Private ruling: Calculating the available fraction for losses transferred into Company income tax consolidated group
Date of advice: 1 August 2017
Published: November 2017
Ruling period: 1 June 200B to 31 May 201C
Date scheme commenced: 1 June 200B

Ruling: Q1: If the modified market value of an entity becoming a member of a consolidated group pursuant to section 707-325 is deemed to be inflated as a result of capital injections pursuant to paragraph 707-325(4)(a), is it acceptable when determining what the hypothetical modified market value amount would have been under paragraph 707-325(2)(b) to give consideration to commercial alternatives to the capital injections available to the Taxpayer at that point in time? | A1: No

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. ● Company A is an Australian private company incorporated in 200A ● Company A acquired all of the units in Investment Trust in 201C. Investment Trust was a standalone entity with no interests in other entities ● In the 201D income year, Company A elected to form an income tax consolidated group (the Group). Company A became the head company of the Group ● At the time of formation of the Group, Company A had carried forward revenue tax losses of $XYZ per its lodged tax returns to the period up to the date of consolidation ● Investment Trust had no carried forward losses at the date of consolidation ● The market value of Investment Trust at the date of consolidation was $ABC, per the Acquisition Agreement, as it was the price willing to be paid by Company A an arm’s length third party ● The independent market value of Company A was deemed to be $XYZ at time of consolidation with the independent market value of the Group totalling $XYX ● Prior to forming the Group, capital raisings of YYX in the years prior to the date formation of the consolidated group occurred ● Company A is satisfied that the injection of cash for additional scrip by shareholders (i.e. capital raising), per the above table, are capital injections ● There is no evidence to suggest that commercial alternatives, to the capital injections, were considered at the time of each capital injection. Assumption(s) The tax losses were transferred to Company A as a result of the continuity of ownership test (COT) being satisfied in relation to the tax losses.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 707-320 | Income Tax Assessment Act 1997 Subsection 707-320(1)-(4) | Income Tax Assessment Act 1997 Section 707-325 | Income Tax Administration Act 1953 Section 359-5

Reasons for decision: Summary: Division 707 provides for the transfer of a loss from an entity (the joining entity) becoming a member of a consolidated group to the head company of the group, if as a general principle, the joining entity could have utilised the loss if it had not become a member of the group. The rate at which transferred losses can be used by the head company is generally limited to that which would have applied had the joining entity remained outside the consolidated group. Subdivision 707-C determines the amount of transferred losses that can be utilised by the head company. Subsection 707-310(1) limits the amount of losses in a particular bundle of losses transferred by references to the available fraction for the bundle. Pursuant to subsection 707-320(1), the available fraction for a bundle of losses at a time is calculated as follows: Modified market value of the real loss-maker at the initial transfer time Transferee's adjusted market value at the initial transfer time The transferee's adjusted market value at the initial transfer time is defined in subsection 707-320(1) to mean the amount that would be the market value, at the initial transfer time, of the transferee to which the losses in the bundle were transferred at that time if: (a) the transferee did not have a loss of any sort for an income year ending before that time, and (b) the balance of the transferee's franking account were nil at that time. The modified market value of the real loss-maker entity is defined in section 707-325. The modified market value of an entity becoming a member of a consolidated group is its market value, assuming: ● it has no losses and the balance of its franking account is nil ● the subsidiary members of the group at the joining time are separate entities and not parts of the head company, and ● the entity’s market value does not include an amount attributable (directly or indirectly) to a membership interest in a member of the group that is a corporate tax entity or an entity that transferred losses to the head company. Certain events may have happened to a loss entity that had the effect of increasing the loss entity’s market value. One such event is an injection of capital into the loss entity. Where this occurs within the 4 years prior to the loss entity joining the consolidated group, the potential inflationary effect the capital injection may have on the loss entity’s market value must be addressed. To this end, there are integrity rules that will apply to prevent the inflation of a loss entity’s modified market value. Where there is a capital injection into a loss entity in the 4 years prior to consolidation that results in an increase in the value of the loss entity that increase in value is excluded from the entity’s modified market value. The amount excluded is the lesser of: ● the difference between (i) the loss entity’s modified market value at the joining time and (ii) what would have been its modified market value if the capital injection(s) had not occurred (the 'hypothetical modified market value), and ● the total increase in the entity’s market value that occurs immediately after each capital injection(s), (the 'initial increase in market value’). To work out the initial increase in market value for each capital injection event, a market valuation of the entity just after the capital injection needs to be established – the 'initial market value’ of the entity. A second market valuation of the entity would need to be established at the same time but on the assumption that the capital injection did not occur – the 'hypothetical initial market value’ of the entity. The calculation of both an initial market valuation and a hypothetical initial market valuation will need to be done for each capital injection event. Where the initial market value is greater than the hypothetical initial market value, the difference is the initial increase in market value of the entity. Consequently, where there are multiple capital injection events in the four years prior to consolidation the sum total of each initial increase in market value is added together to arrive at the total increase in the entity’s market value that occurs after the capital injections. These rules prevent a loss entity from seeking to obtain a higher available fraction by inflating its market value before joining the consolidated group. | Detailed Reasoning - Application to your circumstances: Company A advised that the bundle of losses (revenue loses0 to be transferred to it on consolidation is $XXX. Company A further advised that it formed an income tax consolidated group in the 201D income year with its wholly owned subsidiary, Investment Trust. Prior to the formation of this group, capital raising occurred into Company A in the years prior to consolidation. Company A accepts that each of the above capital raisings constitute an 'injection of capital’ for the purpose of section 707-325. Accordingly, regard must be had as to whether the integrity rules, designed to prevent the modified market value of the loss (joining) entity from being inflated, applies. If the rules apply, Company A’s modified market value will be reduced accordingly. In this context, Company A has asked if, when working out its hypothetical modified market value, it can give consideration to commercial alternatives to the capital injections available to it at each time the injections occurred. In order to accept that there were commercial alternatives to the capital injections, a taxpayer must have contemporaneous records to demonstrate that in the lead up to the capital injection, a number of commercial alternatives were being considered and were dismissed in favour of the capital injection. These contemporaneous records would presumably inform the valuer as to what assumptions may be made (e.g. if borrowing, at what rate and term; effect on cash flows and outcomes for business) when assessing the hypothetical modified market value of the joining entity. Company A has no contemporaneous evidence to evince that commercial alternatives were considered at the time of each of the capital injections. In light of this, no commercial alternatives may be considered when undertaking its hypothetical modified market valuation calculation for the purpose of section 707-325. | Detailed Reasoning - Conclusion: On the basis no commercial alternatives to the capital injections were considered at the time (i.e. there are no contemporaneous documentation to support otherwise), it is not acceptable when determining what the hypothetical modified market value under section 707-325 to give consideration to commercial alternatives to the capital injections.