriately to head companies with SAPs. However, the application of these rules to SAPs is still being developed.

Application and transitional provisions

3.48 The rules dealing with foreign tax credits for consolidated groups apply from 1 July 2002.

3.49 Item 2 in Schedule 10 provides that the repeal and replacement of section 160AFE by the Schedule will apply to income years commencing after 30 June 2003 and non-membership periods commencing after that date. References to non-membership periods is necessary because section 701-30 of the Consolidation Bill introduced on 16 May 2002 treats the beginning and end of such periods as the beginning and end of an income year but the periods are not actually an income year of the subsidiary member.

3.50 A new section 160AFE was required to remove the provisions relating to the transfer of excess credits between companies in a wholly-owned group. The new section 160AFE will maintain the policy of the current section 160AFE that allows taxpayers to carry forward excess credits for 5 years. [Schedule 10, item 1, section 160AFE of the ITAA 1936]

3.51 Item 3 is an exception to the application of section 160AFE provided for in item 2. It ensures that the redrafted section 160AFE applies to a consolidated group or MEC group that comes into existence prior to 1 July 2003 or on the first day of the head company’s first income year that starts after 1 July 2003 (provided that day is before 1 July 2004). The new section 160AFE will apply for income years, or non-membership periods, starting on or after that first day of the consolidated or MEC group.

3.52 By exception, the new section 160AFE will apply for income years, or non-membership periods, starting after 30 June 2003 where the taxpayer does not become a member of a consolidated group or MEC group. It has the same application where a group with a head company that has a SAP does not consolidate from the first day of an income year which is after 1 July 2003 but before 1 July 2004.

3.53 Additionally, item 3 ensures that the current section 160AFE (which includes the grouping provisions) continues to apply prior to consolidation. This will mean that up until the time of consolidation, companies in a wholly-owned group (including the company that becomes the head company of the group) can transfer excess credits from one to another when determining their pre-consolidation tax liabilities. Any excess credits remaining on the consolidation day can be used by the head company in accordance with the rules set out in sections 717-15 and 717-20.

3.54 Special rules are being developed to deal with the situation where a consolidated group comes into existence during the 2002-2003 income year to ensure the application of the new section 160AFE will apply for the period from the date of consolidation until the end of the income year. These rules will also ensure that the current section 160AFE will operate until the date of consolidation (or 1 July 2003 if that is earlier for those with SAPs to allow excess foreign tax credits to be transferred between all members of a wholly-owned group in that period.

3.55 Additionally for SAPs, further measures will be added to terminate the operation of the existing section 160AFE and to apply the new section 160AFE from 1 July 2003 (or the consolidation day if that is earlier) where the:

• head company with the SAP consolidates during the 2003-2004 income year (other than on the first day of its income year);

3.56 Item 4 ensures that where credits have been allowed in an earlier income year under section 160AFE prior to its amendment such use of the credits will satisfy the rule in the new paragraph 160AFE(3)(d).

Consequential amendments

3.57 Consequential amendments have been made to subsection 995-1(1) of the ITAA 1997 to include a new dictionary term, ‘excess foreign tax credits’. [Schedule 12, item 1]

3.58 Other amendments consequential to the measures in this chapter will be included in subsequent legislation.

Outline of chapter

4.1 This chapter explains various additional rules of a minor or technical nature which are included in this bill. These amendments consist of modifications to various consolidation rules in the ITAA 1997 and related income tax legislation dealing with membership rules, utilisation of losses, cost setting, imputation and the removal of grouping provisions. The amendments explained in this chapter are contained in Schedules 1, 8 and 11 to this bill.

Context of reform

4.2 In response to submissions received during consultation, changes have been made to the consolidation membership rules to remove the exclusion relating to the membership of certain co-operatives. One of the underlying reasons why certain entities are excluded from the membership of a consolidatable or consolidated group is to ensure that the integrity of the regime is protected. These changes do not compromise this objective.

4.3 Amendments are also required to the transitional rules for losses to rectify a deficiency identified during consultations.

4.4 This bill also introduces amendments to various imputation provisions in the consolidation rules which are necessary to correct cross references to provisions in the proposed imputation rules to Part 3.6 of the ITAA 1997.

4.5 The amendments in this bill clarify how the final year, in which the loss transfer rules of Division 170 of the ITAA 1997 apply, is to be treated when a subsidiary becomes a member of a consolidated group. Submissions received following introduction of the Consolidation Bill on 16 May 2002 indicate that the measure contained therein requires further clarification.

Summary of new law

4.6 The following is a summary of technical and other minor amendments contained in this bill:

• co-operative companies are no longer specifically excluded from being members of a consolidatable or consolidated group;

• amendments to the transitional rules for losses will maintain the intent of the ‘value and loss donor’ concession by allowing losses to be ‘donated’ by a company even where that company has a nil modified market value;

• amendments to various imputation provisions in the consolidation rules will correct cross references to provisions in the proposed imputation rules to Part 3.6 of the ITAA 1997; and

• technical amendments will clarify the application of the loss transfer rules in relation to the final year of a subsidiary before it joins a consolidated group.

Comparison of key features of new law and current law

*New law*	*Current law*
The exclusion that prevented certain co-operative companies from being a member of a consolidatable or consolidated group has been removed.	Certain co-operative companies are specifically excluded from membership of a consolidatable or consolidated group.
Under the transitional rules for losses, a company is able donate a loss where it has a modified market value of nil. The conditions for donating a loss will be met where there is an effective donation of nil value.	Under the transitional rules for losses, a company cannot donate a loss unless it has also donated value. Therefore it cannot donate a loss if it has a modified market value of nil.
Various references in the consolidation imputation rules to provisions in the proposed imputation rules to Part 3.6 of the ITAA 1997 are updated.	Consolidation imputation rules do not currently make correct cross-references to the proposed imputation rules.
For the removal of doubt, amendments confirm that the final year in which loss transfer rules apply consists of the number of days up to the time a subsidiary joins a consolidated group.	Rules are intended to apply as if the final year consists of the period up until consolidation time.

Detailed explanation of new law

Membership rules

4.7 Subsection 703-20(2), item 4 in the table of the Consolidation Bill introduced on 16 May 2002 excluded from membership of a consolidatable or consolidated group a company if, assuming it applied at the time an amount of its assessable income as described in paragraph 120(1)(c) of the ITAA 1936, the company could deduct an amount because of that paragraph. In response to submissions received on this matter, this exclusion has now been removed. Removing this restriction will ensure that such companies are not disadvantaged by the repeal of the grouping provisions that are being replaced by the consolidation measure (without compromising the objects of single entity treatment). However, due to the operation of the single entity principle, access to the paragraph 120(1)(c) deduction as well as access to deductions for distributions made to shareholders may be lost if such a company becomes a member of a consolidated group. [Schedule 1, item 1, subsection 703-20(2), item 4 in the table]

Amendments to the transitional rules for losses

4.8 The ‘available fraction’ method set out in Subdivision 707-C of the ITAA 1997 sets a limit on the utilisation of losses transferred to a consolidated group by reference to the contribution to group income expected to be made by the entity that made the losses. The available fraction is basically the proportion the loss entity’s market value bears to the value of the group at the time the entity joins the group.

4.9 The ‘value and loss donor’ concession in Subdivision 707-C of the IT(TP) Act 1997 recognises that, under the existing loss transfer rules in Division 170 of the ITAA 1997, a company can use its losses to shelter not just its own income but also the income of certain other company members of the same wholly-owned group. This concession therefore seeks to provide, on transition into consolidation, the same rate of utilisation of losses that would be achievable under the existing loss transfer rules. The concession is only available on a transitional basis because the loss transfer rules will be repealed as a result of the introduction of the consolidation regime.

4.10 The value and loss donor concession operates to allow value and losses to effectively be combined (i.e. by being ‘donated’) to achieve a higher available fraction (and therefore a faster rate of loss utilisation). However, the rules currently only allow a company (the first company) to donate losses to another company where the first company has also donated value to the other company. This means that a company that has a nil ‘modified market value’ (i.e. broadly market value determined on the basis of certain assumptions) is unable to donate its losses to another company. This outcome is inconsistent with the current loss transfer rules, which allow losses to be transferred by a company even if that company has no income of its own.

4.11 Amendments to the IT(TP) Act 1997 will ensure that the intent of the transitional concession is maintained by allowing losses to be donated by a company even where it has a nil modified market value. To achieve this, the amendments will provide for the conditions for donating a loss to be met where there is an effective donation of nil value. [Schedule 8,
items 1 to 10]

Imputation – updating of simplified imputation references

4.12 The Consolidation Bill introduced on 16 May 2002 contained franking rules relating to the operation of franking accounts of head companies and subsidiary members of consolidated groups. The operation of those rules is based on the rules introduced in the Imputation Bill. The Consolidation Bill also refers to provisions in the Imputation Bill. As a result of the re-numbering of the provisions in the Imputation Bill, it is necessary to correct certain section references made to it by the Consolidation Bill. These corrections are as follows:

• paragraph 709-60(3)(c) of the Consolidation Bill refers to item 6 in the table in section 160-115. Owing to the renumbering of the imputation provisions, the cross-reference is to be changed to item 5 of the table in section 205-15;

• subsection 709-70(2) of the Consolidation Bill refers to section 160-115. The cross-reference is to be changed to section 205-15; and

• subsection 709-75(2) of the Consolidation Bill refers to section 160-130. The cross-reference is to be changed to section 205-30.

Removal of loss transfer provisions

4.13 Part 3 of Schedule 3 to the Consolidation Bill introduced on 16 May 2002 contains application provisions for the removal of the current loss transfer rules contained in Division 170 of the ITAA 1997. In general, the existing rules are to be phased out commensurate with the introduction of the consolidation regime. Specific rules have been devised to set the maximum limits for transfer of a loss in the final year before Division 170 (in its form prior to the enactment of the Consolidation Bill ceases to apply to wholly-owned company groups.

4.14 The maximum limits for this final year are determined by applying the existing rules in Division 170. Those limits are then further apportioned under Part 3 of Schedule 3, depending on the date of consolidation or whether a choice to consolidate is made at all.

4.15 In some cases, a subsidiary will join a consolidated group part way through its regular income year or accounting period. This will result in a truncated income year at the time of consolidation. Given that in such cases, the ‘final year’ before current Division 170 ceases to apply will be shortened to less than a normal period of 365 days, this shortening will be taken into account for the purposes of working out the maximum limit under Part 3.

4.16 Accordingly, for the purposes of the fractional figure obtained under subitems 39(4) and 39(6) of Part 3, the denominator will in appropriate cases equal the number of days in the subsidiary company’s income year that have actually elapsed at the time it joins a consolidated group. This is the intended result in certain cases, in recognition of the fact that, for example, certain subsidiaries may not have the same accounting period for income tax purposes as their head company, or may be constrained by the consolidation date of that head company. [Schedule 11, item 1, subitem 39(9)]

4.17 Therefore, if the final income year (for the purposes of use of loss transfer rules) is truncated when the subsidiary company first becomes a member of a consolidated group, that final year is treated as consisting of only the period up to consolidation time. [Schedule 11, item 1, subitem 39(9)]

4.18 This was the intended outcome of the application of the original provisions contained in the Consolidation Bill introduced on 16 May 2002. It was suggested after introduction of that Consolidation Bill, however, that this intention was not manifest. The provision in question has therefore been amended to clarify and affirm the original intention.

Subsidiary A is a December balancer. Its head company chooses to consolidate on 1 July 2002. At that time, only 6 months of A’s normal income year has elapsed. The denominator for the purposes of working out A’s ‘final year’ figure in item 39 should in this case equal 181 days. Under item 38, the ‘apportioning day’ is 1 July 2002. Therefore, the fractional figure obtained by application of item 39 will equal 1 and will therefore not reduce the figure obtained by working out the limits as usual under Division 170.

Application and transitional provisions

4.19 These amendments will take effect immediately after the commencement of the Consolidation Bill introduced on 16 May 2002.

Policy objective

Background

5.1 The consolidation measures in this bill supplements those contained in the Consolidation Bill introduced on 16 May 2002. Further consolidation legislation is scheduled for introduction later this year.

5.2 An overview of the consolidation regime was contained in Chapter 1 of the explanatory memorandum to the above bill. The regulation impact statement in Chapter 14 of the explanatory memorandum to that bill discussed the policy objectives, implementation options and an assessment of the impacts of the consolidation regime both in its initial transition phase and as a mature system.

5.3 This bill is part of the legislative program implementing the New Business Tax System. Other bills have already been introduced and passed.

5.4 Consolidation is expected to address both efficiency and integrity problems existing in the taxation of wholly-owned entity groups, many of which arise from this inconsistent treatment. These include:

• double taxation where gains are taxed when realised and then taxed again on the disposal of equity;

• loss cascading by the creation of multiple tax losses from the one economic loss; and

• value shifting to create artificial losses where there is no actual economic loss.

The objectives of the consolidation measure in this bill

5.5 The object of the consolidation regime is to improve efficiency and reduce compliance costs by providing a business environment in which some highly complex business structures are no longer seen as necessary.

• modify the existing cost setting rules to accommodate the formation of a consolidated group under the asset-based model discussed in A Platform for Consultation and recommended in A Tax System Redesigned;

• reduce compliance costs by having special rules that apply where consolidated groups form within the transitional period (1 July 2002 to 30 June 2004) to provide an election to retain the existing tax costs of assets on formation; and

• implement the single entity principle for international tax aspects and avoid double taxation, by providing that only the head company operate an attribution account and utilise foreign tax credits on behalf of the consolidated group.

Implementation options and assessment of impacts

5.7 Implementation options and impacts of both transitioning to and being part of the consolidation regime were fully explored in the regulation impact statement referred to in paragraph 5.2. In particular, reference was made to the earlier material from A Platform for Consultation and A Tax System Redesigned which has been the subject of extensive consultation.

5.8 Paragraphs 5.9 to 5.15 discuss some of the implementation and assessment issues associated with the consolidation measure being introduced in this bill.

5.9 The formation cost setting provisions in this bill reflect the modifications required to the cost setting rules for the basic case of a single entity joining an existing consolidated group. The modifications take into account that there may be more than one entity becoming a subsidiary member.

5.10 The transitional cost setting provisions being introduced in this bill are expected to reduce compliance costs by removing the need for consolidated groups to re-value assets as required under the ongoing tax cost setting rules.

5.11 The implications of treating groups as a single entity for international taxation were discussed in A Platform for Consultation on pages 552 to 564. This bill contains the rules for attribution accounts and foreign tax credits within the consolidation regime.

5.12 The single entity principle under the consolidation regime is expected to result in reduced compliance and record keeping costs. The head company will have a single attribution account for the group rather than each member of the group having to keep these account records. Further, under the amendments in this bill, foreign tax credits for the consolidated group will be pooled.

5.13 The single entity rule will mean only the head company includes foreign income in its assessable income. As a result, only the head company will need to calculate credits for foreign tax to reduce its Australian tax liabilities. The foreign tax credit amendments in this bill will ensure the head company will be able to use credits for foreign tax paid by subsidiary members to reduce the head company’s Australian tax liabilities.

5.14 An additional feature will be that the provisions will also allow existing excess foreign tax credits of entities that become subsidiary members of a consolidated group to be available to the head company of the group.

5.15 Similarly, existing balances in attribution accounts maintained by companies that become subsidiary members will be transferred to the head company, to avoid double Australian taxation. This is fairer than cancelling these balances and easier to comply with than requiring each member to maintain the accounts.

Consultation

5.16 The consultation process leading up to the introduction of the Consolidation Bill on 16 May 2002 was described in the regulation impact statement accompanying that bill. That process commenced with the release of the Government’s tax reform document: Tax Reform: not a new tax, a new tax system in August 1998 and concluded with the release of the several documents about business tax reform, in particular, A Platform for Consultation and A Tax System Redesigned canvassed options, discussed issues and sought public input.

5.17 The development of the consolidation measure in this bill has continued within the framework of consultation established for business tax reform whereby draft legislation has been exposed to a focus group of external users during its development. Issues raised during the consultation process have, as far as possible, been taken into account in the development of the consolidation measure in this bill.

Conclusion

5.18 The consolidation regime is expected to support a more efficient, innovative and internationally competitive Australian business sector, to reduce compliance costs and to establish a simpler and more structurally sound business tax system.

5.19 The consolidation measure contained in this bill, which cover cost setting transitional and formation rules as well as international aspects in respect of attribution accounts and foreign tax credits, will contribute to that outcome.

Outline of chapter

6.1 The Imputation Bill introduced into Parliament on 30 May 2002 contained core rules for the new simplified imputation system. As a result of the introduction of that bill, certain consequential amendments are required to other areas of the imputation system not covered by those rules. This bill provides consequential amendments to the provisions currently referred to in the taxation laws as the ‘exempting and former exempting company provisions’. The amendments explained in this chapter are contained in Schedule 13 to this bill.

6.2 Broadly speaking, these provisions are concerned with limiting franking credits available for trading by:

• prescribing that franked distributions paid by corporate tax entities, which are effectively owned by non-residents or tax exempt entities, will provide franking benefits to members in limited circumstances only; and

• quarantining the franking surpluses of corporate tax entities which were formerly effectively owned by non-residents or tax exempt entities.

6.3 Non-residents and tax-exempt entities generally obtain less benefit from franking credits than other resident members. These provisions ensure that entities effectively owned by non-residents and tax-exempt entities cannot trade the benefits of the franking credits.

Summary of new law

6.4 As a result of the introduction of core rules for the new simplified imputation system, certain consequential amendments are needed to other areas of the imputation provisions, including the exempting and former exempting company provisions.

• update references and processes in the exempting and former exempting company provisions so that they are consistent with the new terms and processes introduced in the new simplified imputation system; and

• relocate the exempting and former exempting company provisions from the ITAA 1936 to the ITAA 1997 using clearer and more accessible drafting techniques developed in the tax law improvement project.

Application of exempting entity rules to consolidated groups

6.6 Further rules are to be introduced into the consolidations regime relating to the application of the exempting entity rules to consolidated groups.

6.7 These rules will allow for the pooling of exempting account surpluses of joining subsidiaries. The operation of the rules will be substantially similar to the franking credit pooling rules introduced in the Consolidation Bill on 16 May 2002 and will ensure that groups are able to pass on the benefit of pre-consolidation exempting credits of joining entities to eligible shareholders.

6.8 In addition, further rules will be introduced to test whether or not a consolidated group is an exempting entity or a former exempting entity as the case may be. Broadly speaking, the tests will apply in a manner consistent with the exempting entity provisions introduced in this bill. These rules will ensure that franking benefits arise for the group’s shareholders only in appropriate circumstances.

Detailed explanation of new law

Scheme of the legislation

• first, it defines the types of taxpayer who have no, or a very limited, use for franking credits – these are called prescribed persons (essentially non-residents and tax-exempt entities). Prescribed persons are defined in a way which includes the entities through which persons, who ultimately have no or little use for franking benefits, hold their interests in the original corporate tax entity as well those persons themselves;

• next, the legislation defines what types of interests in entities count in working out who owns a true interest in an entity – these are called accountable interests; and

• finally, it defines when an entity is effectively owned by prescribed persons by testing whether prescribed persons own 95% or more of the accountable interests in the entity or, alternatively, substantially bear the risks and opportunities of owning the accountable interests in the entity.

6.10 Where a corporate tax entity is effectively owned by prescribed persons it is taken to be an exempting entity. Franked distributions made by exempting entities only confer limited benefits to recipients as follows:

• a tax offset entitlement for franked distributions made to members holding eligible employee shares, or other corporate tax entities in certain cases; and

• a franking credit arising in the franking account of a recipient exempting entity in certain cases.

6.11 Where an exempting entity ceases to be effectively owned by prescribed persons, it is taken to be a former exempting entity. In these cases the franking account is converted into an exempting account and the entity establishes a new franking account. The exempting account is then quarantined so that distributions franked with exempting credits only confer a franking benefit for eligible continuing substantial shareholders or members holding eligible employee shares.

Consequential amendments

6.12 The consequential amendments will update references and processes in the exempting and former exempting company provisions so that they are consistent with the new terms and processes introduced in the simplified imputation system. Broadly speaking, this will mean that references in the ITAA 1936 to the terms ‘company’, ‘shareholder’, and ‘dividend’ will be changed to ‘corporate tax entity, ‘member’, and ‘distribution’ respectively. Furthermore, consistent with the rules that apply to ordinary companies, the franking and exempting account balances of exempting and former exempting entities will be maintained on a tax paid basis.

6.13 The amendments will also relocate the existing exempting and former exempting company provisions contained in the ITAA 1936 and insert them, in a rewritten form, into Division 208 of the ITAA 1997.

6.14 Table 6.1 provides references to which provisions in the ITAA 1997 replace the equivalent provisions in the ITAA 1936.

Table 6.1: Translation of the ITAA 1936 provisions into equivalent ITAA 1997 provisions

*Provision*	*ITAA 1936 reference*	*ITAA 1997 reference*
What are exempting entities?	160APHBA	208-20
Effective ownership of entity by prescribed persons.	160APHBB	208-25
Accountable membership interests.	160APHBC	208-30
Accountable partial interests.	160APHBD	208-35
Prescribed persons.	160APHBF	208-40
Persons taken to be prescribed persons.	160APHBG	208-45
Former exempting entities.	160APHBE	208-50
Franking with an exempting credit.	160AQFA	208-60
Amount of the exempting credit on a distribution.	160AQFA	208-70
Distribution statements.	160AQH	208-80
Equal franking with exempting credits.	160AQFA, 160AQG	208-90 208-95 208-100
Exempting credits arising in the exempting account of former exempting entities.		208-115
	160AQCNG	208-115 (item 1)
	160AQCNF	208-115 (item 2)
	160AQCNF	208-115 (item 3)
	160AQZC, 160AQCNF	208-115 (item 4)
	160AQCNM	208-115 (item 5)
	160AQCNM	208-115 (item 6)
	160AQCNO	208-115 (item 7)
	160AQCNL	208-115 (item 8)
Exempting debits arising in the exempting account of former exempting entities.		208-120
	160AQCNH	208-120 (item 1)
	160AQCNE	208-120 (item 2)
	160AQCNN	208-120 (item 3)
	160AQCBA(3)	208-120 (item 4)
	160AQCB	208-120 (item 5)
	160AQCNP	208-120 (item 6)
	160AQCNK	208-120 (item 7)
Exempting surplus or deficit.	160AQCND	208-125
Franking credits arising when an exempting or former exempting entity.		208-130
	160AQCNH	208-130 (item 1)
	160AQCNF	208-130 (item 2)
	160AQCNF	208-130 (item 3)
	160AQZC, 160AQCNF	208-130 (item 4)
	160APPA	208-130 (item 5)
	160APPA	208-130 (item 6)
	160AQZB 160APPA	208-130 (item 7)
	160AQCNP	208-130 (item 8)
	No equivalent provision	208-130 (item 9)
	160AQCNK	208-130 (item 10)
Relationships needed for franking credit to arise.	160APPA	208-135
Membership of the same effectively wholly-owned group.	160APHBI	208-140
Franking debits arising when an exempting or former exempting entity.		208-145
	160AQCNG	208-145 (item 1)
	160AQCNO	208-145 (item 2)
	No equivalent provision	208-145 (item 3)
	160AQCNL	208-190 (item 4)
	No equivalent provision	208-190 (item 5)
Residency requirement.	Various	208-150
Eligible continuing substantial member.	160APHBJ	208-155
Distributions affected by manipulation of the imputation system.	160AQCNF, 160APPA	208-160
Amount of franking or exempting credit arising from receipt of exempt income.	160AQCNF, 160APPA	208-165
Amount of franking or exempting credit arising where 177EA determination made.	160AQCNF, 160APPA	208-170
When does a distribution franked with an exempting credit flow indirectly?	160AQZB	208-175
What is the entity’s share of the exempting credit on the distribution?	160AQZC	208-180
Minister may convert exempting surplus to franking surplus.	160AQCNP	208-185
No tax effect for members receiving distributions from exempting entities.	160AQTA	208-195
Tax effect for distributions made by exempting entities to exempting entities.	160AQTA, 46F	208-200
Exception for distributions to employees holding eligible employee shares.	160AQTA	208-205
What are subsidiaries?	160AQTC	208-210
What are eligible employee shares?	160APHBH	208-215
No tax effect for members receiving distributions from former exempting entities.	160AQTB	208-225
Tax effect for distributions made by former exempting entities to exempting and former exempting entities.	160AQTB, 46F	208-230
Exception for distributions to employees holding eligible employee shares.	160AQTB	208-235
Distributions to certain individuals.	160AQTB(4)	208-240

Application and transitional provisions

6.15 The exempting and former exempting company provisions contained in the ITAA 1936 cease to apply to events arising after 30 June 2002 [Schedule 3, item 1, section 160AOAA of the Imputation Bill]. The new exempting and former exempting entity provisions contained in the ITAA 1997 apply to events arising on or after 1 July 2002 [Schedule 1, item 1, section 201-5 of the Imputation Bill].

Outline of chapter

7.1 This chapter contains an overview of the general value shifting regime (GVSR), comprising direct value shifting (DVS) and indirect value shifting (IVS) rules. The amendments discussed in this chapter are contained in Schedule 15 to this bill. Further discussion of the GVSR is contained in the following chapters:

• Chapter 8: DVS rules affecting equity or loan interests in companies and trusts;

• Chapter 9: DVS rules relating to creating rights in respect of non-depreciating assets;

(Chapter 13 discusses amendments to loss integrity measures which contain a special value shifting rule).

• Division 725 (direct value shifts affecting equity or loan interests in companies and trusts); and

• Division 723 (direct value shifts by creating rights in respect of non-depreciating assets).

7.3 The IVS rules (Chapter 10) are contained in Division 727. This Division deals with indirect value shifts affecting equity or loan interests in companies and trusts, but only where the indirect value shift involves non-arm’s length dealings.

7.4 Schedule 15 inserts Divisions 723, 725 and 727 into the ITAA 1997. They replace the current value shifting rules, being Division 138 (value shifting by asset stripping), Division 139 (value shifting through debt forgiveness) and Division 140 (share value shifting) of the ITAA 1997.

7.5 Broadly, the new Divisions will commence on 1 July 2002 for all entities including those with SAPs. Division 723 will apply to rights created after 30 June 2002. Divisions 725 and 727 will apply to all value shifts happening after 30 June 2002, except for those happening under a scheme entered into before 27 June 2002.. These value shifts are to be addressed under the current value shifting rules. The current value shifting rules will also continue to apply in respect of value shifts that happen before 1 July 2002.

• the important differences between the concepts of a direct value shift and an indirect value shift;

Context of reform

7.7 The GVSR is a component of the New Business Tax System announced in Treasurer’s Press Release No. 58 of 21 September 1999 (refer to Attachment K). Further details were announced in Treasurer’s Press Release No. 16 of 22 March 2001. The proposal was further foreshadowed in the Minister for Revenue and Assistant Treasurer’s Press Release No. C57/02 of 14 May 2002.

7.8 The GVSR is based on Recommendations 6.12 to 6.16 of A Tax System Redesigned and will deliver significant integrity benefits to the New Business Tax System.

• distortion of gains and losses when interests are sold, rendered worthless or otherwise come to an end; and

• opportunities for inappropriate deferral or avoidance of tax liabilities where the value shift results in an interest decreasing in value, or inappropriate taxation where the value shift results in an interest increasing in value:

− value shifting makes it possible for a taxpayer to bring forward losses and defer gains by shifting value out of assets which are due to be realised in the short term and into assets which are not due to be realised until some time later; and

− value shifting arrangements distort the relationship between an asset’s market value and its adjustable value (e.g. cost base), thereby bringing inappropriate gains and losses to account upon realisation.

7.10 The current value shifting provisions are a patchwork of complex rules that have serious design flaws. For example:

• only a limited number of value shifting arrangements, or arrangements involving particular structures, are addressed, for example:

− share value shifting is addressed but value shifting involving interests in trusts is not;

− direct value shifts involving equity are addressed, but not value shifting out of loans, or between loans and equity;

− asset stripping provisions apply only to certain types of shifts involving certain types of assets or transactions, for example, where debts are forgiven, but not where assets are cancelled; or where asset transfers or creations occur at less than market value, and not where they occur at greater than market value; and

− asset stripping provisions apply only to 100% commonly-owned (including group) companies: companies that are controlled but are less than 100% owned are not covered, and there is no coverage of trusts;

• the existing law is complicated and beset by tests which makes compliance difficult and expensive;

• some aspects of the existing value shifting provisions apply too widely which can lead to unintended outcomes (e.g. for in specie distributions in the asset stripping rules);

• de minimis rules are for share value shifting rules, impractical, and for asset stripping rules, non-existent; and

• there is no exclusion for small value entities (including small business) from complex areas of the value shifting rules where such rules need not apply to them to preserve integrity.

7.11 These design flaws, with others, mean the existing value shifting rules are unsustainable in the new environment that includes consolidation. The GVSR will address these flaws in a comprehensive and systemic way.

• the consistent application of value shifting rules to interests in companies, and in fixed and non-fixed trusts (i.e. not just shares);

• that control tests apply to determine affected entities (thereby excluding almost all interests in listed entities) and for closely-held entities only, common ownership and active participation tests support the control framework;

• there is a consistent treatment of transactions with the same economic effect, through the use of a generalised concept of value shifting transactions and events;

• that compliance costs are minimised by a realistic targeting of the measures – this is achieved by an appropriate range of exclusions and safe-harbours, by a de minimis exception, and by excluding small business entities where this is appropriate; and

• the integrity of the proposed consolidation regime, and of the CGT rules generally, is enhanced.

Summary of new law

7.13 Following is a summary of the new law in respect of the key principles of the GVSR.

What is the GVSR?	The GVSR consists of DVS rules and IVS rules that impact primarily on equity and loan interests in companies and trusts. There is a special DVS rule that deals with rights created over non-depreciating assets.
What is a value shift?	Usually, a value shift occurs when something is done that results in the value of one thing increasing (or being issued at a discount to market value), and the value of another thing decreasing.
What value shifts are subject to the GVSR?	There are 3 main areas. The DVS rules deal mainly with shifts in value involving equity and loan interests in a single entity. Such a shift might arise from the issue of new interests at a discount, or from the variation of interests’ existing rights (refer to Chapter 8). There is also a DVS rule dealing with the realisation of a non-depreciating asset at a loss where the loss (or part of it) arises because of a right created over the asset in an associate, and the market value of the right was not fully brought to tax on creation. There are back-up provisions if the asset has been subject to a CGT roll-over (including a replacement-asset roll-over), or if those replacement assets are themselves rolled over (refer to Chapter 9). The IVS rules deal with value shifts between entities where the entities have not dealt at arm’s length (refer to Chapter 10). This impacts upon the values of interests held directly or indirectly in those entities, so the value shifting effect countered is referred to as indirect.
Who is affected by the GVSR?	Broadly, the DVS rules impact on the controllers and their associates, of an entity, or active participants (if the entity is closely-held) in a value shifting scheme involving the entity, and in limited cases on the owner of an asset over which a right has been created at undervalue in favour of an associate, or the owner of replacement interests if the asset has been rolled over. The IVS rules impact on certain entities with interests (affected owners) in a ‘losing’ or ‘gaining’ entity in relation to an indirect value shift. A ‘losing’ entity is one that loses value because of the shift. A ‘gaining’ entity is one that gains value. To be an affected owner, one must be, broadly speaking, a controller, or associate of a controller, of the losing and gaining entity or a common ownership, or an active participant test must be satisfied. The active participant and common ownership tests apply only to closely-held entities. Generally, the GVSR will not affect owners of interests who do not satisfy some controller/associate test, are not common owners (where there is more than one entity) and have not actively participated in the scheme (refer to Chapter 11 for who is an affected owner).
What assets are affected by the GVSR?	The GVSR generally only applies to equity or loans (including options and rights to acquire equity or loans) in a company or trust, that are owned by an ‘affected owner’. Non-depreciating assets which decrease in value because of rights created in associates over them, together with replacement interests if such assets are rolled over, are also within the GVSR. The DVS rules apply to interests held directly in entities whereas the IVS rules can apply to interests held directly, or indirectly, in entities. There are different consequences for particular interests according to whether the interest is held on capital account, or as a revenue asset or as trading stock..
What is the effect of a value shift?	The consequences of a value shift for an owner of an interest depend upon whether the DVS or IVS rules apply. A direct value shift can result in: • a deemed gain (as if the asset had been partly disposed of) but not a loss; • adjustments to adjustable values (e.g. cost bases) to realign the relationship of that value to market value; or • (under the special created rights rule) a reduction in a loss on realisation of a non-depreciating asset, whose market value was affected by created rights, or an adjustment to prevent such a loss arising on replacement interests if the non-depreciating asset was rolled over. An indirect value shift does not cause a deemed gain or loss to arise but can result in adjustments to realised losses and gains or adjustments to adjustable values to realign these values in accordance with shifts in market value (refer to Chapters 8 and 9 for DVS consequences and Chapter 10 for IVS consequences generally).
Is there any need to show a tax avoidance purpose?	No, the measures apply to value shifting schemes without any requirement for finding a tax avoidance purpose, whether main, dominant or incidental. Part IVA of the ITAA 1936 is not excluded from applying in the case of a value shift.
Does the GVSR apply to all value shifts?	No, the GVSR only applies to material value shifts. There are de minimis exceptions for: • direct value shifts that total less than $150,000 in respect of the overall scheme; • shortfalls (i.e. excesses of market value over taxed value) not exceeding $50,000 on creating of rights over non-depreciating assets; and • indirect value shifts that do not exceed $50,000. There are also a number of exclusions and safe-harbours, especially in the IVS rules.
What are some ways in which the consequences of the GVSR can be avoided?	The GVSR can be avoided completely by: • issuing interests (equity and loans) in entities at market value; • creating rights over a non-depreciating asset for full market value consideration; and • in an IVS context only, entities providing economic benefits to each other at market value, or otherwise dealing at arm’s length.
How does the GVSR relate to consolidated groups?	The GVSR does not affect interests in consolidated group members that are reconstructed under the consolidation rules. The GVSR applies to dealings between non-consolidated entities, as well as to dealings between consolidated groups and non-group entities, where relevant control etc. thresholds and various other requirements are met. This ensures that there is no advantage in keeping less than 100% controlled entities outside a consolidated group for the purpose of value shifting with them, or from electing not to consolidate groups of 100% owned entities in the expectation of deriving tax advantages from value shifting. Rules dealing with value shifting out of interests in entities forming part of consolidated or MEC groups where the interests are not reconstructed under the consolidation rules will be included in a later bill. Other interaction issues between the GVSR and consolidated or MEC groups will also be addressed.

Comparison of key features of new law and current law

*New law*	*Current law*
The GVSR will generally apply to all arrangements which materially change the market value of interests in entities. A realisation of a non-depreciating asset at a loss where a right is, or has been, created for less than market value consideration in an associate is also potentially within the GVSR. Special rules apply if the asset is subject to a roll-over (refer to Chapter 9).	Only certain forms of value shifting are addressed: • Division 138 (where CGT assets are transferred or created at less than market value); • Division 139 (where debt forgiveness results in a value shift); and • Division 140 (broadly, where value is shifted between share and similar interests in a company).
DVS rules apply to arrangements where value is shifted from an equity or loan interest in a company or trust, by direct means such as a variation of rights, or issue of interests at undervalue (refer to Chapter 8). The value shift can occur between shares owned by the same entity or by different entities. There will be a special relieving rule where a direct value shift reverses.	Division 140 applies to arrangements where value is shifted from a share in a company, by direct means such as a variation of rights, or issue of interests at undervalue. The value shift can occur between shares owned by the same entity or by different entities. There is no relieving rule for a share value shift that reverses.
IVS rules apply where the provision of economic benefits by companies or trusts to another entity results in a shift of value. Usually, there will be a shifting of value between direct or indirect interests in those entities (refer to Chapter 10).	Divisions 138 and 139 only apply to assets and forgiven debts (between 100% owned companies) and not services (although rights in relation to services may currently be captured by Division 138). Adjustments are required only to direct and indirect interests in the companies involved in the value shift.
The GVSR applies to value shifts involving interests in companies, and in fixed and non-fixed trusts. The GVSR can apply to any entity that owns an asset from which a right is created in an associate at less than market value.	Value shifts involving assets owned by, or interests in, companies are caught by the current law.
The relevant valuation standard is market value, although there are a number of proxies for market value that can be used as a substitute for it in particular cases.	The relevant valuation standard is market value, although there are some proxies for market value that can be used as a substitute for it in particular cases.
The GVSR can affect controllers and their associates, as well as common owners, their associates, and owners who have actively participated in the value shift (where the entity is, or entities are, closely-held). Common ownership for IVS purposes requires that the entities be closely-held and can be less than 100% commonality, but not less than 80% commonality (on an associate inclusive basis). There is no need for common owners of 2 entities to hold interests in the same proportions in both, although where their proportional interests are not the same, at least one owner must (on an associate inclusive basis) have a stake in each entity that is, or exceeds 40% or there must be a group of 16 or fewer owners who (on an associate inclusive basis) hold the 80% or greater stake (refer to Chapter 11).	Divisions 138 and 139 only apply where there are 2 companies under 100% common ownership (whether because of interests held in the same proportions or 100% grouping). Division 140 requires there to be a controller of the company at some stage during the value shifting scheme.
Gains in relation to an interest in an entity will sometimes be realised at the time of a decrease in value of the interest under a direct value shift. Gains may arise where value is shifted between interests of different owners, or from post-CGT to pre-CGT interests on capital account of the same owner, or between interests with a different tax character of the same owner (e.g. from a trading stock interest to an interest on capital account). A direct value shift involving the creation of a right out of a non-depreciating asset may result in an increased gain or reduced loss upon realisation of the non-depreciating underlying asset. Gains and losses will not be triggered in respect of an indirect value shift, but realised losses on affected interests in the losing entity or gains on affected interests in the gaining entity may be adjusted, or adjustments to adjustable values (e.g. cost bases and reduced cost bases) of these interests may be made just before the time of the value shift to address the effect of it. Unlike adjustments under current Divisions 138 and 139, IVS reductions to adjustable values may be made on a ‘loss-focused’ basis, that is, only if the value shift would have led to the interest realising a loss if it was disposed of at the time of the value shift.	Capital gains may arise under Division 140 in the case of: • share value shifts between share interests of different owners; or • share value shifts from post-CGT to pre-CGT shares of the same entity. Gains and losses are not triggered under Division 138 or 139, there are only cost base and reduced cost base adjustments.
Losses cannot be made on a value shifting arrangement.	Losses cannot be made on a value shifting arrangement.
Entities that are eligible to be in the STS or have (with affiliated and connected entities) net assets that would not exceed the $5 million small business CGT maximum net asset value threshold are excluded from having to make adjustments under the IVS rules.	There are no excluded entities.
The GVSR include de minimis exceptions for: • direct value shifts that total less than $150,000 for the entire scheme; • up to $50,000 shortfalls where rights are created out of a non-depreciating asset; and • indirect value shifts not exceeding $50,000.	Division 140 contains a de minimis exception of 5% in respect of a particular interest or $100,000 in respect of the entire scheme. Divisions 138 and 139 do not have any de minimis exceptions.

Detailed explanation of new law

Direct value shifting – involving interests in companies or trusts

7.14 DVS rules apply to arrangements where value is shifted from an equity or loan interest held directly in a company or trust, such that an existing direct interest in the same company or trust increases in market value. Alternatively, a new interest in the company or trust can be issued at a discount to market value which devalues other interests in the entity. [Schedule 15, item 1, section 725-145]

7.15 The decrease must be reasonably attributable to some thing or things done under a scheme. The required nexus between the thing or things done and the decrease in value is a lower standard than direct causation. Things done that would satisfy this nexus include a company proposing to buy-back shares in it, or a variation of rights that attach to an interest in an entity. [Schedule 15, item 1, paragraph 725-145(1)(b)]

7.16 DVS rules may apply even if the parties involved deal at arm’s length, or the thing done is done for market value consideration. This is because the essence of a direct value shift is that it involves a disposal of economic value, without a legal disposal, at least where value passes between different persons.

7.17 The DVS rules deal with the shifting of value out of equity or loan interests (‘interests’) in a single company or trust, usually to other interests which correspondingly increase in value in the company or trust. [Schedule 15, item 1, section 725-160]

7.18 The DVS rules do not apply to all companies and trusts and they do not apply to all interest holders. Essentially, there is a control requirement (affecting controllers and their associates) and where this is satisfied any active participants may also be affected (but only for closely-held entities). [Schedule 15, item 1, sections 725-55, 725-80 and 725-85]

What are the consequences of a direct value shift?

7.19 A direct value shift can result in the happening of a taxing event and adjustments to adjustable values (e.g. cost bases), or simply in adjustments to such values. [Schedule 15, item 1, Subdivisions 725-C to E]

7.20 The precise consequences of a direct value shift will depend upon whether the interests affected by value shifting:

• have increased or decreased in value (or been issued at a discount to market value);

• could have, prior to the value shift, realised a gain or loss for income tax purposes.

7.21 Where a shift has the same economic effect as a part disposal of an asset to another person (e.g. a transfer of value to an associate), it is broadly treated as if it were a part disposal, allocating a proportionate part of the interest’s adjustable value (e.g. cost base) to the value shifted to be compared against the amount of value shifted (equivalent to a disposal price).

7.22 The shift can give rise to a taxing event, and adjustments to adjustable values occur in relation to interests that decrease in value and increase in value to ensure that inappropriate outcomes do not arise on their ultimate realisation.

7.23 In all but one case, where the shift occurs between interests of the same tax character owned by the same person, the relationship of adjustable value to market value is realigned to prevent opportunities for crystallising losses or reduced gains on devalued interests but deferring gains or reduced losses on interests that have increased in value. This is done by adjusting the adjustable values of the affected decreased and increased value interests.

7.24 If the shift is from post-CGT to pre-CGT interests (that are not trading stock or revenue assets) of the same person, or between a persons’ interests of different tax character (i.e. capital account, revenue account or trading stock), a taxing event as well as realignment of adjustable value may occur.

Lee owns all one million A class shares in company Wolf Pty Ltd, which have a market value of $20 each, and Yorgie owns one million B class shares in the same company, which have a market value of $10 each.

Lee and Yorgie agree to vary the rights attaching to both classes of shares, resulting in the market value of the A class shares decreasing by $10 each and the market value of the B class shares increasing, also by $10 each.

The total market value of Lee’s A class shares has fallen by $10 million and the total market value of Yorgie’s B class shares has increased correspondingly by $10 million. Thus, there has been a direct value shift from Lee to Yorgie of $10 million.

This has the same economic effect as if Lee disposed of half of his shareholding to Yorgie. Assuming the total cost base for all Lee’s shares is $5 million, Lee makes capital gains of $7.5 million and his total cost bases for the A class shares is reduced to $2.5 million.

Yorgie must make cost base uplifts to avoid double taxation. Assuming his shares had cost bases of $4 million his cost bases in total are increased to $14 million.

Direct value shifting – creation of rights out of, or over, a non-depreciating underlying asset

• by the creation of that right for less than market value, where the market value of the right exceeds the consideration recognised for tax purposes by more than $50,000; and

• the underlying asset is realised (in full or in part) by the entity that created the right (or an entity that acquired the underlying asset under a CGT roll-over) at a loss attributable at least in part to the right (or the underlying asset is rolled over and the loss could be obtained on realisation of replacement interests).

7.27 Broadly, the loss realised by the entity is denied to the extent it is attributable to the right (and comparable adjustments are made to ensure that the loss cannot be realised on replacement interests if the underlying asset has been rolled over). [Schedule 15, item 1, sections 723-10 and 723-15]

Fry Co owns land with a reduced cost base of $40 million and a market value of $45 million. Fry Co grants a 6 year lease to Jones Trust, an associate, for no premium and no rental is to be paid under the lease. The market value of the land decreases by $10 million to $35 million as a result of the creation of this right.

Fry Co then disposes of its reversionary interest in the land to a third party in an arm’s length dealing for $35 million.

This ensures Fry Co and its associate retain rent free use of the land for the 6 years, and that a capital loss of $5 million would but for the DVS rule be realised. However, economically, no loss has been suffered.

If Fry Co did not sell the land until after the 6 year period had expired, there would be no reduction to any capital loss made on its realisation because the right no longer affects its market value.

7.28 Division 723 can apply where the underlying asset is dealt with on capital account, or is an item of trading stock or a revenue asset. There are special rules to reduce or remove the impact of the Division where the right has been realised and a capital gain or assessable income accrues to an associate. There are also special rules to deal with situations where the underlying asset is rolled over, including where replacement interests for a roll-over are involved.

Indirect value shifting

7.29 IVS rules deal with the consequential effects on the values of interests that are held directly or indirectly in entities involved in a non-arm’s length dealing, for example, transferring an asset, or providing services at under or over value.

• economic benefits are provided by one entity to another (whether or not it receives anything in return) ‘in connection with’ a scheme;

• the market value of the benefits received is not equal to the market value of the benefits provided, such that there is a losing entity and a gaining entity;

• the losing entity must be either a company or a trust (except certain superannuation entities); and

7.31 The IVS rules are not attracted if parties deal at arm’s length, or where economic benefits are exchanged for market value [Schedule 15, item 1, paragraph 727-100(b) and subsection 727-150(3)]. The transfer of assets at market value will not affect the value of the entities involved, nor will it affect the value of interests in those entities. Certain events that may not strictly amount to a provision of economic benefits by one entity to another (e.g. something that constitutes a direct value shift) may be captured by the IVS rules.

7.32 The losing and gaining entities need not be a party to the scheme [Schedule 15, item 1, subsection 727-150(5)]. A party to the scheme is an entity that participates in the entering into or carrying out of the scheme. Whether or not an entity is a party to the scheme is not relevant to how the measures operate.

Down Co transfers an asset with a market value of $300,000 to the Up Trust in return for a single cash payment of $100,000, in a non-arm’s length dealing.

Ming owns all of the shares in Down Co and all the interests in Up Trust. As a consequence, the market value of Ming’s shares in Down Co has declined by $200,000 and the market value of her interests in Up Trust has increased by $200,000.

There has been an indirect value shift of $200,000 from Ming’s shares in Down Co to her interests in Up Trust.

7.33 The IVS rules do not operate on the primary value shift arising from the non-arm’s length dealing. That is, the IVS rules do not adjust the quantum of the benefits for tax purposes generally (i.e. they do not adjust assessable income or deductions in respect of the provision or receipt of those benefits). However, they do address the consequential or indirect effects of the value shift upon:

• the value of interests held in the losing entity and the gaining entity; and

• the value of direct and indirect interests held in entities that own interests in the losing entity and gaining entity.

7.34 They do not deem any taxing point to arise at the time of the shift. Rather they may adjust (directly) a loss or gain on ‘realisation’ of an affected interest under the realisation time method or, where a choice is made, certain adjustable values of the interest (e.g. CGT cost base) may be adjusted as at the time of the shift itself (which will ultimately affect the outcomes on realisation of the interests) under the AVM.

7.35 While the realisation time method allows entities to disregard the effect of an indirect value shift unless an interest in the losing entity is realised at a loss, reductions of gains for interests in the gaining entity are, broadly speaking, limited to the amount of realised losses reduced under this method. It does not apply to cases where the value shift means that losses that would otherwise be made on interests in the gaining entity are reduced. [Schedule 15, item 1, Subdivision 727-G]

7.36 Because the realisation time method can limit relief for interests realised in the gaining entity, a choice may be made to make adjustments to the adjustable values of interests in both the losing and gaining entity as at the time of the value shift. The adjustments to interests in the losing entity may be made on a ‘loss-focused’ basis, that is, only making a reduction to the extent that the shift would have resulted in a loss on the interest if it were realised at the time of the shift, with increases to the adjustable values of interests in the gaining entity broadly limited by reductions. Greater uplifts may be obtained in certain circumstances if the reductions are not ‘loss-focused’ so this method may also be chosen.

7.37 Generally, a choice cannot be made to use an adjustable value adjustment approach after the time for lodging a tax return for the year in which any interest in the losing entity or gaining entity is first realised. [Schedule 15, item 1, Subdivision 727-H]

A Co, B Co, C Co and D Co all have the same ultimate controller. In a non-arm’s length dealing, C Co sells an asset with a market value of $10 million to D Co for $5 million. There has been a shift of $5 million from C Co to D Co.

The IVS rules do not have any effect on the transaction between D Co (gaining entity) or C Co (losing entity).

But they may impact on tax consequences for interests held directly or indirectly in D Co and C Co.

No adjustment need be made using the realisation time method unless an interest in the losing entity (C Co) is realised at a loss. If that happens, for example, if B Co sells its interest in C Co, the loss it would otherwise have made of $5 million is reduced to nil to take account of the effect of the value shift.

Similarly, if A Co then sells its interest in D Co for a gain that is $5 million more than it would otherwise have made but for the value shift, the gain may be reduced by an amount of $5 million.

But if A Co sells its interest in D Co first, no realised losses would have been denied, and no relief would be available for the realisation of D Co.

Thus, a choice may be made to make a full set of adjustable value adjustments in respect of interests in both the losing and gaining entity immediately before the time of the indirect value shift.

As previously noted, the adjustments may be done using a ‘loss-focused’ approach, or may be done using a non-loss focused approach, if considered advantageous by the entity making the choice.

For example, the loss-focused approach would reduce the values for tax purposes of A Co’s interest in B Co by $5 million, and B Co’s interest in C Co also by $5 million as at the time of the value shift, and correspondingly increase the adjustable value of A Co’s interest in D Co by $5 million (assuming it remains reflected in its value when realised).

If, however, the value of C Co was still $10 million (rather than $5 million) after the shift, then no reductions would be made under the loss-focused approach for direct and indirect interests in C Co and no uplifts would be available for the interests in D Co.

A choice to use a non-loss focussed approach would result in reductions of $5 million in relation to the direct and indirect interests in C Co, in order to obtain up to a $5 million increase for the interests in D Co.

Which entities are affected by IVS?

7.38 Indirect value shifts will only have consequences for ‘affected owners’. Affected owners can arise in the following situations:

• at least one of the above tests is met and there is at least one ‘active participant’ in the scheme and the entities are closely-held.

7.39 The IVS rules do not tax gains or allow losses because of the value shift between the losing and gaining entities, but they may require adjustments to adjustable values (both up and down) to account for the value shifted, or reductions to realised losses or gains. This ensures no inappropriate tax outcomes if, for example, some interests are sold before others.

• it is not greater than $50,000 [Schedule 15, item 1, section 727-215];

• services are provided for at least their direct cost or no more than a commercially realistic price [Schedule 15, item 1, sections 727-230 and 727-235];

• in many cases, an asset is transferred for at least its cost [Schedule 15, item 1, section 727-220];

• it consists of a distribution [Schedule 15, item 1, section 727-250]; or

• in most cases, if value is shifted down a wholly-owned chain of entities [Schedule 15, item 1, section 727-260].

7.41 Some specific exclusions apply if the realisation time method is applied to make the IVS adjustments. These include most value shifts which principally involve services, unless certain criteria are satisfied (e.g. the shifts have to be significant in dollar terms and meet set criteria). It is also not necessary to adjust for a value shift that happened more than 4 years before realisation of an interest, if the shift is less than $500,000. [Schedule 15, item 1, section 727-700 and paragraph 727-610(2)(d)]

7.42 Entities that are eligible to be in the STS, or would satisfy the $5 million maximum net asset value threshold for the CGT small business concessions, are not required to make adjustments under the IVS rules. [Schedule 15, item 1, subsections 727-470(2) and (3)]

Interaction between the direct value shift and indirect value shift

7.43 Although the DVS and IVS rules have different operative elements, it is possible for one set of facts to potentially attract both sets of value shifting measures. In these cases, the DVS rules take precedence. [Schedule 15, item 1, Subdivision 722-L]

Controller Co causes Plato Co to issue redeemable preference shares with a face value and market value of $200,000 to Aristotle Co who pays $40,000. This is a direct value shift under Division 725. Controller Co owns the interests that decrease in value.

This also gives rise to an indirect value shift under Division 727. Plato Co (losing entity) provides economic benefits with a greater market value than what he receives from Aristotle Co (gaining entity). The IVS rules will not apply to Controller Co or Aristotle Co’s interests in Plato Co.

7.44 Other circumstances may arise where it is appropriate for both the DVS and IVS rules to be triggered.

An entity may create rights in an associate in respect of a non-depreciating asset which causes an IVS to occur.

Assume that Down Co and Up Co have the same ultimate controller. Owner Co creates a right over land that it owns in favour of Right Co, an associate, for no consideration. This results in a decrease in the market value of land. Owner Co then sells the land to an arm’s length party at its (now reduced) market value for a loss.

Under the DVS created rights rule, Owner Co’s loss may be reduced. Under the IVS rules, the creation of the right is the one-sided provision of an economic benefit from Owner Co to Right Co in a non-arm’s length dealing. As Down Co and Up Co have the same ultimate controller, the IVS rules will apply. Down Co and Up Co’s respective cost bases in Owner Co and Right Co may need to be adjusted (as well as cost bases of interests held in Down Co and Up Co by their members) unless the realisation time method is used.

This demonstrates how consequences under both DVS and IVS rules might be triggered by the same events.

*Feature*	*DVS – interests in companies and trusts*	*DVS – creating a right*	*IVS*
Where are the rules located?	Division 725.	Division 723.	Division 727.
Consequences	There are 2 types of consequences: • deemed gain (as if there was a part disposal) but not a loss; and • changes to adjustable values for tax purposes (e.g. cost bases).	Loss denied or reduced upon realisation or part realisation of the underlying non-depreciating asset (underlying asset). There may also be consequences for replacement interests if the underlying asset has been rolled over.	Under the realisation time approach, reductions to realised losses for interests in the losing entity and reductions to gains for interests in the gaining entity. The quantum of adjustments for interests in the gaining entity are linked to adjustments in the losing entity. Under the optional adjustable value approach, adjustments to the adjustable values of interests in the losing entity and the gaining entity as at the time of the value shift. A loss-focused or non-loss focused approach may be used.
What sort of value shift is within the scope of the GVSR?	Interests in a company or trust that decrease in value because of something done under a scheme. There must be a corresponding increase in market value of another interest in that company or trust, or an interest issued at undervalue.	Where a right is created in an associate over an underlying asset and a decrease in the market value of that asset is attributable at least in part to the existence of the right. .	Where entities enter into unequal arrangements (by not dealing at arm’s length), which consequently impact upon the values of interests held directly or indirectly in those entities.
Are there any arrangements excluded or safe-harbours provided?	Issue of new interests at market value. Share buy-backs at less than market value to which Division 16K of the ITAA 1936 applies – but uplifts may be available as if reductions occurred under DVS. There are special rules for neutral value shifts, value shifts that reverse and bonus issues.	Rights created for full market value consideration. Rights created that effect a part realisation of the underlying asset. Rights created upon death. Rights created that are conservation covenants.	General exclusions and safe-harbours (realisation time method or AVM). • Benefits provided at market value. • Arm’s length dealings. • Where the losing entity is a superannuation related entity. • Most distributions. • Certain value shifts involving services provided for direct cost or not for more than a commercially realistic price. • Many assets disposed of at cost. • Many depreciating assets transferred at adjustable value or book value. Exclusions and safe-harbours only for realisation time method. • Value shifts more than 4 years before realisation and less than $500,000. • Service-related value shifts unless subject to a specific inclusion.
Are there de minimis rules?	DVS of less than $150,000 for the entire scheme.	Yes, where the shortfall on creating the right (i.e. the excess of the market value of the right over the amount recognised for tax purposes) is $50,000 or less.	Yes, where indirect value shift is $50,000 or less.
What types of assets can be subject to a value shift?	Interests in a company or trust, consisting of equity or loans (including options or rights to acquire). Interests may be held on capital account, revenue account or as trading stock.	Any asset, other than a depreciating asset. Asset may be held on capital account, revenue account or as trading stock.	Interests in a company or trust, consisting of equity or loans (including options or rights to acquire). These interests can be held on capital account, revenue account or as trading stock.
Who are affected owners?	Entities that own equity or loan interests in the target entity and: • control the target entity, or are an associate of the controller; • are an associate of that associate in some cases; or • have actively participated in, or directly facilitated, the value shifting scheme (if closely-held).	An entity that created the right and realises the underlying asset, or an entity thatacquires the underlying asset under a roll-over, provided that the right is held by an associate of that entity when it realises the underlying asset. An entity that holds replacement interests where the underlying asset has been rolled over (or replacement interests for a roll-over of those replacement interests) may be affected.	Entities that own equity or loan interests in the losing or gaining entity and: • have, or have a connection with, an ultimate controller; • are, or have a connection with, the common owners (if the losing or gaining entity is closely-held); or • actively participated in, or directly facilitated, the value shifting scheme (if the losing or gaining entity is closely-held).
Entities excluded from making adjustments	Nil.	Nil.	Interest holders that are eligible to be STS taxpayers or who satisfy the small business CGT maximum net asset value threshold ($5 million or less net assets).
Can the GVSR apply within a consolidated group?	No.	No.	No.

Outline of chapter

8.1 This chapter provides a detailed discussion of the operation of the DVS rules in Division 725. This chapter also explains amendments contained in Schedule 15 to this bill.

Context of reform

8.2 DVS rules were recommended in A Tax System Redesigned (see Recommendations 6.14 and 6.15) as part of the response to generalised value shifting on assets. The DVS rules outlined in this chapter relate to value shifts involving equity or loan interests in companies or trusts. A further DVS rule, dealing with the creation of rights over assets is discussed in Chapter 9.

8.3 The DVS rules discussed in this chapter implement fully the principles underlying Recommendations 6.14 and 6.15 of A Tax System Redesigned.

8.4 The DVS rules only apply to value shifts involving direct equity or loan interests in companies or trusts that are controlled. The DVS rules impact mainly on controllers and their associates who have interests in a controlled company or trust. If the company or trust is also closely-held, the rules may impact on active participants in a DVS scheme who have interests in the company or trust. All of these interest owners are affected owners for the DVS rules.

8.5 If value is shifted between affected owners’ interests, this Division results in a rearrangement of those interests’ adjustable values (e.g. cost bases) to prevent inappropriate losses or gains from later arising on realisation of the interests.

8.6 A taxing event may happen if value is shifted from an interest which has a pre-shift gain or profit to an interest of a different affected owner. This has the economic effect of a disposal.

8.7 Similarly, a taxing event may result if value is shifted within interests of the same affected owner and the shifted value cannot be later taxed at all, or taxed in the same way, on the increased value interest (or interest issued at a discount). This may occur, for example, if value is shifted from a post-CGT interest to a pre-CGT interest, or from trading stock to a post-CGT interest that is not trading stock.

8.8 Affected owners will now receive recognition for value shifted from pre-CGT interests to post-CGT interests. This is not a feature of existing Division 140 of the ITAA 1997 dealing with share value shifting.

8.9 Although it is not feasible to maintain pre-CGT status for the shifted value, regard is had to this amount in providing uplifts for increased value interests or interests issued at a discount. This implements Recommendation 6.15 of A Tax System Redesigned.

8.10 Consistent with Recommendation 6.14(iii), there is no taxing event crystallising a loss on a direct value shifting arrangement.

8.11 In many respects, the methodologies adopted in Division 725 are modelled on Division 140 of the ITAA 1997. However, there are significant differences in the scope and application of the new measures. These are summarised below in the ‘new law’ to ‘old law’ comparison.

Summary of new law

8.12 Division 725 applies to direct value shifts under schemes involving direct equity or loan interests in a target entity (company or trust) that is controlled.

8.13 A scheme does not have to have been entered into with a tax avoidance purpose for the Division to apply to it.

8.14 Specifically, a value shift under this Division relates to a thing or things done under a scheme involving equity or loan interests in the target entity that results in a decreased value interest and an increased value interest (or an interest issued at a discount to market value). An interest issued at a discount does not actually increase in value, but the effect of it is to cause a decrease in the value of other interests.

8.15 In a direct value shift, value is shifted between entity interests without a disposal occurring, although the economic effect achieved is similar if the value is shifted between different persons. If the value passes between interests held by the same person, at the very least the relationship between adjustable values and market values of the interests becomes distorted.

8.16 Only affected owners of impacted interests, at the time of the decrease or increase in market value, or issue, are impacted by the Division. Affected owners are mainly the controller of the entity, associates of the controller and, if the target entity is closely-held, active participants (if any) in relation to the scheme.

• from or to whom the value is shifted (e.g. from another affected owner, from the affected owner’s own interests or from a non-affected owner (e.g. a minority shareholder)); and

• the tax character of the interests involved (i.e. whether they are held on capital account, or whether they are revenue assets or trading stock of the owner).

8.18 The consequences include a possible taxing event for a pre-shift gain or profit (no losses are taken to occur) and adjustable value (e.g. cost base) realignment.

8.19 In general, the following consequences can arise for particular types of value shift:

• for shifts between interests held by the same affected owner – adjustable value realignment only unless value is shifted from post-CGT to pre-CGT interests or between interests of a different tax character (in these cases pre-shift gains may be taxed);

• for shifts between interests held by different affected owners – adjustable value realignment (in some cases, pre-shift gains may be taxed); or

• for shifts involving interests held by owners that are not affected owners – there are no consequences.

8.20 The Division does not apply to a direct value shift occurring wholly within a consolidated group where all of the affected interests will be subject to reconstruction under the consolidation rules.

8.21 There is also a de minimis exclusion. If the total value shift out of all down interests under the same scheme (whether the interests are held by affected owners or others) is less than $150,000 the Division will generally not apply.

The consequences may include realignment of adjustable values (e.g. cost bases) of interests and in some cases taxing events may also occur.

An entity controls the target entity at some time during the period of the scheme (section 725-55).

There is an affected owner of a ‘down interest’, an ‘up interest’ or both (sections 725-80 and 725-85).

The target entity, controller or associate, or active participant do a thing or things under the scheme to which the direct value shift is reasonably attributable (section 725-65).

A non-reversing DVS under a scheme involving equity or loan interests in a target entity may have consequences under Subdivisions 725-C to 725-F if all of the below are satisfied (section 725-50).

Direct value shift (Subdivision 725-B and section 725-70)

• an increase in market value or an issue at a discount (an ‘up interest’).

EXAMPLES: VARIATION IN SHARE RIGHTS, OR ISSUE OF UNITS IN A UNIT TRUST FOR LESS THAN THEIR MARKET VALUE.

The consequences may include realignment of adjustable values (e.g. cost bases) of interests and in some cases taxing events may occur.

Richard, a resident individual, wholly-owns and controls Richard Co, a resident private company, which he incorporated in 1986. Richard holds 2 ordinary shares each worth $1 million and each with a cost base of $0.1 million.

If Richard were to sell 50% of his shareholding (i.e. one share) to his brother Stan for $0.1 million, the CGT market value substitution rule in section 116-20 of the ITAA 1997 would apply so that a capital gain (ignoring indexation and the CGT discount) of $0.9 million would arise (i.e. $1 million sale proceeds less $0.1 million cost base).

However, if instead of selling a share to Stan, Richard were to cause Richard Co to issue 2 ordinary shares to Stan for $0.1 million each, Richard would not have disposed of anything, but would effectively shift $0.9 million in value to Stan without tax effect (but for the DVS rules).

Richard’s shares would now be worth 2 × ($2.2 million ÷ 4) = $1.1 million and Stan’s shares, for which he paid $0.2 million, would also be worth $1.1 million.

(Note: if the shares had been issued to Stan for $1 million each, there would have been no value shift and no application of the Division).

In broad terms, the Division deals with such a transaction by assessing a gain to Richard because he has shifted value out of a gain interest to an associate. The amount of the gain assessed is based on the value shifted from the shares less a pro-rata allocation of their adjustable values.

Richard shifted $900,000 value to Stan. This represents 45% of the pre-shift value of his interests ($2 million). That proportion of cost base of his shares is allowed as a reduction (i.e. 45% ÷ $200,000 = $90,000). The gain is $810,000 ($900,000 – $90,000).

Assuming Stan’s shares continue to reflect the shifted value, their cost base would be increased by the value shifted to them (i.e. $450,000 each), so the value would not, on later sale of the shares, be taxed again under the ordinary CGT rules. Each of Stan’s shares would now be worth $550,000 and each would have that amount as a cost base.

A similar result would have followed if Richard and Stan had both owned shares in the company from the time of incorporation, and a shift were achieved by varying the rights attaching to their shares.

A similar result would also have followed if, instead of a company, the entity were a unit trust and either units were issued at undervalue to an associate or unit rights were varied (assuming that a new trust does not result).

Comparison of key features of new law and current law

*New law*	*Current law*
Applies to target entities being companies, fixed trusts and some non-fixed trusts.	Applies only to companies.
Also applies to active participants in a scheme who hold interests, but only in closely-held entities that are controlled.	Applies only to controllers of a target entity and to their associates.
Also applies to debt interests.	Applies to equity interests.
More realistic de minimis threshold ($150,000 on a scheme basis).	Low de minimis threshold (less than 5% reduction on an interest basis and $100,000 on a scheme basis), especially on the percentage limit.
Provision for special relief where a value shift under a scheme reverses on its own terms.	No special relief is available where a value shift reverses on its own terms.
No materiality requirement for uplifts – taxpayers may choose to calculate small uplifts (there must still be a material decrease for the Division to apply).	Only material uplifts are allowed (as a compliance cost saving measure).
Also addresses revenue consequences for interests held as trading stock or revenue assets.	Addresses CGT consequences only for interests.
Uplifts available for shifts from pre-CGT interests.	No uplifts for shifts from pre-CGT interests.
Uplifts available for off-market buy-backs at undervalue.	No uplifts available for off-market buy-backs at undervalue.
Excludes interest holder from gain treatment where value shift is neutral for that holder, even if it is not neutral for other affected holders.	Excludes an interest holder from gain treatment in a neutral value shift only if the shift is neutral for all affected holders.

Detailed explanation of new law

Object of Division 725

8.25 One object of the Division is to prevent inappropriate losses arising on the realisation of equity or loan interests from which value has been shifted to other equity or loan interests in the same entity.

8.26 Another object of the Division is to prevent inappropriate gains from arising on the realisation of equity interests in the same entity to which the value has been shifted.

8.27 The object is achieved by adjusting the adjustable values of interests owned by entities involved in the value shift to take account of the changes in market value attributable to it. In some cases, the value shift is treated as a partial realisation, from which an immediate gain (but not a loss) may result. [Schedule 15, item 1, section 725-45]

Threshold conditions for the application of Division 725

8.28 A direct value shift under a scheme involving equity or loan interests in a company or a trust (called the target entity), has consequences for an entity with such interests if:

• there is a sufficient causal nexus between the thing or things done under the scheme and the value shift;

• the entity is an ‘affected owner’ of a down interest or an up interest or both;

• the de minimis exclusion does not apply (i.e. the shift involves a material decrease).

Is there a direct value shift under a scheme involving equity or loan interests in an entity?

8.29 There is a direct value shift under a scheme involving equity or loan interests in a target entity if:

• there is a decrease in market value of one or more equity or loan interests in the target entity that is reasonably attributable to one or more things done under the scheme and occurs at or after the time when that thing, or the first of those things, is done – called a down interest and the time the decrease happens is its decrease time; and

• one or more equity or loan interests in the target entity increases in market value or is issued at a discount, and the increase, or issue, is reasonably attributable to the thing, or one or more of those things done, and occurs at or after the time the thing, or first of those things, is done – called an up interest and the time the increase or issue happens is its increase time.

8.30 A more detailed discussion of these requirements follows in paragraphs 8.48 to 8.89.

8.31 If the decrease or increase or issue (as applicable) is only partly attributable to the scheme, the Division applies only to that extent. [Schedule 15, item 1, section 725-165]

8.32 Common examples of things that may result in a direct value shift include issuing shares or trust units at a discount, proposing to buy back shares at less than market value or varying share rights.

Nature of a direct value shift

• the decrease in market value of the down interests and the increase in market value of the up interests (or interests issued at a discount to market value) [Schedule 15, item 1, subsection 725-160(2)]; and

• that Division 725 assumes, and proceeds on the basis that, the direct value shift is from each of the down interests to each of the up interests [Schedule 15, item 1, subsection 725-160(3)].

8.34 The assumption in the second dot point is important because it avoids entities having to actually determine as a matter of fact, the precise amount of value shifted from one interest to another interest. Grouping tests for interests make such calculations more straightforward, especially in a scheme involving many interests, and affected owners.

Controlling entity test and active participant test

8.35 Broadly, the Division has no application to a direct value shift under a scheme unless an entity controls (for value shifting purposes) the target entity at some time during the scheme period (from the time the scheme is entered into until it has been carried out). [Schedule 15, item 1, section 725-55]

8.36 It is not necessary for the entity to still be the controller of the target entity when any decrease in market value of an interest actually occurs.

8.37 There may also be more than one controller of a target entity during the course of the scheme.

Affected owners

8.39 Only ‘affected owners’ of down and up interests under the shift are potentially impacted by the Division.

8.40 An entity is an affected owner of a down interest if it owns the interest at the decrease time and either:

• the entity is the controller or an associate of the controller at some time during or after the scheme period; or

• the target entity is closely-held at some time during the scheme period and the entity is an active participant in the scheme.

8.41 An entity is an affected owner of an up interest if the entity owns the interest at the time it increases in value or is issued to the entity at a discount and:

− the entity is the controller, or an associate of the controller at some time during or after the scheme period, or an associate of an associate of the controller during or after the scheme period where the second mentioned associate was an affected owner of down interests; or

− the target entity is closely-held at some time during the scheme period and the entity is an active participant in the scheme.

8.42 An entity is an ‘active participant’ if the target entity is closely-held and it has actively participated in or directly facilitated the entering into or carrying out of the scheme, and it owns a down or up interest at the decrease or increase time (as relevant) or has an interest issued to it at a discount. [Schedule 15, item 1, subsection 725-65(2)]

Reversals

8.44 There is an exception that provides special relief from the requirement to calculate gains and make adjustments where a value shift reverses.

8.45 A direct value shift will not have consequences under Division 725 if it is more likely than not that there will be a reversal within 4 years. The reversal must occur under the terms of the same scheme. [Schedule 15, item 1, subsection 725-90(1)]

8.46 The concept of reversal is based on the ‘state of affairs’ that arises because of the thing, or things, done under the scheme to which the decrease in value of equity or loan interests is reasonably attributable. It must be the case that without the state of affairs the direct value shift would not have happened. A reversal happens where the state of affairs ceases to exist. [Schedule 15, item 1, subsection 725-90(1)]

8.47 The state of affairs can include the effects and consequences of the things done, as well as the circumstances brought about by those things. A state of affairs can cease to exist partially or gradually over a period of time. If the state of affairs has not fully ceased to exist by the end of the 4 year period, the exception will stop applying. [Schedule 15, item 1, subsection 725-90(2)]

8.48 The exception will also stop applying if the state of affairs exists when a down or up interest of an affected owner is realised within the 4 year period. If the exception stops applying it is as if it had never applied. [Schedule 15, item 1, subsections 725-90(2) and (3)]

8.49 A direct value shift that happens when the reversal occurs will also have no consequences under Division 725. [Schedule 15, item 1, section 725-95]

Under a scheme, special voting rights are attached to the A Class shares. As a result, the market value of the A Class shares increases, and the market value of the B Class shares decreases. Under the terms of the scheme, the special voting rights will cease to apply after 2 years.

The consequences under Division 725 will not apply to the direct value shift that happens when the special voting rights are attached (from B Class shares to A Class shares).

The consequences under Division 725 will not apply to the direct value shift that happens when the special rights cease to apply (from A Class shares to B Class shares).

8.50 The exclusion will cease to apply (and is treated as never having applied) if, before the reversal happens, a realisation event happens to down interests or up interests of an affected owner, or the 4 year period expires. Where this happens, the consequences under Division 725 are applied from the earlier time when the direct value shift happened. This may result in an assessment for an earlier income year having to be amended. [Schedule 15, item 1, subsection 725-90(1)]

Scheme and related issues

8.51 Division 725 requires the existence of a scheme to trigger its operation. It must be the case that:

Scheme

8.52 Scheme is very broadly defined in the tax law. It is defined in subsection 995-1(1) of the ITAA 1997 as encompassing:

• any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings; and

• any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

8.53 A tax avoidance purpose in respect of a scheme is not required for the application of Division 725. It is the effect of the scheme, and the effect of things done under the scheme, that are relevant.

8.54 What acts or omissions constitute a scheme is a question of fact. A series of events or transactions may form part of one scheme. This ensures that even if, for instance, a share value shift proceeds over a long period, each decrease in value of a share may be attributed to a single scheme.

8.55 If variations occur to things agreed to under a scheme, such variations will ordinarily amount to a new scheme, except where the variations were clearly contemplated by, and consistent with, the earlier scheme.

A finalised scheme to issue shares at undervalue by 5%, is later varied by the parties so that the shares are to be issued at undervalue by 30%. These constitute 2 separate schemes.

What is a thing done?

8.56 A thing done takes its ordinary meaning. A thing done could, in limited circumstances, include a thing omitted to be done. For example, it could include failing to use the option of a casting vote in an otherwise tied ballot. However, something omitted to be done would not include inadvertent omissions and oversights.

8.57 References to a thing done under a scheme include (but are not limited to) things such as the issuing of new interests at a discount, the buying back of existing interests or the changing of the various rights attached to interests.

Who must do the thing or things?

• by a controller of the target entity or by an associate of the controller at some time during or after (but not before) the scheme period; or

The thing or things can be done either alone or with others. [Schedule 15, item 1, subsection 725-65(1)]

The scheme must involve equity or loan interests in the target entity

8.59 The DVS rules require that the thing or things must be done under a scheme that involves equity or loan interests in an entity. This requires there to be a direct connection between the thing or things done under the scheme and the equity or loan interest or interests in the entity.

8.60 A thing done under a scheme that causes an asset of an entity to change in value, which is reflected in the value of interests in the entity, is not sufficient to involve the interest. A purely incidental value shift, for example, a value shift resulting from particular investments undertaken by the entity, will not trigger Division 725.

Equity or loan interest in an entity

8.61 The DVS rules apply only to direct interests in target entities and not to interests held through other entities in the target entity. Direct interests are referred to as ‘equity or loan interests’. The DVS rules apply to interests held on capital account (the most usual case) but also have implications for interests held as trading stock or as revenue assets.

8.62 An equity or loan interest in an entity can be a primary interest, or a secondary interest, in the entity [Schedule 15, item 1, subsection 727-520(1)]. A primary interest in an entity can be a primary equity interest or a primary loan interest in an entity [Schedule 15, item 1, subsection 727-520(2)].

8.63 A primary equity interest in a company is a share in the company or an interest as joint owner of a share. [Schedule 15, item 1, subsection 727-520(3), item 1 in the table]

8.64 A primary equity interest in a trust is an interest in the trust income or trust capital, or any other interest in the trust or an interest as a joint owner in one of these interests. [Schedule 15, item 1, subsection 727-520(3), item 2 in the table]

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

8.66 A secondary interest is a right or option to acquire an existing primary interest in an entity, for example, a share or a loan, or to have the entity issue these type of interests. It does not apply to a put option, as this is not an option to acquire an interest. [Schedule 15, item 1, subsections 727-520(5) to (7)]

Relevant trust interests

8.67 While an interest in a trust includes any other interest in the trust apart from an interest in the trust income and capital, in practical terms the DVS rules can only apply in relation to a trust interest:

• in which the rights attaching to it are defined with particularity in the terms of the deed of settlement.

8.69 An interest in a non-fixed trust which merely entitles the holder to have the trust estate properly administered and to be considered by the trustee in exercising a power of appointment to distribute income or capital of the trust is not the type of interest to which Division 725 has any practical application. This is because such an interest cannot decrease or increase in market value.

8.70 However, Division 725 is capable of having practical application to the extent that an interest in a non-fixed trust has value capable of being measured and quantified (e.g. but not limited to, an interest in a trust that is fixed in respect of either income or capital).

Decrease in market value and related issues

8.71 There must be a material decrease in the market value of at least one equity or loan interest for the Division to apply. Equity or loan interests in an entity that have decreased in market value as a result of something done under a scheme are referred to as down interests. [Schedule 15, item 1, subsection 725-155(1)]

8.72 The decrease in market value of the down interests must be reasonably attributable to the thing or things done under the scheme and happen after the thing or first of the things. [Schedule 15, item 1, paragraph 725-145(1)(b)]

Decrease in market value must be material

8.73 A down interest will be regarded as having sustained a material decrease in market value if the sum of all of the decreases of the market value of that and all other down interests, arising from direct value shifts occurring under a single scheme, is at least $150,000. [Schedule 15, item 1, section 725-70]

There are 50 A class shares in Alpha Co with a market value of $100,000 each, and 20 B class shares with a market value of $5,000 each. The controller of Alpha Co owns all the A class shares. An associate of the controller owns 10 of the B class shares, and an unrelated entity owns the other 10 shares.

If the controller causes Alpha Co to vary the share rights attaching to the A and B class shares, and shifts 10% of the A class value to the B class shares, the Division applies because the overall value shifted would have been $500,000 (i.e. 10% × 50 × $100,000).

8.74 The materiality requirement is designed to reduce the cost of complying with the value shifting provisions. It ensures that the provisions are not triggered by relatively small shifts of value.

8.75 The new law adopts a more practical threshold than does Division 140, especially given the difficulty of determining whether a 5% shift has occurred in respect of a particular interest.

8.76 Under a particular scheme there may be a series of direct value shifts reducing the market value of a down interest. In such a case, the sum of all the decreases is used to determine whether there is a material decrease in the market value of the interest. If, for instance, a value shift takes place in 2 stages so that initially there is a decrease in the market value of an interest and then, at some time later, a further decrease in the market value of the same interest, both are taken into account.

8.77 Unlike Division 140 there is no materiality requirement for increased value shares in Division 725. The rationale for this is that, provided the Division has been triggered in respect of a material decrease, taxpayers should be able to calculate any uplift (even a small one) to which they are entitled. There is, however, no obligation upon them to do so (e.g. if the costs of determining the appropriate amount would exceed any tax reduction obtained).

8.78 There is also a rule that ensures that the $150,000 threshold cannot be accessed inappropriately. In particular, the threshold will not apply if 2 or more direct value shifts happened under different schemes, and it is reasonable to conclude that the sole or main reason for this was to access the benefit of the threshold. [Schedule 15, item 1, subsection 725-70(2)]

Decrease must be reasonably attributable to the thing or things done under the scheme

8.79 The decrease in the market value of an interest must be reasonably attributable to the thing or things done under the scheme. This is an objective test and may be met even though the decrease was not intended. A similar nexus must exist between the thing or things done under the scheme and the increase in value (or issue at a discount) of other interests. Purely coincidental decreases and increases will not trigger the share value shifting provisions.

8.80 If the decrease (and/or increase) in market value of an interest was caused partly by doing something under the scheme and partly by some unconnected event (such as market forces), the DVS rules apply only to that part of the decrease (or increase or discount issue) that was caused by the thing done under the scheme. [Schedule 15, item 1, section 725-165]

Can there be a decrease in market value of an interest that is later extinguished under the terms of the scheme?

8.81 There can be a decrease in market value of an interest that is extinguished under the terms of the scheme. The legislation requires that at the time, or after the thing is done, interests decrease in value. In the case of a proposed cancellation or ending of an interest, the decrease in market value would generally occur at the time of the proposal, rather than when the interest ended, or it may occur immediately before the interest ends.

Does the decrease have to be permanent or everlasting?

8.82 The decrease need not be permanent or everlasting. The DVS rules may apply to certain temporary shifts in value, although a special rule is proposed to apply where a value shift reverses under the terms of the same scheme that gave rise to it.

8.83 For example, the issue of a dividend access share may, depending on factual circumstances and the particular rights attaching to the access share, cause a temporary reduction in value of other shares in the entity. The reduction in value might in certain cases persist until losses in another entity are used up, at which time, dividend flows return to normal. A temporary decrease of this kind may be sufficient to activate Division 725, however the special rule discussed previously in paragraphs 8.44 to 8.50 may apply.

Increase in market value or issue of an interest at a discount and related issues

8.84 Any equity or loan interests in an entity that are issued at a discount, and any equity or loan interests in the entity that increase in market value are referred to as up interests. [Schedule 15, item 1, subsection 725-155(2)]

8.85 The increase in market value of an up interest (or the interest issued at a discount) must be reasonably attributable to the thing or things done under the scheme in respect of which the decrease in value of the down interest was reasonably attributable. The increase must happen after the thing or first of the things is done. [Schedule 15, item 1, subsections 725-145(2) and (3)]

When is an interest issued at a discount?

8.86 An issue of an interest at a discount is, broadly speaking, the issue of the interest at a discount to market value. That is, the money or market value of property that is the payment for the interest is less than the market value of the interest at the time it is issued. Such an interest is not an ‘increased value’ interest as such, because it commences with the value greater than what was paid for it. However, in a DVS context, it is analogous to an increased value interest, because it embodies the value shifted from a ‘down interest’.

8.87 An equity interest is issued at a discount if its market value when it is issued is greater than the payment received by the issuing entity. The payment received can include property. [Schedule 15, item 1, subsections 725-150(1) and (2)]

A share is issued in return for a payment of $10. The share is worth $30 at the time of issue. The share is issued at a discount, with the discount being in this case $20.

Issue of loan interest at a discount

8.88 Broadly, the same principle that applies for an equity interest issued at a discount applies for an issue of a loan interest at a discount. A loan interest issued at a discount is one that at the time of issue has a market value greater than its face value. This would not be expected to occur frequently, but it could occur if, for example, the agreed rate of interest payable on the loan was more than the market rate for a loan of that type.

What about an interest issued at overvalue – that is, for a payment of more than its market value at the time of issue?

8.89 The issue of an interest for more than its market value at the time of issue does not cause a direct value shift to occur, because it does not cause the decrease in value of another interest. Note that in such cases, the adjustable value for the acquired interest may not be equal to the amount of the payment actually made (e.g. if the interest is not acquired in an arm’s length dealing).

Increase or discount issue reasonably attributable to the thing or things done under the scheme

8.90 The increase in market value of an interest or discount issue must be either reasonably attributable to the thing or things done under the scheme in respect of which the decrease was reasonably attributable, or it must be that thing or things.

8.91 In the case of a discount issue, the issue itself will often be the thing done under the scheme that causes the decrease. However, if the discount issue is announced, the announcement, rather than the actual issue, may be the thing in respect of which the decrease is more reasonably attributable. This will depend on the facts and when the change in market value occurs.

Interaction with other provisions

8.92 Issues arise as to the interaction of the DVS rules with other provisions in the ITAA 1936 and the ITAA 1997.

Part IVA of the ITAA 1936

8.93 Part IVA of the ITAA 1936, containing the general anti-avoidance provisions of the taxation law, is not precluded from applying to a scheme within the meaning of the DVS rules. However, the more specific rules, to the extent they do apply, would ordinarily apply in preference to Part IVA.

Share buy-back provisions: Division 16K of Part III of the ITAA 1936

8.94 In certain circumstances the DVS rules could apply to the off-market buy-back of a share at less than market value. This would happen, for example, if the shares to be bought back are shares of the controller of the company, and the decrease in value of those shares as a result of the proposed buy-back at less than market value causes an increase in value of an associate’s shares.

8.95 Under subsection 159GZZZQ(2) of Division 16K of Part III of the ITAA 1936, the deeming of market value (based on what would be the market value of the shares if the buy-back had not been proposed and did not occur) would increase the purchase price to the market value of the share for the purposes of the buy-back provisions. This would ensure that any gain reflected in the value shifted to the associate’s share would be realised under the ordinary CGT provisions. Therefore, it would be unnecessary for the DVS rules to determine the consequences in respect of the ‘decreased value share’.

8.96 To prevent double taxation if the market value rule applies to a share buy-back which resulted in a decrease in value of the shares to be bought back, the adjustable values of those shares are not reduced and there are no taxing events generating gains for them.

8.97 The value shifting provisions allow uplifts in relation to the value shifted. Uplifts to the adjustable values of shares reflect the increase in value of the shares because of the off-market buy-back. Under Division 140 of the ITAA 1997 no uplifts are available in these circumstances. [Schedule 15, item 1, section 725-230]

Interaction with the bonus interest provisions

8.98 In broad terms, the DVS rules will apply normally where bonus equities (e.g. bonus shares and bonus units) are issued at a discount to an entity in relation to original equities owned by it. However, certain of the outcomes from applying the DVS rules will be varied to take account of the effect of other provisions that deal with the issue of bonus equities. These other provisions are section 6BA of the ITAA 1936 and Subdivision 130-A of the ITAA 1997 (bonus equity provisions).

8.99 Outcomes for the original and bonus equities of an entity under the DVS rules will be varied to the extent that the direct value shift is between such equities. The effect of the DVS rules will be varied where:

• Subdivision 130-A applies, none of the bonus equities are a dividend or otherwise assessable and:

− the original equities were acquired pre-CGT and the entity was required to, and did, pay an amount for the bonus equities; and

8.101 This treatment recognises that the bonus equity provisions deal with the effect of bonus issues and it is inappropriate to allow the DVS rules to also apply. For example, in cases covered by the second of the items in the first dot point in paragraph 8.99, it would be inappropriate to allow further uplifts under the DVS rules as the cost bases of such interests have been marked to market value under the bonus equity provisions. Further rules will be included in a later bill to deal with direct value shifts between the original and bonus equities of different affected owners.

8.102 In all other cases, not covered in paragraphs 8.99 or 8.101, the DVS rules and bonus equity provisions will apply together. For example, if the bonus equity is a dividend, Subdivision 130-A includes the amount of the dividend in the cost base of the bonus equity. The cost base of the bonus equity when issued is then taken to be the payment the issuing entity receives for the issue of the bonus equity (except if the issuing entity is a corporate unit trust or public trading trust), for the purpose of working out if the bonus equity was issued at a discount. If this payment is less than the market value of the bonus equity when issued it will be an equity interest issued at a discount in terms of the DVS rules. The DVS rules can then apply if the other requirements of those rules are met. [Schedule 15, item 1, section 725-150]

8.103 A similar analysis flows where section 6BA applies to bonus shares that are dividends. If Subdivision 130-A and section 6BA apply to the same bonus share, the greater of the cost base and consideration worked out under those provisions is used to work out if the bonus equity was issued at a discount. [Schedule 15, item 1, subsections 725-150(4) and (5)]

Consequences of a direct value shift

Flow of value shifts

8.104 Earlier it was noted that DVS rules proceed on the basis that there is a direct value shift between each down interest and each up interest under a direct value shift. [Schedule 15, item 1, subsection 725-160(3)]

8.106 The direct value shift from a down interest to one of a number of up interests is taken to be a fraction of the value shifted (i.e. decrease in market value) from the down interest under the scheme. The fraction is the market value increase of the up interest because of the direct value shift over the total increase in market value of all up interests under the scheme. [Schedule 15, item 1, subsection 725-160(3)]

Which shifts in value between interests are affected?

8.107 Diagram 8.3 shows the shifts in value that can occur. Of these shifts in value, the DVS rules are concerned only with shifts between down and up interests that are owned by affected owners. That is, the provisions do not deal with value shifted to or from entities that are not affected owners (third parties in the diagram). [Schedule 15, item 1, section 725-250, items 9 and 10 in the table and section 725-335, items 10 and 11 in the table]

8.108 Entities that are not affected owners are not likely to have been actively involved in the direct value shift, or associated with entities controlling the target entity during the period of the scheme. It is not appropriate for value shifts to, or from, the interests of non-affected owners to be covered by the DVS rules.

8.109 Table 8.2 sets out direct value shifts that are covered by the DVS rules. [Schedule 15, item 1, sections 725-250 and 725-335]

*Item no.*	*Down interest owned by:*	*Up interest owned by:*
1	Controller	Controller
2	Controller	Associate of controller
3	Controller	Associate of associate of controller (if associate of controller owned down interests)
4	Controller	Active participant
5	Associate of controller	Controller
6	Associate of controller	Associate of controller
7	Associate of controller	Associate of associate of controller (if associate of controller owned down interests)
8	Associate of controller	Active participant
9	Active participant	Controller
10	Active participant	Associate of controller
11	Active participant	Associate of associate of controller (if associate of controller owned down interests)
12	Active participant	Active participant

8.110 Items 1 to 5 and 9 represent all of the direct value shifts that can occur involving a controller. The 3 cases are direct value shifts:

• from a down interest of the controller to an up interest of an associate of the controller, to an associate of an associate of the controller, or to an active participant (items 2 to 4); and

• to an up interest of the controller from a down interest of an associate of the controller or from an active participant (items 5 and 9).

8.111 These 3 shifts of value are covered by the DVS rules and will be considered later. The positions of associates of a controller and active participants, viewed from their own perspectives, are similar to that of the controller.

8.112 The consequences for down and up interests of affected owners depend upon a number of factors. The 2 main factors are:

• the character or tax character (e.g. asset held on capital account, trading stock or revenue asset) of the interests.

What happens to the interests of affected owners that are involved in a DVS scheme?

8.113 The DVS rules change the adjustable values of each down interest and up interest of affected owners to take account of the market value decreases and increases that happen under the scheme. Without such changes, inappropriate losses and gains can be made when these interests are realised.

Ken holds the 4 shares on issue in Cart Co on capital account. Ken acquired them post-CGT. Two shares are class A and the others are class B. Ken causes Cart Co to vary the rights of the A class shares so that their market value decreases. The market value of the B class shares increase because of what Ken and Cart Co did.

If Ken were to sell one of his A class shares in Cart Co after the value shift, he would make a capital loss of $50. This is inappropriate because there is no economic loss of $50 to Ken. The value has been shifted to other interests held by Ken.

On the other hand, if Ken sold one B class share, he would make a capital gain of $150. Of this gain, $50 does not represent an economic gain. This again is inappropriate.

From an economic point of view, an appropriate result is only possible if the matching gains and losses occurred at the same time. This will often not be the case under a realisation-based tax system. The DVS rules deal with value shifts such as these.

Changes to adjustable values

8.114 Changes are made to the adjustable values of interests regardless of when the affected owner acquired them. That is, the adjustable values of interests acquired before, on, or after 20 September 1985 are changed. The adjustable values of pre-CGT interests are adjusted because they may be relevant in some other places in the ITAA 1997 (e.g. section 165-115F in Subdivision 165-CC requires notional capital gains and losses to be calculated for all CGT assets, or in section 115-45 of the capital gains provisions). [Schedule 15, item 1, subsection 725-240(7)]

8.115 Increases are made to the adjustable values of up interests that are primary or secondary loan interests. It would rarely occur that the market value of a loan would exceed its face value as a result of a value shifting scheme. But it is possible, for example, if a scheme involves increasing the interest rate on a loan to well above what would be a market rate for an equivalent loan. It is also conceivable that there could be an increase in the market value of a loan if the loan was worth less than face value immediately before the shift.

Taxing events

8.116 Taxing events that generate a gain can arise where value is shifted out of certain affected owners’ down interests under a direct value shift. Such taxing events happen to each down interest individually. [Schedule 15, item 1, section 104-240, paragraphs 725-310(1)(c) and 725-320(1)(c)]

Relevance of who owns the interests

8.117 The ownership of down interests and up interests is relevant in determining the consequences for those interests under the DVS rules.

8.118 A direct value shift between a down interest and an up interest of the same character (asset held on capital account, trading stock or revenue asset), and owned by the same affected owner, is generally treated in a different way from a shift from that owner’s down interest to an up interest of another affected owner. A shift in value between the same affected owner’s interests that have different characteristics (e.g. revenue asset ‘down interest’ to a trading stock ‘up interest’) is also treated differently.

What cases receive disposal and roll-over treatment?

8.119 If value is shifted between down interests and up interests of the same character, and these are owned by the same affected owner, roll-over treatment (i.e. effectively transfer of some adjustable value) happens. Changes are made to the adjustable values of the owner’s interests and there are no taxing events generating a gain. Roll-over treatment ensures that inappropriate gains or losses do not arise when these interests are later realised.

8.120 Roll-over treatment is appropriate as the affected owner maintains ‘ownership’ of the value shifted (which keeps its character) from its down interest to its up interest. The decrease and increase in the market values (or discounts given) of the affected owner’s interests in the target entity reflect the direct value shift and the interests’ adjustable values are changed correspondingly.

8.121 Effective disposal treatment applies to all direct value shifts between down interests and up interests that do not receive roll-over treatment. The most common examples are where:

• value shifts between a down interest and an up interest owned by an affected owner, and the interests have different characteristics;

• a down interest is owned by an affected owner and value is shifted to an up interest of another affected owner; or

• an up interest is owned by an affected owner and value is shifted to that interest from another affected owner’s down interest.

8.122 Disposal treatment changes the adjustable values of relevant interests in a similar way to roll-over treatment, except that uplifts may be higher to reflect the fact that value has already been taxed. In addition, taxing events generating a gain can happen. No losses are deemed to arise as a result of a direct value shift.

When roll-over treatment does not apply?

8.123 There are a number of situations where roll-over treatment does not apply to direct value shifts between down and up interests that are owned by the same affected owner.

8.124 One of these situations is where an affected owner owns down and up interests of different characters (e.g. some shares are held as capital assets and some are held as trading stock) and value is shifted between them.

8.125 In these cases, the character of the value shifted can be changed (e.g. revenue gains can be converted to discounted capital gains). It is appropriate to bring to account any gains on the transfer (disposal treatment). [Schedule 15, item 1, section 725-245, items 2 and 3 in the table and section 725-335, items 2 and 4 in the table]

What is disposal treatment?

8.126 How reductions are made to the adjustable values of down interests under the disposal treatment depends on whether there is a pre-shift gain or loss on the down interest. [Schedule 15, item 1, subsection 725-210(1)]

8.127 A down interest has a pre-shift gain if its market value is greater than its adjustable value, immediately before the decrease time. Similarly, there is a pre-shift loss if the market value of the down interest is the same as, or less than, its adjustable value immediately before the decrease time. [Schedule 15, item 1, subsections 725-210(2) and (3)]

8.128 It is necessary to work out if there is a pre-shift gain or loss on an interest using both its cost base and reduced cost base as the adjustable value. This is so that appropriate reductions can be worked out for the cost base and reduced cost base adjustable values of a down interest. For example, if the pre-shift market value of the down interest is less than the cost base of the interest, but greater than its reduced cost base, there will be a pre-shift loss relevant to the cost base and a pre-shift gain for reduced cost base [Schedule 15, item 1, paragraphs 725-240(6)(c) and (d)]. If the interest is trading stock or a revenue asset, the relevant adjustable values for these attributes must also be used [Schedule 15, item 1, sections 725-315 and 725-325].

8.129 Disposal treatment ensures that the adjustable value of a down interest with a pre-shift gain is reduced by reference to the proportion of the pre-value shift adjustable value of the down interest that relates to the value shifted from the down interest to an up interest. The amount of the reduction can be thought of as the adjustable value that would have been used in calculating a gain or loss on a direct value shift from a down interest to an up interest if the shift in value were a taxing event at the decrease time. [Schedule 15, item 1, section 725-365, step 3 in the method statement]

8.130 The value shifted from the down interest to the up interest is the proportion of the decrease in market value of the down interest under the value shift to the up interest. The proportion is the increase in market value (or discount given) of the up interest to the sum of the increases in market value of, and discounts given on, all up interests. [Schedule 15, item 1, section 725-365, step 2 in the method statement]

An affected owner, Alf, has, on capital account, 3 post-CGT down interests of the same class each with a pre-shift adjustable value of $1 million and pre-shift market values each of $2 million. There is a direct value shift of $2 million in total from these interests to a different class of interests, 2 of which are held by another affected owner, Betty, and 2 that are not so held. (These are the only interests on issue). These 4 interests increase in market value from $4 million to $6 million in total (or to $1.5 million each).

The value shifted from the interests of Alf to those of Betty according to step 2 in the method statement in section 725-365 is $1 million.

$2 million (sum of market value decreases) × $1 million (sum of increases for affected owners) ÷ $2 million (sum of increases for all owners).

The notional adjustable value of the value shifted from Alf’s interests to Betty’s is $0.5 million.

$3 million (sum of Alf’s pre-shift adjustable values) × $1 million (value shifted to Betty’s interests) ÷ $6 million (pre-shift market value of Alf’s interests).

The decrease in adjustable value for each of Alf’s down interests would be (step 4 in the method statement) $0.5 million ÷ 3 = $0.166667 million for each interest.

Alf would also have a taxable gain under step 5 of $0.166667 million on each interest (total $0.5 million).

8.131 It is important to note that the market value effect of factors other than those causing the direct value shift need to be disregarded when working out decreases and increases in market values of interests under the scheme. [Schedule 15, item 1, section 725-165]

8.132 Broadly, where there is a pre-shift loss on a down interest, the adjustable value of the interest is reduced on the basis of the value shifted to each up interest [Schedule 15, item 1, section 725-380]. This treatment ensures that pre-value shift losses are not inappropriately removed (as may be the case if the rule for gains, which reduces adjustable value proportionately to the value shifted, were used).

An interest has a pre-shift adjustable value (reduced cost base) of $600, a pre-shift market value of $400, and a $200 market value is shifted from the interest to that of a different affected owner. The adjustable value (reduced cost base) is reduced by $200 and not by $200 ÷ $400 × $600 = $300. This appropriately preserves the pre-value shift loss on the interest.

8.133 The increase to the adjustable value of an up interest is made taking into account the value shifted to that interest from a down interest. The increases calculated in this way approximate what the value shifted would have cost the affected owner if it acquired the value shifted at its market value. [Schedule 15, item 1, section 725-370, steps 2 and 3 in the method statement and section 725-375, step 2 in the method statement]

Considering the position of Betty in Example 8.7, and applying the method statement in section 725-375, the value shifted to Betty’s interests is $1 million as follows:

Applying step 2: $1 million (market value increases) × $2 million (sum of decreases in market value of down interests) ÷ $2 million (total value of the direct value shift).

The increase in adjustable values for each of Betty’s 2 interests is $1 million ÷ 2 = $500,000 (step 3).

8.134 The value shift relevant for working out the increase to the adjustable value of an up interest depends upon whether the sum of the decreases in market value of all down interests because of the scheme is greater than, equal to, or less than the sum of the increases in market value of, and discounts given on, all up interests. [Schedule 15, item 1, section 725-375, step 2 in the method statement]

8.135 Generally, an increase to the adjustable value of an up interest will reflect the increase in market value of the interest because of the direct value shift from a down interest.

8.136 However, the above approach ensures that an increasing adjustment cannot exceed the direct value shift from the down interest. In some cases, the increase can be less than the direct value shift from the down interest.

8.137 This happens where the decreases in market values of the down interests relating to the thing done under the scheme are greater than the increases in market values of, and discounts given on, the up interests. In such cases the increase to adjustable values for the up interest should not exceed the increase in its market value because of the direct value shift.

8.138 It should be noted that an uplift to the adjustable value of an up interest can only be made to the extent that the increase in market value is reflected in the interest at a later time.

• for an interest held on capital account – the time a CGT event happens to it [Schedule 15, item 1, subsection 725-240(5)];

− when the interest is disposed of, if it happens in the income year the increase time happens in;

− at the end of income years where the closing value of trading stock is worked out at cost;

− when the interest is disposed of in the income year in which the increase time happens, or in a later income year if the closing value of trading stock for the previous year was at cost; [Schedule 15, item 1, subsection 725-310(4)] and

• for an interest held on revenue account – the time when it is disposed of or otherwise realised [Schedule 15, item 1, subsection 725-320(4)].

8.140 Taxing events generating a gain can happen in disposal treatment cases where a down interest has a pre-shift gain. This occurs if value is shifted between the interests of different affected owners, or if the interests are owned by the same affected owner but have different characteristics.

8.141 In such cases, the transfer of value from the owner of the down interest is treated as if it were a disposal of the value to the holder of the up interest. Any gains (CGT, trading stock or revenue) are included in assessable income.

8.142 Gains are generally worked out with regard to the difference between the amount of the value shifted and the portion of the adjustable value of the down interest relating to the value shifted. [Schedule 15, item 1, section 725-365, step 5 in the method statement]

What is roll-over treatment?

8.143 Reductions to the adjustable values of down interests are made with reference to the proportion of the adjustable value that relates to the value shifted in pre-shift gain cases, and to the value shifted in pre-shift loss cases. This is the same as disposal treatment. [Schedule 15, item 1, section 725-365, steps 1 to 4 in the method statement]

Returning to Example 8.7, assume that Alf held the interests previously referred to as being owned by Betty, and assume that he held them on capital account and they are post-CGT up interests. The same reduction in adjustable value of Alf’s decreased value shares as calculated for the disposal case (to Betty) would occur for the transfer to his other shares. There would, however, be no taxing event because value has simply moved between interests held by the same person.

8.144 How the increase to the adjustable value of an up interest is worked out depends upon whether the down interest from which the value is shifted has a pre-shift gain or not. If the down interest has a pre-shift gain, any increase is with regard to the proportion of the down interest’s adjustable value that relates to the value shifted [Schedule 15, item 1, section 725-370, step 3 in the method statement]. In pre-shift loss cases, the increase is on the basis of the value shifted [Schedule 15, item 1, section 725-375, step 3 in the method statement].

Continuing Example 8.10, the increase to the adjustable value of Alf’s shares (that increased in value by $1 million) is calculated using the method statement in section 725-370. The increase in adjustable value is:

8.145 Changes to the adjustable values of interests in a pre-shift loss roll-over case will be less than the changes that will arise if the pre-shift gain method is used. This is because in pre-shift loss cases the portion of the adjustable value relating to the value shifted is always greater than the value shifted.

8.146 Allowing changes to be made using the higher amounts will effectively allow unrealised losses to be transferred between interests under the roll-over treatment. [Schedule 15, item 1, section 725-380, steps 2 and 3 in the method statement]

8.147 The detailed Example 8.12 at the end of this chapter covers disposal and roll-over cases.

Effect of the character of the down and up interests

8.148 The consequences of a scheme for down interests and up interests also depends on the character of the interests. That is, on whether they are held solely on capital account, or are trading stock or revenue assets. [Schedule 15, item 1, subsection 725-205(1)]

8.149 The most common case is where all of an affected owner’s down and up interests are held on capital account at the decrease or increase time (or time of issue) for each interest. For this reason, there are specific rules in the DVS provisions (Subdivision 725-D – see section 725-240) to deal with the CGT consequences for these interests. [Schedule 15, item 1, note to subsection 725-205(2)]

8.150 Separate rules (Subdivision 725-E) exist for the less common situation where one, or more, of the down or up interests of an affected owner are held as trading stock or revenue assets at the decrease or increase time for each interest. These rules deal with the trading stock and revenue asset consequences of the direct value shift for these interests. [Schedule 15, item 1, note to subsection 725-205(2)]

8.151 The DVS rules and tables are structured in this way to help simplify the presentation of the law.

8.152 The rules for interests which are held as trading stock or revenue assets will not be relevant for most affected owners holding down interests or up interests because their interests will be held on capital account.

*Direct value shift between:*	*CGT consequences for you are covered by:*	*Revenue consequences for you are covered by:*
*Down interest*	*Up interest*
Your – CGT	Your – CGT	Tables in sections 725-245 and 725-250 (Subdivision 725-D)
Others	Your – CGT	Table in section 725-250 (Subdivision 725-D)
Your – CGT	Others	Tables in sections 725-245 and 725-250 (Subdivision 725-D)
Your – revenue	Your – revenue	Table in section 725-250 (Subdivision 725-D)	Table in section 725-335 (Subdivision 725-E)
Your – revenue	Your – CGT	Tables in sections 725-245 and 725-250 (Subdivision 725-D)	Table in section 725-335 (Subdivision 725-E)
Your – CGT	Your – revenue	Tables in section 725-245 and 725-250 (Subdivision 725-D)	Table in section 725-335 (Subdivision 725-E)
Other	Your – revenue	Table in section 725-250 (Subdivision 725-D)	Table in section 725-335 (Subdivision 725-E)
Your – revenue	Other	Tables in sections 725-245 and 725-250 (Subdivision 725-D)	Table in section 725-335 (Subdivision 725-E)

• Your – CGT is an interest of an affected owner that is neither trading stock nor a revenue asset;

• Your – revenue is an interest of an affected owner that is trading stock or a revenue asset; and

8.154 The character of other affected owners interests are not relevant to how an affected owner’s (your) interests are dealt with under the DVS rules. This is because direct value shifts to, or from, other owners receive disposal treatment. Character is only relevant for direct value shifts between interests of the same owner in working out if roll-over or disposal treatment should apply.

CGT consequences of the DVS scheme

8.155 Subdivision 725-D contains tables that specify the CGT consequences of the DVS scheme. [Schedule 15, item 1, sections 725-245 and 725-250]

8.156 The tables apply from the perspective of an affected owner (you) with a down interest or up interest. One table outlines when to work out changes to adjustable values [Schedule 15, item 1, section 725-250]. Another table outlines when there will be taxing events generating a gain [Schedule 15, item 1, section 725-245]. The methods for working out the changes to adjustable values and the gains are covered in Subdivision 725 F.

8.157 The tables reflect the fact that there can be direct value shifts from a down interest to a number of different up interests under a DVS scheme. The possible direct value shifts that can happen between the interests of affected owners are listed in the table in section 725-250. [Schedule 15, item 1, section 725-250]

• the cost bases and reduced cost bases of up interests can be increased; and/or

8.159 There may be a number of consequences for a down interest or an up interest under a DVS scheme. For example, where there are direct value shifts from an affected owner’s down interest to its own up interest, and to another affected owner’s up interest, the adjustable value of the down interest will be reduced with regard to 2 amounts (relating to each of the value shifts).

8.160 There may also be one or more tax events generating a gain for the down interest. Multiple changes to adjustable value and taxing events generating a gain can happen to the same interest under a DVS scheme. The change to the adjustable value is the total of the reductions or increases in such cases. [Schedule 15, item 1, subsections 725-255(2) and (3)]

8.161 As noted in paragraph 8.71, a down interest is only affected by the DVS rules if there is a material decrease in its market value. [Schedule 15, item 1, section 725-70]

8.162 The changes to adjustable values and taxing events generating a gain outlined in the table generally reflect the roll-over and disposal treatments. The relevant treatments where all interests are held on capital account are summarised in Table 8.4.

*Affected owner of CGT down interest:*	*Affected owner of CGT up interest:*	*Treatment*
You – pre-shift gain • pre-CGT asset • post-CGT asset	You • pre-CGT asset • post-CGT asset	Roll-over *[Schedule 15, item 1, section 725-250, items 1 and 2 in the table]*
You – pre-shift gain • pre-CGT asset • post-CGT asset	You • post-CGT asset • pre-CGT asset	Disposal^[1] *[Schedule 15, item 1, section 725-250, items 3 and 4 in the table; Schedule 15, item 1, section 725-245, item 1 in the table]*
You – pre-shift loss	You	Roll-over *[Schedule 15, item 1, section 725-250, item 5 in the table]*
You – pre-shift gain	Other	Disposal^[2] *[Schedule 15, item 1, section 725-250, item 6 in the table; Schedule 15,* *item 1, section 725-245, item 4 in the table]*
You – pre-shift loss	Other	Disposal^[3] *[Schedule 15, item 1, section 725-250, item 7 in the table]*
Other	You	Disposal^[4] *[Schedule 15, item 1, section 725-250, item 8 in the table]*

8.163 If the adjustable value of an asset held on capital account is to be changed under these provisions, then both the cost base and reduced cost base of the asset must be adjusted. The table in section 725-250 is applied twice, once on the basis that the adjustable value is cost base and also with the adjustable value being reduced cost base. [Schedule 15, item 1, subsections 725-240(3) and (4)]

8.164 The gain for a taxing event that happens to a down interest that is an asset held on capital account is worked out using the cost base of the asset as the adjustable value [Schedule 15, item 1, subsection 725-240(2)]. Any gain from this taxing event is a capital gain (under CGT event K8, see section 104-240 of the ITAA 1997).

8.165 The timing of changes to adjustable values and taxing events generating a gain are listed in Table 8.5. [Schedule 15, item 1, subsections 104-240(2), 725-240(3) and (4)]

*Change or event*	*Time it takes place*
Decrease in the cost base and reduced cost base of a down interest.	At the decrease time for the interest.
Increase in the cost base and reduced cost base of an up interest that increases in market value because of the direct value shift.	At the increase time for the interest.
Taxing event generating a gain for a down interest.	At the decrease time for the interest.

Consequences for trading stock or revenue assets

8.166 The consequences of a direct value shift between a down interest and an up interest, at least one of which is trading stock or a revenue asset, are dealt with in a similar way to that just discussed for assets held on capital account. The same interest can have a number of adjustable value changes or taxing events. [Schedule 15, item 1, subsections 725-240(1), 725-310(1) and 725-320(1) and section 725-340]

8.167 If an interest is trading stock the adjustable values which are changed are the cost base, reduced cost base and Division 70 (ITAA 1997) value or cost of the interest. The Division 70 value or cost of an interest is, at a particular time:

• its trading stock value at the start of the income year in which the particular time occurs – if the interest was trading stock of its owner since the start of that year; or

8.168 For interests that are revenue assets, their cost bases, reduced cost bases and ‘revenue asset’ costs are relevant. Revenue asset cost is a revenue asset’s cost at a point in time. It is the sum of amounts that would be subtracted from the gross disposal proceeds in working out any profit or loss that would be made if the revenue asset interest were disposed of at the point in time. This applies for the adjustable values of down interests and up interests whose market value increases because of the direct value shift [Schedule 15, item 1, subsections 725-325(1) and (2)]. The revenue asset cost for up interests issued at a discount is the consideration paid for the interest [Schedule 15, item 1, subsection 725-325(3)].

8.169 Of the above adjustable values, only the reduced cost base is not relevant in determining if there is a gain from taxing events.

8.170 The table and other rules in section 725-335 deal with direct value shifts between down and up interests, where one or more of the affected owner’s interests are trading stock or revenue assets. The section deals with the trading stock and revenue asset consequences of the direct value shift. Each possible shift in value between the interests of affected owners is covered. The consequences of each shift are specified. Again, roll-over and disposal treatments apply as appropriate to the different direct value shifts.

8.171 The tables in Subdivision 725-D are still applied to determine the CGT consequences of the direct value shift. There can be different CGT consequences to those outlined in paragraphs 8.155 to 8.165 where one or more of the interests has a revenue asset or trading stock character.

8.172 One of the main differences between the table in Subdivision 725-D and the approach in section 725-335 is the way changes to CGT adjustable values are made for some direct value shifts between the down interests (with pre-shift gains) and up interests of the same affected owner.

8.173 Where all interests are held on capital account, value shifts between CGT down and up interests, which are either both post or pre-CGT assets, get roll-over treatment. [Schedule 15, item 1, section 725-250, items 1 and 2 in the table]

8.174 Where one of these interests is trading stock or a revenue asset there is disposal treatment (for CGT, trading stock and revenue asset adjustable values). [Schedule 15, item 1, section 725-245, items 2 and 3 in the table and section 725-250, item 4 in the table]

8.175 This change to the CGT treatment aligns any CGT and revenue asset gains, which arise from taxing events (section 118-20 of the ITAA 1997 applies to stop the same gain being assessed twice). If this were not done difficulties would arise in tracking when capital and revenue gains are made and by whom. This ensures that the same economic gain is only taxed once.

8.176 Another consequence of CGT disposal treatment applying is that, for pre-shift gain cases, a taxing event will happen where the down interest is trading stock. Section 118-25 of the ITAA 1997 disregards capital gains on trading stock.

8.177 Other differences in CGT treatment arise if there is a direct value shift between an affected owner’s down interests (that have pre-shift gains) and up interests, both of which are either trading stock or revenue assets. The differences are shown in Table 8.6.

*Value shift*	*Up and down interests both held on capital account*	*Up and down interests both trading stock or revenue assets*
Post-CGT down interest to post-CGT up interest	CGT roll-over *[Schedule 15, item 1, section 725-250, item 1 in the table]*	CGT roll-over *[Schedule 15, item 1, section 725-250, item 1 in the table]* Revenue/trading stock roll-over *[Schedule 15, item 1, section 725-335, item 1 in the table]*
Pre-CGT down interest to pre-CGT up interest	CGT roll-over *[Schedule 15, item 1, section 725-250, item 2 in the table]*	CGT roll-over *[Schedule 15, item 1, section 725-250, item 2 in the table]* Revenue/trading stock roll-over *[Schedule 15, item 1, section 725-335, item 1 in the table]*
Post-CGT down interest to pre-CGT up interest	CGT disposal *[Schedule 15, item 1, section 725-245, item 1 in the table and section 725-250, item 4 in the table]*	CGT roll-over *[Schedule 15, item 1, section 725-250, item 1 in the table]* Revenue asset/trading stock roll-over *[Schedule 15, item 1, section 725-335, item 1 in the table]*
Pre-CGT down interest to post-CGT up interest	Disposal *[Schedule 15, item 1, section 725-250, item 3 in the table]*	CGT disposal *[Schedule 15, item 1, section 725-250, item 3 in the table]* Revenue asset/trading stock roll-over *[Schedule 15, item 1, section 725-335, item 1 in the table]*

8.178 The CGT treatment change for the post-CGT to pre-CGT scenario ensures that the benefit of the roll-over at the revenue level is not removed because a capital gain arises. The approach also aligns the time when any gains will be made.

8.179 In the pre-CGT to post-CGT case, the adjustable values for CGT purposes receive disposal treatment and roll-over treatment is given to the revenue asset’s adjustable value. This ensures that the pre-CGT gain transferred under the direct value shift is not taxed as a capital gain when the up interest is realised. No taxing event generating a gain arises on the direct value shift itself.

8.180 The adjustable values for trading stock that are changed under the table in section 725-335 are listed in Table 8.7. [Schedule 15, item 1, section 725-315]

*Interest*	*Adjustable value immediately before the decrease or increase time*
Down interest	• interest’s value as trading stock at the start of the income year – where the interest is trading stock of the owner from the start of the income year in which the decrease time occurs; or • interest’s cost – in all other cases.
Up interest	• interest’s value as trading stock at the start of the income year – where the interest is trading stock of the owner from the start of the income year in which the increase time occurs; or • interest’s cost – in all other cases.

8.181 The above values are adjusted by the amounts worked out applying the table in section 725-335. The method for achieving the change to adjustable value where the interest is trading stock is to treat the interest as having been sold and bought back. [Schedule 15, item 1, section 725-310]

8.182 The affected owner is treated as if they had sold the down interest that is trading stock to a third party, at arm’s length and in the ordinary course of business, for its adjustable value immediately before the decrease time. The owner is then taken to have bought back the interest for its adjustable value, as reduced by the total of the amounts worked out by applying the section 725-335 table. This happens immediately after the decrease time. [Schedule 15, item 1, subsection 725-310(2)]

8.183 A similar method is used to increase the adjustable values of an up interest that is trading stock. No assessable or deductible amounts arise for trading stock purposes as a result of the sale and repurchase. [Schedule 15, item 1, subsection 725-310(3)]

8.184 If there is an earlier direct value shift in the income year that affected the same trading stock interest, the interest’s adjustable value for the later value shift is its cost (being the reduced or increased adjustable value after the earlier direct value shift). [Schedule 15, item 1, note to section 725-315]

8.185 The method for changing the adjustable values of revenue assets is similar to that for trading stock. One important difference is that the asset retains its character as a revenue asset from the time it is bought back. [Schedule 15, item 1, subsections 725-320(2) and (3)]

8.186 If an item of trading stock or a revenue asset that is a down interest has a tax event generating a gain, the affected owner must include the gain in its assessable income. The gain is assessable income of the year in which the decrease time happens. [Schedule 15, item 1, subsection 725-335(4); Schedule 15, item 1, subsection 725-310(5)]

8.187 Gains are calculated, depending on the character of the down interest, with regard to cost base, Division 70 value or cost and revenue asset cost. Where a capital gain and revenue asset gain arise for the same DVS, section 118-20 of the ITAA 1997 applies to prevent the same amount being taxed twice. A capital gain that arises on a trading stock down interest is disregarded under section 118-25 of the ITAA 1997.

Neutral direct value shifts

8.188 The consequences of a direct value shift between a down and up interest are different for shifts that are neutral for an affected owner.

8.189 This will be the case where the total of the decreases in market value of the affected owner’s down interests is equal to the sum of the total of the increases in market value of the owner’s up interests and the total of discounts received by the owner on the issue of up interests to it. [Schedule 15, item 1, section 725-220]

8.190 The consequences change because the tables in Subdivisions 725-D and E are applied as if the only down or up interests that exist are those held by the particular affected owner. This results in the direct value shift only being between that owner’s down and up interests.

8.191 Under Division 140 of the ITAA 1997 this treatment was only available where the direct value shifts of all affected owners under the DVS scheme were neutral (see section 140-50 of the ITAA 1997). Now this treatment can apply on an affected owner by affected owner basis.

How to work out the amount of changes to adjustable values and gains from taxing events

8.192 Subdivision 725-F contains method statements to work out changes to adjustable values and gains. The nature and type of calculations have already been discussed.

8.193 Increases and decreases to adjustable values and gains must be worked out for each affected interest. A group approach is used to reduce the number of calculations that must be performed in many cases.

8.194 The group approach requires groups of down and up interests with the same attributes to be identified. Relevant attributes that the interests in a group may have include the same adjustable value, the market value of the interests increased or decreased by the same amount under the direct value shift. [Schedule 15, item 1, section 725-365, step 1 in the method statement]

8.195 Where each member of a group has the same attributes, the formulae in the method statements can apply as if there was a direct value shift between one down interest and another up interest. The result of these calculations are then divided by the number of interests in the group to arrive at the relevant amount of adjustment or gain for individual interests. [Schedule 15, item 1, section 725-365, step 4 in the method statement]

8.196 This approach sits somewhere between the previous approaches in Division 19B of the ITAA 1936 (interest by interest approach) and Division 140 of the ITAA 1997 (average effects of the value shift).

8.197 The individual interest approach in Division 19B can result in inaccurate or inappropriate results in some cases, unless calculations are done to several decimal places.

8.198 On the other hand, Division 140 can average the value shift effects over interests whose market values are affected to different extents. The group approach appropriately allows averaging within groups of like interests, and takes account of different market value effects of the direct value shifts between different groups of interests.

Les is the only controller of XYZ Co, a prosperous and ever-growing firm. XYZ Co was incorporated on 12 February 1988. The share structure of XYZ Co is as follows.

There are 50 on issue and they give preferential rights to capital over B class shares. Les has 40 of these. Andrew also has 5 shares and 5 are held by Peter. Andrew has been an associate of Les’s for many years. Peter has never been an associate of Les or Andrew. Andrew is a trader in shares and his shares are trading stock of his business.

These have no rights to capital, but are preferential as to dividends over A and B. There are 10 of these on issue to Les.

Les has always held his shares on capital account. Andrew, Peter and Les all acquired their shares some years ago and still hold them after the share rights are varied.

Les alone causes XYZ Co to vary the share rights attaching to the A, B and C class shares so that their market values alter. The effects of the value shift are not expected to reverse.

• there are decreases in the market value of A and C class shares in XYZ Co that are reasonably attributable to what Les did under the scheme (down interests); and

• there are increases in the market value of B Class shares in XYZ Co that are reasonably attributable to what Les did under the scheme.

There will be consequences for affected owners of down and up interests in XYZ Co because:

The affected owners, for whom adjustments of adjustable values and taxing events (where relevant) may apply are as follows:

• Les is an affected owner of down interests (A class shares, C class shares), as he is a controller of XYZ Co during the scheme period;

• for the same reason, he is an affected owner of up interests (B class shares); and

• Andrew is an affected owner of down interests as he is an associate of the controller (Les) during the scheme period.

Peter is not an associate of Les, or an associate of Andrew (he is an associate of Les who holds down interests). As the scheme has been implemented by the sole acts of Les, it can be concluded that Peter is not an active participant. Therefore, Peter is not an affected owner, and the up interests and down interests held by him will not be adjusted under Division 725. Adjustments will also not be made for value shifts between the interests held by Les or Andrew and those held by Peter.

Only Subdivision 725-D applies here because none of Les’s interests is trading stock or a revenue asset.

The down interests held by Les (A class and C class shares) will be subject to changes in adjustable value for the value shifted to his up interests (B class shares) (section 725-250, item 1 in the table). As the 2 classes of shares do not have the same adjustable values, a separate application of the method statement in section 725-365 will be required for each group.

The decrease to the adjustable value of each of Les’s A class shares is $10 ($400 / 40 shares). The cost base (and reduced cost base) of each A Class share is reduced by $10 to $90.

The decrease to the adjustable value of each of Les’s C class shares is $86.67 (866.67 ÷ 10 shares). The cost base (and reduced cost base) of each C class share is reduced by $86.67 to $113.33.

No adjustments will be required for the shift to the B class shares held by Peter, as Peter is not an affected owner under the scheme (section 725-250, item 9 in the table).

It is important to note that this is not a neutral value shift for Les, as the total increase in market value of interests held by him,
(50 × $14,000 = $700,000) does not equal the total decrease in market value of his down interests,
((40 × $2,000) + $1.3 million = $1.38 million).

Reductions to the adjustable value of a down interest are made at the decrease time.

As above, only Subdivision 725-D applies here. To work out the adjustment to Les’s up interests (B class shares), work out the increases for the value shifted from Les’s A and C class shares, and for the value shifted from Andrew’s A class shares.

To work out the shift from Les’s A and C class shares use the method statement in section 725-370.

To work out the shift from Andrew’s A class shares, the method statement in section 725-375 applies.

Therefore, the cost base (and reduced cost base) of each B class share held by Les is increased by $125.33 ($25.33 + $100) to $225.33.

As Andrew’s down interests are trading stock, the shift from those interests to the up interests held by Les will have both CGT and revenue consequences (Subdivisions 725-D and E). (As before, there are no consequences under the Division for the shift to up interests held by Peter). This is a disposal case.

There will be an adjustment to the adjustable value of Andrew’s A class shares for the shift to Les’s B Class shares (section 725 –250, item 6 in the table). The adjustment is worked out under section 725-365:

The decrease to the adjustable value of each of Andrew’s A class shares is $10 per share ($50 ÷ 5 shares). The cost base (and reduced cost base) of each of Andrew’s shares is reduced by $10 to $90.

There is also a taxing event for the shift. The amount of the gain for each share under CGT event K8, worked out under step 4
(($5,000 – $50) ÷ 5 shares) equals $990. As the interests are trading stock, the CGT provisions will apply to disregard the gain (refer to section 118-25).

Trading stock value adjustments, and a taxing event generating a gain, will apply to the shift (section 725-335, item 7 in the table). The amount of the adjustment, as well as the amount to be included in assessable income are worked out under section 725-365. Applying the method statement, the adjustable value under Division 70 of the ITAA 1997 of each of Andrew’s A class shares will be reduced $10 to $90, and the amount to be included in assessable income will be $990 (($5,000 – $50) ÷ 5 shares) per share. The gains will be included in the assessable income of the year in which the decrease time happens.

For trading stock purposes, Andrew will be treated as if he sold each of his A class shares for their pre-shift adjustable value ($100 per share) and repurchased them for their reduced adjustable value ($90 per share). This is the method for adjusting the adjustable values of trading stock under Subdivision 725-E.

The application of the method statement provides the same adjustments (capital and revenue) in this case because the cost base, reduced cost base and Division 70 value are the same. Where this is not the case different adjustments will be made to the different attributes.

All increases to adjustable values of up interests are made to the extent that the increase is reflected in the market value of the interest when a CGT event, or various other things, happen to the interest (e.g. subsection 725-240(5)).

Application and transitional provisions

Consequential amendments

8.200 There are a number of consequential amendments. A discussion of these is included in Chapter 12.

Chapter 9
Direct value shifting by creating a right over a non-depreciating asset

Outline of chapter

9.1 This chapter explains the consequences under new Division 723 where an underlying asset is realised at a loss, the loss is partly or wholly attributable to the existence of a right created over the asset in an associate, and the creation of the right was not itself fully brought to tax. This chapter explains amendments contained in Schedule 15 to this bill.

Context of reform

9.2 Recommendation 6.14 of A Tax System Redesigned recognises that value shifting can occur where rights are created over an underlying asset.

9.3 If a right is created over an underlying asset in a related party (e.g. an associate) and either no consideration, or less than market value consideration, is received for the right, current tax law does not universally require that the market value of the right be used to determine the tax consequences of the creation.

9.4 For example, CGT event D1 (section 104-35 of the ITAA 1997) does not have the effect that capital proceeds equal to market value are taken to have been received in circumstances where a right over an underlying asset is created in an associate and no capital proceeds are actually received in return for the right. Also, if a lease is granted and the lease premium for CGT event F1 is less than the market value of the lease, the market value substitution rule in the CGT provisions does not deem the market value to have been received (see section 116-25).

9.5 In certain circumstances, a right created over the asset may have reduced its market value, allowing it to be realised (e.g. disposed of) for a lower price than would have been received but for the creation and continuing existence of the right. In such a case, the realisation of the asset may lead to a loss that would not have arisen on the realisation of the underlying asset had the right not existed. It may also lead to a larger loss.

9.6 In circumstances where the current tax rules do not assess the creator of the right on its market value (less applicable costs), it is inappropriate that a loss or increased loss can be obtained on the realisation of the underlying asset because of the continued existence of the right.

Summary of new law

9.7 Broadly, if a right over an underlying asset (not being a depreciating asset) is created in an associate of the creator without realising the underlying asset in part, and the consideration for the right as calculated for tax purposes is less than its market value by more than $50,000, there may be consequences under new Division 723 if the underlying asset is realised (in full or in part) at a loss because of the right. The Division does not apply if the right was created upon death of the owner of the underlying asset, or is a conservation covenant over land.

9.8 There will only be consequences if, just before the time of realisation of the underlying asset at a loss, the right is still in existence and held by an associate of the entity realising the underlying asset. Broadly, any loss on realisation of the underlying asset:

• for an entity that acquired the asset from the creator of the right as a result of a roll-over, or series of roll-overs, for which, or for each of which, the transferor and transferee were associates,

• the extent to which the right suppresses the market value of the underlying asset at realisation; and

• the difference (if any) between the market value of the right when it was created and the consideration given for it at that time for tax purposes.

9.9 To prevent double taxation, the decrease amount is itself reduced by a gain realised for tax purposes (other than a disregarded gain) on the right before, at, or within 4 years after realisation of the underlying asset. The amount must be realised by an entity that was an associate of the entity realising the underlying asset just before the time of realisation. There are similar consequences where the underlying asset is realised at the same time the right is granted.

Comparison of key features of new law and current law

*New law*	*Current law*
Can prevent or reduce a loss on the full or part realisation of an underlying asset in circumstances where some or all of the loss arises because a right in an associate was created over the asset. This will only happen if the market value of the right exceeds the taxable proceeds for the right by more than $50,000. Can also prevent or reduce a capital loss on the realisation of replacement assets for the underlying asset acquired under CGT roll-overs (or where the replacement assets are themselves rolled over).	A loss is not prevented or reduced on the realisation of an underlying asset to the extent a right created in an associate over the asset suppresses the market value of the asset at the time of realisation.

Detailed explanation of new law

Scope of Division 723

9.10 Division 723 may have consequences for a loss that would otherwise have been made on realisation (in whole or in part) of an underlying asset that is not a depreciating asset, where a right is, or has been, created by the owner of the asset in an associate. The Division may be attracted if the consideration given by the associate was less than the market value of the right and the existing tax law has not, or does not, deem the owner to have received market value consideration for creating the right. The Division may also have consequences for a loss that would otherwise have been made on realisation of replacement interests in some cases if the underlying asset is, or has been, subject to CGT roll-over, or if those replacement interests have themselves been subject to CGT roll-over.

9.11 The main purpose of the Division is, broadly, to reduce a loss that would otherwise be made for tax purposes on realisation of an underlying asset where the loss is attributable (in full or in part) to value shifted out of the underlying asset by the creation of the right, and the value has not been brought to tax either when the right was created or subsequently on realisation of the right. [Schedule 15, item 1, subsection 723-1]

9.12 Division 723 has a de minimis rule which requires that the difference between the consideration for tax purposes and the market value of the right when created must exceed $50,000 for the Division to apply [Schedule 15, item 1, paragraphs 723-10(1)(f) and 723-15(1)(d)]. This is subject to an exception where it is reasonable to conclude that multiple rights are created to take advantage of the $50,000 threshold [Schedule 15, item 1, section 723-35].

9.13 The Division will not apply where the right created is a conservation covenant, or, broadly, where a right is created on the death of the asset’s owner. [Schedule 15, item 1, subsections 723-20(1) and (2)]

9.14 Division 723 will also not apply where the creation of the right effects a part realisation or disposal in part of the underlying asset, or where a more specific provision of the tax law treats the granting of the right as a disposal of the underlying asset (e.g. CGT event F2, section 104-115 of the ITAA 1997 (which is about the consequences of granting a long-term lease).

9.15 Division 723 will not apply to transfers of the underlying asset within a consolidated group because such groups are treated as a single entity for tax purposes.

Key requirements

9.16 The following basic requirements must all be established for the Division to have consequences:

• there must be a loss that would, but for the Division, have been realised for income tax purposes from a realisation event happening to a CGT asset of the taxpayer:

− this asset, which may be held as a capital asset, as trading stock or as a revenue asset, is the ‘underlying asset’. Division 723 does not apply if the loss is made on realisation of a depreciating asset;

• at, or before, the time of the realisation event (the ‘realisation time’), the taxpayer (or, in limited circumstances a previous owner of the underlying asset – see paragraph 9.17) must have created in an associate a right in respect of the underlying asset:

− a right is created in this sense if it is created or otherwise conferred on or vested in the associate. The right need not be a form of property, but it must be a right of a legal or equitable nature that would be recognised by the courts. A right includes an option; and

− the meaning of associate is as provided for in section 318 of the ITAA 1936;

− immediately before that realisation time, the right must still be in existence and must be owned by an associate of the taxpayer; and

− a decrease in the underlying asset’s market value must have occurred when the right was created, or since it was created, and must be reasonably attributable to the creating of the right;

• creating the right must have involved a CGT event (other than one happening to only part of the asset) whose capital proceeds are less than the market value of the right when created. The difference between the capital proceeds and that market value is referred to as the shortfall on creating the right. The shortfall on creating the right must generally be more than $50,000:

− a CGT event happens, and there can be capital proceeds, even if the CGT asset is also an item of trading stock or a revenue asset, and even though a capital gain may be disregarded in whole or in part;

− if the associate gives consideration of at least the market value of the right, the Division will not apply; and

− in some cases the market value substitution rule in section 116-20 of the ITAA 1997 may apply in respect of the creation of the right. There will then be no shortfall on creating the right – it is the capital proceeds for tax purposes rather than the actual proceeds that are relevant – and no consequences occur under Division 723. However, the market value substitution rule does not apply, for example, in terms of ascertaining a premium on the grant or renewal of a lease (CGT event F1) or if a right is created for the purposes of CGT event D1 in return for no actual capital proceeds; and

• the market value of the underlying asset when it is realised must be less than it would have been if the right no longer existed at that time, or less than it would have been if the right had not been created at the realisation time. Any difference is called the deficit on realisation:

− if the right is no longer in existence when the underlying asset is sold, there will be no deficit on realisation and no consequences under the Division for a loss that arises on realisation of the underlying asset.

9.17 The Division may also apply in limited circumstances where the entity realising the underlying asset is not the entity that created the right. Providing the entity realising the asset acquired it under a CGT roll-over, or series of CGT roll-overs, and immediately after each of the CGT events to which roll-over applied, the transferor and transferee were associated, Division 723 may apply.

The trustee of V Trust creates a right over an underlying asset in D Co, its associate at the time, for no consideration and market value proceeds are not taken to have been received for tax purposes. The trustee of V Trust later transfers the underlying asset to a company, Z Co, in exchange for all the shares in Z Co, and roll-over is chosen under Subdivision 122-A. Z Co is an associate of V Trust immediately after the roll-over. If Z Co sells the underlying asset for a loss, Division 723 may have consequences.

9.18 The Division may have consequences for the realisation at a loss of underlying assets held on capital account, or as items of trading stock or revenue assets. If a CGT asset is also an item of trading stock, or a revenue asset, the Division applies to the asset in its character as a CGT asset and again in its character as an item of trading stock or as a revenue asset. [Schedule 15, item 1, section 723-40]

9.19 An asset is a revenue asset if, and only if, the profit or loss on your disposing of, ceasing to own, or otherwise realising, the asset would be taken into account, in calculating your assessable income or tax loss, otherwise than as a capital gain, trading stock, or a depreciating asset. [Schedule 15, item 19, section 977-50]

9.20 Division 723 only has consequences when a realisation event has happened and, but for the Division, a loss would have been realised for tax purposes. Chapter 12 discusses ‘realisation event’ and in what circumstances the event realises a loss for income tax purposes.

Prevention or reduction of a loss

9.21 If the requirements for the application of the Division are satisfied, the loss realised on the underlying asset is reduced by the lesser of the shortfall on creating the right and the deficit on realisation. The amount cannot exceed the difference, if any, between the market value of the right when created and the consideration for tax purposes (actual or deemed) determined in respect of the creation. [Schedule 15, item 1, subsections 723-10(3) and 15(2)]

9.22 The amount of reduction is itself reduced by the amount of any gain (other than a disregarded gain) that is realised on the right before, at, or within 4 years after the realisation time for the underlying asset, and is realised by an owner of the right that is, or was, an associate of the owner of the underlying asset when it was realised. [Schedule 15, item 1, subsections 723-10(3), (4) and 15(3)]

When is a gain realised for tax purposes by a realisation event?

9.23 New Division 977 should be referred to in working out a gain realised for tax purposes by a realisation event that happens to the right: see Chapter 12.

9.24 For a right that was held as a revenue asset or as trading stock, the amount of the gain worked out might vary according to whether Division 977 is applied to it in its character as a revenue asset, an item of trading stock or a CGT asset. Section 723-50 contains rules to determine which of the possible amounts is used in applying Division 723. Broadly, in such a case, if the asset is trading stock, the gain is that worked out under section 977-35 or 977-40, and if it is a revenue asset, it is the greater of the gain calculated under a CGT event (see section 977-15) and for a revenue asset (see section 977-55).

X Co owns an asset (an underlying asset) with a cost base (and reduced cost base) of $40 million and a market value of $50 million. X Co grants a right to an associate (B Co) allowing B Co unrestricted and exclusive use of the underlying asset for a period of 6 years. No charge is made by X Co to B Co, whether on the initial granting of the right or during the period for which the right was granted. Existing tax rules do not impute a market value consideration to the creator of the right in this situation.

The existence of the right reduces the market value of the underlying asset by $15 million to $35 million. X Co sells the underlying asset sometime thereafter for $33 million; the further decrease in market value is attributable to the existence of the right in a changed economic environment.

But for the operation of Division 723, a capital loss of $7 million ($40 million less $33 million) would be made on the realisation of the asset.

This is inappropriate, taking into account that the market value of the created right was not subject to the operation of the tax rules, and that, bearing in mind the use of the asset secured by the entity associated with the owner of the underlying asset, no economic loss has actually been suffered by the owner of the underlying asset.

The effect of section 723-10 is that the capital loss of $7 million that would otherwise have arisen is reduced by $15 million that is, the lesser of the shortfall on creating the right ($15 million) and the deficit on realisation ($17 million). The capital loss is reduced to nil because a capital loss cannot be reduced below zero.

If B Co realised part of its right (before, at the time of, or within 4 years after X Co sells the underlying asset) and made for tax purposes an assessable gain of $12 million that was not disregarded, then the $7 million capital loss that would have been made but for Division 723 by X Co on the underlying asset, is reduced by only $ 3 million (i.e. reduced by $15 million less $12 million).

9.25 The Division also applies when only some part of the underlying asset is realised (e.g. a disposal in part) or an interest is created in the underlying asset. [Schedule 15, item 1, section 723-25]

9.26 In determining by how much a loss arising on realisation of the underlying asset is to be reduced, the shortfall on creating the right and deficit on realisation are each multiplied by a fraction: the market value of the part realised or interest created as a proportion of the market value of the underlying asset. This has the effect that the adjustment to the loss incurred is based not on the whole reduction in value resulting from the earlier creation of a right over the asset, but only so much of that reduction in value as is reflected in the part of the asset realised, or in the interest created.

Using the facts in Example 9.2, but assuming that B Co did not realise any gain on the right:

If X Co had disposed of only 30% of the underlying asset for $9.9 million it would, but for Division 723, have made a loss of $2.1 million (i.e. $12 million reduced cost base less $9.9 million).

As the lesser of these ($4.5 million) exceeds the loss on disposal of 30% of the asset, the loss is reduced to nil.

Consequences for replacement interests for rolled-over underlying assets

9.27 Where the underlying asset has been transferred to an associate under a replacement asset roll-over (e.g. Subdivision 122-A), Division 723 may also have consequences when interests received as consideration for the asset are realised at a loss. It may also apply to interests that replace those interests if they, in turn, are transferred under a replacement asset roll-over and the new interests are realised at a loss before the underlying asset is itself realised. The reason Division 723 may have such consequences is that the reduced cost base of interests received under a roll-over is derived from the reduced cost base of the underlying asset, and this creates the potential for the unrealised loss on the underlying asset to be mirrored in a duplicate loss on the interests.

9.28 If the Division affects an interest received on transfer of the underlying asset, the reduced cost base of the interest is reduced by applying a formula. The formula takes the amount by which a loss on the underlying asset would have been reduced under Division 723 if the underlying asset had been realised at that time, and apportions it across all the interests received as consideration for the transfer. The portion attributable to each interest is applied to reduce the reduced cost base of the interest. [Schedule 15, item 1, subsections 723-105(1) to (3)]

9.29 In some instances the formula may not accurately determine how much of the unrealised loss on the underlying asset is reflected in the value of the interest that was realised. When this happens, the reduced cost base of the interest is instead reduced by an amount that is appropriate taking into account the amount by which a loss on realisation of the underlying asset would have been reduced, and the number and extent of all other interests that the owner of the realised interest received under a roll-over arrangement, or successive roll-over arrangements, in connection with transfer of the underlying asset. [Schedule 15, item 1, subsection 723-105(4)]

Assume that in Example 9.1, the trustee of V Trust sells the replacement shares in Z Co, rather than Z Co selling the underlying asset. The reduced cost bases of the replacement shares are to be reduced in accordance with the formula or, in unusual circumstances, by a reasonable amount, immediately before they are realised having regard to the amount by which any loss on the underlying asset would have been reduced if it, rather than the replacement shares, had been realised. This will also apply to the realisation of replacement assets for the shares if they, themselves, were the subject of a replacement asset roll-over.

9.30 As with realisations of the underlying asset itself, gains made on realisation of the created right may be taken into account.

9.31 Any adjustment required to the reduced cost bases of interests would generally be made when a particular interest is first realised after the transfer of the underlying asset. The reduced cost base of the interest would be reduced if a loss arises on that realisation, whether or not a CGT roll-over applies to the realisation event. Adjustments made at this time would then be taken into account in setting the reduced cost base of any further interests received as consideration for the transfer of the interest if a replacement asset roll-over applies to that transfer.

9.32 For the most part, the adjustments made on this first realisation of a particular replacement interest will be sufficient for the purposes of Division 723. No adjustments will be necessary to the reduced cost base of a further interest or interests received as consideration for a transfer, with CGT roll-over, of that replacement interest. Rarely, however, adjustments will be required in respect of these further interests to prevent a loss arising that duplicates the loss on the underlying asset. This could happen where no reduction was made on the initial realisation but there is a loss when the further interest is realised. Provision is made for reducing the reduced cost bases of the further replacement interests in such cases. [Schedule 15, item 1, section 723-110]

9.33 As noted in paragraph 9.22, the amount by which a loss on realisation of the underlying asset is reduced under Division 723 may take into account any gains made on realisation of the right up to 4 years after that time. If the right is realised after adjustments have been made to the reduced cost bases of interests that were received on transfer of the underlying asset, the Division does not permit this adjustment to be reviewed in the same way. This will be examined further once the measures are operating.

9.34 The Division does not apply to replacement interests that are realised at a loss after the underlying asset is realised. Measures in relation to interests realised after that time are under consideration.

Application and transitional provisions

9.35 This Division can apply to rights created on or after 1 July 2002. [Schedule 15, item 2 of the IT(TP) Act 1997]

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:

• it removes complications if other transactions occur before realisation; and

• 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, affected entities 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’.

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.

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.

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:

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

• 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:

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.

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:

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

• 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 other exclusions from the need to make adjustments under the Division. The following indirect value shifts have no consequences under the Division:

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

• 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.

• 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.

• 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.

• 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.

Comparison of key features of new law and current law

*New law*	*Current law*
Applies to companies and trusts where control or common ownership tests are satisfied. The common ownership test applies only to closely-held entities.	Applies only to 100% commonly owned companies (including group companies).
Equity and loan interests on capital account, trading stock, or revenue account are covered.	Only equity and loan interests on capital account are covered.
Applies to the full range of value shifting by way of provision of economic benefits.	Applies only to asset transfers and creations, and debt forgiveness.
Also captures ‘overvalue’ transfers.	If assets are transferred or created, the law applies only to transfers or creations at less than their market value.
Consistent treatment of creation of rights depending on economic substance rather than legal form.	Inconsistent treatment for value shifting purposes of rights granted for less than their value (e.g. rights subject to CGT event D1, leases, and options).
De minimis exclusions.	No de minimis exclusion.
Exclusion for distributions.	No exclusion for distributions.
Arm’s length dealing exclusion.	No arm’s length dealing exclusion.
More extensive safe-harbours, particularly for value shifts involving provision of services.	Safe-harbours for depreciable asset transfers, grouped asset transfers, and (generally) assets transferred for not less than indexed cost (or market value if less).

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?

• 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

• 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.

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.

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.)

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 entity loses 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

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.

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.

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.

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)]

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.

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]

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.

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.

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:

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 10.5: 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.

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 the exclusion 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.

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 (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)]

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.

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.

Red Co holds 100% of the shares in Blue Co, but the companies are not consolidated. In March 2003 Blue 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.

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)]

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 shifts recognises 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.

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 for 95% 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]

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 interest to 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 1936 in 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)]

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.

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.

• 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

	*Conditions for losing entity and gaining entity*	*De minimis conditions for value shift*	*Additional valuation thresholds*
Other provision of tax law applies. (727-705)	In relation to a tax return of a losing entity or gaining entity, a provision of the ITAA 1936 or the ITAA 1997 includes or varies an amount relevant to working out taxable income, a tax loss or a net capital loss.	The amount included or varied must be: • referrable to services by losing entity under an indirect value shift; and • at least $100,000. Losing entity or gaining entity (as relevant) must be aware or ought reasonably to be aware of the inclusion or variation.	Nil.
Ongoing or recent service arrangement. (727-710)	There are one or more SVSs under which services were first provided in the current or immediately preceding year, or are yet to be provided.	MV of affected owners’ primary interests in losing entity reduced by at least $100,000 by these SVSs.	Where relevant adjustable values of primary interests in a losing entity total more than $2 million, a formula method applies to raise the threshold above which the exclusion will not apply (see subsection 727-710(3)). Maximum threshold: market value reduced by $500,000.
Non-group service provider. (727-720)	• losing entity for an SVS not a group service provider at any time during ownership period (to work this out, see subsection 727-715(1)); and • for that SVS, losing entity provides services other than in ordinary course of business.	MV of affected owners’ primary interests in losing entity reduced by at least $500,000 by that SVS and related SVSs (to work out if there are any related SVSs, see paragraph 727-720(2)(b)).	Where relevant adjustable values of primary interests in losing entity total more than $10 million, a formula method applies to raise the threshold above which the exclusion will not apply (see subsection 727-720(3)). Maximum threshold: market value reduced by $5 million.
Group service provider. (727-715)	Losing entity for a SVS is a group service provider at some time during ownership period (to work this out, see subsection 727-715(1)).	MV of affected owners’ primary interests in losing entity reduced by at least $500,000 by all SVSs for which it is the losing entity that have occurred during ownership period.	MV reduction must also exceed lesser of $5 million per annum (to a maximum of $25 million) or 5% of the adjustable values of affected owners’ primary interests in the losing entity (worked out at the time specified in paragraph 727-715(4)).

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]

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]

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

10.209 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.

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]

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.

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)]

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)]

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]

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]

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]

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))]

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:

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.

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)]

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.

Is it reasonable to conclude that, if the IVS time happened at the time of the realisation (for which the potential gaining entity is the gaining entity and the prospective losing entity is the losing entity) the potential gaining entity and prospective losing entity would satisfy for that IVS:

Is it reasonable to conclude that there will be a value shift from the prospective losing entity to another entity (a potential gaining entity) under the scheme? (The potential gaining entity need not be identified or in existence at the time of the realisation event.)

Is there a scheme under which an entity (the prospective losing entity) is to provide economic benefits?

Is the prospective losing entity at the time of the scheme, a company or trust (not an excluded superannuation entity)?

Have equity or loan interests in the prospective losing entity been realised at a loss when no IVS time has happened for the scheme?

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.

• 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;

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

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.

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;

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)]

H Co wholly owns X Co. X Co has 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

Chapter 11
Control and ownership tests for the general value shifting regime and affected owners

Outline of chapter

11.1 This chapter explains the various control and common ownership tests which apply to determine whether an entity is (or entities are) covered by the value shifting rules, and also which interest holders (referred to as ‘affected owners’) are potentially affected. The amendments explained in this chapter are contained in Schedule 15 to this bill.

11.2 It explains the different tests for control and common ownership, and who is an affected owner for the purposes of the DVS and IVS rules in Divisions 725 and 727, and the key concepts relevant in applying these tests. Different tests apply for the purposes of Division 723, and these are discussed in Chapter 9.

11.3 Controllers and their associates (and sometimes associates of associates) may be affected owners where the control tests are met. Where the common ownership tests are met, then common owners and their associates may be impacted. The common ownership tests apply only to closely-held entities. Active participants may also be affected owners where the control or common ownership tests are satisfied, but this is only the case where the entities are closely-held.

Context of reform

11.4 The current income tax law prescribes consequences for value shifts that occur in a limited number of circumstances, and only for value shifts where the interests in a company are involved.

11.5 Robust anti-value shifting rules are needed to support the integrity of the tax system by ensuring that the value of interests in companies and trusts cannot be manipulated to generate tax advantages.

11.6 In contrast with the current law, the range of entities that may be affected by the GVSR has been expanded. However, the rules are limited to entities that control entities involved in the value shifting scheme, those who commonly-own entities so involved, those who actively participate in the scheme, or those who have a particular relationship to the controlling entity or common owners.

11.7 These tests save compliance costs for entities that are not in any way involved in the value shifting scheme.

Summary of new law

11.8. Not all entities that own interests affected by a direct or indirect value shift are within the scope of the new rules. There are only consequences for ‘affected owners’.

Direct value shift

11.9 A direct value shift only has consequences where a controlling entity test is satisfied, and then only for the controller, its associates (and associates of associates in some cases), and for any active participants in the value shift if the controlled entity is closely-held. Refer to paragraphs 11.12 to 11.32 for further details.

Indirect value shift

11.10 An indirect value shift has consequences only if the losing and gaining entity satisfy an ultimate controller test or, if both are closely-held, a common ownership test. An affected owner may be a controller, common-owner, losing entity, gaining entity, and certain other entities related to these entities (including associates). An active participant in the scheme (if both losing and gaining entities are closely-held) can also be an affected owner. Refer to paragraphs 11.33 to 11.141 for further details.

Comparison of key features of new law and current law

*New law*	*Current law*
The DVS rules apply to owners of an interest in a company or trust involved in a value shift where the owner is: • a controller or its associate, and in some cases: • an associate of that associate; or • an active participant in the scheme (if the company or trust is closely-held).	Division 140 (share value shifting) applies to owners of an interest in a company involved in a value shift where the owner is: • a controller (for CGT purposes) or its associate, and in some cases: • an associate of that associate.
The IVS rules apply to an owner of an interest in companies and trusts involved in certain value shifts that is: • an ultimate controller, or an intermediate controller; • an ultimate owner, or an entity through which an ultimate owner’s interests have been traced where a common ownership nexus is satisfied (for interests in entities that are closely-held); • the losing entity or gaining entity; • an associate of any of the above; or • an active participant in the scheme (if the entities are closely-held). Owners of interests in entities that themselves own interests in entities affected by the IVS rules may also be affected by the IVS rules.	Division 138 (asset stripping) and Division 139 (debt forgiveness) apply to certain value shifts between 100% owned companies. They affect owners of interests in companies that are under common ownership.
Common ownership (the common ownership nexus) is a wider test that requires control (for a non-fixed trust) or at least 80% common ownership (for companies and fixed trusts). There is no need for interests to be owned in precisely the same proportions.	Common ownership is linked to membership of a wholly-owned group or ownership held by the same individuals in the same proportions.
An entity that owns an interest and actively participates, or directly facilitates, the value shifting scheme is within the scope of the GVSR. This only applies where the entity subject to the value shift is closely-held.	There is no equivalent.
Control of companies and trusts is defined exclusively for value shifting purposes, but the tests share common ground with other control tests in the tax law. These control tests apply for the DVS and IVS rules.	Control tests for companies and trusts have been developed in the existing tax law. In particular: • controlled foreign company provisions; • trust loss provisions; and • share value shifting provisions.

Detailed explanation of new law

11.11 Who is an affected owner will depend upon whether the DVS or IVS rules are being applied. [Schedule 15, item 25, definition of ‘affected owner’ in subsection 995-1(1) of the ITAA 1997]

Who are affected owners for a direct value shift?

11.12 The DVS rules only apply to ‘affected owners’ of up or down interests. [Schedule 15, item 1, paragraph 725-50(1)(d)]

11.13 An up interest is an equity or loan interest that increases in market value, or is issued at a discount to market value. A down interest is an equity or loan interest that decreases in market value [Schedule 15, item 1, section 725-155]. Diagram 11.1 demonstrates when there may be affected owners for a direct value shift.

• firstly, determine whether the controlling entity test in section 725-55 is satisfied (i.e. did an entity control the target entity at some time during the period of the value shifting scheme);

• secondly, determine whether the entity holds an interest that has decreased in market value (called a down interest), or increased in market value or was issued to it at a discount (each called an up interest); and

• thirdly, apply the affected owner tests in either section 725-80 (for down interest holders) or section 725-85 (for up interest holders) to that interest holder.

Step 1: Is the controlling entity test satisfied?

11.15 The controlling entity test is satisfied if an entity controls (for value shifting purposes) the target entity at some time during the period when the scheme is entered into and ending when it has been carried out (the ‘scheme period’) [Schedule 15, item 1, section 725-55]. It is not necessary for the control relationship to exist over the entire scheme period.

11.16 The rules in Subdivision 727-E set out who is a controller of an entity for value shifting purposes. There are different tests for companies, fixed trusts and non-fixed trusts. These are explained in paragraphs 11.93 to 11.114.

Step 2: Ownership of an up interest or a down interest

11.17 An entity must work out if it owns an up interest or a down interest at the time of the interest’s increase or decrease in market value (or is issued an up interest at a discount). An entity must own an interest at this time to be an affected owner. For a detailed discussion of the meaning of up interests and down interests refer to Chapter 8.

Step 3: Range of affected owners depends on whether interest goes up or down in value

11.18 The rules for determining whether an owner is an affected owner vary depending on whether the affected interest is an up interest or a down interest. There are some tests that are common to both sections 725-80 (about down interests) and 725-85 (about up interests) and some that apply only in relation to up interests.

11.19 There can never be an affected owner of an up interest in an entity unless there is at least one affected owner of a down interest. [Schedule 15, item 1, paragraph 725-85(a)]

Controller or an associate

11.20 The controller of the target company or trust referred to in step 1 who also satisfies step 2 will always be an affected owner of an up or down interest in the entity. [Schedule 15, item 1, paragraphs 725-80(a) and 725-85(c)]

11.21 The controller of an entity is properly within the scope of the DVS rules because by virtue of the control, it is in a position to shape the transactions that give rise to the value shift.

11.22 Similarly, an entity that was an associate of a controller at some time during or after the scheme period, is also an affected owner of an up interest or a down interest. This requirement will be satisfied even if the controlling entity is not a controller at the time the relevant association is established. In the absence of applying the rules to associates, a related party could reap the benefits of the value shifting scheme instead of the controller and thereby avoid the DVS rules. [Schedule 15, item 1, paragraphs 725-80(b) and 725-85(d) and (e)]

11.23 The concept of ‘associate’ is well known in the income tax law and takes its meaning from section 318 of the ITAA 1936. The tests for who is an associate is wider than that of control and looks at the relationship between entities.

11.24 If there is more than one controller during the scheme period then each of them (together with their associates) will be affected owners if they own a down interest or an up interest at the relevant time (see step 2).

Active participants or direct facilitators

11.25 A holder of an up or down interest who actively participates or directly facilitates the entering into or carrying out of the scheme under which the value shift occurs, is also an affected owner [Schedule 15, item 1, paragraphs 725-80(c), 725-85(f) and 725-65(2)]. The kinds of acts or omissions that could amount to active participation or direct facilitation are discussed in paragraphs 11.115 to 11.141.

11.26 It is a further requirement that at some time during the scheme period the target entity was closely-held. A closely-held entity is one that has fewer than 300 members or beneficiaries (as applicable).

11.27 In some circumstances, an entity is treated as having fewer than 300 members or beneficiaries (as applicable) [Schedule 15, item 1, subsection 725-65(3)]. Direct and indirect interests must be taken into account in applying these conditions.

11.28 A company is taken to have less than 300 members if there are up to 20 individuals who between them own shares in that company for their own benefit. Those shares must carry rights to at least 75% of the company’s income or capital, or voting power. These are the same conditions as set out in subsection 124-810(3) of the ITAA 1997 (in the scrip for scrip CGT roll-over provisions).

11.29 Similarly, a fixed trust is taken to have less than 300 beneficiaries if there are up to 20 individuals who between them own fixed interests in that trust for their own benefit. Those fixed entitlements must carry rights to at least 75% of the trust’s income or capital, or voting on activities of the trust. This is set out in subsection 124-810(4) of the ITAA 1997 (in the scrip for scrip CGT roll-over provisions).

11.30 Furthermore, a company or fixed trust is treated as having less than 300 members or beneficiaries where it is reasonable to conclude that rights attaching to interests in that entity could be varied so that ownership become concentrated. The matters relevant to this conclusion are set out in subsection 124-810(5) of the ITAA 1997 (in the scrip for scrip CGT roll-over provisions).

11.31 A non-fixed trust is always taken to have less than 300 beneficiaries [Schedule 15, item 1, subsection 725-65(4)]. This treatment overcomes the problem at general law concerning the nature of the interest held by a discretionary object. Such a beneficiary does not have an interest in the trust income or capital until the trustee declares an entitlement.

Additional affected owners (up interests only): associate of an associate of a controller

• an associate of the controller, at some time during or after the scheme period, is an affected owner of a down interest; and

The down interest holder and up interest holders 1 and 2 are members of the target entity. The controller varies rights that results in some interests increasing in value and others decreasing in value, that is, a direct value shift.

Up interest holder 1 is an affected owner for the DVS rules under paragraph 725-85(e). It is an associate of a down interest holder who is an associate of the controller.

However, up interest holder 2 is not an affected owner for the direct value shifting rules because it has no relationship with the controller or its associates, nor did it actively participate in the scheme.

Who are affected owners for an indirect value shift?

11.33 Division 727 applies to an indirect value shift that arises from economic benefits being provided by one entity (the losing entity) to another (the gaining entity) in connection with a scheme. This nexus is satisfied if:

• the providing of the benefit is reasonably attributable to an act or omission under the scheme by any entity.

11.34 Although the range of entities that can cause an economic benefit to be provided in connection with a scheme is quite large, there are only consequences if the entities are controlled (or commonly-owned, if both entities are closely-held) and there are only consequences for an ‘affected owner’ of certain equity or loan interests in the losing entity or the gaining entity.

11.35 The rationale underlying the control and common ownership tests and the tests for who is an affected owner under the IVS rules is that the rules should impact on an entity that can (on an associate-inclusive basis) control or shape the events that give rise to the indirect value shift or to make some contribution towards this end.

11.36 Furthermore, the IVS rules impact on interests in entities not involved directly in the unequal flow of economic benefits. Consequently, entities owning interests in affected owners may themselves be affected owners.

Are there affected owners for an indirect value shift?

11.37 Diagram 11.2 demonstrates whether there are affected owners for an indirect value shift.

11.38 Working out who is an affected owner in an indirect value shift is a 2 step process:

− the ultimate controller test [Schedule 15, item 1, section 727-105]; and/or

− the common ownership nexus test [Schedule 15, item 1, section 727-110]; and

The ultimate controller case

Step 1: Is the ultimate controller test satisfied?

11.39 The ultimate controller test is satisfied if, at a time during the IVS period, the losing entity or the gaining entity control each other or the losing entity and the gaining entity have the same ultimate controller. The test is also satisfied if, at some time during that period, the ultimate controller of the losing entity is the same as the ultimate controller of the gaining entity at a different time. [Schedule 15, item 1, section 727-105]

Smith Co is the ultimate controller of losing entity James Co at one point in time during the IVS period. Smith Co is the ultimate controller of gaining entity Jones Co at another point in time during the IVS period. The ultimate controller test is satisfied for both James Co and Jones Co.

11.40 This test applies to companies and trusts that are widely or closely-held.

11.41 An entity is an ultimate controller of a company or trust if it controls that company or trust, provided there is no other entity that is an ultimate controller of both [Schedule 15, item 1, section 727-350]. Control refers to control (for value shifting purposes) as set out in Subdivision 727-E. The concept of control is discussed in paragraphs 11.89 to 11.114.

Step 2: Determining the affected owners

11.42 Where the gaining and losing entities have the same ultimate controller at any time between immediately before the entering into of a scheme and the IVS time (IVS period), then the following entities will be affected owners:

• an entity that is an associate of the above entities at any time after the commencement of the scheme.

[Schedule 15, item 1, subsection 727-530(1), items 1, 3 and 4 in the table]

11.43 An intermediate controller is an entity that at some time during the IVS period controls either the losing entity or the gaining entity, and is itself controlled by another entity that is an ultimate controller of both the losing and gaining entities. [Schedule 15, item 1, subsection 727- 530(2)]

This is an example of how an intermediate controller and its associate come within the scope of the IVS rules.

Discovery Co and Hartog Plate Co have not dealt at arm’s length in relation to the provision of benefits under a scheme and an indirect value shift has resulted.

At the time of the value shift, Batavia Trust is an ultimate controller of both Discovery Co (which it controls after taking into account direct and indirect interests) and Hartog Plate Co (in which it has a 65% direct interest).

Associates of Batavia Trust that hold interests in either the losing entity (Discovery Co) or gaining entity (Hartog Plate Co) are affected owners for IVS purposes. Consequently, the beneficiaries of Batavia Trust are affected owners.

Endeavour Co is an intermediate controller of Discovery Co and therefore an affected owner. Captain Cook Co is an associate of Endeavour Co and therefore an affected owner in respect of its interest in the gaining entity.

The common ownership case

Step 1: Is the common ownership nexus test satisfied?

11.44 The common ownership nexus test cannot apply if at all times during the IVS period the gaining entity or the losing entity has 300 or more members [Schedule 15, item 1, paragraph 727-110(1)(a)]. Both entities must be closely-held at some time during the IVS period for the common ownership nexus test to be satisfied.

11.45 In some cases an entity will be treated as if it does not have 300 or more members [Schedule 15, item 1, subsection 727-110(2)]. For a discussion about when an entity will be regarded as having less that 300 members refer to paragraphs 11.28 to 11.31.

11.46 The test also requires that within the IVS period the losing entity and the gaining entity have a common ownership nexus. [Schedule 15, item 1, paragraph 727-110(1)(b)]

Meaning of common ownership nexus

11.47 The table in section 727-400 sets out the conditions that must be met before 2 entities can be said to have a ‘common ownership nexus’. That table has 5 items that deal with combinations of companies, fixed trusts and non-fixed trusts for which common ownership might be examined in applying the IVS rules. These 5 combinations are discussed in paragraphs 11.53 to 11.72. [Schedule 15, item 1, section 727-400]

11.48 The table deals only with these combinations of entities because only companies, fixed trusts and non-fixed trusts can be losing entities under the IVS rules and, although gaining entities can be entities other than companies or trusts, the test is limited to these entities.

11.49 The common ownership nexus examines who holds particular rights, that are incidental to the ownership, of 2 entities. Where the same ‘ultimate owners’ (on an associate-inclusive basis) hold such rights in excess of certain thresholds, the 2 entities are taken to satisfy the common ownership nexus. Cases where a single ultimate owner holds the relevant rights, or where the 2 entities are non-fixed trusts, are covered by the ultimate controller test. An ultimate owner is an entity referred to in subsection 149-15(3) of the ITAA 1997. It includes individuals, certain governments and companies whose constitutions prevent them from making any distribution to members.

11.50 The kinds of rights or features that are examined in determining whether 2 entities have common owners differ according to the nature of the entities that are being tested. These features are set out in Table 11.1.

11.51 In tracing ownership, and some rights which are a proxy for ownership, it is necessary to take into account interests and rights that are held both directly and indirectly. This will involve tracing through interposed entities. [Schedule 15, item 1, subsection 727-415(2)]

11.52 Furthermore, it should be noted that in tracing ownership, some interests (e.g. finance shares) are excluded, and that the interests of 2 or more ultimate owners may be aggregated in some circumstances [Schedule 15, item 1, subsections 727-405(5) and 727-415(4)]. These are discussed in paragraphs 11.74 to 11.80.

Combination 1 – both entities are companies

11.53 Two companies have a common ownership nexus if, during the IVS period, the same ultimate owners have ‘ultimate stakes’ totalling 80% or more in each company. The ultimate stakes in each company need not be held at the same time during the IVS period [Schedule 15, item 1, section 727-400, item 1 in the table]. The profile of the percentage of ultimate stakes held by the ultimate owners is also relevant to whether a common ownership nexus exists (see paragraphs 11.55 to 11.58). An ultimate owner has an ultimate stake in a company to the extent (expressed as a percentage) they control the voting power, or hold rights to dividends or rights to capital distributions in the company [Schedule 15, item 1, section 727-405].

11.54 The ultimate stake of an affected owner is determined on an associate-inclusive basis. This is discussed in paragraphs 11.75 to 11.78.

11.55 Ultimate stakes of 80% or more in a company need to be established for one of the 3 rights. It will not be met, for instance, where one ultimate owner has 40% of the rights to dividends and another has 45% of the rights to capital distributions. Similarly, commonality must be established as between similar rights in each company. For example, 2 companies do not necessarily have a common ownership nexus where the same ultimate owners hold 80% of the voting power in one, and 80% of the rights to dividends in the other.

11.56 If the requirement that the same ultimate owners have ‘ultimate stakes’ totalling 80% or more in each company is met, there is a further condition that must be satisfied before there will be a common ownership nexus. The condition is met if one of 3 situations exist. [Schedule 15, item 1, subsection 727-400(2)]

• one of the ultimate owners has ultimate stakes of at least 40% in each company [Schedule 15, item 1, subsection 727-400(3)];

• each ultimate owner holds the same percentage of ultimate stakes in each company [Schedule 15, item 1, subsection 727-400(4)]; or

• 16 or fewer ultimate owners have the ultimate stakes that satisfy the 80% or more ultimate stakes requirement [Schedule 15, item 1, subsection 727-400(5)].

11.58 The first and last items in paragraph 11.57 can apply where each ultimate owner does not hold the same percentage of ultimate stakes in each company. Both of these items will be met in many cases.

11.59 The 40% or more item in paragraph 11.57 can apply where an ultimate owner has a significant interest in both companies and the remaining ownership is widely-held (more than 15 other entities). The last item will cover such situations as where 2 individuals have 20% ultimate stakes in one company and 25% in the other, and another 2 individuals have 25% ultimate stakes in the two companies.

11.60 It is necessary to trace through direct and indirect holdings in working out who are the ultimate owners of each company.

11.61 A consequence of looking at voting power and rights to dividends and capital distributions is that 2 companies could potentially have 3 sets of ultimate owners.

Mika Dolls Pty Ltd and Vonny Pty Ltd provide each other with economic benefits in a non-arm’s length dealing. They are a gaining entity and a losing entity respectively.

Tom, Jessica and Emmalee are joint shareholders in Mika Dolls Pty Ltd. They hold voting and distribution rights of 20%, 35% and 45% respectively.

Tom, Jessica, Emmalee and Sam are joint shareholders in Vonny Pty Ltd. They hold voting power of 20%, 20%, 40% and 20% respectively. However, rights to distributions are held in proportions of 5%, 5%, 5% and 85%.

Mika Pty Ltd and Vonny Pty Ltd have a common ownership nexus because the same entities (Tom, Jessica and Emmalee) hold at least 80% of the voting power in each company. Emmalee’s holdings meet the requirement that one owner have a 40% or greater interest in both companies. In this case, the 16 or fewer entities item is also met.

This is so even though the test is not met in relation to rights to dividends and capital distributions.

Applying item 2 of affected owner’s table in subsection 727-530(1), Tom, Jessica and Emmalee are affected owners of Mika Dolls Pty Ltd. They are owners of primary equity interests in a gaining entity.

Similarly, Tom, Jessica and Emmalee are affected owners of Vonny Pty Ltd, and are owners of primary equity interests in a losing entity.

Lusitania Co and Gandolf Co are gaining and losing entities respectively in an indirect value shift. They have the following ownership structures.

Lusitania Co and Gandolf Co have a common ownership nexus with Bernie and Andrew as ultimate owners. After tracing interests through interposed entities, Bernie and Andrew hold 100% of the interests in Lusitania Co, and 80% of the interests in Gandolf Co.

As a result, Bernie and Andrew are affected owners under the common ownership nexus test.

The entities through which the indirect interests that Bernie and Andrew hold are traced (Nero Co, Anita Co, Caesar Trust and Jobba Co) will also be affected owners under the common ownership nexus test.

(Note: Bernie satisfies the ultimate controller test. Practically, the common ownership test is therefore only relevant for Andrew.)

The same principles apply where combinations 2 to 4 of losing and gaining entities are found.

Combination 2 – both entities are fixed trusts

11.62 Two fixed trusts have a common ownership nexus if the same ultimate owners hold ultimate stakes, consisting of the rights to receive distributions of income or capital, totalling at least 80% in each fixed trust. [Schedule 15, item 1, section 727-400, item 2 in the table and section 727-410]

11.63 Commonality needs to be established for only one of these rights, and not for both. However, commonality must be established as between similar rights. For example, 2 fixed trusts do not necessarily have a common ownership nexus where 2 ultimate owners hold 80% of the rights to income in one, and 80% of the rights to capital in the other.

11.64 The principles regarding commonality, associate-inclusive basis and profile of holdings discussed in paragraphs 11.53 to 11.58 also apply here.

Wormy Trust and Scoob Trust are fixed trusts. They provide each other with unequal economic benefits in a non-arm’s length dealing.

Sue, Len and Siobhan are beneficiaries in Wormy Trust. They hold rights to income and capital in the shares of 60%, 25% and 15% respectively.

Len and Siobhan are also beneficiaries in the Scoob Trust, holding rights to capital and a share of the income in proportions of 50% each.

Wormy Trust and Scoob Trust do not have a common ownership nexus because the same entities (Len and Siobhan) do not hold at least 80% of the rights to income or capital in each fixed trust.

11.65 It is necessary to trace through direct and indirect holdings in working out who are the ultimate owners of each fixed trust. [Schedule 15, item 1, subsection 727-415(2)]

Combination 3 – company and fixed trust

11.66 A company and fixed trust have a common ownership nexus if the same ultimate owners have ultimate stakes totalling at least 80% in the company and the fixed trust. Again, the principles regarding commonality, associate-inclusive basis and profile of holdings discussed in paragraphs 11.53 to 11.58 also apply here. [Schedule 15, item 1, section 727-400, item 3 in the table]

11.67 It is necessary to trace through direct and indirect holdings in working out who are the ultimate owners of the company or fixed trust. [Schedule 15, item 1, subsection 727-415(2)]

Combination 4 – company and non-fixed trust

11.68 A company and non-fixed trust have a common ownership nexus if the same ultimate owners:

11.69 Whether an ultimate owner controls a non-fixed trust is worked out by applying the tests in section 727-365 (discussed in paragraphs 11.105 to 11.111). The principles regarding the associate-inclusive basis of these tests (discussed in paragraph 11.54) also apply here.

11.70 It is necessary to trace through direct and indirect holdings in working out who are the ultimate owners of the company or a controller of the non-fixed trust. [Schedule 15, item 1, subsection 727-415(2)]

Example 11.7: Affected owners of a company and non-fixed trust under common ownership

Alicia is the sole capital beneficiary (not being a fixed entitlement) in Gandolf Discretionary Trust. Jack is the trustee of the trust.

After tracing through direct and indirect interests, it can be determined that Lusitania Co and Gandolf Discretionary Trust have a common ownership nexus with Jack and Alicia being ultimate owners. This means that Alicia and Jack are affected owners. Alicia’s associate Liam is also an affected owner because he is an ultimate owner as a result of applying subsection 727-415(4).

Furthermore, Stoney Co is an affected owner because it has been necessary to trace Alicia’s and Jack’s ownership rights through it.

The income beneficiaries of Gandolf Discretionary Trust are not affected owners because they are not ultimate owners, nor are they associates of Alicia, Jack or Stoney Co (affected owners because of the common ownership nexus), nor has it been necessary to trace through their interests.

(Note: Alicia and Liam satisfy the ultimate controller test. Practically, the common ownership test is therefore only relevant for Jack.)

Combination 5 – fixed trust and non-fixed trust

11.71 A fixed trust and non-fixed trust have a common ownership nexus if the same ultimate owners:

11.72 It is necessary to trace through direct and indirect holdings in working out who are the ultimate owners of the fixed trust or a controller of the non-fixed trust [Schedule 15, item 1, subsection 727-415(2)]. The principles regarding the associate-inclusive basis of these tests (discussed in paragraph 11.54) also apply here.

Other matters relevant to tracing interests for the common ownership nexus test

Ownership or rights held jointly

11.73 If ownership or other particular rights in a company or trust are held by 2 or more entities jointly or in common, each entity is treated as holding a proportion of the ownership or rights, worked out on a reasonable basis. The total of the proportions for any particular ownership interest or right cannot exceed one. [Schedule 15, item 1, subsection 727-415(3)]

Ownership or rights held by associate

11.74 The common ownership nexus requires the ultimate owners to be identified, rather than taking the more limited approach of looking to who is the immediate and direct owner of any particular interest, or rights in respect of an interest in an entity.

11.75 The ownership or other particular rights in a company or trust that are ultimately held by associates of an ultimate owner, who are themselves ultimate owners, may be treated as being held by the ultimate owner. This is for the purpose of working out if the ultimate owner and other ultimate owners have ultimate stakes that result in a common ownership nexus for two entities. This rule can apply separately to each ultimate owner who has associates. [Schedule 15, item 1, subsections 727-415(4) and (5)]

11.76 The effect of this rule is to aggregate the ownership or particular rights held ultimately by an ultimate owner (directly and indirectly) with those held by associate ultimate owners. This prevents the common ownership nexus test from being avoided by splitting rights amongst associates. For example, where one ultimate owner has an ultimate stake of 90% in one company and an associated ultimate owner has an 80% ultimate stake in the other company.

11.77 The policy is for the common ownership nexus test to reflect the fact that an ultimate owner and associates are sufficiently related that they can be seen as a single economic agent.

The attribution rule in subsection 727-415(4) operates so that Len is taken to hold an 85% interest in the rights to income and capital of Wormy Trust. As in Example 5.6, Len and Siobhan are, together, ultimate owners (as to 100%) of Scoob Trust.

Consequently, Wormy Trust and Scoob Trust have a common ownership nexus. As a result of the attribution rule, Len and Siobhan together are ultimate owners with ownership rights greater than 80% in respect of each fixed trust. The 40% or greater, and 16 or fewer, items of the additional condition are also met. Len and Siobhan will be affected owners.

The attribution rule also applies so that Sue is taken to hold an 85% interest in the rights to income and capital of Wormy trust, and a 50% interest to the rights to income and capital of Scoob Trust. Again, Wormy Trust and Scoob Trust have a common ownership nexus. Sue and Siobhan together are ultimate owners with ownership rights greater than 80% in respect of each fixed trust. The 40% or greater, and 16 or fewer, items of the additional condition are also met. Sue will be an affected owner.

Exclusions

Finance shares are ignored

11.79 Finance shares are ignored for the purposes of tracing ownership in a company. A finance share is a share whose dividends are more akin to the payment of interest on a loan, rather than a true sharing in the risks and rewards of the activities of the company. [Schedule 15, item 1, subsection 727-405(5)]

11.80 Whether a dividend can reasonably be regarded as being equivalent to interest on a loan, requires an objective consideration of:

• the conditions that apply to the payment, for example, whether payments are cumulative or not; and

Step 2: Determining the affected owners

11.81 The first set of affected owners (because the common ownership nexus test is satisfied) is each ultimate owner in the gaining and losing entity, the ownership interests of which have been taken into account in order to establish that the common ownership nexus has been satisfied at any time in the IVS period. Any entity through which these ownership interests have been traced is also an affected owner, as are the losing entity and gaining entity. [Schedule 15, item 1, subsection 727- 530(1), paragraphs (a) and (b) of item 2 and 3 in the table]

11.82 The second set of affected owners where the common ownership nexus applies is any entity that, at any time after the scheme was entered into, is an associate of one of the affected owners mentioned in the preceding paragraph. [Schedule 15, item 1, subsection 727- 530(1), item 4 in the table]

11.83 The reason that these owners are subject to the IVS rules is that a high degree of common ownership between closely-held entities gives rise to a significant risk that the provision of economic benefits under a scheme is by way of the direction of another entity or entities, or at least is tacitly approved or encouraged by them.

11.84 In this way, the common ownership nexus test shares some of the elements that underpin the ultimate controller test, and can be seen as a supplement to that test.

Active participants

11.85 An active participant in a scheme may be an affected owner if the ultimate controller test is satisfied and the losing and gaining entities are closely-held at some time in the IVS period, or the common ownership nexus test applies. [Schedule 15, item 1, subsection 727-530(1), item 5 in the table]

11.86 An entity is an active participant in a scheme if the entity has actively participated in or directly facilitated the entering into of the scheme or at some time during the IVS period actively participated in or directly facilitated the carrying out of the scheme [Schedule 15, item 1, paragraph 727- 530(3)(b)]. The kinds of acts or omissions that could amount to active participation or direct facilitation are discussed in paragraphs 11.115 to 11.141.

11.87 An entity is not an active participant if it did not own an equity or loan interest in the losing or gaining entity, or an indirect equity or loan interest in either of those entities at some time during the IVS period. [Schedule 15, item 1, paragraph 727- 530(3)(c)]

11.88 The losing or gaining entity cannot be an active participant. [Schedule 15, item 1, paragraph 727- 530(3)(d)]

When does one entity control another (for value shifting purposes)?

11.89 The circumstances in which one entity can be said to control another are set out in Subdivision 727-E of this bill. This Subdivision sets out an exclusive code for control (for value shifting purposes). [Schedule 15, item 1, section 727-375]

11.90 However, these tests share characteristics of control tests drawn from other areas in the existing income tax law, for example, provisions dealing with CFCs (Part X of the ITAA 1936), thin capitalisation (Division 16F of the ITAA 1936), trust losses (Schedule 1F to the ITAA 1936) and share value shifting (Division 140 of the ITAA 1997).

11.91 There are separate control tests for companies, fixed trusts and non-fixed trusts. These tests cater for the particular characteristics of each entity.

11.92 In applying the percentage stake tests referred to in paragraphs 11.94 and 11.95, double counting of direct and indirect interests is prevented [Schedule 15, item 1, section 727-370]. This is discussed in paragraphs 11.112 to 11.114.

When does an entity control a company?

11.93 There are 3 tests for control of a company, which are similar to those which apply in the CFC provisions. They are the:

50% stake test

11.94 An entity controls a company if, alone or together with its associates, it has at least 50% of voting, dividend or capital rights in the company, either directly or indirectly. [Schedule 15, item 1, subsection 727-355(1)]

40% stake test

11.95 An entity (the test entity) also controls a company if, alone or together with its associates, it has at least 40% of voting, dividend or capital rights in the company, either directly or indirectly. However, a 40% or more stake is not enough to establish control if there is another entity that alone, or with its associates (other than the test entity and its associates), in fact controls the company. [Schedule 15, item 1, subsection 727-355(2)]

11.96 An entity also controls a company if, alone or together with associates, it actually controls the company. Control here takes on its ordinary meaning, and this test recognises that there are some circumstances in which control can exist in the absence of the tracing tests being satisfied. For example, an entity may own a 30% interest in a company whose board of directors is accustomed to acting upon that entity’s instructions. Such an entity controls the company for value shifting purposes. [Schedule 15, item 1, subsection 727-355(3)]

When does an entity control a fixed trust?

11.97 A fixed trust is a trust in which entities have fixed entitlements to all of the income and capital of the trust [Schedule 15, item 40, definition of ‘fixed trust’ in subsection 995-1(1) of the ITAA 1997]. Generally, an entity has a fixed entitlement if it is a beneficiary with a vested and indefeasible interest in a share of the income or capital of the trust. ‘Fixed entitlement’ takes on the same meaning as in the trust loss rules in Division 272 of Schedule 1F to the ITAA 1936.

11.98 There are a number of tests for determining control of a fixed trust. These are:

40% stake test

11.99 An entity controls a fixed trust if, alone or together with associates, the entity has the right to receive (either directly or indirectly through one or more interposed entities) at least 40% of any distribution of income or capital of the trust (that could be made) to members of the trust. [Schedule 15, item 1, subsection 727-360(1)]

Other tests

Tests based on control of the trust income or capital

11.100 An entity also controls a fixed trust if the entity, or an associate (relevant entity):

• either alone or together with associates, has the power to obtain the beneficial enjoyment of the trust’s income or capital;

• can control in any way at all, the application of trust income or capital; or

Trustee tests

11.101 A relevant entity controls a fixed trust if it can remove or appoint a trustee of the trust. [Schedule 15, item 1, paragraph 727-360(2)(e)]

11.102 A relevant entity also controls a fixed trust if a trustee is accustomed, or under an obligation, or might reasonably be expected to act in accordance with that entity’s directions, instructions or wishes. [Schedule 15, item 1, paragraph 727-360(2)(d)]

11.103 Whether a trustee is accustomed or might reasonably be expected to act in accordance with the directions, instructions or wishes of another is determined having regard to all the circumstances of the case. For example, the mere presence in the trust deed of a requirement that the trustee should have no regard to such directions, instructions or wishes would not prevent the examination of the actual circumstances to determine whether an entity controls the trust.

• the amount of any property or services transferred to the trust by the entities; and

• any arrangement or understanding between the entities and a settlor or persons who have benefited under the trust in the past.

When does an entity control a non-fixed trust?

11.105 A non-fixed trust is a trust that is not a ‘fixed trust’ [Schedule 15, item 62, definition of ‘non-fixed trust’ in subsection 995-1(1) of the ITAA 1997]. Basically, if there is any discretion as to which beneficiaries will receive a share of the income or capital of the trust, that trust will be a non-fixed trust. Trusts that have both fixed and non-fixed elements (hybrid trusts) are non-fixed trusts.

11.106 There are 2 categories of tests for control of a non-fixed trust. These tests look to:

Trustee tests

11.107 An entity controls a non-fixed trust if it (or an associate) is a trustee of the trust, or can remove or appoint a trustee of the trust (either alone or together with associates). [Schedule 15, item 1, paragraphs 727-365(1)(a) and (b)]

11.108 An entity also controls a non-fixed trust in situations where the trustee is:

in accordance with the entity’s directions, instructions or wishes [Schedule 15, item 1, paragraph 727-365(1)(c)]. This applies whether or not the directions, instructions or wishes are those of the entity alone, or of the entity and any other entity [Schedule 15, item 1, subparagraphs 727-365(1)(c)(i) and (ii)].

11.109 This extends to situations where those directions, instructions or wishes are of an associate of the entity, or of an associate and any other entity [Schedule 15, item 1, subparagraph 727-365(1)(c)(ii)]. In this case, the relationship of the associate and the trustee will be enough to satisfy the control test.

Tests based on control of the trust income or capital

11.110 An entity also controls a non-fixed trust if the entity, either alone or together with associates, has the power to obtain the beneficial enjoyment of trust income or capital, or can control in any way at all, the application of trust income or capital, or can under a scheme, gain that enjoyment or control. [Schedule 15, item 1, subsection 727-365(2)]

11.111 An entity also controls a non-fixed trust if it, or any of its associates, can benefit under the trust (other than because of a fixed entitlement to income or capital of the trust). This test focuses on the capacity of an entity, or an associate, to receive capital or income of a trust. For example, any entity that is an object of a discretionary trust will be taken to control the non-fixed trust. An entity will also have the required control if it, or it and its associates, have a right to receive 40% or more of any distribution of trust income or capital. [Schedule 15, item 1, subsection 727-365(3)]

How are interests traced when applying the stake tests?

11.112 The stake tests measure control in terms of percentages. Any capacity to exercise voting power, or other entitlement that an entity may have, must take into account both direct and indirect interests. This requires the entity to trace through interests held in interposed entities, where those entities have a direct or indirect interest in the relevant entity.

11.113 Section 727-370 provides that where a direct and indirect interest gives rise to the same percentage being counted twice, the indirect interest is to be ignored.

11.114 This rule applies in working out the amount of voting power an entity (alone or with associates) has or can control, and its interest in any rights to receive dividends or capital from a company, or distributions of income or capital from a trust.

Active participation and direct facilitation

How are these concepts relevant to the value shifting measures?

11.115 An entity that has actively participated in, or directly facilitated, the entering into or carrying out of a scheme, may be subject to the value shifting provisions because:

• the entity is an ‘affected owner’ of an interest in the entity that is the target entity for the direct value shift [Schedule 15, item 1, paragraphs 725-80(c) and 85(f)]; or

• the entity is an ‘affected owner’ of an interest (direct or indirect) in the entity that is involved in the indirect value shift [Schedule 15, item 1, subsection 727- 530(1), item 5 in the table].

11.116 An entity may actively participate or directly facilitate a scheme under which the value shift occurs, even if it does not satisfy any of the control tests (for value shifting purposes) as set out in Subdivision 727-E.

11.117 It is recognised that it is easier to implement a value shifting scheme in the absence of control where the entity is closely-held. Consequently, the active participant tests only apply if the target entity, or losing entity and gaining entity, have fewer than 300 members.

When does an entity actively participate in a scheme?

11.118 Active participation is not a term of art and takes on its ordinary and natural meaning. It is a term of limitation because mere participation in the scheme is not enough, there must be active participation. Consequently, not all forms of involvement in a scheme will amount to active participation.

11.119 Whether an entity has actively participated in or directly facilitated a scheme is a question of fact to be decided having regard to all of the circumstances. Whilst an exhaustive list of all circumstances that satisfy this test cannot be made, some guidance can be given.

11.120 The Macquarie Dictionary defines active as in a state of action, in actual progress or motion and capable of exerting influence. Participate means to take or have a part or share, as with others.

11.121 There is no requirement for the participation to involve other entities, although often it will. This is because participation must be interpreted in the context of the scheme. ‘Scheme’ is defined broadly in the ITAA 1997 and includes a unilateral course of action. Consequently, an entity can participate in a scheme by acting alone.

11.122 Active participation can involve the doing of some act that is capable of exerting an influence over the scheme from which the value shift arises. The participation must take place in connection with the scheme; there is no need to show that there is a nexus between the acts or conduct that make up the active participation and the value shift.

11.123 Furthermore, the importance of the act to the success or effect of the scheme, whether great or slight, is not a relevant consideration.

11.124 Generally, the existence of a common purpose or agreement between parties to a scheme will result in the active participation test being satisfied. However, this is not a prerequisite.

11.125 Typically, actions such as voting for a value shift proposal, or arranging for economic benefits to be provided under a scheme, will be actions that amount to active participation in the scheme. These are actions that promote the performance of the scheme.

Lachlan, Helen and Emmalee are shareholders and directors in The Shack Pty Ltd, a closely-held company with 3 members. Emmalee holds only a 10% interest, but under the Articles, must consent to all changes in the capital structure of The Shack Pty Ltd.

Lachlan and Helen, as directors, prepare and pass the resolutions for the variation of share rights as between the shares, affecting the market value of all interests. Emmalee gives her consent.

Emmalee has actively participated in a scheme under which a direct value shift has arisen. The giving of consent is sufficient to amount to active participation.

11.126 It is not necessary to point to any single act that the entity has done, and which has resulted in a value shift, in order to show that it has actively participated in the scheme. For example, the value shifting provisions will apply where an entity encourages or counsels others to embark upon the scheme that results in the value shift. This encouragement may comprise the taking of preparatory action that sets the scheme in motion, or the exerting of any kind of pressure upon others to implement the scheme.

11.127 In these circumstances, the policy of the law is to apply the value shifting provisions because it cannot be said that the entity is merely a fortuitous recipient of the benefits of the value shift without any involvement.

Active compared with passive

11.128 The word active is used in contradistinction with passive. The Macquarie Dictionary defines passive as not acting with open or positive action, being acted upon or the object of action by another.

11.129 An entity can participate, or become involved, in a scheme even if it does not engage in some positive action, or is subjected to the actions undertaken by another. However, if an entity has done no more than received the benefit of the value shift, then it cannot be said that it has actively participated in the scheme.

Knowledge requirements

11.130 The concept of active participation requires there to be a degree of knowledge of the scheme. An entity cannot be said to actively participate in a scheme where it does not have some appreciation of the consequences of its participation in the context of the scheme. This is consistent with the position that entities that have acted inadvertently are intended to be brought within the value shifting measures.

11.131 The degree of knowledge required is at least some awareness of the existence of the scheme. There is no need for the entity to be fully aware of each and every step of the scheme, nor of its precise nature. Neither is there any requirement for a common agreement between the entity and others that have entered into or carried out the scheme.

11.132 Knowledge of the scheme will not of itself result in an entity coming within the scope of the value shifting rules. There must be some conduct amounting to participation in the scheme (for direct value shifting) or the provision of economic benefits (for indirect value shifting) or direct facilitation. However, simply observing the scheme unfold or merely acquiescing is not enough to bring an entity into the value shifting provisions.

What amounts to direct facilitation?

11.133 The words direct facilitation expand the types of conduct that attract the value shifting provisions. There are many ways in which an entity might help bring about, or facilitate, a value shift. Some of these ways will amount to active participation, but direct facilitation is a wider concept than this.

11.134 Direct facilitation is a wider concept than active participation in 2 significant ways:

11.135 As with active participation, the entity doing the facilitation must have some knowledge or awareness of the scheme.

Acts or omissions

11.136 An entity can facilitate the entering into or carrying out of a scheme by an act or omission. Facilitation occurs when that act or omission helps forward the scheme, or makes it easier or less difficult for the scheme to be entered into, or carried out.

11.137 A failure to act can facilitate a scheme where the entity is under a specific duty to act, or may exercise a right, but refrains from doing so. For example, a shareholder may be aware of a breach of the Corporations Act 2001, or a beneficiary of a breach of trust, that occurs in the course of a value shifting scheme but is content to ignore it. Such inactivity constitutes a departure from simply observing the scheme, and brings the entity closer to being a participant in the scheme.

11.138 Direct facilitation is a conduct based test. It looks at what was done by an entity, or what that entity failed to do, and evaluates the significance of the act or omission in light of the scheme as a whole. It connotes a lower degree of involvement in the scheme to that of an entity that actively participates in a scheme.

11.139 The casual link that is required between the act or omission and the promotion of the scheme is a direct one. It is not enough for the act or omission of the entity to have made it easier for the scheme to be implemented in some remote, roundabout or insignificant way. The effect must be such that it can be said that the act or omission has contributed directly and immediately to the progression of the scheme.

Suz and Kathy are the only shareholders in Nic Pty Ltd. Suz holds both pre-CGT and post-CGT interests, that together amount to only 25% of the voting power in Nic Pty Ltd, with Kathy holding the other 75%. Suz has a right of veto in respect of most matters.

Kathy proposes a scheme that will shift value between the pre-CGT and post-CGT interests owned by Suz. The resolution is passed after a vote is held. Suz abstains, and fails to exercise her veto.

Suz is potentially caught within the scope of the DVS rules because her failure to exercise the veto has directly assisted the successful implementation of the scheme. Here, although Suz has not done anything, that omission amounts to active participation in, or direct facilitation of, the scheme.

11.140 An entity that has directly facilitated the scheme may not be a party to the scheme, whereas an active participant will invariably be a party to the scheme. It follows from this that, as with active participants, there need not be an agreement or common purpose as between the entity facilitating and others involved in the scheme.

11.141 Whether an act or omission has directly facilitated a scheme is a question of fact that is to be determined having regard to all of the circumstances.

Consequential amendments

11.142 There are consequential amendments. A discussion of these is included in Chapter 12.

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.

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.

Consequential amendments

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

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 :

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

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

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:

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:

• 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);

• 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

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.

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:

• 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);

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:

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

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

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

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

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:

• 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);

• 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);

• 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);

[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]

Chapter 13
Amendments to allow global method of asset valuations in loss integrity measures

Outline of chapter

13.1 This chapter explains amendments to Subdivisions 165-CC and 165-CD of the ITAA 1997 that will allow assets of a company to be valued globally (in globo) in calculating the company’s unrealised net loss (for Subdivision 165-CC purposes) and its adjusted unrealised loss (for Subdivision 165-CD purposes). This is referred to as the global method.

13.2 Subdivision 165-CD will also be amended by the inclusion of a special value shifting rule to ensure that the use of the global method in that Subdivision cannot lead to duplication of unrealised losses. The amendments explained in this chapter are contained in Schedule 14 to this bill.

Context of reform

13.3 Subdivisions 165-CC and 165-CD were introduced into the ITAA 1997 during 1999 and 2000 in the New Business Tax System (Integrity and Other Measures) Act 1999 and in the New Business Tax System (Miscellaneous) Act (No. 2) 2000. They implemented recommendations in A Tax System Redesigned principally concerned with inappropriate access to, and duplication of, a company’s realised and unrealised losses. These recommendations were Recommendations 6.10 and 6.9(a).

Subdivision 165-CC

13.4 Specifically, Subdivision 165-CC ensures that where a company has a change of ownership or control (a changeover time), capital losses or deductions later obtained in respect of assets held at the changeover time, to the extent of the company’s unrealised net loss balance (if any) at the changeover time, can only be accessed by the company if it passes the same business test. Subdivision 165-CC may also impact on the ability of a company to access losses that have been deferred by Subdivision 170-D on assets held by the company before the changeover time. The Subdivision applies to changes of ownership or control from 11 November 1999.

Subdivision 165-CD

13.5 Subdivision 165-CD prevents the realised and unrealised losses of a company that has had an alteration time (usually a change of ownership or control) from being duplicated for income tax purposes in respect of significant equity or debt interests that entities other than individuals have in the company. Subdivision 165-CD applies to alteration times from 11 November 1999.

Individual asset market valuations required

13.6 In calculating unrealised gains and unrealised losses on assets for Subdivision 165-CC purposes, and in calculating unrealised losses on assets for Subdivision 165-CD purposes, the existing law requires that the market values (or other specified values) of individual assets be determined. Unrealised gains are not relevant for the operation of Subdivision 165-CD which adjusts only the reduced cost bases (and other tax attributes used for calculating losses) of equity or debt interests in a loss company. This produces the correct outcomes in terms of the policy aims of the Subdivisions.

13.7 However, in particular cases compliance costs (especially valuation costs) might be less if assets could be valued together (i.e. globally) rather than individually.

13.8 The rules will therefore be refined to allow, as an option, the use of the global method of valuing assets.

13.9 The integrity currently achieved by Subdivision 165-CD is maintained by including a special value shifting rule in that Subdivision. This will ensure that where the unrealised gain value of a company is captured in a global asset valuation at an alteration time, and the value is later removed from the company, it will not be possible to duplicate the company’s unrealised losses at that alteration time on realisation of an equity or debt interest in the company.

Summary of new law

Global method can be used in Subdivisions 165-CC and 165-CD

13.10 Subdivisions 165-CC and 165-CD are being amended to allow the optional use of global asset valuations to determine the amounts of unrealised net loss or adjusted unrealised loss under those Subdivisions. As the method is optional and could not disadvantage taxpayers compared with the current law, it may be chosen in respect of changeover times and alteration times that happen from 11 November 1999.

Choice for global method in Subdivisions 165-CC and 165-CD

13.11 Broadly, it will be possible for the company calculating an unrealised net loss or an adjusted unrealised loss to make a choice to use a global method in respect of changeover or alteration times happening to it from 11 November 1999. The choice may be made on or before the day the company lodges its income tax return for the income year in which the relevant changeover time or alteration time occurred, or such later day as the Commissioner allows. If the changeover or alteration time happens before the day on which this bill receives Royal Assent, the choice need not be made until 6 months after that day.

Special value shifting rule in Subdivision 165-CD if interest realised at a loss after global method used

13.12 Subdivision 165-CD will contain a special value shifting rule. It will apply where the global method has been used in calculating an adjusted unrealised loss of a company at an alteration time, and a significant equity or debt interest in that company is later realised. If that realisation would (but for the rule) realise a loss for income tax purposes, and it would duplicate what would have been an amount of the company’s adjusted unrealised loss if only unrealised losses on assets had been determined at that time, the realised loss is adjusted. This is achieved by treating the company as having an amount of adjusted unrealised loss at the alteration time for the purposes of making adjustments under section 165-115ZA in respect of the interest.

• an equity or debt interest would, but for the rule, be realised at a loss for income tax purposes;

• it was a significant equity or debt interest in a company immediately before an alteration time for which the global method was used; and

• the alteration time was the latest when the equity or debt interest was a significant equity or debt interest in the company.

The realised loss will not be allowed to the extent that the company has paid dividends, returned capital, or otherwise shifted value while the interest remained a significant equity or debt interest in the company unless it can be shown that this removal of value is:

• not reasonably attributable to unrealised gain value on assets acquired for at least $10,000 at the alteration time; or

• has not given rise to a reduction to the reduced cost base of the interest.

13.14 The rule is structured in this way to focus on readily observable transactions and events that may signal that unrealised losses at the alteration time when the global method was used have been exposed. An examination of these matters will enable a more ready assurance that loss duplication has or has not been exposed than would a less direct methodology. These matters are specifically required to be examined. There may be circumstances, however, where relevant value has been shifted but the realised loss itself does not, to some extent, reasonably relate to an amount of adjusted unrealised loss that the company would have had at the alteration time if individual loss assets had been identified. For example, it may relate to a loss of the company that accrued after the alteration time. To that extent the realised loss will not be adjusted. This may be demonstrated by any reasonable approach or methodology, including one where the company’s asset values for tax purposes at the alteration time are compared with the net value of the company at the realisation time (as discussed in Example 13.6). It does not require that individual loss asset values be known or determined. The test is that it must reasonably be concluded that the realised loss on the interest could not duplicate unrealised losses at the alteration time.

Transitional rule

13.15 A special transitional rule will apply for an alteration time (for which the global method is used) before the day this bill receives Royal Assent. In respect of those alteration times, there is no requirement to consider specifically the effect of distributions or other value shifted while the interest was a significant equity or debt interest in determining whether the loss on the interest may be affected. Instead, the entity that would otherwise realise the interest at a loss may directly choose to use any other approach to conclude reasonably that the loss could not duplicate an unrealised loss on an asset at the alteration time.

Choice to use transitional approach if interest realised at a loss for Subdivision 165-CD purposes

13.16 A choice to use a transitional approach if an interest is realised at a loss for Subdivision 165-CD purposes must be made by the entity that owns the equity or debt interest concerned. The choice must be made by the later of the time an income tax return is lodged for the income year in which the realisation event happened, or by such later time as the Commissioner allows, or 6 months after the relevant alteration time when the global method was used happened, but not in any event within 6 months after the date this bill receives Royal Assent.

Notice requirements

Extension of notice period

13.17 A general extension of the notice period for the purposes of section 165-115ZC is given because of the amendments made to the method of determining the amount of adjusted unrealised loss. It is not limited to situations where the global method is chosen. This extension is relevant for alteration times that happen before this bill receives Royal Assent. In such cases, a notice required under subsection 165-115ZC(4) or (5) must now be given within 6 months after the day this bill receives the Royal Assent. If a notice has already been given, and because of amendments made by this bill, the notice no longer complies with the requirements in section 165-115ZC, a further notice may be given varying the original notice (including by providing further information) as long as it is done within 6 months after this bill receives Royal Assent or within a further period allowed by the Commissioner.

Interest realised at a loss after the global method used

13.18 There are no notice requirements where an interest is realised at a loss after the global method has been used and an amount, or extra amount, of adjusted unrealised loss is taken to have existed at the alteration time.

Comparison of key features of new law and current law

*New law*	*Current law*
There is an option to value assets globally for the purposes of determining the unrealised net loss.	An unrealised net loss of a company at a changeover time under Subdivision 165-CC is determined having regard to the market value (or other specified value) of assets considered individually.
There is an option to value assets globally for the purposes of determining the adjusted unrealised loss.	An adjusted unrealised loss of a company at an alteration time under Subdivision 165-CD is determined having regard to the market value (or other specified value) of assets considered individually.
There is a provision that may require an adjustment in respect of an interest realised at a loss after an alteration time happens to a company where an unrealised loss is exposed by the removal, after the alteration time, of unrealised gain value, captured in a global asset valuation.	There is no provision requiring an adjustment if, after an alteration time, an interest is realised at a loss. Such a rule is not needed because the asset valuation methodology under the current Subdivision 165-CD excludes unrealised gain assets and adjustments required under Subdivision 165-CD already prevent duplication of unrealised losses at the alteration time.

Detailed explanation of new law

Amendment of guides to reflect availability of the global method of valuing assets

13.19 The guide material in Subdivisions 165-CC and 165-CD is updated to show that a company can now choose, in calculating its unrealised net loss or its adjusted unrealised loss, to work out the market value of each of its assets individually, or the market value of all of its assets together. [Schedule 14, item 1, subsection 165-115AA(2) and item 6, subsection 165-115GC(5)]

13.20 The guide material has also been rationalised generally by dividing it into more sections and by correcting a minor error in relation to describing the application of the $5 million net asset test which excludes companies from having to count unrealised losses. Consistently with the operation of section 152-15, the guide now reflects the fact that a net asset value of $5 million, or below that amount, will satisfy the test. [Schedule 14, item 1, subsection 165-115AA(1), sections 165-115 and 165-115AA and item 6, sections 165-115GA, 165-115GB and 165-115GC]

Option to choose the individual asset method or the global method

Subdivision 165-CC

13.21 The individual asset method applies for working out the company’s unrealised net loss in respect of a changeover time (the relevant time) unless the company chooses the global method. [Schedule 14, item 3, section 165-115E]

13.22 A choice to use the global method must be made on or before the day the company lodges its income tax return for the income year in which the relevant time occurred, or on or before such later day as the Commissioner allows, but not earlier than 6 months after the date this bill receives Royal Assent in a case where the changeover time happens before that date. [Schedule 14, item 4, subsection 165-115E(4) and item 16, section 165 115E of the IT(TP) Act 1997]

13.23 If the global method is chosen, the company does not have the choice of excluding assets acquired for less than $10,000. [Schedule 14, item 2, subsection 165-115A(1B) and item 4, section 165-115E(2)]

13.24 The global method of working out whether a company has an unrealised net loss is set out in a method statement. [Schedule 14, item 4, subsection 165-115E(2)]

Step 1

13.25 Step 1 of the method statement requires that the total market value of all CGT assets that the company owned at the relevant time using a valuation method that would generally be regarded as appropriate in the circumstances.

13.26 The law does not prescribe any particular valuation method, nor does it require that the valuation be undertaken by a qualified valuer. However, the method used must be one that qualified valuers would regard as appropriate for use in the particular circumstances to determine market value, having regard to the activities of the company, the particular types of assets it holds, and any other relevant matters. It must also be a valuation of the total market value of the assets, and not a valuation of the business of the company.

Step 2

13.27 Step 2 aggregates the cost bases of the CGT assets owned at the relevant time. Only if an asset’s cost base is less than the amount that, for an item of trading stock, would be compared with its market value under section 165-115F (i.e. on an individual asset basis) for calculating a notional revenue gain or notional revenue loss, or, for a revenue asset, would similarly be compared, is the trading stock or revenue asset amount used instead. This ensures that the unrealised net loss calculated under the global method could not be less than it would be under the individual asset method. [Schedule 14, item 4, subsection 165-115E(3)]

If asset (A) has a reduced cost base of $2,000 and a cost base of $5,000 and asset (B) has a reduced cost base of $4,000 and a cost base of $4,500, then $5,000 and $4,500 are to be used in respect of these assets in determining the total of amounts for all assets of the company under step 2. Because the market value of individual assets are not known, and it is not known whether individually they are unrealised gain or unrealised loss assets, this approach ensures that if a net unrealised loss results from the global method, it could not be less than what would have been calculated had the individual asset method been used.

Step 3

13.28 If the step 2 amount exceeds the step 1 amount, the excess is the company’s preliminary unrealised loss at the relevant time. Adding deferred losses or deductions (if any) under Subdivision 170-D referred to in paragraph 165-115A(1A)(b), gives the company’s unrealised net loss at the relevant time.

Y Co has a changeover time on 10 June 2000. Y Co has net assets at that time exceeding $5 million. Y Co chooses to use the global method of determining its unrealised net loss for that changeover time. Y Co has 3 assets (A), (B) and (C) with the following tax characteristics:

(A) is trading stock (on hand at the beginning of the income year) with a Division 70 value of $15,000. Its cost base and reduced cost base are nil (because its acquisition cost is deductible for tax purposes);

(B) is land held on capital account with a cost base and reduced cost base of $700,000; and

Y Co values these assets globally at the changeover time and arrives at a market value of $580,000 (step 1 amount).

Y Co’s preliminary unrealised net loss at that time is the excess of $815,000 over $580,000 (i.e. $235,000). Assuming no deferred Subdivision 170-D amounts are involved, $235,000 is also Y Co’s unrealised net loss.

Subdivision 165-CD

13.29 The individual asset method applies for working out the company’s adjusted unrealised loss in respect of an alteration time unless the company chooses the global method. [Schedule 14, item 11, subsection 165-115U(1)]

13.30 A choice to use the global method must be made on or before the day the company lodges its income tax return for the income year in which the alteration time occurred, or on or before such later day as the Commissioner allows [Schedule 14, item 11, subsection 165-115U(1D)]. If the alteration time happens before this bill receives Royal Assent, the choice does not have to be made earlier than 6 months after the day of Royal Assent [Schedule 14, item 16, section 165-115U in the IT(TP) Act 1997].

Notices

13.31 A general extension of the notice period for the purposes of section 165-115ZC is given because of the amendments made to the method of determining the amount of adjusted unrealised loss. This is relevant for alteration times that happen before this bill receives Royal Assent. In such cases, a notice required under subsection 165-115ZC(4) or (5) must now be given within 6 months after the day this bill receives Royal Assent. If a notice has already been given, and because of amendments made by this bill, the notice no longer complies with the requirements in section 165-115ZC, a further notice may be given varying the original notice (including by providing further information) as long as it is done within 6 months after this bill receives Royal Assent or within a further period allowed by the Commissioner. [Schedule 14, item 16, section 165-115ZC of the IT(TP) Act 1997]

The global method

13.32 The global method of working out whether a company has an adjusted unrealised loss is set out in a method statement. [Schedule 14, item 11, subsection 165-115U(1B)]

Step 1

13.33 Step 1 of the method statement requires that the total market value of all CGT assets (including those acquired for less than $10,000) that the company owned at the relevant alteration time be worked out using a valuation method that would generally be regarded as appropriate in the circumstances.

13.34 As is the case with the global method in Subdivision 165-CC, the law does not prescribe any particular valuation method, nor does it require that the valuation be undertaken by a qualified valuer. However, the method used must be one that qualified valuers would regard as appropriate for use in the particular circumstances to determine market value, having regard to the activities of the company, the particular types of assets it holds, and any other relevant matters. It must also be a valuation of the total market value of the assets, and not a valuation of the business of the company.

Step 2

13.35 Step 2 requires a determination of the total of the cost bases of CGT assets owned at the alteration time. In certain circumstances a greater amount for a particular asset must be used. This is on the assumption that the alteration time was a changeover time for Subdivision 165-CC and that a greater amount than cost base would be compared with the asset’s market value under section 165-115F for a CGT asset as trading stock, or as a revenue asset.

13.36 That assumption is needed for 2 reasons. Firstly, an alteration time may not also be a changeover time, even though it often will be. Secondly, the individual asset method rules in Subdivision 165-CD do not have rules for calculating unrealised gains on assets, so these rules must be notionally borrowed for Subdivision 165-CD purposes.

13.37 The use of the greater amount ensures that in calculating an adjusted unrealised loss using the global method losses are not understated relative to what would be calculated under the individual asset method. [Schedule 14, item 11, subsection 165-115U(1C)]

Step 3

13.38 If the step 2 amount exceeds the step 1 amount, the excess is the company’s adjusted unrealised loss at the relevant alteration time.

Other modifications to the operation of Subdivision 165-CD to accommodate the global method

13.39 Several modifications are made to Subdivision 165-CD to accommodate the use of the global method in that Subdivision. These are summarised as follows:

• the rule in step 1 of the method statements for the individual asset method that ensures notional losses and trading stock decreases counted at an earlier alteration time are not counted again at a later alteration time, does not apply where the global method was used at the earlier alteration time because this does not provide for individual asset valuations [Schedule 14, item 11, subsection 165-115U(1A) and item 13, subsection 165-115W(1A)];

• section 165-115T, which ensures that previously counted individual asset unrealised losses are not counted again as realised losses at a later alteration time, does not apply where the global method was used because it did not calculate individual asset unrealised losses [Schedule 14, item 9, subsection 165-115T(2)]; and

• the exclusion for non-economic unrealised losses on individual assets does not apply where the global method is used [Schedule 14, item 7, subsection 165-115R(6A) and item 8, subsection 165-115S(6A)].

Repeal of subsections 165-115F(7) and 165-115V(8)

13.40 Subsections 165-115F(7) and 165-115V(8) which give the Commissioner express authority to give advice about asset valuation, including the grouping together of assets for valuation, to reduce compliance costs associated with the Subdivision, are repealed. The global method removes the need for such provisions. [Schedule 14, items 5 and 12]

Special value shifting rule in Subdivision 165-CD where the global method is used and interest is realised at a loss for income tax purposes

13.41 A special rule applies in circumstances where the global method has been used to calculate an adjusted unrealised loss at an alteration time and, after that time, an equity or debt interest that would have been a relevant equity or debt interest in the company immediately before the alteration time (assuming the company had an overall loss at that time) is realised at a loss for income tax purposes.

13.42 The special rule is designed to prevent the global method sheltering from adjustment, and allowing the duplication of, what would have been an amount of adjusted unrealised loss calculated at the alteration time using the individual asset method. The special rule only applies in circumstances where a relevant equity or debt interest is realised at a loss for income tax purposes and it cannot be demonstrated that the loss is either:

• not attributable to the removal from the loss company of gain value on an asset owned by the company at the alteration time that sheltered an unrealised loss under the global method; or

• does not reflect an amount of unrealised loss that would have been determined had the individual asset method been used.

13.43 The problem with which the special rule deals can best be demonstrated by example.

X Co has a wholly-owned subsidiary Y Co. Post-CGT, X Co capitalised Y Co with $200 million. Y Co acquired 2 assets each costing $100 million.

A share issue at market value ($200 million) by Y Co to X Co causes an alteration time to happen for Y Co. At that time it has no realised losses, and in respect of its 2 assets (other than the $200 million invested), assume that, were the individual asset values to be known, one would have an unrealised gain of $60 million (market value $160 million), and the other an unrealised loss of $60 million (market value $40 million).

Y Co uses the global method and determines that at the alteration time (i.e. just before the share issue) the market value of all its assets is $200 million and that the cost bases for the assets is also $200 million.

Y Co does not, under the global method, have an adjusted unrealised loss and there would be no reductions to the reduced cost bases of X Co’s shares in Y Co under section 165-115ZA. If the individual asset method had been used, the unrealised gain would not have been relevant, and the reduced cost base of X Co’s (original) shares in Y Co would have been reduced by section 165-115ZA from $200 million to $140 million to prevent any subsequent duplication of the unrealised loss in Y Co of $60 million.

Following use of the global method, Y Co decides to sell the asset with the unrealised gain of $60 million and, after $18 million tax (at 30%), it pays the balance of $42 million as a franked dividend to X Co. Y Co is then worth only $340 million (on an asset basis, but ignoring any potential tax value of the unrealised loss). X Co then sells 20% of Y Co (using 40% of its original shareholding) for $68 million and would make a capital loss of $12 million (i.e. the reduced cost bases of X Co’s shares in Y Co sold are $80 million (40% of $200 million).

That $12 million would duplicate part of the unrealised loss of $60 million on Y Co’s asset at the alteration time. If the individual asset method had been used, the reduced cost bases of the later disposed of shares would have been reduced by $24 million (40% of $60 million) to $56 million and no capital losses would have been made (nor would capital gains have been made because the cost bases of the shares ($80 million) are not affected by Subdivision 165-CD adjustments).

Although the reduced cost bases of the shares are reduced by $24 million, the loss on realisation was only $12 million as a result of the dilution effect of issuing the new shares.

13.44 The approach by which the special rule addresses this problem is to treat the company as having a separate amount of adjusted unrealised loss that is relevant for determining the adjustments (or further adjustments) to be made by sections 165-115ZA and 165-115ZB in relation only to the equity or debt interest realised at a loss.

Main requirements

• a realisation event that realises a loss for income tax purposes (including a loss to which Subdivision 170-D applies) must happen to an equity or debt interest in a company. Whether a loss would be realised is determined without regard to any adjustments that the special rule may require. What constitutes a realisation event and realisation at a loss is set out in Division 977, and is discussed in Chapter 12.

• the equity or debt must have been, or have been part of, a relevant equity interest (see section 165-115X) or a relevant debt interest (see section 165-115Y) in the company at an alteration time for it when the global method was used to determine the adjusted unrealised loss. If the global method was used, the company is taken to have been a loss company for these purposes. The alteration time must be the latest one for the company when both the global method was used and the equity or debt was a relevant equity or relevant debt interest in it immediately before that time. If the individual asset method is used for an alteration time of the company after the global method has been used, and the equity or debt is still, or is still part of, a relevant equity or debt interest in respect of that alteration time, any adjustments required in respect of that alteration time will remove the problem that the special rule seeks to overcome.

13.46 If these requirements are met, then certain amounts may, subject to specific exclusions, be treated as an amount (or extra amount) of, adjusted unrealised loss for the company in respect of that alteration time. This is used for adjusting the loss attributes (e.g. reduced cost bases) of the realised equity or debt. The amount of adjusted unrealised loss, or extra amount of adjusted unrealised loss, cannot exceed the amount of loss realised for tax purposes on the equity or debt. [Schedule 14, item 15, subsection 165-115ZD(4)]

13.47 The amount is then used for the purpose of making adjustments immediately before the alteration time in respect of the equity or debt under sections 165-115ZB and 165-115ZA. The adjustments are to be worked out and applied in accordance with subsection 165-115ZB(6) (the non-formula method) [Schedule 14, item 15, subsection 165-115ZD(3)]. Broadly, this will require reasonable adjustments to prevent loss duplication on the interest. This must take into account the fact that the amount of adjusted unrealised loss for the purpose of the special rule (see paragraph 13.48) is limited to the amount of realised loss on the interest and is not to be diluted because there are other interests in the company.

Amounts that may become, or may add to, an amount of adjusted unrealised loss

13.48 The amount of adjusted unrealised loss is worked out in a method statement [Schedule 14, item 15, subsection 165-115ZD(4)]. Broadly, the method statement operates as follows. Step 1 adds the distributions or value shifts from the company that could result in the exposure of unrealised losses at the alteration time. If this exceeds the loss actually realised for income tax purposes on the equity or debt, step 2 reduces the step 1 amount by the excess. A rule to deal with the case where the realised loss is less than or equal to the step 1 amount will be included in a later bill. Step 3 reduces further (if applicable) the step 2 amount by so much of the realised loss that is not reasonably attributable to unrealised losses on assets at the alteration time. This can be shown by any appropriate methodology whether or not individual asset losses are known. The net result is the adjusted unrealised loss for the purposes of the special rule.

Amounts for the purposes of step 1

13.49 The first amount for step 1 is the amount of dividends paid or other distributions of capital or income by the company during the period (relevant period) starting at the alteration time and ending at the realisation event [Schedule 14, item 15, subsection 165-115ZD(5), items 1 to 3 in the table]. If the equity or debt realised ceases to be part of a relevant equity interest or relevant debt interest in the company before the realisation event, the relevant period ceases instead immediately before that time.

13.50 The second amount for step 1 is the amount of any income tax the company becomes liable to pay at any time that is reasonably attributable to a realisation event happening during the relevant period to an asset owned by the company at the alteration time, other than an asset it acquired for less than $10,000. [Schedule 14, item 15, subsection 165-115ZD(5), item 4 in the table]

13.51 The third amount for step 1 is the amount of any outgoing or loss for which the company becomes liable at any time that is reasonably attributable to the realisation during the relevant period, of an asset owned by the company at the alteration time, other than an asset it acquired for less than $10,000 [Schedule 14, item 15, subsection 165-115ZD(5), item 5 in the table]. This would cover an incidental cost of selling the asset. Broadly, the second and third amounts for step 1 are intended to address the removal from the company of ‘gain value’ at the alteration time that relates, generally, to the costs of realising and becoming liable for tax on that gain.

13.52 The fourth amount for step 1 is the amount of value shifted by the company to its associate by way of a CGT event happening to the asset during the relevant period in respect of which less than market value capital proceeds are obtained by the company. [Schedule14, item 15, subsection 165-115ZD(5), item 6 in the table and subsection 165-115ZD(7)]

Exclusions

13.53 The step 1 amounts do not include amounts that are not reasonably attributable or referable to value that was reflected in a notional capital gain or notional revenue gain that the company had at the alteration time in respect of the CGT asset, or, to avoid double counting, to the extent the transaction, dealing or event referred to in step 1 reduced the reduced cost base of the equity or debt. [Schedule 14, item 15, paragraphs 165-115ZD(5)(a) and (b)]

13.54 The reason for these exclusions is that the outlay, distribution or value shift would not have exposed an amount of adjusted unrealised loss that would have been taken into account at the alteration time if the individual asset method had been used, or the tax law otherwise adjusts for the exposure.

Continuing Example 13.3, but for the special rule, X Co would make a capital loss of $12 million on the realisation of its shares in Y Co. But, after the alteration time, Y Co paid tax of $18 million that was reasonably attributable to an unrealised gain on an asset owned at the alteration time, and also paid a dividend of $42 million similarly reasonably attributable to that unrealised gain. None of the exclusions applies, and it cannot reasonably be concluded that the loss that would otherwise be realised on the interest does not give duplicate tax recognition for the unrealised loss on Y Co’s asset at the alteration time. Y Co’s adjusted unrealised loss at the alteration time is taken to be $60 million for the purposes of applying sections 165-115ZA and 165-115ZB to the realised interests. In effect, their reduced cost bases are reduced by $24 million (40% of $60 million) to $56 million immediately before the alteration time. This prevents any duplicate capital loss from being realised.

Becoming a member of a consolidated group

13.56 If the global method has been used and an equity or debt interest is held by members of a consolidated group in an entity that joins the group, subsection 705-65(3A) as proposed in this bill may (by assuming a disposal of the equity or debt for market value consideration immediately before the joining time) have the effect that comparable adjustments to those already described have to be done for consolidation cost setting purposes. A similar approach applies in the formation case.

Immediately before the joining time, members of a consolidated group have shares in a joining entity with a reduced cost base of $70 million and a market value of $30 million. At the joining entity’s last alteration time for which the global method was used and the shares were part of a relevant equity interest in the company immediately before the alteration time.

An assumed disposal of the shares would realise a loss for income tax purposes of $40 million, so reductions to the reduced cost bases of the shares may be required as a result of subsection 165-115ZD(1) of the ITAA 1997 applying.

This ensures that the consolidation cost setting rules do not admit into allocable cost amounts representing duplicates of unrealised losses at an alteration time.

If the membership interest was a revenue asset, and a deduction for income tax purposes of $40 million (i.e. net loss on realisation) would have arisen for income tax purposes had it been disposed of immediately before the joining time, there would have been no capital loss (because of the operation of subsection 110-55(9) of the ITAA 1997) but the $40 million (as a loss on a realised revenue asset) would, via sections 705-65(3A), 165-115ZD and 165-115ZA result in a similar reduction to reduced cost base of the interest for consolidation cost setting purposes.

Transitional rule

13.57 There is a special transitional application of section 165-115ZD(1) for alteration times that happen before Royal Assent [Schedule 14, item 16, subsection 165-115ZD(1) of the IT(TP) Act 1997]. This can apply by choice in the general case where there is an actual realisation of an interest, and also for cost setting purposes under the consolidation rules.

13.58 A choice to use a transitional approach if an interest is realised at a loss for Subdivision 165-CD purposes must be made by the entity that owns the equity or debt interest concerned. The choice must be made by the later of the time an income tax return is lodged for the income year in which the realisation event happened, or by such later time as the Commissioner allows, or 6 months after the relevant alteration time when the global method was used happened, but not in any event within 6 months after the date this bill receives Royal Assent. [Schedule 14, item 16, section 165-115ZD of the IT(TP) Act 1997]

13.59 The main difference between the transitional and ordinary application of section 165-115ZD(1) is that under the transitional rule, there is no requirement to consider distributions or value shifts in ascertaining whether unrealised losses are exposed.

13.60 Broadly, any method or approach which, directly or indirectly, may allow a reasonable conclusion to be drawn or inferred, that a realised loss on an equity or debt interest could not duplicate an unrealised loss at the alteration time, can be used. (Such an approach can also be used in the non-transition case, but there is a specific requirement there to have regard to distributions or value shifted).

13.61 A way that a reasonable conclusion might be drawn is as follows. A comparison might be made between the equity or debt’s proportional share in the total of amounts calculated for the purposes of step 2 of the method statement in subsection 165-115U(1B) at the alteration time, and the equity or debt’s proportional share in the company’s adjusted net asset value. The adjusted net asset value is an amount being the market value of all the company’s assets at the realisation time less (plus) a net increase (decrease) in the company’s liabilities between the relevant alteration time and the realisation time.

13.62 Without regard to changes in liabilities, an increase in the market value of assets may (inappropriately) be taken to have increased the value of shares and other interests in the company (e.g. if the increase in asset value is matched by an increase in borrowing), and a decrease in the market value of assets may (inappropriately) be taken to have decreased the value of interests (e.g. if liabilities have been repaid).

13.63 If it can be shown that the equity or debt’s proportional share in the company’s adjusted net asset value is at least equal to its proportional share in the company’s step 2 amount, no additional amount of adjusted unrealised loss would arise.

13.64 If the proportionate share is less then an amount of adjusted unrealised loss may be needed to prevent loss duplication, but this would depend on the extent to which adjustments had been made previously and other factors.

XYZ Co is wholly-owned by ABC Co immediately before 12 December 2001. ABC Co acquired all its shares in 1998 for $63 million, and holds them on capital account.

XYZ Co, which has no realised losses, has a step 2 amount of $63 million at 12 December 2001.

Total market value of assets (using a generally accepted valuation approach) = $60 million.

ABC Co sold 60% of its shares in XYZ Co to Acquirer Co, an associate, on 12 December 2001 for $36 million triggering a change in ownership of XYZ Co and an alteration time. ABC Co remains an associate of Acquirer Co. The global method was chosen for determining the adjusted unrealised loss in respect of that alteration time. An amount of $3 million was the company’s adjusted unrealised loss at that time, and adjustments under section 165-115ZA were made on that basis. On these facts, the reduced cost base of ABC Co’s entire 100% share holding would have been reduced by $3 million, from $63 million to $60 million. No capital loss would be obtained on the disposal of the 60% interest (sale proceeds $36 million and reduced cost base $36 million ($37.8 million less Subdivision 165-CD reduction of $1.8 million)).

In June 2002, a further parcel of shares held by ABC Co representing 10% of the equity in XYZ Co (and 25% of ABC Co’s remaining holding in XYZ Co) was sold. This sale does not cause another alteration time for XYZ Co to happen.

Because the holding sold by ABC Co was a relevant equity interest in XYZ Co immediately before the initial alteration time, if the interest is disposed of at a loss, it would be necessary to examine whether further Subdivision 165-CD reductions are required in respect of it because of subsection 165-115ZD in relation to the initial alteration referred to above where the global method was used. Assume that ABC Co chooses to use the transitional rule because it has asset valuation data at the realisation time, and does not want to have regard to distributions and value shifts made since the alteration time.

If the 10% interest of ABC Co in XYZ Co were in fact sold at a small loss (e.g. because it is a minority interest), and if it can be concluded that the adjusted net asset value is at least $60 million (i.e. unchanged from the position on 12 December 2001) then, under the transitional rule relating to section 165-115ZD, no later reduction to reduced cost base under section 165-115ZA in respect of the earlier alteration time would be required in respect of the interest. The $0.3 million reduction already made at the alteration time is sufficient to prevent any unrealised loss at the alteration time being duplicated at the time the realisation event happens to the interest. Any loss arising on the disposed of the interest would not be duplicating an unrealised loss of XYZ Co at the alteration time.

However, if the adjusted net asset value has fallen to $50 million, it may be necessary to make further reductions (with effect from 12 December 2001) because of section 165-115ZD(1) in the IT(TP) Act 1997 under section 165-115ZA to the interest that
was sold based on the difference between $1.3 million
(i.e. 10% × ($63 million – $50 million)) and the $0.3 million already factored into reductions (i.e. $1 million). On the facts available, it would prima facie be necessary to reduce the reduced cost base of the shares sold by ABC Co by a further $1 million, or if this does not produce a reasonable outcome the reduction would be based on the extent to which the total $10 million decrease in net asset value is reflected in the value of the disposed of interest.

This example illustrates what happens when the proportional interest of a relevant equity interest in the assets of a loss company changes after an alteration time.

Assume a shareholder owns all of the issued shares in a company (100 shares) and it holds them on capital account. The total reduced cost base of the shares is $5 million.

An alteration time happens for the company and it uses the global method to ascertain that it had an adjusted unrealised loss of $2 million (total asset market valuation $3 million and step 2 amount $5 million).

As the shares are part of a relevant equity interest in relation to the alteration time, their total reduced cost base are reduced to $3 million.

Later, asset value of $1 million is removed from the company (for which there are no cost base or reduced cost base adjustments), but an additional 50 shares are issued contemporaneously to make up the deficiency (total extra capital contributed $1 million). This is not an alteration time.

A disposal then occurs of 10% of the equity that existed immediately before the alteration time. Assume this does not cause another alteration time to happen.

A capital loss of $100,000 (reduced cost base $300,000 less capital proceeds $200,000) would be made in respect of the disposal (subject to any adjustment required under section 165-115ZD of the ITAA 1997 or section 165-115ZD of the IT(TP) Act 1997 if the transitional rule is chosen).

Assume the transitional rule is chosen. Although total asset market values have remained unchanged ($3 million) since the alteration time, there has been a decline in the proportional asset value attributable to the disposed of interest (i.e. $300,000 reduced to $200,000
(10/150 × $3 million)). Thus, there would need to be an additional adjustment amount under section 165-115ZA so that the reduced cost base of the disposed of interest is reduced by $100,000 and no capital loss is then made.

Application and consequential amendments

13.65 The amendments apply to a time at or after 1 pm, by legal time in the Australian Capital Territory, on 11 November 1999. [Schedule 14, item 19]

13.66 As a result of the amendments, the dictionary contains 2 new terms – global method and individual asset method. [Schedule 14, items 17 and 18]

Policy objective

Background

14.1 The GVSR is an important integrity measure in the Government’s broad ranging reforms to give Australia a New Business Tax System. The GVSR is based on the recommendations of the Review of Business Taxation, which was instituted by the Government to consider reform of Australia’s business tax system.

14.2 Recommendations 6.12 to 6.16 of A Tax System Redesigned recommended the introduction of a GVSR to replace the current value shifting rules in Divisions 138, 139 and 140 of the ITAA 1997. The Government indicated its acceptance of these recommendations in Treasurer’s Press Release No. 58 of 21 September 1999. Treasurer’s Press Release No. 16 of March 2001 deferred commencement date of those recommendations to 1 July 2002. The GVSR was further foreshadowed in the Minister for Revenue and Assistant Treasurer’s Press Release No. C57/02 of 14 May 2002.

What is value shifting

14.3 Broadly, ‘value shifting’ describes transactions and other arrangements that reduce the value of some assets and (usually) increase the value of other assets. Assets for these purposes include shares in companies and interests in trusts. The assets involved may be owned by the same taxpayer or by different taxpayers. The assets may be held on capital account or may be trading stock or revenue assets.

Distortions of tax outcomes

14.4 Where assets are held on capital account, most capital gains (capital losses) are calculated as the difference between an asset’s cost base (reduced cost base) and its market value when the asset is realised.

14.5 Value shifting arrangements can distort the relationship between an asset’s market value and its relevant cost base without generating either a taxing point (e.g. a disposal), or without generating other tax adjustments under the normal rules. When assets are realised, inappropriate losses and gains may result.

14.6 Where assets are held on revenue account, or as trading stock, value shifting arrangements can have a similar effect on the relationship between the market value of the asset and the values that are used to work out what amounts are included in assessable income or as deductions when the asset is realised.

14.7 For assets where gains are brought to tax, and losses allowed, on a realisation basis, value shifting presents a particular problem to the integrity of the tax system. It is possible to create losses by shifting value out of assets, yet defer gains on assets to which the value is shifted by choosing not to realise them.

Situations where value shifting can occur

14.8 Types of situations where value shifting transactions can commonly occur include:

• modifications to rights attaching to equity or loan interests in companies or trusts, and new issues of interests in these entities at a discount to market value;

• internal restructures of group of entities, involving the transfer of assets and the cancellation and issue of interests;

• transfers or creations of assets or debt forgiveness for less or more than market value; and

• new and continuing service arrangements involving commonly controlled or commonly owned entities that are conducted on a non-arm’s length, non-market value basis.

Problems with the current value shifting rules

14.9 The current value shifting rules are flawed in several key respects, including:

• they focus on particular types of value shift involving particular types of entities – the current tax law has arisen in an ad hoc fashion and therefore lacks a sound base;

• appropriate exclusions are non-transparent and, in some cases, non-existent;

• complex rules apply to entities of all sizes and types although the risk of value shifting involving smaller entities is less in some cases.

As a consequence the associated compliance costs are high and the integrity benefits achieved uncertain and debatable.

Objectives

14.10 The aim of the GVSR is to add integrity, equity and efficiency to the business tax system by:

• achieving comparable integrity in respect of value shifting outside consolidated groups to that attained within consolidated groups by its cost setting rules;

• enhancing the integrity of the CGT rules by implementing a generalised regime to replace the current value shifting rules which are deficient in many respects; and

• providing consistent and comprehensive tax treatment for the impact of value shifting.

14.11 The proposed changes to the taxation law are intended to have the effects as listed in paragraphs 14.12 to 14.20.

14.12 Usually, the GVSR will adjust realised losses or gains, or realign values for tax purposes (e.g. cost bases) of assets affected by value shifting, in order to ensure that inappropriate gains or losses do not arise when they are realised. Sometimes, a value shift out of an asset may be effectively treated as a part disposal of the asset with possible taxable gain (but not loss) consequences.

14.13 The GVSR will apply mainly to equity and loan interests in certain companies and trusts that are affected directly, or indirectly, by value shifting arrangements. (One part of the GVSR deals with the creation of rights at less than market value in associates over non-depreciating assets and the impact of such value shifting at that, or a later time).

14.14 Affected equity and loan interests are those in companies and trusts that satisfy a control test, or, if the entities are closely-held, a common ownership test (set at a minimum 80% level).

14.15 Affected interest holders are usually controllers and their associates, or common owners and their associates. Active participants in value shifting arrangements involving closely-held entities may also be subject to the GVSR.

14.16 The GVSR will apply to equity and loan interests held on capital account and on revenue account (i.e. as trading stock or revenue assets).

14.17 The GVSR does not implement a domestic transfer pricing regime which restates the tax values of economic benefits provided and received. It does, however, provide certain consequences if interests are realised in affected entities that have exchanged unequal value benefits in non-arm’s length transactions.

14.18 The GVSR will replace the current share value shifting and asset stripping rules in the tax law.

14.19 Importantly, for compliance cost reasons, taxpayers able to satisfy the CGT small business $5 million net asset threshold and taxpayers eligible for the STS are excluded from the IVS rules of the GVSR.

14.20 Generally, and subject to some transitional arrangements, the GVSR will apply to value shifting that happens on or after 1 July 2002.

Minor change to the loss integrity measures and insertion of a special value shifting rule

14.21 In addition, some minor changes are proposed to the loss integrity measures, introduced in 1999 and 2000, that deal with the duplication of companies’ realised and unrealised losses (Subdivisions 165-CC and 165-CD of the ITAA 1997).

14.22 Compliance costs can be significantly reduced in these measures by allowing the choice to value an entity’s assets globally to determine its unrealised loss position. The current rules require that assets be valued individually. A special value shifting rule will be inserted in Subdivision 165-CD to ensure that the inclusion of gain asset value in a global valuation will not result in any significant loss of integrity in that Subdivision. There will be a small compliance cost increase in complying with this value shifting rule, however this increase is expected to be significantly outweighed by the compliance cost reductions associated with allowing global asset valuations.

14.23 The global asset valuation option will also assist cost setting under the consolidation rules where entities have been subject to the integrity measures.

14.24 These minor amendments, being optional and favourable to taxpayers in comparison with the current law, will apply from 11 November 1999 being the date that Subdivisions 165-CC and 165-CD commenced.

Implementation options

14.25 The GVSR is based on Chapter 29 of A Platform for Consultation and Recommendations 6.12 to 6.16 of A Tax System Redesigned.

Option 1

14.26 The implementation of the recommendations in A Tax System Redesigned without any modification was the first option considered for the GVSR (option 1). Option 1 would involve the implementation of a GVSR having the following features:

• it would apply to assets having tax values determined on a realisation basis under the tax value method;

• it would apply to interests in, and assets of, entities (and their associates) that are controlled by other entities (and their associates);

• it would apply to non-controlling interests in entities, but only where the holders of those minority interests actively participate in, or otherwise facilitate, value shifting arrangements;

• it would include de minimis exceptions that would balance integrity considerations and the containment of compliance costs;

• it would apply to direct value shifts (involving the shift of value directly from an asset or interests) not covered by other reform measures, including value shifts from pre-CGT assets to post-CGT acquired assets;

• that gains or losses not be crystallised for indirect value shifts (where an arrangement affects the value of an entity and, as a result, the values of interests in an entity are indirectly affected). A tax value adjustment method, using a loss-focused approach to working out adjustments was to be used instead; and

• it would replace the current share value shifting and asset stripping rules from 1 July 2000.

Option 2

14.27 A modified option (option 2) is based on the recommendations in A Tax System Redesigned modified in certain ways. These modifications:

• apply the recommendations in A Tax System Redesigned in the context of the current tax regime, modified for the deferred commencement of the consolidation regime until 1 July 2002 – recognising that it would not be appropriate to continue with the existing value shifting rules until such time as a new way of calculating income and deductions was implemented;

• extend the application of the GVSR to cases of value shifting not explicitly referred to in A Tax System Redesigned but consistent with its policy thrust (e.g. value shifting by individual controllers of companies), or to cases of value shifting that were expected to be dealt with under another measure that has not yet been implemented (e.g. a comprehensive rights regime); and

• apply the policy of the measure in a practical way by not extending some of the rules to certain classes of taxpayers (i.e. small business taxpayers) where the integrity benefits that would be achieved would be far outweighed by the compliance costs imposed. The modifications also address matters raised and discussed in consultation with representatives of industry and the profession.

14.28 In summary, the modified GVSR would broadly operate in a similar way to option 1, with the key modifications being an extension to deal with certain value shifting where rights are created over assets, and an exclusion for small business and taxpayers eligible for the STS from most of the GVSR. Most other changes implement the original policy in a more practical and cost-minimising way.

14.29 Option 2 is the result of extensive consultation on option 1 and also adjusts option 1 so that its intent applies in the context of the current tax regime, rather than the one envisaged when option 1 was being developed. Table 14.1 summarises the modifications to the A Tax System Redesigned recommendations and the reasons for them.

*Option 2*	*Option 2 compared with option 1*
Apply the value shifting rules to closely held companies and trusts where there is a very high degree of ‘common ownership’ as well as in control cases – recommendations referred only to ‘controlled’ entities.	Option 1, in being restricted to controlled entities, could have allowed significant value shifting to occur where there was a high degree of common ownership in entities. This risk is most evident in closely-held entities, and the common ownership tests are limited to them. Option 2 recognises, and addresses the potential for significant value shifting in these cases.
Apply the value shifting rules if value is shifted out of a company or trust to any other entity, including an individual – recommendations did not apply to transfers to an individual.	Option 1 would have allowed, for example, an individual controlling a company to shift value to himself or herself and sell the shares in the company for an artificial loss. Option 2 recognises, and addresses the potential for significant value shifting in these cases.
Apply the value shifting rules to assets being taxed on a ‘realisation basis’ under the current law – recommendations referred to assets having tax values determined on a realisation basis under the new law.	Option 2 aligns the GVSR recommendations with language and concepts under the current law, whereas option 1 referred to concepts that do not currently exist.
Allow taxpayers choice of method for effecting IVS adjustments – adjustable value adjustment at the time of the shift or reduction of gains or losses on realisation –recommendations provided only for adjustable value adjustments at the time of the value shift.	Option 2 provides taxpayers with maximum flexibility in complying with the policy outcomes intended for the GVSR and avoids unnecessary adjustments in some cases. This can be achieved without any discernible loss of integrity in the measure. Consultation revealed a strong preference for option 2 in this regard. Option 1 would have provided less flexibility and may have resulted in unnecessary adjustments in some cases.
To provide that in particular cases, taxable gains may arise if value is shifted between assets of a different nature, for example, the shift occurs from shares that are held as trading stock to shares that are not held as trading stock –recommendations did not address the fact that value shifts involving the same person’s interests could involve a shift between interests of a different tax character.	Option 2 ensures that inappropriate tax advantages are not obtained by applying the mere realignment of adjustable values in cases where value is shifted between assets of a different nature held by the same taxpayer. Option 1 could have allowed value of one tax character (e.g. income on trading stock or a revenue asset) to be shifted to become value of another tax character (e.g. capital gain) to facilitate the offset of capital losses or to obtain the CGT discount (neither of which is available for non-CGT income).
Apply the value shifting rules to certain arrangements in which a right is created over an underlying asset held by an associate and the devalued underlying asset is sold – recommendations suggested this would be addressed under a comprehensive rights regime.	Option 2 addresses some value shifting potential where rights are created over assets in the absence of a comprehensive regime for the taxation of rights. Option 1, if implemented, would have left unaddressed potentially significant value shifting opportunities.
Exclude, for compliance cost reasons, small business taxpayers and taxpayers eligible for the STS from the IVS rules of the GVSR –recommendations did not expressly exclude such taxpayers.	Option 2 recognises that in the process of balancing integrity benefits with compliance costs, small business and STS eligible taxpayers can be excluded from the IVS rules of the GVSR. The general anti-avoidance provisions in the tax law are still capable of applying to value shifting arrangements and schemes. Option 1 could have imposed compliance costs on certain entities that would far outweigh any integrity benefits achieved.

Assessment of impacts

14.30 As option 2 has been developed and refined from option 1 against the backdrop of the current tax regime (rather than the one envisaged when option 1 was formulated) and as it responds to the detailed consultations undertaken (see Table 14.1), this latter option will not be assessed further. The assessment below concentrates on the impacts of option 2.

Impact group identification

14.32 There are a number of taxpayers that are subject to the current value shifting rules that will be subject to the GVSR. They are:

• controllers and associates that hold equity interests in companies that are subject to share value shifting adjustments; and

• taxpayers holding equity or loan interests in companies that are 100% commonly owned, and that are subject to value shifting adjustments when the companies shift value by asset stripping or debt forgiveness.

14.33 These taxpayers will be required to make the same type of adjustments under the GVSR. The application of different methods for calculating adjustments may reduce the compliance costs associated with the measure for these taxpayers.

14.34 There are a number of taxpayers that are not subject to the current value shifting rules that will be subject to the GVSR. They are:

• controllers and associates that hold equity or loan interests in controlled trusts subject to DVS arrangements (e.g. variation of rights) – however, the ‘interests’ of mere objects in discretionary trusts are not subject to value shifting adjustments;

• controllers, associates and common owners that hold interests in trusts that satisfy common control or common ownership tests with other trusts or companies – in circumstances where there is an indirect effect on the value of the interests from value shifting – however, the ‘interests’ of mere objects in discretionary trusts are not subject to value shifting adjustments;

• controllers, associates or common owners with loan interests in controlled or commonly owned companies that are not covered by the value stripping rules in the current law;

• controllers, associates or common owners with equity interests in controlled companies, or closely-held companies with less than 100% but more than 80% common ownership;

• in some cases involving closely-held entities, persons, with interests in entities, who do not form part of a control or common ownership framework that actively participate in a value shifting scheme; and

• taxpayers creating rights over assets at less than market value in favour of their associates where the underlying assets (or replacement assets) are realised by the taxpayers or certain other parties at reduced values for losses.

14.35 Taxpayers affected by the GVSR will need to make appropriate adjustments to account for the effect of value shifting transactions on the values of their assets to ensure that inappropriate gains and losses do not arise on the realisation of those assets.

14.36 There are a number of entities subject to the current value shifting rules that will not be affected by the GVSR. The GVSR will not impact on:

• entities with interests in consolidated group members and MEC group members whose values for tax purposes are reconstructed under consolidation rules; and

• interest holders affected by an indirect value shift that can satisfy the CGT small business taxpayer $5 million net asset test or are eligible for the STS.

14.37 Also, transactions that involve small value shifts will not be subject to the GVSR.

14.38 Many of the GVSR rules are ‘loss-focused’ which means that they may only have a practical application if an interest is realised at a loss.

14.39 Additionally, transactions and dealings that can be shown to have been done at arm’s length, or for market value, will largely avoid the GVSR except for cases involving variations in rights of equity and loan interests in trusts.

Analysis of costs and benefits associated with implementation

Compliance costs

14.40 Taxpayers to whom the current value shifting rules apply would expect a small increase in compliance costs as they familiarise themselves with the GVSR. Overall taxpayers should benefit from the GVSR by moving from an ad hoc set of rules to an integrated and clearer set of rules.

14.41 For taxpayers not currently subject to the current value shifting rules and that are not excluded from the GSVR there will be a small to moderate increase in compliance costs. Such costs may arise, for example, from the familiarisation process, and establishing methods of measuring, and in many cases minimising, their exposure to the GVSR. For example, taxpayer’s that control entities that provide services to other related parties may need to set up systems to determine the market value of the services provided, or the costs of providing those services.

• taxpayers able to satisfy the small business CGT $5 million threshold and taxpayers eligible for the STS will be excluded from the IVS rules of the GVSR; and

• interests in entities that enter the proposed consolidation regime and whose values for tax purposes are reconstructed by those rules will not be subject to the GVSR.

14.43 For all entities subject to the GVSR, the introduction of guidance material by the ATO will reduce compliance costs, as it will assist with an understanding of the measures.

14.44 In addition, the minor amendments to the loss duplication rules in Subdivisions 165-CC and 165-CD of the ITAA 1997 will provide significant relief from compliance costs by allowing taxpayers to value assets globally rather than individually.

Administrative costs

14.46 The ATO will release a detailed guide to the GVSR on its website taking into account the views of a representative sample of likely users of this material.

14.47 The ATO information booklets will need to be modified to include a reference to the new GVSR. Also, it is the ATO practice to produce information sheets and, where required, update the website to reflect the amendments ahead of printing the new booklets. The ATO is constantly updating information on its website and its booklets, return forms, schedules and guides are updated annually. The impact on administration from these amendments will be folded into this process. Therefore, there should be minimal additional cost to administration in this respect.

14.48 ATO staff will need to be trained on the GVSR in order to deal with requests for advice. This training will be part of on-going internal training, therefore additional administration costs in this respect will be minimal.

Government revenue

14.49 There is expected to be a gain to revenue over the next 4 years in respect of introducing the GVSR as follows:

14.50 The reason for the nil amount in the first year is that the GVSR will impact mostly at the time of assessment.

14.51 There is expected to be no significant change to revenue in respect of the minor amendments to the loss duplication rules in Subdivisions 165-CC and 165-CD of the ITAA 1997.

Economic benefits

14.52 The core economic benefit of the GVSR will be that the true value of gains or losses made on assets, in particular interests in trusts and companies, will be less distorted.

14.53 There may be some changes to the behaviour of entities to the GVSR who may choose to deal at arm’s length, at market value, or within the safe-harbours provided by the GVSR, to avoid adjustments, or later adjustments when assets are realised.

14.54 There will be efficiency benefits in that there will be no systemic tax advantage to value shifting outside consolidation.

14.55 Overall, and in the longer term, there should not be a significant increase in compliance costs.

Consultation

14.56 In the development of this measure, there was significant consultation with tax practitioners and industry professionals. Special attention was given to the development of appropriate safe-harbours, de minimis exclusions, and a loss-focused realisation approach to many adjustments, so that entities would not be required to undertake elaborate transfer pricing analysis or benchmarking to market value to avoid the operation of the GVSR. Special attention was given to the treatment of services in this respect.

14.57 A cross-section of representatives of potentially affected parties participated in the consultation. These included representatives of large business and smaller business.

14.58 The GVSR recommendations and modifications were discussed and considered in detail. There was, in general, support for option 2 in preference to option 1 because of the exclusions for small business and taxpayers eligible for the STS, and for the greater flexibility in making IVS adjustments. The extensions to the GVSR as recommended to address the creation of rights in particular circumstances, and cases where individuals obtained value shifting advantages, were not considered to be unreasonable extensions of to the regime as originally recommended.

Conclusion

14.59 The preferred implementation option, option 2, builds on the recommendations in A Tax System Redesigned to ensure that the GVSR is implemented in such a way as to maximise the integrity benefits of the measure but at the same time keeping compliance and administration costs as small as possible. The modifications made by the GVSR strengthen those recommendations as they:

• enhance the integrity of the measure by ensuring that the measure applies in circumstances not expressly mentioned in A Tax System Redesigned but consistent with the overall policy thrust of the recommended measure; and

• introduce realistic limits on the compliance costs associated with the measure while preserving its integrity.

14.60 The GVSR will strengthen the integrity of the tax law by establishing a set of value shifting rules that will:

• provide a more consistent and comprehensive tax treatment for the transfers of value.

• there will be less distortions on the gains and losses realised on assets affected by a value shift; and

• there will be no disincentive to members of a wholly-owned group entering into the consolidation regime, as there will be no systemic tax advantage for value shifting outside consolidation.

14.62 Overall, this proposal will strengthen community confidence in the integrity of the tax system in that it will apply equitably in the community.

Outline of chapter

15.1 Part 1 of Schedule 16 to this bill amends the ITAA 1997 to insert Division 125. This Division allows CGT roll-over when a CGT event happens to original interests in a company or trust under a demerger and new or replacement interests are received in the demerged entity. The roll-over allows a capital gain or loss made from a CGT event happening to original interests to be deferred. Certain capital gains or capital losses made by members of a demerger group, because of a demerger, are disregarded.

15.2 Part 2 of Schedule 16 to this bill amends the ITAA 1936 to exempt certain dividends arising under a demerger.

15.3 Part 3 of Schedule 16 to this bill makes consequential amendments to the CGT provisions and dictionary in the ITAA 1997.

15.4 This proposed legislation does not cover linkages with consolidations and other regimes currently before Parliament. Integrity rules for non-widely-held entities demerging will also need to be added. These and other consequential amendments are planned to be addressed at the earliest opportunity.

Context of reform

15.5 The CGT relief and dividend exemption will facilitate the demerging of entities by ensuring that tax considerations are not an impediment to restructuring a business. These amendments are based on Recommendation 19.4 of A Tax System Redesigned, and recognise that there should be no taxing event for a restructuring that leaves members in the same economic position as they were just before the restructuring.

15.6 The CGT relief provided for demergers complements the scrip for scrip roll-over provided under Subdivision 124-M of the ITAA 1997. A Tax System Redesigned recommended tax relief for both demergers and for takeovers and mergers achieved by scrip for scrip exchanges.

Summary of new law

Capital gains tax roll-over for interest owners

15.7 Subdivision 125-B provides CGT roll-over to owners of a head entity of a demerger group if, under a demerger:

• at least 80% of the demerger group’s ownership interests in the demerged entity are acquired by the owners of the head entity; and

• each owner receives the same proportion of new interests in the demerged entity as their proportion of original interests, just before the demerger, in the head entity.

15.8 Roll-over is available for CGT events that happen on or after 1 July 2002 under a demerger. Broadly, the effect of the roll-over is to defer the making of a capital gain or capital loss, and is chosen by the owners of the interests in the head entity for each of their affected interests. The cost base of the owner’s original interests is then apportioned across these interests and new interests acquired under the demerger.

15.9 Owners of pre-CGT interests in the head entity are able to treat their new interests in the demerged entity as pre-CGT interests. The proportion of pre-CGT original interests in the head entity, just before the demerger, is applied to determine the number of pre-CGT new interests in the demerged entity.

15.10 If an owner of a head entity receives something other than new interests in the demerged entity, such as cash, the roll-over is not available.

Capital gains tax exemption for members of demerger groups

15.11 Subdivision 125-C provides that certain capital gains or capital losses made by a demerging entity are disregarded. An entity cannot choose for this exemption not to apply. Certain other CGT consequences for other members of a demerger group under a demerger are also disregarded or altered.

15.12 A capital loss that is attributable to a value shift under a demerger may be reduced. The reduced cost base of an asset of the demerger group may be reduced if the asset is subject to roll-over after the demerger.

Dividend exemption

15.13 An assessable dividend arising as a result of a demerger happening is exempt. Integrity rules will limit this exemption where there is a scheme that has a purpose of obtaining that non-assessable dividend. To the extent that a dividend is not a demerger dividend the normal rules relating to dividends apply.

15.14 The entity paying the dividend chooses, for all shareholders, that the dividend be treated as a demerger dividend.

Diagram 15.1: Summary of the relief available and the tests that must be satisfied

Comparison of key features of new law and current law

Detailed explanation of new law

Capital gains tax roll-over for interest owners

15.15 Demerger roll-over is available to all entities, other than discretionary trusts and superannuation funds, when a demerging entity or entities transfer or issue:

• at least 80% of the demerger group’s ownership interests in a demerged entity to the interest owners of the head entity; and

15.16 Demerger roll-over is available for the owners of interests in the head entity of a demerger group.

What is a demerger group?

15.17 A demerger group is a group of companies or trusts, comprising a head entity and at least one demerger subsidiary. [Schedule 16, Part 1, subsection 125-65(1)]

15.18 A demerger group does not include a discretionary trust. It is difficult to establish, with any degree of certainty, the real economic ownership of the assets of a discretionary trust, and it is equally difficult to test whether that ownership has been maintained. [Schedule 16, Part 1, subsection 125-65(2)]

What is a head entity?

15.19 A company or trust is the head entity of a demerger group if no other member of the group owns any interests in the company or trust. [Schedule 16, Part 1, subsections 125-65(3) and (4)]

In this example Company A is the head entity of the demerger group which comprises Companies A, B and C and Trust D. This is the only demerger group within this structure. It is not possible for Companies B and C and Trust D to treat themselves as a demerger group, and to attempt to demerge shares to Company A as the owner of shares in the head entity, being Company B.

What is a demerger subsidiary?

15.20 A company is a demerger subsidiary of another company or trust if that company or trust, either alone or together with other entities of the demerger group, own, or have the right to acquire, ownership interests in the company that entitle them to:

• receive more than 20% of any distribution of income or capital by the company; or

• exercise, or control the exercise of, more that 20% of the voting power of the company.

15.21 A trust is a demerger subsidiary of another trust or a company if that trust or company, either alone or together with other entities of the demerger group, own, or have the right to acquire, ownership interests in the trust that entitle them to receive more than 20% of any distribution of income or capital by the trustee. [Schedule 16, Part 1, subsection 125-65(6)]

To continue Example 15.1, Companies B and C and Trust D are demerger subsidiaries of the demerger group.

What is a demerging entity?

15.22 A demerging entity is an entity that is a member of a demerger group and, under a demerger, is (either alone or together with other members of the demerger group):

• disposing of at least 80% of the group’s total ownership interests in a demerger subsidiary; or

• ending, in a manner described in CGT event C2 or C3, at least 80% of the group’s total ownership interests in the demerger subsidiary; or

• disposing of and ending the ownership interests in some combination that results in the group no longer owning at least 80% of the total ownership interests in the demerger subsidiary.

15.23 All of the members of a demerger group, including the head entity, that own interests in a demerged entity may be demerging entities. The 80% total ownership interest requirement is tested by having regard to the number, nature and value of those interests. [Schedule 16, Part 1, subsection 125-70(7)]

What is a demerged entity?

15.24 A demerged entity is the entity that was a member of a demerger group and, under a demerger, its ownership interests are acquired by the owners of the head entity. [Schedule 16, Part 1, subsection 125-70(6)]

What are ownership interests?

• shares in a company, other than a dual listed company voting share (providing there are not more than 5 dual listed company voting shares in the company – refer to paragraphs 15.34 to 15.36);

• options, rights or similar interests that entitle the owner to acquire a share in a company or a unit or other interest in the trust. These ownership interests must have originally been issued by the company or trustee, and can be acquired from any other owner of the interest.

What is a demerger?

15.26 A demerger happens when all of the conditions for a restructure are satisfied. There is no defined mechanism for the demerger. It might occur via a capital reduction that is satisfied by the transfer or issue of ownership interests in the demerged entity, via a declaration of dividend that is satisfied by the transfer or issue of ownership interests in the demerged entity, or via some combination of these mechanisms.

When does a demerger happen?

15.27 A demerger happens when a demerger group restructures and under that restructure:

• a demerger group transfers or issues at least 80% of the interests it owns in an entity (the demerged entity) to the owners of interests in the group’s head entity;

• a CGT event happens to the owners of original interests in the head entity or the owners simply acquire new interest;

• just before the restructuring, more than 50% of original interests in the group’s head entity were owned by Australian residents, or by foreign residents whose new interests have the necessary connection with Australia just after they acquire them;

• each head entity interest owner owns, just after the demerger, the same proportion (as practically possible) of ownership interests in the demerged entity as they owned in the head entity of the demerger group just before the demerger (proportion test);

• the market value (or a reasonable approximation of that market value) of the remaining original interests and the new interests, just after the demerger, must reasonably have been expected to be not less than the market value of the original interests just before the demerger (market value test); and

• the new interests must be of a similar kind as the original interests. Table 15.1 sets out the acceptable new interests that can be acquired for each kind of original ownership interest.

Proportionate ownership test

15.28 One of the conditions for a demerger is that ownership interests in the demerger group are maintained. There are 2 tests that determine whether this condition is met. The first test is that proportionate interests in the head entity and in the demerged entity remain the same, so far as is practicable.

Rose owns 5% of the ownership interests in the head entity that is demerging Stapled Limited, its 100% subsidiary. Under the demerger Rose must receive new interests that equal 5% of the ownership interests in Stapled Limited.

If the head entity had owned 40% of the ownership interests in Stapled Limited, Rose must receive 2% of those interests, which equates to 5% of the head entity’s interests in Stapled Limited.

15.29 In testing whether proportionate interests have been maintained, certain types of ownership interests can be excluded (refer to paragraphs 15.30 to 15.36). [Schedule 16, Part 1, subsection 125-70(2)]

Exclude certain qualifying ownership interests

15.30 Certain qualifying shares and rights can be excluded from the determination of the proportions tests. [Schedule 16, Part 1, section 125-75]

15.31 Division 13A of the ITAA 1936 defines employee share schemes and qualifying shares and rights. It also details the income tax treatment of shares and rights acquired under employee share schemes.

15.32 Shares or rights acquired under an employee share scheme are qualifying shares or rights if:

• all the shares and rights in the company available for acquisition under the scheme are ordinary shares or rights to acquire ordinary shares;

• when the entity acquired the interest, at least 75% of the permanent employees (as defined in section 139GB of the ITAA 1936) of the employer (as defined in section 139GA of the ITAA 1936) were, or had earlier been entitled to, acquire under the scheme ownership interests in either the company or the company’s holding company (as defined in section 139GC of the ITAA 1936); and

and the ownership interest may be excluded from the proportionate ownership test if it is not a fully-paid ordinary share. [Schedule 16, Part 1, subsections 125-75(1) and (2)]

15.33 An equivalent exclusion applies to trusts. [Schedule 16, Part 1, subsection 125-75(3)]

Exclude dual listed company voting shares

15.34 In calculating the proportion of ownership interests in the head entity and in the demerged entity, a dual listed company voting share may be disregarded. [Schedule 16, Part 1, subsection 125-60(2)]

15.35 A dual listed company voting share is a share in a company, being the head entity of a demerger group, issued as part of a dual listed company arrangement that does not have any rights to financial entitlements (except the amount paid up on the share and a dividend paid that is the equivalent of a dividend paid on an ordinary share). [Schedule 16, Part 1, subsection 125-60(3)]

15.36 The definition of a dual listed company arrangement will be refined following tax treaty discussions with other countries and industry representatives. [Schedule 16, Part 1, subsections 125-60(4)]

Market value test

15.37 The second test that ownership interests in the demerger group are maintained is that the proportionate market values of the interests in the demerger group as a whole are maintained pre- and post-demerger.

15.38 Under this test the total market value of each and every owner’s ownership interest in the demerged entity and the head entity, just after the demerger, must not be less that the total market value of the original ownership interests in the head entity, just before the demerger. [Schedule 16, Part 1, subsection 125-70(3)]

15.39 This test ensures that only demergers that are expected to have a positive effect on the market value of the demerger group are eligible for relief. It also guards against a value shift between owners of the head entity happening under a demerger.

15.40 An anticipated reasonable approximation of the market value of interests can be used in applying the market value test for the interests after the demerger. An estimate, determined earlier in the demerger process, of the expected market values at the time of the demerger, may be an acceptable anticipated reasonable approximation. This allows the test to be satisfied if circumstances outside the control of the demerger group resulted in an actual reduction in market values just after the demerger. A general downturn in the stock market is an example of such a circumstance. [Schedule 16, Part 1, subsection 125-70(4)]

15.41 In determining the market value all relevant factors should be taken into account, including the number, nature and value of the interests.

Ownership interests in a head entity undertaking a demerger comprise ordinary shares and options. The head entity decides to issue only ordinary shares as new interests in the demerged entity. It determines that one ordinary share will be issued by the demerged entity for every 3 options in the head entity. In determining the 1:3 allocation, the head entity took account of a range of factors including:

When is roll-over available?

• the owner of an interest in the head entity acquires an interest in the demerged entity; and

Exceptions

Non-resident interest owner and no necessary connection with Australia

15.44 Roll-over is not available if the interest owner is a foreign resident and the new interests acquired under the demerger do not have the necessary connection with Australia just after they were acquired. [Schedule 16, Part 1, subsection 125-55(2)]

Other roll-overs and provisions

15.45 Roll-over is not available under Division 125 if another CGT roll-over can be utilised. [Schedule 16, Part 1, subsection 125-55(3)]

15.46 An off-market purchase of shares (a share buy-back) for the purposes of Division 16K of Part III of the ITAA 1936 is not a demerger. [Schedule 16, Part 1, subsection 125-70(5)]

Different ownership interests

15.47 Roll-over is not available for ownership interests acquired under a demerger that are not of a similar kind to the original ownership interests. That is, if the original interest is a share in a company or an option or right to acquire a share in a company the new interest must also be one of those types of interests. It cannot be a unit or trust interest or an option or right to acquire a unit or trust interest. [Schedule 16, Part 1, paragraph 125-70(1)(e)]

In this example there are 2 demerger groups. One group consists of the Family Company and the Unit Trust. The other group consists of the Family Unit Trust and the Unit Trust. However, if the interests in the Unit Trust were transferred to the shareholders of the Family Company and to the unit holders of the Family Unit Trust, only the unit holders would qualify for demerger relief. This is because the shareholders are receiving interests in a different kind of entity to the entity in which they own an interest.

Disproportionate demerger

15.48 Roll-over is not available if, under the demerger, certain owners of ownership interests in the head entity are excluded from participating in the demerger. This might occur if certain classes of interests (other than dual listing company voting shares or certain employee benefits) are not allocated ownership interests in the demerged entity. [Schedule 16, Part 1, subsection 125-70(2)]

Something other than a new interest in the demerged entity is received

15.49 Roll-over is not available for an interest owner who receives something other than a new interest in the demerged entity, for example, cash. This is the case even if the interest owner also receives a new interest in the demerged entity. This exception arises from the combined effect of the proportion test and the market value test. That is, neither of these tests can be satisfied if an original owner receives something other than new interests in the demerged entity. [Schedule 16, Part 1, subsections 125-70(2) and (3)]

CGT events happening to remaining interests in a demerged entity

15.50 Following a demerger that qualified for relief under Division 125, the demerger group cannot demerge any remaining ownership interests it owns in the demerged entity under this Division. [Schedule 16, Part 1, section 125-100]

What roll-over is provided to owners of interests?

15.51 If an interest owner can choose to obtain a roll-over, the CGT consequences are as described in paragraphs 15.52 to 15.54.

Post-CGT interests

15.52 A capital gain or capital loss made from an original interest is disregarded. [Schedule 16, Part 1, subsection 125-80(1)]

15.53 The first element of the cost base and reduced cost base of each new interest that is not taken to be acquired pre-CGT (before 20 September 1985) and of each remaining original interest that was acquired post-CGT (on or after 20 September 1985) is a proportion of the sum of the cost bases of the post-CGT original interests, just before the demerger. [Schedule 16, Part 1, subsection 125-80(2)]

Pre-CGT interests

15.54 The same proportion of pre-CGT original interests owned by an interest owner in the demerger group’s head entity just before the demerger is applied to the new interests acquired by the interest owners to determine the number of new interests taken to be pre-CGT interests. Interest owners who dispose of interests, after the demerger, that are treated as being pre-CGT interests will need to consider whether CGT event K6 (certain pre-CGT interests subject to CGT) happens. [Schedule 16, Part 1, subsections 125-80(4) to (7)]

A Pty Ltd wholly owns B Pty Ltd. A demerger happens where
A Pty Ltd transfers its shareholding in B Pty Ltd to its shareholders. Just before the demerger Ingrid owns 1,000 ordinary shares in
A Pty Ltd of which 300 were acquired before 20 September 1985. As part of the demerger, Ingrid acquired 150 B Pty Ltd shares.

The number of B Pty Ltd shares Ingrid received that are taken to be acquired before 20 September 1985 is:

What cost base adjustments are required if roll-over does not apply?

Cost base and reduced cost base adjustments

15.55 If, under a demerger, a CGT event does not happen to the original interests owned by the owners of the head entity or those owners do not choose roll-over, the cost base and reduced cost base of those interests must be adjusted to reflect the change in value caused by the demerger. If such adjustments are made, no other adjustments can be made under the ITAA 1997 because of something that happens under the demerger. [Schedule 16, Part 1, sections 125-85, 125-90 and 125-95]

Capital gains tax exemption for members of demerger groups

15.56 Certain capital gains or capital losses made by a demerging entity are disregarded. An entity cannot choose for this exemption not to apply. Certain other CGT consequences for other members of a demerger group under a demerger are also disregarded or altered.

What relief is available to a demerger group?

15.57 A demerging entity disregards a capital gain or capital loss made from CGT event A1, C2, C3 or K6 happening to its ownership interests in a demerged entity under a demerger. [Schedule 16, Part 1, section 125-155]

What relief is available to a demerged entity?

15.58 CGT event J1 does not happen to a demerged entity or to any other member of the demerger group when CGT event A1 or C2 happens to a demerging entity under a demerger. [Schedule 16, Part 1, section 125-160]

What adjustments are required after the demerger?

Capital loss adjustments

15.59 If, because of a demerger, a capital loss is ultimately made by a member of a demerger group because the demerger decreased the market value of an asset, the capital loss is reduced by the amount reasonably attributable to the reduction in the market value of that asset caused by the demerger. [Schedule 16, Part 1, section 125-165]

Cost base reductions

15.60 If, because of a demerger, the value of an asset is reduced and that asset is transferred after the demerger, the reduced cost base of the asset is reduced by the decrease in value caused by the demerger. [Schedule 16, Part 1, section 125-170]

Corporate unit trusts and public trading trusts

15.61 For the purposes of Division 125, corporate unit trusts and public trading trusts are treated as if they are companies and ownership interests in them are treated as if they are interests in a company. [Schedule 16, Part 1, section 125-230]

Dividend exemption

15.62 An assessable dividend arising as a result of a demerger happening is exempt. Integrity rules will limit this exemption where there is a scheme that has a purpose of obtaining that non-assessable dividend. To the extent that a dividend is not a demerger dividend the normal rules relating to dividends apply.

What are the taxation consequences for a demerger dividend?

Income tax

15.63 Owners of the interests in the head entity acquiring ownership interests in the demerged entity under the demerger may be treated as receiving an assessable dividend. The part of the distribution that is treated as an assessable dividend will depend on how the demerger is done, and on the accounting position of the demerging entity, and on how much of the dividend is attributable to profits of the entity. The dividend component of a genuine demerger will not result in either assessable income or exempt income for the interest owner. [Schedule 16, Part 2, item 10, subsections 44(3) and (4)]

15.64 This treatment is achieved by identifying a demerger dividend arising under the demerger. The demerger dividend for each owner of interests in the head entity is the total market value of the new interests in the demerged entity that each owner of the head entity acquires under the demerger. Depending on how the demerger is done, the demerger dividend might include an otherwise assessable dividend component. It might also consist wholly of a return of capital to the interest owner, or of some combination of capital and profit. [Schedule 16, Part 2, item 4, subsection 6(1)]

15.65 A demerger dividend is taken not to be paid out of profits and is not assessable income or exempt income if, just after the demerger, at least 50% of the market value of CGT assets owned by the demerged entity or its demerger subsidiaries are used in the carrying on of a business by those entities. This rule ensures that the demerged entity is a viable, independent entity, capable of conducting business in its own right. [Schedule 16, Part 2, item 10, subsections 44(3) to (5)]

15.66 The demerging entity may elect not to claim the demerger dividend exemption. This will mean that the shareholders of the interests in the head entity may treat the assessable dividend component of the demerger dividend as being paid out of profits. The election applies to all interest owners. The demerging entity cannot choose to allocate demerger dividends to certain interest owners and not to others under the demerger. [Schedule 16, Part 2, item 10, subsection 44(2)]

Integrity rules supporting the dividend exemption

15.67 The demerger dividend exemption is supported by an integrity rule that is aimed at limiting the exemption to genuine demergers, rather than demergers that are directed at obtaining the dividend exemption. The effect of the integrity rule applying to a demerger is to exclude part or all of the demerger dividend from the demerger dividend exemption. So much of that excluded amount would then be considered within section 44 of the ITAA 1936, as an assessable dividend. [Schedule 16, Part 2, item 11, sections 45B and 45BA]

Diagram 15.2: Describes the combined effect of the demerger dividend provisions and the integrity rule

15.68 The integrity rule is based on the existing model within section 45B of the ITAA 1936, and utilises the existing framework of a determination by the Commissioner of a tax benefit arising under a scheme. The provision now has the dual purpose of determining whether the taxpayer has received a capital benefit or a demerger benefit, under a relevant scheme. [Schedule 16, Part 2, item 11, subsections 45B(1), (4) and (5)]

15.69 In making that determination a number of factors are to be taken into account. In addition to the original factors contained within subsections 45B(5) and (6) of the ITAA 1936, which have been modified to reflect the dual purpose one additional factor has been added. [Schedule 16, Part 2, item 11, paragraph 45B(8)(j)]

15.70 One consequence of this dual approach is that a distribution occurring under a demerger may be considered as a demerger benefit and as a capital benefit for the purposes of section 45B of the ITAA 1936. A demerger dividend that is not a demerger benefit cannot then be treated as a capital benefit. [Schedule 16, Part 2, item 11, subsection 45B(6)]

Withholding tax

15.71 For non-resident shareholders acquiring ownership interests under the demerger, any assessable dividend component of the demerger dividend may require withholding tax to be withheld by the demerging entity. A withholding tax exemption is provided for the assessable dividend component of the demerger dividend. This exemption ensures that the taxation treatment for non-resident shareholders under a demerger is consistent with that for resident shareholders. [Schedule 16, Part 2, items 19 and 20, subsections 128B(1) and (3C)]

Private company dividends

15.72 In certain cases involving the demerger of a private company, Division 7A of Part III of the ITAA 1936 could apply to treat part or all of the value of the demerger dividend as a dividend paid out of profits. An additional rule is provided to ensure that this deeming provision cannot apply to a demerger dividend. [Schedule 16, Part 2, items 17 and 18, sections 109B and 109RA]

Application and transitional provisions

15.73 The changes made by Schedule 16 apply to CGT events that happen on or after 1 July 2002. [Schedule 16, Part 5, item 55]

15.74 A company can choose to apply section 45B of the ITAA 1936, as it existed before the date of Royal Assent, to payments made in respect of shares in the company under a demerger that happens on or after 1 July 2002 and before the proposed amendments receive Royal Assent if certain conditions are met. [Schedule 16, Part 4, item 54]

Consequential amendments

Cross referencing provisions

15.75 The amendments in this bill may affect the calculation of a capital gain or a capital loss in relation to other CGT events or CGT roll-overs. Consequential amendments to certain sections are required to give effect to the dual purpose of section 45B of the ITAA 1936 and to sign post the reader to the demerger provisions. The consequential amendments usually take the form of a note. [Schedule 16, items 12 to 16,
21 to 28, 31 and 34 to 43]

15.76 Guide material will be inserted to assist readers in obtaining an overview of the provisions in Division 125. [Schedule 16, Part 1,
sections 125-1, 125-5, 125-50, 125-150 and 125-225]

Finding tables

15.77 The finding tables within Division 112 of the ITAA 1997 are up-dated to reflect the amendments made by inserting the demerger provisions. [Schedule 16, items 29, 30, 32 and 33]

Definitions

15.78 Defined terms required for the demerger provisions are to be inserted into the dictionary in subsection 6(1) of the ITAA 1936 and subsection 995-1(1) of the ITAA 1997. [Schedule 16, items 2 to 9 and 44 to 53]

Policy objective

16.1 The policy objective is to increase efficiency by allowing greater flexibility in structuring businesses, providing an overall benefit to the economy. The aim of the measure is also to enhance the competitiveness of Australia’s business sector.

Implementation options

16.2 The Review of Business Taxation originally recommended in A Tax System Redesigned a demerger roll-over (Recommendation 19.4). It was seen as a mirror of the scrip for scrip roll-over provided for takeovers.

16.3 The options for providing demerger relief that were considered are outlined in paragraphs 16.4 to 16.10.

Option 1: No tax consequences for members (Recommendation 19.4 of A Tax System Redesigned)

16.4 Recommendation 19.4 of A Tax System Redesigned provides for taxation relief for the members of the entity that reorganises its affairs. It proposed that relief was to be available for widely-held entities only, as it would be difficult to obtain valuations for entities that were not widely-held.

16.5 It should be noted that the recommendation was made in the context of an entities regime where most entities would be taxed as companies.

Option 2: Provide roll-over relief to members and an exemption at the entity level only

16.6 Given that the members of the demerging entity will hold interests in the same proportion in both entities after the demerger, it was seen as appropriate to provide roll-over relief at this level. This is consistent with the policy basis for other roll-overs in the tax law where there is a corporate restructure and ownership is maintained.

16.7 As the members of the entity will have their taxation liability deferred, it would seem inappropriate to tax the entity, which they own, on the same transaction. This could be said to amount to double taxation, as on realisation of their interest, or any other CGT event occurring in relation to those interests, the tax on the single transaction will be crystallised.

Option 3: Provide CGT relief at the member level and exempt tax on payments that amount to dividends

16.8 If the transfer of the interests in the new entity by the demerging entity were considered to be a dividend, it would seem appropriate to exempt taxation on the dividend when paid to the shareholders. This is on the same basis as in paragraph 16.7 – that the payment of tax by the company on the distribution of that dividend will amount to double taxation. This is because the tax is levied under income tax, as opposed to capital gains tax. On disposal of their interest in the demerged entities, and without some compensating factor (such as an increase in the cost base of their interests) the shareholders will be paying CGT on the increase in value of their shares in the original entity – such an increase is already captured as part of the value of the dividend paid on demerger.

Option 4: Provide CGT relief at the member and entity level and an exemption from the current dividend rules

16.9 This option is an expanded combination of options 1 and 2. It provides for a deferral of the CGT liability for the members, while providing a CGT exemption for the entity. This takes account of the CGT implications of a demerger and avoids double taxation of the gains made on the CGT asset as discussed in paragraph 16.7.

16.10 The CGT relief would not be sufficient on its own in situations where the entity transfers the replacement interests. In these circumstances, the distribution by an entity that is a company could constitute an assessable dividend, and would be taxed under the income tax law. The tax liability that could arise would restrict how a demerger would be structured and hence limit the flexibility that is intended to be provided by this measure.

Assessment of impacts

Impact group identification

Members of companies and trusts

16.11 The proposed roll-over will affect investors in companies and trusts. Under a demerger the member will receive replacement interests in different entities. Depending on the method of restructure the member could acquire interests in the original entity and additional entities or interests in new entities. This may affect the value of their interests compared with the interest in the original entity.

Companies and trusts

16.12 This measure will affect those companies and fixed trusts that wish to restructure their affairs by splitting their operations.

Other entities wishing to restructure and members of these entities

16.13 The amendments will only apply to companies and fixed trusts. Therefore, other entities and their members, such as superannuation funds, will be at a commercial disadvantage. However, most of these entities are already concessionally taxed when compared with companies.

Analysis of costs and benefits associated with each implementation option

General comments

16.14 The level of compliance costs that may be incurred under a demerger restructure depends on the structure of the demerger group. The method used for the demerger will also have an impact on the compliance costs incurred by all entities involved. Further, any compliance costs are driven more by commercial decisions of the entity demerging rather than tax considerations. For example, if there was a single company (the head entity) that was spinning off one of its branches, it is anticipated that the compliance costs would be minimal given the simple structure of the business. However, if a demerger group involves several subsidiaries and it is planned that several of the subsidiaries will be spun off under the single demerger, the compliance costs may be high. In the second instance, the head entity may need to do extensive valuations in order to satisfy other regulatory requirements. Where possible the demerger legislation allows these valuations to be used in satisfying the tests for demerger relief. As the numbers of demerger scenarios are so varied, the compliance costs for this measure cannot be reliably quantified. Analysis of the possible qualitative costs that may be incurred is outlined in Table 16.1.

	*Option 1*	*Option 2*	*Option 3*	*Option 4*
*Compliance costs*	*Initial costs*	*Initial costs*	*Initial costs*	*Initial costs*
Interest owners^[6]	There are a variety of ways that interest owners can familiarise themselves with the amendments including: going to see their tax agent; obtaining information from the ATO on the new provisions; and contacting the entity in which they own an interest for more information on the proposed demerger. The interest owner may require assistance in calculating the cost base adjustments required under the demerger provisions. The interest owner may choose to contact their tax agent to do this, or approach the ATO for assistance.	As for option 1.	As for option 1.	As for option 1.
	*Ongoing costs*	*Ongoing costs*	*Ongoing costs*	*Ongoing costs*
	The interest owner will need to keep a record of the cost bases of their original and new interests. This should add very little to the compliance costs of the interest owner because there should already be a record system in place to keep track of the cost base and events that may have happened to the original interests.	As for option 1.	As for option 1.	As for option 1.
Entity^[7]	*Initial costs*	*Initial costs*	*Initial costs*	*Initial costs*
	Seeking advice on the relief available. Preparing information documents for its interest holders. The amount of information that is required to be given to interest owners depends on whether the entities involved are listed on the Australian Stock Exchange or not. There are certain Corporations Act 2001 requirements that may need to be satisfied if the entity is a company. May need to value the assets being disposed of in order to calculate the capital gain or loss that may arise on demerger.	As for option 1, except that the entity would not incur additional valuation costs for the assets disposed under the demerger because of the exemption from CGT on the disposal of assets, and because these valuations can be used in satisfying the demerger provisions.	As for option 1. The entity may incur an additional cost in requesting advice from the Commissioner on the possible application of the demerger dividend integrity rules.	As for option 2. The entity may incur an additional cost in requesting advice from the Commissioner on the possible application of the demerger dividend integrity rules
	*Ongoing costs*	*Ongoing costs*	*Ongoing costs*	*Ongoing*
	There should be minimal ongoing costs for the entity that owned interests in the spun-off entity.	As for option 1.	As for option 1.	As for option 1.
*Administration costs*	*Initial costs*	*Initial costs*	*Initial costs*	*Initial costs*
	Making changes to material prepared for taxpayers, tax practitioners and industry for education about the demerger rules. Costs will be minimal as the ATO’s CGT booklets, return forms, schedules and guides are updated annually. Training staff on the new rules will be done internally as part of on-going ATO training. The additional costs would be minimal. Providing advice on the demerger rules. The costs will depend on the effectiveness of the ATO’s and industry’s education programs.	As for option 1.	The costs in providing advice may be higher, given the integrity measures around the exemption of the dividend. The entity may request advice from the Commissioner on the possible application of the demerger dividend integrity rules that may not be required under options 1 and 2.	As for option 3.
	*Ongoing costs*	*Ongoing costs*	*Ongoing costs*	*Ongoing costs*
	Costs will continue to be incurred on providing advice on the concession but these costs should reduce over time.	As with option 1.	As with option 1. The costs may not reduce as rapidly over time as under option 1 because of the possibility of needing advice from the Commissioner on the possible application of the demerger dividend integrity rules.	As with option 3.
*Revenue costs*	Unquantifiable but small, provided the shareholder CGT tax relief offsets the revenue gain from demergers that are in response to the Government’s proposal.	Unquantifiable. In order to estimate the cost of this option requires data in relation to the cost base of the spun off entity which is not available.	Unquantifiable. The dividend exemption should not adversely affect revenue collections by decreasing assessable dividends, because of the integrity rule.	Unquantifiable. The reasons for this revenue estimate is a combination of the reasons given in options 1 to 3.
*Benefits*	The amendments will facilitate a structure of an entity, which should provide it with a more economically efficient structure. The flow-on effects from the economic efficiency include increased productivity and benefits to the community overall.	As with option 1.	As with option 1.	As with option 1.

Consultation

16.15 Extensive consultation with industry and their representatives has taken place in relation to the amendments. There were a number of consultation sessions held in Melbourne and Sydney which focused on the draft legislation implementing option 4. Industry members and their representatives are supportive of this measure.

Conclusion and recommended option

16.16 The recommended option is option 4. After several consultation sessions with the relevant stakeholders, including industry and their representatives, it was determined that the recommendation for the demerger measure, as described in A Tax System Redesigned, would be too restrictive. It did not provide enough flexibility for entities to restructure their affairs to take advantage of the most efficient structures for their businesses.

16.17 Recommendation 19.4 A Tax System Redesigned was also expressed in terms of a consistent entities regime, where all but a handful of entities would be taxed as companies. That regime has not been implemented. The demerger rules in this measure had to take account of the current regimes.

16.18 By providing the concessions, taxation will not be an impediment to business reorganisation by way of demerger. Facilitating the demerger of entities in this way ensures that taxation does not unnecessarily drive the choice of structure in which a business should operate.

16.19 Options 1, 2 and 3 only deal partially with the possible tax impediments to a demerger.

16.20 Compliance costs while unquantifiable are not likely to be significantly higher because of a demerger.

16.21 Option 4 delivers the benefits in a manner that most satisfies industry’s requirements and therefore is the preferred option.

*2001-2002*	*2002-2003*	*2003-2004*	*2004-2005*	*2005-2006*
nil	$180 million	$370 million	$335 million	$280 million

*2002-2003*	*2003-2004*	*2004-2005*	*2005-2006*
nil	$150 million	$160 million	$170 million

	*Post-CGT original equity in respect of which bonus equity, not being a dividend or assessable, is issued:*	*Pre-CGT original equity in respect of which bonus equity, not being a dividend or assessable, issued in relation to it for an amount paid:*	*Original share in respect of which bonus shares are issued for no consideration, and the bonus share is not a dividend, or a rebatable dividend:*
*Outcomes where value shifts from your original interests (described in row 1) to your bonus interests:*
Your original interests	No reductions or taxing events generating a gain	Normal reductions and taxing events generating a gain	No reductions or taxing events generating a gain
Your bonus interests	No uplifts	No uplifts	No uplifts

*Type of share*	*MV pre-shift per share (total)*	*MV post-shift per share (total)*	*Adjustable value^[5] per share pre-shift*
A class (× 50)	$10,000 ($500,000)	$8,000 ($400,000)	$100
B class (× 100)	$2,000 ($200,000)	$16,000 ($1,600,000)	$100
C class (× 10)	$150,000 ($1,500,000)	$20,000 ($200,000)	$200
Total market values of all shares	$2,200,000	$2,200,000

*Type of entity*	*Features*
Company	Rights to voting power, dividends and capital distributions.
Fixed trust	Rights to a share of the income or capital of the trust.
Non-fixed trust	Control.

*Type of share*	*Adjustable value (cost base/ reduced cost base)*	*Market value before the rights changed*	*Market value after the rights changed*
Class A share	$100	$150	$50
Class B share	$200	$250	$350

	*Scheme or arrangement entered into*	*Value shift happens*	*Which law applies?*
*Creation of right over underlying asset*
	Not relevant	Before 1 July 2002	Existing law
	Not relevant	After 30 June 2002	Division 723
*Direct value shift involving interest in company or trust*
	Before 27 June 2002	Anytime	Existing law (Division 140)
	From 27 June 2002 and before 1 July 2002	At least some value shifts happen before 1 July 2002	Existing law (Division 140)
	From 27 June 2002	All value shifts happen after 30 June 2002	Division 725
*Indirect value shift*
	Before 27 June 2002	Any time	Existing law (Division 138 or Division139)
	From 27 June 2002 but before 1 July 2002	Scheme IVS time from 1 July 2002 or IVS time has not occurred but affected interest realised from 1 July 2002	Division 727 applies, unless trigger event under Division 138 or Division 139 happens before 1 July 2002, in which case existing law (Division 138 or 139) applies
	From 1 July 2002	From 1 July 2002	Division 727

*New law*	*Current law*
Demergers can occur in a way that best suits the needs of the entity group. The immediate taxation consequences of these demergers will generally be deferred (for the owners of the entity) or eliminated (for the demerging entity).	Demergers could have adverse taxation consequences for the owners of the entity, and for the demerging entity. This outcome generally prevented certain restructures that would otherwise produce economic benefits for the entity group.
For all types of demergers, the effect of the demerger will be reflected in the cost bases of the original and new interests. There can be no capital gain arising at that time, unless the interest owner chooses not to claim demerger relief.	CGT event G1 required cost base adjustments to original interests in the entity, which did not accurately reflect the effect of the demerger on the original and new interests. In certain cases, the interest owner may have had a capital gain as a result of the capital reduction.
Any dividend component, to the extent that it is a demerger dividend, is not assessable income of the shareholder. Integrity rules support this exemption.	Any dividend component of a demerger would result in an assessable amount for the shareholders of the entity.

*If the original interests were:*	*The new interests must be:*
• shares; • shares and options, rights or similar interests to acquire shares; or • options, rights or similar interests to acquire shares.	• shares; • shares and options, rights or similar interests to acquire shares; or • options, rights or similar interests to acquire shares.
• units or interests in a trust; • units or interests in a trust and options, rights or similar interests to acquire units or interests in a trust; or • options, rights or similar interests to acquire units or interests in a trust.	• units or interests in a trust; • units or interests in a trust and options, rights or similar interests to acquire units or interests in a trust; or • options, rights or similar interests to acquire units or interests in a trust.

Commonwealth of Australia Explanatory Memoranda