Private ruling: Integration of Australian businesses
Published: August 2012
Ruling period: 2011 income year to 2015 income year.
Date scheme commenced: 2010 income year.

Ruling: Q1: Will Subdivision 705-C of the Income Tax Assessment Act 1997 (ITAA 1997) apply to set the tax cost setting amounts of the assets of Company B when it is acquired by Company A? | A1: Yes. | Q2: Will Subdivision 705-C of the ITAA 1997 apply to set the tax cost setting amounts of the assets of Company A when it is acquired by Partnership A? | A2: Yes. | Q3: Have the following liabilities been appropriately included in step 2 of the allocable cost amount for Company A in accordance with sections 705-70, 705-75 and 705-80 of the ITAA 1997? Foreign borrowing Foreign currency derivatives Promissory note Deferred tax liability | A3: Yes. Yes. Yes. Yes. | Q4: Has the appropriate approach been applied to determine the tax cost setting amount of goodwill using a residual method in accordance with section 705-35 of the ITAA 1997 and Taxation Ruling 2005/17? | A4: Yes. | Q5: Have the accrued trade rebates been appropriately treated as a reduction to trade receivables for the purposes of the tax cost setting process in accordance with section 705-25 of the ITAA 1997? | A5: Yes. | Q6: Has the deferred income in relation to supplier incentive payments disclosed as liabilities on the balance sheet of Company A been appropriately excluded from step 2 in determining the allocable cost amount for Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997? Have the lease incentive payments received and disclosed as liabilities on the consolidated balance sheet of Company A been appropriately included at step 2 in determining the allocable cost amount for Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997? | A6: Yes. Yes. | Q7: Will losses made on amounts borrowed by MEC Group 2 as part of the Australian integration steps be deductible in accordance with section 230-15 of the ITAA 1997, assuming that MEC Group 2 does not exceed the thin capitalisation safe harbour limit? | A7: Yes. | Q8: Will partnership distributions made by Partnership A be treated as dividends in accordance with section 94L of the Income Tax Assessment Act 1936 (ITAA 1936) and be frankable in accordance with Division 202 of the ITAA 1997?? | A8: Yes. | Q9: Will any capital gain made by Overseas Co 7 on the transfer of Company B to Overseas Partnership be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 5 on the transfer of Company A to Overseas Co 6 be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 6 on the transfer of Company A to Overseas Co 3 be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Partnership on the transfer of Company B to Overseas Co 3 be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 3 on the transfer of Company B to Company A be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 3 on the transfer of Company A to Partnership A be disregarded under Division 855 of the ITAA 1997? | A9: Yes. Yes. Yes. Yes. Yes. Yes.

Relevant facts and circumstances: All legislative references are to the Income Tax Assessment Act 1997 unless otherwise specified. Background Overseas Co 1 acquired Overseas Co 2. Both Overseas Co 1 and Overseas Co 2 held indirect investments in Australia at the time of this acquisition. The entities in which Overseas Co 1 held indirect interests (Australian Business 1) were consolidated for income tax purposes via Consolidated Group 1. All the assets of Consolidated Group 1 were acquired post-20 September 1985 (by virtue of section 160ZZS of the ITAA 1936 or Division 149 if they were originally acquired prior to 20 September 1985). Company A was the head company of Consolidated Group 1 The entities in which Overseas Co 2 held indirect interests (Australian Business 2) were consolidated for income tax purposes via MEC Group 1. All the assets of MEC Group 1 were acquired post-20 September 1985 (by virtue of section 160ZZS of the ITAA 1936 or Division 149 if they were originally acquired prior to 20 September 1985). Company B was the provisional head company of MEC Group 1. Following its global acquisition of Overseas Co 2, Overseas Co 1 undertook a reorganisation to align Australian Business 1 and Australian Business 2 (the Australian integration). The following two consolidation events occurred on the same day as part of the Australian integration: MEC Group 1 was acquired by Consolidated Group 1; and Consolidated Group 1 was acquired by MEC Group 2. The consolidation regime contained in Part 3-90 consequently required entry allocable cost amount (ACA) calculations to be undertaken in respect of these two events. Entities involved in the Australian integration Company B Company B is an Australian resident for income tax purposes. As stated above, Company B was the provisional head company of the former MEC Group 1 which ran Australian Business 2. Based on market valuations, the sum of the market values of Company B's taxable Australian real property assets did not exceed the sum of the market values of its assets which are not taxable Australian real property assets. Company B became a member of Consolidated Group 1 upon its acquisition by Company A. Company B is now a member of MEC Group 2 as a consequence of Partnership A's acquisition of Company A. MEC Group 2 Head Co MEC Group 2 Head Co is an Australian resident for income tax purposes. MEC Group 2 Head Co is wholly owned by Overseas Co 3 (a foreign resident company) and indirectly owned by Overseas Co 1. MEC Group 2 Head Co is the provisional head company of MEC Group 2. Company A Company A is an Australian resident for income tax purposes. As stated above, Company A was the head company of Consolidated Group 1 (which ran Australian Business 1) prior to its acquisition by Partnership A. Based on market valuations, the sum of the market values of Company A's taxable Australian real property assets did not exceed the sum of the market values of its assets which are not taxable Australian real property assets. Partnership A Overseas Co 3 and Overseas Co 4 entered into a Limited Partnership Deed (the Partnership Agreement). Partnership A was consequently formed. Overseas Co 3 holds a limited partnership interest in Partnership A. Overseas Co 4 holds the remaining general partnership interest. The Partnership Agreement states that the partners will carry on the business in common with a view to profit. The business of Partnership A is: · the holding of shares in Company B; · the management of the distribution or reinvestment of dividend income from this investment; and · servicing the borrowings to fund the acquisition of the investment. The Partnership Agreement states that the partners will have a joint undivided interest in the Partnership Property. Partnership A has not at any time been registered under Part 2 of the Venture Capital Act 2002 , as: · a venture capital limited partnership; · an early stage venture capital limited partnership; or · an Australian venture capital fund of funds. Partnership A is also not a general partner in one or more of the following: · one or more venture capital limited partnerships; · one or more early stage venture capital limited partnerships; or · one or more Australian venture capital fund of funds. None of the circumstances outlined in section 202-45 apply to the distributions made by Partnership A. Partnership A is an eligible tier-1 company of Overseas Co 1 and is a member of MEC Group 2. Investment Holdings Co Investment Holdings Co is an Australian resident for income tax purposes. Investment Holdings Co is wholly owned by Overseas Partnership (which is also recognised as a foreign resident company) and was part of Australian Business 1. Structures prior to the Australian integration As stated above, prior to the Australian integration, Company B was the provisional head company of MEC Group 1 which ran Australian Business 2. At the time MEC Group 1 was formed, there was more than one eligible tier-1 company. Similarly, Company A, was the head company of Consolidated Group 1 (which ran Australian Business 1) prior to the Australian integration. Transfers of Australian Business 1 entities Overseas Co 5 (a foreign resident company) transferred Company A to Overseas Co 6 (another foreign resident company). On the same day, Overseas Co 6 subsequently transferred Company A to Overseas Co 3 in exchange for shares in Overseas Co 3. Transfers of Australian Business 2 entities Overseas Co 7 (a foreign resident company) transferred Company B to Overseas Partnership for shares and equity interests. Overseas Co 3 acquired Company B from Overseas Partnership for two separate notes, one in Australian dollars and one in a foreign currency. Formation of Partnership A Overseas Co 3 formed a new Australian limited partnership (Partnership A) with Overseas Co 4. Overseas Co 3 also formed MEC Group 2 Head Co, a new Australian company. As stated above, MEC Group 2 Head Co became the provisional head company of the newly-formed MEC Group 2. The MEC Group 2 was established as a holding structure for the combined Australian Business 1 and Australian Business 2, and was effectively dormant until Company A was acquired by Partnership A (see below for more detail on this transaction). The Australian integration MEC Group 1 acquired by Consolidated Group 1 Overseas Co 3 transferred Company B to Company A for shares in Company A and for a note. Given that Company B was, at the time of this transfer, the provisional head company of the former MEC Group 1, the result of Company B being transferred to Company A was that the former MEC Group 1 joined Consolidated Group 1. All members of the former MEC Group 1 became members of Consolidated Group 1 upon Company A's acquisition of Company B. The former MEC Group 1 did not include any transitional foreign-held subsidiaries at this time. Upon this consolidation, the assets and liabilities of Company B and its subsidiaries were recognised at their fair value in accordance with 'AASB 3 - Business Combinations' (AASB 3). Consolidated Group 1 acquired by Partnership A On the same day on which MEC Group 1 was acquired by Consolidated Group 1, 100% of the membership interests in Company A were acquired by Partnership A in a single transaction. Consequently, Company A (and Consolidated Group 1) became part of MEC Group 2 of which Partnership A was an eligible tier-1 company. All members of Consolidated Group 1 became members of MEC Group 2 at the acquisition time as a result of Partnership A's acquisition of the membership interests in Company A. Consolidated Group 1 did not include any transitional foreign-held subsidiaries at this time. A tax consolidation report and tax consolidation analysis was prepared in order to establish the tax cost setting amounts (TCSAs) of Company A's assets upon its acquisition by Partnership A. This report was later updated to reflect changes including the 29 June 2012 enacted amendments to TOFA and consolidation interactions. This work included: · identifying the key asset classes of Consolidated Group 1; · determining the tax value allocated to those asset categories; · calculating the ACA of Consolidated Group 1; · allocating the ACA to retained cost base assets of Consolidated Group 1; and · spreading the remaining ACA across Consolidated Group 1's reset cost base assets. Liabilities - foreign borrowing Company A borrowed foreign moneys from Overseas Co 8 via documented interest bearing loans to fund foreign investments. The principal was required to be repaid to Overseas Co 8 at the end of the loan term. The loan, functioned as a natural hedge against foreign exchange (FOREX) volatility on Consolidated Group 1's investments in Overseas Investments 1 and Overseas Investments 2 (together, the Overseas Investments). Just before the joining time (of Company A joining MEC Group 2) these borrowings remained outstanding and existed on the balance sheet of Company A. At the time of Partnership A's acquisition of Company A, the borrowings were included in Step 2 of the ACA calculation. The borrowings recognised on Company A's balance sheet included an unrealised loss due to the FOREX movement that had not yet been recognised for tax purposes. A reduction was initially made to the Step 2 amount under subsection 705-75(1) in respect of the borrowings based on an analysis that the unrealised FOREX losses would give rise to a future deduction to the head company of MEC Group 2. An addendum to the ruling application and amended tax consolidation report have subsequently been issued to incorporate the 29 June 2012 legislative amendments. Based on this law change, no adjustment was ultimately made to the Step 2 amount under subsection 705-75(1). Due to a difference between recognition of the FOREX losses for accounting and tax purposes, a notional ACA calculation was prepared. Based on this notional ACA calculation no adjustment was made under section 705-80 based on the following analysis: · the notional ACA is required to be prepared assuming that the accounting liability had been taken into account for tax purposes at the same time as for accounting purposes; · in preparing this notional ACA calculation the unrealised FOREX losses are assumed to have been realised and treated as deductible during the period from the initial investment to the joining time; · Company A had sufficient taxable income over this period to offset these notional deductions and therefore no notional tax losses arise, and the Step 6 amount will not change as part of the notional calculation; · as the FOREX losses are taken to be realised for the purposes of the notional calculation, a future deduction will not be available to MEC Group 2 Head Co and, as such, the reduction under section 705-75 is no longer required. The notional Step 2 amount will therefore be higher than the original ACA calculation; · as the FOREX losses are taken to be realised before the joining time, the notional taxable income of Company A for the relevant income year would be lower than the actual taxable income. This would result in the amount of tax payable by Company A being lower in the notional calculation and therefore the provision for taxation would also be lower; · the provision for taxation is a liability that is included in Step 2 of the ACA calculation. Therefore the notional reduction to the provision for taxation also reduces the notional ACA; and · the reduction to the provision for taxation in the notional ACA calculation corresponds with the reduction to Step 2 in the original ACA calculation. As a result there is no difference between the original ACA calculation and the notional ACA calculation and no adjustment is required under section 705-80 when Company A joined MEC Group 2. Liabilities - Foreign currency derivatives During the relevant income year, Company A entered into various forward exchange currency contracts to hedge the FOREX risk on its foreign currency trade creditors. These forward contracts were recognised by Company A as derivatives based on paragraph 9 of 'AASB 139 - Financial Instruments: Recognition and Measurement' (AASB 139). Some of the derivatives were designated as cash flow hedges by Company A based on paragraph 86 of AASB 139, and were accounted for as such. These derivatives were recognised by Company A at the same time for accounting and tax purposes. Other derivatives were accounted for by Company A as separate financial liabilities in the balance sheet of Company A based on paragraph 11 of 'AASB 132 - Financial Instruments: Presentation' (AASB 132). These derivatives were recognised by Company A at different times for accounting and tax purposes as the loss recognised in the income statement was unrealised for tax purposes. The derivatives were included in Step 2 of the ACA calculation when Company A joined MEC Group 2. A reduction was initially made to the Step 2 amount under subsection 705-75(1) in respect of the derivatives based on an analysis that the derivatives would give rise to a future deduction to MEC Group 2 Head Co when realised. An addendum to the ruling application and amended tax consolidation report have subsequently been issued to incorporate the abovementioned 29 June 2012 legislative amendments. Based on this law change, no adjustment was ultimately made to the Step 2 amount under subsection 705-75(1). Due to a difference between recognition of the FOREX losses for accounting and tax purposes, a notional ACA calculation was prepared. Based on this notional ACA calculation no adjustment was made under 705-80 based on the following analysis: · the notional ACA is required to be prepared assuming that the accounting liability had been taken into account for tax purposes at the same time as for accounting purposes; · in preparing this notional ACA calculation the derivatives are assumed to have been realised and treated as deductible during the relevant income year; · Company A had sufficient taxable income in the relevant income year to offset these notional deductions and therefore no notional tax losses arise, and the Step 6 amount will not change as part of the notional calculation; · as the derivatives are taken to be realised for the purposes of the notional calculation, a future deduction will not be available to MEC Group 2 Head Co and, as such, the reduction under section 705-75 is no longer required. The notional Step 2 amount will therefore be higher than the original ACA calculation; · as the derivatives are taken to be realised before the joining time, the notional taxable income of Company A will be lower and therefore the provision for taxation would also be lower; · the provision for taxation is a liability that is included in Step 2 of the ACA calculation. Therefore the notional reduction to the provision for taxation also reduces the notional ACA; and · the reduction to the provision for taxation in the notional ACA calculation corresponds with the reduction to Step 2 in the original ACA calculation. As a result there is no difference between the original ACA calculation and the notional ACA calculation and no adjustment is required under section 705-80 when Company A joined MEC Group 2. Liabilities - Promissory note On the same day that Company A joined MEC Group 2, as part of the Australian integration, Company A acquired shares in Company B from Overseas Co 3. As explained above, this acquisition was partially funded by the issue of a promissory note from Company A to Overseas Co 3. This loan note was a non-interest bearing note denominated in Australian dollars, with the principal required to be repaid to Overseas Co 3 on the same day as it was issued. The loan note was repaid by Company A (as explained below at 'Refinancing of Company A's debt') after it joined MEC Group 2. The loan note was included in Step 2 of the ACA calculation when Company A joined MEC Group 2. As the loan note was denominated in Australian dollars and consequently there were no unrealised gains or losses associated with the note, no reduction was made to Step 2 under section 705-75. Company A recognised the promissory note at the same time for tax and accounting purposes. As such, no adjustment was made to Step 2 under section 705-80. Liabilities - Deferred tax liability A deferred tax liability (DTL) was included at Step 2 of the ACA calculation upon Company A joining MEC Group 2. This DTL was in relation to the accounting and tax timing difference in inventory, property, plant and equipment and investments. This DTL existed at the joining time of Company A to MEC Group 2 (i.e. after Company B joined Consolidated Group 1). The DTL included in Step 2 subsequently changed when the ACA spread to the assets of Company A as their tax base changed. This then required the ACA to be recalculated with reference to the new DTL in accordance with subsection 705-70(1A). In recognising the DTL for the purposes of Step 2, an automated (formula based) method was used to calculate the appropriate amount rather than the administrative shortcuts outlined in the ATO's Consolidation Reference Manual. This process worked as follows: · The ACA is first calculated based on a particular value of DTL. This could be the DTL carried by the joining entity before the joining time, or a considered estimate of what that value might be. · This ACA amount is then allocated to the reset cost base assets of the joining entity to determine their cost setting amounts. This in turn allows an amount for the DTL to be determined for the head company based on the TCSAs. If this new DTL is different to the DTL used in the first ACA calculation, a second ACA calculation is required using the new DTL. This process is automatically repeated by formula until the DTL determined for the head company is the same as that used in the last iteration; that is, until there is no longer any variation in the value of the DTL between iterations. No reduction was made to the Step 2 amount under subsection 705-75(1) based on an analysis that the DTL would not give rise to a future deduction to MEC Group 2 Head Co. As Company A's recognition of the DTL for tax purposes was the same as for accounting purposes, no adjustment was made to Step 2 under section 705-80. Liabilities - Incentive payments At the time of Company A joining MEC Group 2, its balance sheet also included credit balances that related to: · prepaid 'sign on' incentive payments from suppliers for a member of MEC Group 1 entering into long term supply contracts (supplier incentive payments); and · upfront lease incentives (in the form of a capital contribution to premises fit-outs and a rent free period) received upon entering into a lease agreement for head office premises. These payments were treated as assessable in the year they were received and were initially included at Step 2 of the ACA calculation. The ACA calculation shown in the updated tax consolidation report however, excludes the supplier incentive payments from the Step 2 amount. The supplier incentive payments relate to two agreements entered into in by a member of MEC Group 1. The agreements required the purchase of any products of a particular type exclusively from the particular supplier for the term of the agreements. Under each of these agreements: · the relevant subsidiaries of Company A are required to purchase any products of a particular type from the supplier for the term of the agreements (i.e. preferred supplier rights); · the supplier must pay the relevant subsidiary an up-front sign on incentive of a specified amount under each agreement; · the incentive payments are for preferred supplier rights granted to the supplier; · the incentive payments are non-refundable; · the supplier must pay Company A an annual rebate amount of a specified amount in the first year and each subsequent year; and · the agreements can be terminated if either party commits a material breach of its obligations under the contracts. The lease for head office premises (to which the lease incentives relate) is an operating lease and does not constitute a finance lease. The lease incentive capital contribution resulted in assets being capitalised to the balance sheet of Company A to which the ACA was subsequently spread. Retained cost base asset - Trade receivables & accrued trade rebates When Partnership A acquired Company A, the balance sheet of Company A included a credit balance that related to accrued trade rebates and was disclosed as a reduction to the face value of trade receivables. These accrued trade rebates primarily related to volume rebates provided to customers and were utilised by these customers to reduce the amount payable to Company A for future sales. The relevant trade receivables will be settled within 12 months. Company A normally receives the net trade receivable amount from customers. As such, the trade receivables and the trade rebates are expected to be realised at the same time. In allocating the ACA, a tax cost setting amount (TCSA) for trade receivables was determined as the trade receivable net of the accrued trade rebates. Reset cost base asset - Goodwill In allocating the ACA to goodwill, goodwill was treated as a residual asset and its value was determined as the excess of the market value of Australian Business 1 and Australian Business 2 over the market value of those businesses' net identifiable assets at the joining time. In determining the market value of Australian Business 1 and Australian Business 2, and of those businesses' identifiable assets net of their liabilities, the assets and liabilities were valued at their commercial values. Sale of Overseas Investments On the same day that the two consolidation events occurred, Investment Holdings Co acquired the Overseas Investments from Finance Co in exchange for Investment Holdings Co assuming foreign loan liabilities held by Finance Co and for cash. Some of the funds used to acquire the Overseas Investments were obtained from Overseas Partnership in exchange for Investment Holdings Co issuing a note in a foreign currency (Note 3). The Loan Note Agreement which constituted Note 3 specified: · the interest payable; · details as to the redemption of the note; and · that the amount subscribed for shall be used to partly fund the consideration for the purchase of investment interests by Investment Holdings Co from Finance Co. Refinancing of Company A's debt On the same day that the two consolidation events occurred, Company A repaid an existing payable owed to Overseas Co 3. This note was used to partly fund Company A's acquisition of Company B. The following steps were undertaken to enable Company A's repayment of its debt to Overseas Co 3: · Overseas Co 3 borrowed funds; · from this cash pool, Overseas Co 3 made interest free loans in Australian dollars and foreign currency to Overseas Co 4; · Overseas Co 4 on-lent this cash to Partnership A in exchange for two interest bearing notes (Note 1 in Australian dollars and Note 2 in a foreign currency); · Partnership A used some of the cash borrowed from Overseas Co 4 to subscribe for shares in Company A; and · Company A used this amount to partly refinance a previous borrowing from Overseas Co 3 which was used by Company A to acquire shares in Company B. The Loan Note Agreement which constituted Note 1 specified: · the interest payable; · details as to the redemption of the note; and · that the amount subscribed for shall be used to invest in the issued share capital of Company A. The Loan Note Agreement which constituted Note 2 also specified: · the interest payable; · details as to the redemption of the note; and · that the amount subscribed for shall be used to invest in the issued share capital of Company A. The funds obtained in exchange for the issuance of Note 2 were contributed to Company A and subsequently lent to Overseas Co 9 to acquire certain overseas businesses (see 'Acquisition of overseas business' below). Completion of the Australian integration After the two consolidation events, the following final steps were undertaken in the Australian integration: · Company B distributed Company X (an entity which was part of Australian Business 2) to Company A; · Company A then distributed Company B to Partnership A; · Partnership A distributed Company A to Company B; and · Company A then transferred Company X to Company Y (an entity which was part of Australian Business 1). TOFA elections MEC Group 2 made the following TOFA elections: · the transitional election in accordance with section 104 of Part 3 of the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 ; · the qualifying FOREX account foreign exchange retranslation election in accordance with Subdivision 230-D; and · the hedging financial arrangements election in accordance with Subdivision 230-E. Acquisition of overseas business The day after the two consolidation events occurred, part of the funds obtained for the issuance of Note 2 were lent to Overseas Co 9 to acquire certain overseas businesses. Post-Australian integration structure The day after the two consolidation events occurred, Company B replaced Company A at the top of the corporate structure.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 94L. | Income Tax Assessment Act 1997 Division 202. | Income Tax Assessment Act 1997 Section 230-15. | Income Tax Assessment Act 1997 Section 705-25. | Income Tax Assessment Act 1997 Section 705-35. | Income Tax Assessment Act 1997 Section 705-70. | Income Tax Assessment Act 1997 Section 705-75. | Income Tax Assessment Act 1997 Section 705-80. | Income Tax Assessment Act 1997 Division 705-C. | Income Tax Assessment Act 1997 Division 855.

Reasons for decision: Summary: Subdivision 705-C of the ITAA 1997 will apply to set the tax cost setting amounts of the assets of Company B when it is acquired by Company A. | Detailed Reasoning - Detailed reasoning: Section 701-10 explains that when an entity becomes a subsidiary member of a consolidated group, the tax cost of each asset of the entity is set at the asset's tax cost setting amount (TCSA) as worked out under Division 705. However, different tax cost setting rules apply depending on the circumstances of the consolidation. In the basic case where an entity becomes a subsidiary member of an existing consolidated group, Subdivision 705-A will operate to determine the TCSA of the joining entity's assets. | Detailed Reasoning - Subdivision 705-C: Subdivision 705-C provides that where a consolidated group is acquired by another consolidated group, modifications are made to the operation of Subdivision 705-A. Subsection 705-175(1) provides that Subdivision 705-C applies if all of the members of a consolidated group (the acquired group) become members of another consolidated group (the acquiring group) at a particular time (the acquisition time) as a result of the acquisition of membership interests in the head company of the acquired group. By virtue of the operation of Subdivision 705-C: · Subdivision 705-A operates so that the TCSAs for assets of the acquired group reflect the cost to the acquiring group of acquiring the former group (paragraph 705-175(2)(b)); and · Subdivision 705-A has effect in relation to the acquiring group as if the only member of the acquired group that is a joining entity of the acquiring group is the entity that was the head company of the acquired group just before the acquisition time (meaning that the subsidiary members of the acquired group are treated as part of the head company of that group and therefore their assets have the tax costs set at the acquisition time) (section 705-185). | Detailed Reasoning - Subdivision 719-C: Subdivision 719-C modifies the tax cost setting rules in Divisions 701 and 705 so that they take account of the special characteristics of MEC groups. Section 719-170 applies if all the members of a MEC group become members of a consolidated group (or another MEC group) as a result of the acquisition of membership interests in the head company and the other eligible tier-1 companies of the acquired MEC group. Under subsection 719-170(2), subsections 705-175(1) and 705-185(1) have effect as if a membership interest in an eligible tier-1 company of an acquired MEC group was a membership interest in the head company of an acquired group. In operation then, where a member of a consolidated group acquires the membership interests in all the eligible tier-1 companies in a MEC group, the members of the acquired MEC group become members of the acquiring consolidated group. If the criteria in subsection 705-175(1) is satisfied - that is, all members of the acquired group become members of the acquiring group at the acquisition time - section 705-185 applies so that the subsidiary members of the MEC group are treated as if they are part of the head company (of that MEC group). As such, Subdivision 705-C operates to enable a modified Subdivision 705-A to set the TCSAs of the assets of the acquired entity. No 'other eligible tier-1 companies' in the acquired MEC group When Company B was acquired by Company A: · Company A was the head company of Consolidated Group 1; · Company B was the provisional head company of former MEC Group 1; and · MEC Group 1 did not contain any other eligible tier-1 companies. As outlined above, in order for section 719-170 to apply (such that Subdivision 705-A as modified by Subdivision 705-C will apply to set the TCSAs of Company B's assets upon joining Consolidated Group 1), subsection 719-170(1) requires that all members of the MEC group become members of the acquiring group because membership interests in the head company and in all other entities that were eligible tier-1 companies of the acquired group are acquired. A question arises as to whether paragraph 719-170(1)(b) operates to require the acquisition of both a head company and other eligible tier-1 companies in order for section 719-170 to apply. If this is the case, section 719-170 would not apply in the circumstance of Company A's acquisition of Company B because only the membership interests of Company B as the provisional head company of MEC Group 1 and not those of any other eligible tier-1 companies were acquired. This interpretation would however be at odds with the intention of Subdivision 719-C, which is to ensure that tax cost setting rules in Divisions 701 and 705 are modified in order to take account of the characteristics of MEC groups, and in doing so, that eligible tier-1 companies of MEC groups are effectively treated in a similar manner as head companies of a consolidated group. 1 As such, subsection 719-170(1) should be read as operating to ensure that section 719-170 applies in respect of a MEC group even if it contains only one eligible tier-1 company which is also the head company. Section 719-170 should be read to apply in the circumstances described above because all members of the MEC group did indeed become members of the acquiring group as the membership interests in Company B, the head company, were acquired. The fact that there were no other eligible tier-1 companies for Company A to acquire does not negate the fact that Company B was acquired and did join Consolidated Group 1 upon that acquisition. Section 719-170 is therefore satisfied if all members of the MEC group become members of the acquiring group because membership interests in the head company and other entities that were eligible tier-1 companies of the acquired group ( if there are any such companies ) are acquired. Based on this reading, given that all members of the former MEC Group 1 became members of Consolidated Group 1 upon Company A's acquisition of Company B, and former MEC Group 1 did not include any transitional foreign-held subsidiaries at the joining time, section 719-170 applies. As such, Subdivision 705-C operates to allow a modified Subdivision 705-A to set the TCSAs of the assets of Company B upon its acquisition by Company A. | Detailed Reasoning - Question 2: Will Subdivision 705-C of the ITAA 1997 apply to set the tax cost setting amounts of the assets of Company A when it is acquired by Partnership A? | Summary: Subdivision 705-C of the ITAA 1997 will apply to set the tax cost setting amounts of the assets of Company A when it is acquired by Partnership A. | Detailed Reasoning - Detailed reasoning: Section 701-10 explains that when an entity becomes a subsidiary member of a consolidated group, the tax cost of each asset of the entity is set at the asset's TCSA as worked out under Division 705. However, different tax cost setting rules apply depending on the circumstances of the consolidation. In the basic case where an entity becomes a subsidiary member of an existing consolidated group, Subdivision 705-A will operate to determine the TCSA of the joining entity's assets. | Detailed Reasoning - Subdivision 705-C: Subdivision 705-C provides that where a consolidated group is acquired by another consolidated group, modifications are made to the operation of Subdivision 705-A. Subsection 705-175(1) provides that Subdivision 705-C applies if all of the members of a consolidated group (the acquired group) become members of another consolidated group (the acquiring group) at a particular time (the acquisition time) as a result of the acquisition of membership interests in the head company of the acquired group. By virtue of the operation of Subdivision 705-C: · Subdivision 705-A operates so that the TCSAs for assets of the acquired group reflect the cost to the acquiring group of acquiring the former group (paragraph 705-175(2)(b)); and · Subdivision 705-A has effect in relation to the acquiring group as if the only member of the acquired group that is a joining entity of the acquiring group is the entity that was the head company of the acquired group just before the acquisition time (meaning that the subsidiary members of the acquired group are treated as part of the head company of that group and therefore their assets have the tax costs set at the acquisition time) (section 705-185). | Detailed Reasoning - Partnership A's acquisition of Company A: When Company A was acquired by Partnership A: · Company A was the head company of Consolidated Group 1; · Partnership A was an eligible tier-1 company of Overseas Co 1 (top company) and a member of MEC Group 2; and · Investment Holdings Co was also an eligible tier-1 company of Overseas Co 1 and a member of MEC Group 2. As outlined above, in order for Subdivision 705-C and consequently a modified Subdivision 705-A to apply to set the TCSAs of Company A's assets upon joining MEC Group 2, all of the members of the acquired group must become members of the acquiring group at the acquisition time as a result of the acquisition of membership interests in the head company of the acquired group. Given that all members of Consolidated Group 1 became members of MEC Group 2 at a particular time (the acquisition time) on the joining date as a result of Partnership A's acquisition of the membership interests in Company A (and the group also did not include any transitional foreign-held subsidiaries at this time), Subdivision 705-C operates to enable a modified application of Subdivision 705-A to set the TCSAs of Company A's assets upon joining MEC Group 2. The fact that MEC Group 1 (with Company B as its provisional head company) was acquired by Company A as the head company of Consolidated Group 1 on the same day does not change the event which subsequently occurred to Consolidated Group 1 upon its joining MEC Group 2 due to its acquisition by Partnership A. Taxation Determination TD 2006/74 (TD 2006/74) considers the question of whether a consolidatable group becomes a consolidated group for an entire day or from a particular time on that day. TD 2006/74 confirms that, whilst a choice may be made by a head company under section 703-50 specifying the day on and after which a consolidatable group is taken to be consolidated, the facts and circumstances of a case may necessitate recognising that the group comes into existence at a particular time on that day in order for the objects of Part 3-90 to be met. Whilst the TD does not consider whether an entity becomes a subsidiary member of an existing consolidated group from a particular day or from a particular time on that day, TD 2006/74's reasoning can also be applied to the scenario where a number of events happen on the same day, such as where MEC Group 1 was acquired by Company A (as the head company of Consolidated Group 1) and Company A was subsequently acquired by Partnership A and consequently joined MEC Group 2. Given that the object of Division 705 is to recognise the cost to the head company of such assets as an amount reflecting the group's cost of acquiring an entity, in the circumstance of Company A joining MEC Group 2, it is only possible to achieve this object at a particular time on the day it joined the group, that is, after MEC Group 1 (with Company B as its provisional head company) was acquired by Company A as the head company of Consolidated Group 1. Based on this reasoning, each event must be considered sequentially in order to achieve the objects of Part 3-90 (as required by TD 2006/74). Consequently, Subdivision 705-C will not be stopped from operating and will apply to enable a modified application of Subdivision 705-A to set the TCSAs of Company A's assets upon joining MEC Group 2. | Detailed Reasoning - Question 3: Have the following liabilities been appropriately included in step 2 of the allocable cost amount for Company A in accordance with sections 705-70, 705-75 and 705-80 of the ITAA 1997? Foreign borrowing Foreign currency derivatives Promissory note Deferred tax liability | Summary: The following liabilities have been appropriately included in step 2 of the allocable cost amount for Company A in accordance with sections 705-70, 705-75 and 705-80 of the ITAA 1997 Foreign borrowing Foreign currency derivatives Promissory note Deferred tax liability Detailed reasoning The steps for working out a group's ACA for a joining entity are set out in the table in section 705-60. Step 2 of this calculation, which ensures that the joining entity's liabilities at the joining time are reflected in the ACA as part of the acquiring group's cost of acquiring that entity is set out in further detail at section 705-70. Subsection 705-70(1) provides that: For the purposes of step 2 in the table in section 705-60, the step 2 amount is worked out by adding up the amounts of each thing (an accounting liability) that, in accordance with the joining entity's accounting principles for tax cost setting, is a liability of the joining entity at the joining time. Adjustments may be made to this Step 2 amount: · where the amount of the accounting liability of the joining entity would be different when it becomes an accounting liability of the joined group (the latter amount is treated as the amount of the liability); · to exclude an amount that is inextricably linked to an asset of the joining entity; · to reduce the amount for some or all of a liability that will become an income tax deduction to the head company; · to reduce the amount of the liability for amounts owed to a member of the group;and · where there is a timing difference between income tax provisions and accounting standards in recognising the liability (there may be an increasing or decreasing adjustment). Taxation Ruling TR 2006/6 (TR 2006/6) provides guidance on recognising and measuring liabilities of a joining entity under subsection 705-70(1) where an entity joins a consolidated group. | Detailed Reasoning - Accounting liability & the accounting construct: The term 'accounting liability' refers to a liability at the joining time that can or must be recognised in a statement of financial position (balance sheet) in accordance with the accounting standards or statements of accounting concepts issued by the Australian Accounting Standards Board (AASB). The Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 1) Bill 2010 also confirms a matter is 'in accordance with a joining entity's accounting principles' if it is in accordance with: · accounting standards; or · if there are no accounting standards applicable to the matter, · authoritative pronouncements of the AASB that apply to the preparation of financial statements. For this purpose, accounting standards or statements of accounting concepts includes double entry accounting conventions, Australian accounting standards, UIG Interpretations, statements of accounting concepts, the Framework for Preparation and Presentation of Financial Statements (the Framework) and other authoritative pronouncements of professional bodies and, where relevant, other national accounting standards setting bodies, that apply to the preparation of financial reports. Paragraph 31 of TR 2006/6 explains that the meaning of the word 'liability' is broadly defined in paragraph 49 of the Framework as "a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits", and that a liability should be recognised if: · it is probable that any future economic benefits associated with the item will flow to or from the entity; and · the item has a cost or value that can be measured with reliability. Except where required by an Australian accounting standard, if a liability does not meet the definition and recognised criteria as outlined in the Framework, joining entities should not include those liabilities or obligations at Step 2 of the ACA calculation. Paragraph 2 of the Framework states that: This Framework is not an Australian Accounting Standard and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Framework overrides any specific Australian Accounting Standard. Paragraph 3 of the Framework goes on to say that: The AASB recognises that in a limited number of cases there may be a conflict between the Framework and an Australian Accounting Standard. In those cases where there is a conflict, the requirements of the Australian Accounting Standard prevail over those of the Framework. It is therefore clear that in considering whether a thing is recognised as an accounting liability, priority is given to the application of specific accounting standards in precedence to the Framework and its definition of a 'liability'. Furthermore, AASB and UIG Interpretations are listed in 'AASB 1048 - Interpretation of Standards' (AASB 1048), giving them authority under the Corporations Act 2001 alongside the Standards. TR 2006/6 reinforces this position, stating: Where an accounting standard or other authoritative pronouncement of the AASB does deal with transactions and events then those standards and pronouncements are mandatory. Transactions and events not dealt with in those standards and pronouncements may be recognised as assets, liabilities and equity in the statement of financial position (balance sheet) where they meet the relevant recognition and measurement criteria used in the Framework. Certain circumstances exist however, where divergence from the application of the accounting construct is required. TR 2006/6 explains that subject to certain exceptions, section 705-58 requires that Part 3-90 be applied separately to each asset and liability even though under the accounting construct they would be set off against each other when presented in a statement of financial position. For example, by virtue of 'AASB 112 - Income Taxes' (AASB 112), offset applies to deferred tax assets and liabilities, however for consolidation purposes, deferred tax assets and liabilities are not set off. Liability of the joining entity at the joining time that can or must be recognised in the entity's statement of financial position. Subsection 705-70(1) requires the adding up of the amounts of each thing that is an accounting liability of the joining entity at the joining time. That is, that the accounting liability can or must be recognised in the entity's statement of financial position. 'At the joining time' is not legislatively defined, however for the purposes of subsection 705-70(1) the phrase should be interpreted as if the single entity rule (SER) did not apply to cause the accounting liability to be that of the head company at that time. Furthermore, the 'joining time' represents an event that takes place at a particular time and triggers the act of joining, from which point in time the SER applies (and all that this entails). As such, treating the particular time referred to as the joining time in the consolidation legislation as if the SER did not apply (for the purposes of subsection 705-70(1)), enables the pre-joining time accounting liabilities of a joining entity to be determined for the purposes of Step 2 of the allocable cost amount (ACA) calculation. This particular time (the joining time) is considered to be a reporting date. As such, this date will define which standards, authoritative pronouncements and statements of accounting concepts are applicable to the recognition and measurement of liabilities at the joining time. Where joining entities have previously produced statements of financial position (balance sheets) in accordance with accounting standards and other authoritative statements, the accounting policies adopted at the joining time would usually be expected to be consistent with those previous statements or balance sheets (with some limited exceptions). Paragraph 90 of the Framework provides that a liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. | Detailed Reasoning - Liabilities of Company A upon joining MEC Group 2: When Company A (and consequently Consolidated Group 1) joined MEC Group 2, calculation of the ACA for Company A was required in accordance with section 705-60, including a calculation of the value of Company A's liabilities worked out under section 705-70. | Detailed Reasoning - Application of section 705-70: Company A borrowed foreign funds from Overseas Co 8 via documented interest bearing loans to fund foreign investments. Just before the joining time, these borrowings remained outstanding and existed on the balance sheet of Company A. The foreign borrowings of Company A constitute financial instruments in accordance with 'AASB 132 - Financial Instruments: Presentation' (AASB 132). As such, the relevant borrowings are accounting liabilities for the purposes of Step 2 of the ACA calculation. As these borrowings (which constitute accounting liabilities) remained outstanding at the time of Partnership A's acquisition of Company A, the borrowings were correctly included in Step 2 of the ACA calculation by virtue of subsection 705-70(1). | Detailed Reasoning - Application of section 705-75: Section 705-75 provides that if some or all of an accounting liability will result in a deduction to the head company, a reduction will be made to the amount to be added for that accounting liability under subsection 705-70(1). The borrowings recognised on Company A's balance sheet included an unrealised loss due to the FOREX movement that had not yet been recognised for tax. However, as the foreign borrowings constitute financial arrangements taxed on a realisation basis for the purposes of Division 230, paragraph 715-375(2)(a) operates to set the value of these liabilities when MEC Group 2 acquired Company A as their accounting values at the joining time. Consequently, the unrealised FOREX loss is effectively disregarded and a future deduction would therefore not arise for MEC Group 2 Head Co (as the provisional head company of MEC Group 2). As such, a reduction to the Step 2 amount under subsection 705-75(1) is not required in this respect. | Detailed Reasoning - Application of section 705-80: Section 705-80 requires a notional ACA calculation to be done where there is a timing difference between income tax provisions and accounting standards in recognising a liability. Essentially, section 705-80 adjusts the amount of a liability included in Step 2 under section 705-70, in order to remove the effects on the ACA of deferred income tax recognition of certain liabilities, gains and losses which result from changes in the amounts of liabilities. This ensures that the ACA is as it would be if the liability, gain or loss were to be recognised for tax purposes at the time it is recognised for accounting purposes. The notional ACA calculation is therefore on the basis of an assumed earlier income tax recognition of the liability, taking into account the effect this would have on Steps 2, 3, 5 and 6 (as required). As set out in the Statement of Facts, due to a difference between recognition of the FOREX losses for accounting and tax purposes, a notional ACA calculation was prepared. Based on this notional ACA calculation (and the analysis provided), no adjustment was required to the Step 2 amount under section 705-80. | Detailed Reasoning - Conclusion: Based on the above analysis, the foreign borrowings were appropriately included in Step 2 of the ACA calculation for Company A in accordance with sections 705-70, 705-75 and 705-80. | Detailed Reasoning - Application of section 705-70: In the income year just before the joining time, Company A entered into various forward exchange currency contracts to hedge the FOREX risk on its foreign currency trade creditors. These forward contracts were recognised as derivatives in accordance with paragraph 9 of 'AASB 139 - Financial Instruments: Recognition and Measurement' (AASB 139). Some of the derivatives were designated as cash flow hedges in accordance with paragraph 86 of AASB 139 and accounted for as such. These derivatives were recognised at the same time for accounting and tax purposes as the impact to the profit and loss was deferred until the hedge was realised. Other derivatives (non-cash flow hedges) were accounted for as separate financial liabilities in the balance sheet of Company A in accordance with paragraph 11 of AASB 132. These derivatives were recognised at different times for accounting and tax purposes as the loss recognised in the income statement was unrealised for tax purposes. As the derivatives are accounting liabilities by virtue of AASB 139, they were correctly included as liabilities in Step 2 of the ACA calculation by virtue of subsection 705-70(1). | Detailed Reasoning - Application of section 705-75: The derivative liability included unrealised losses in respect of both the cash flow hedges and other derivatives not recognised as hedges. The derivatives constitute financial arrangements for the purposes of Division 230. Accordingly, paragraph 715-375(2)(a) operates to set the value of these liabilities when MEC Group 2 acquired Company A as their accounting values at the joining time. Consequently, the unrealised losses are effectively disregarded and a future deduction would therefore not arise for MEC Group 2 Head Co (as the provisional head company of MEC Group 2). As such, a reduction to the Step 2 amount under subsection 705-75(1) is not required in this respect. | Detailed Reasoning - Application of section 705-80: As the cash flow hedges were recognised by Company A at the same time for tax and accounting purposes, no adjustment to Step 2 was required in respect of these hedges under section 705-80. However, the derivatives that were not designated as hedges were recognised at different times for accounting and tax purposes (as the loss recognised in the income statement was unrealised for tax purposes). As such, a notional ACA calculation was prepared on the basis that the liability was recognised at the same time for tax purposes as it was for accounting purposes. Based on this notional ACA calculation (and the analysis provided), no adjustment was required to Step 2 under section 705-80. | Detailed Reasoning - Conclusion: Based on the above analysis, the foreign currency derivatives were appropriately included in Step 2 of the ACA calculation for Company A in accordance with sections 705-70, 705-75 and 705-80. | Detailed Reasoning - Application of section 705-70: As part of the Australian integration, Company A acquired shares in Company B from Overseas Co 3. As explained above, this acquisition was partially funded by the issue of a loan note from Company A to Overseas Co 3. This loan note was a non-interest bearing note, with the principal required to be repaid to Overseas Co 3 on the same day it was issued (being the same day on which Company A joined MEC Group 2). As such, the promissory note constitutes an accounting liability by virtue of AASB 132. As stated above however, the concept of the 'joining time' is integral to the operation of subsection 705-70(1), as it determines the point at which the joining entity's liabilities are recognised and measured. Subsection 705-10(1) recognises that the 'joining time' is a particular time and TR 2006/6 provides the further context that: …the phrase 'at the joining time' in subsection 705-70(1) has to be interpreted as if the single entity rule did not apply… 2 Accordingly, the point in time where an entity's liabilities are relevant for the calculation of the ACA is just before the joining time (i.e. when the SER did not apply). As explained in Question 2 above, for entities that became subsidiary members of MEC Group 2 , this time would fall some time after Company A's acquisition of Company B (the first consolidation event which occurred on the same day as the promissory note was issued) and before the repayment of the promissory note later on that day. As the loan note (which is an accounting liability) remained outstanding just before Company A joined MEC Group 2, it is correctly included in Step 2 of the ACA calculation by virtue of subsection 705-70(1). | Detailed Reasoning - Application of sections 705-75 & 705-80: As the recognition of the loan note for tax purposes was the same as for accounting purposes, there were no unrealised gains or losses associated with the note. As such, no reduction to Step 2 was required to be made under section 705-75, nor was an adjustment to Step 2 needed under section 705-80. | Detailed Reasoning - Conclusion: Consequently, the promissory note was appropriately included in Step 2 of the ACA calculation for Company A in accordance with sections 705-70, 705-75 and 705-80. | Detailed Reasoning - Deferred tax liability: A deferred tax liability (DTL) primarily arising as a result of the accounting and tax timing difference in inventory, property, plant and equipment was included at Step 2 of the ACA calculation upon Company A joining MEC Group 2. AASB 112 prescribes the accounting treatment for the recognition and measurement of income taxes, including the recognition and measurement of deferred tax assets (DTA) and DTLs. Paragraph 5 of AASB 112 defines DTLs as the amounts of income tax payable in future periods in respect of taxable differences. Company A's DTL therefore constitutes an accounting liability that is correctly taken into account at Step 2 of the ACA process under subsection 705-70(1A). | Detailed Reasoning - Application of subsection 705-70(1A): As explained above, the liabilities included in Step 2 are the amounts that would be recognised in the joining entity's notional financial statement at the joining time, determined in accordance with the entity's accounting principles for tax cost setting. If however, the amount of the joining entity's liability would be different when it became an accounting liability of the joined group (in accordance with the joining entity's accounting principles), the amount of the liability is the latter amount (as per subsection 705-70(1A)). A DTL is an example of an accounting liability affected by this rule. The purpose of subsection 705-70(1A) - in determining the value of a DTL to be included in Step 2 - is to ensure that the appropriate amount of ACA is allocated to reset cost base assets. This is in the context of the assumption that when a consolidated group acquires another entity, the head company acquires this entity for the market value of the joining entity's net assets, and in determining what to pay for this acquisition, the head company will factor in the value of DTL in the joining entity that will be recognised by the group at the joining time. However, if not for the adjustment required under subsection 705-70(1A), the higher acquisition price, coupled with the existing value of DTL in the joining entity would create a double count in the ACA. This is why subsection 705-70(1A) requires that the value of the DTL to be used at Step 2 is the value of the DTL of the joined group rather than the DTL included in the joining entity's financial statements immediately before the joining time. Determining this correct value may take several iterations. The process used by Company A to determine this amount was as follows: · The ACA is first calculated based on a particular value of DTL. This could be the DTL carried by the joining entity before the joining time, or a considered estimate of what that value might be. · This ACA amount is then allocated to the reset cost base assets of the joining entity to determine their cost setting amounts. This in turn allows an amount for the DTL to be determined for the head company based on the TCSAs. If this new DTL is different to the DTL used in the first ACA calculation, a second ACA calculation is required using the new DTL. This process is automatically repeated by formula until the DTL determined for the head company is the same as that used in the last iteration; that is, until there is no longer any variation in the value of the DTL between iterations. Whilst Company A has not used the administrative shortcut methods articulated by the Commissioner in the Consolidation Reference Manual, the adjustment of DTL in accordance with subsection 705-70(1A) is appropriate. This is because the automated (formula based) method used to calculate the appropriate amount (as outlined above), ensured that the amount of the DTL included at Step 2 was the value of the DTL to MEC Group 2 (the joined group) rather than the value of the DTL to Company A (the joining entity), as required by subsection 705-70(1A). | Detailed Reasoning - Application of sections 705-75 & 705-80: As the DTL would not give rise to a future deduction to MEC Group 2 Head Co, no reduction was required to be made to the Step 2 amount under subsection 705-75(1). Furthermore, as the recognition of the DTL for tax purposes was the same as for accounting purposes, no adjustment to Step 2 was required under section 705-80. | Detailed Reasoning - Conclusion: Consequently, the DTL was appropriately included in Step 2 of the ACA calculation for Company A in accordance with sections 705-70, 705-75 and 705-80. | Detailed Reasoning - Question 4: Has the appropriate approach been applied to determine the tax cost setting amount of goodwill using a residual method in accordance with section 705-35 of the ITAA 1997 and Taxation Ruling 2005/17? | Summary: The appropriate approach was applied to determine the tax cost setting amount of goodwill using a residual method in accordance with section 705-35 of the ITAA 1997 and Taxation Ruling 2005/17. | Detailed Reasoning - Detailed reasoning: Under the consolidation regime contained in Part 3-90, all assets of a joining entity (that is not a chosen transitional entity) that exist at the joining time are recognised as assets for the purposes of setting a TCSA. Section 701-10 explains that when an entity becomes a subsidiary member of a consolidated group, the tax cost of each asset of the entity is set at the asset's TCSA as worked out under Division 705. Subsection 705-35(1) provides that the TCSA for each asset that is not a retained cost base asset (i.e. a reset cost base asset) or an excluded asset is worked out by: · working out the joined group's ACA for the joining entity; and · reducing that amount by the total of the TCSAs for each retained cost base asset; and · allocating the result to each of the joining entity's reset cost base assets in proportion to their market values. The goodwill of a joining entity is one such reset cost base asset for the purposes of subsection 705-35(1) that is identified and valued when the entity joins a group (unless it is a chosen transitional entity). 3 Taxation Ruling TR 2005/17 (TR 2005/17) provides the Commissioner's view on the identification and tax cost setting of goodwill for the purposes of Part 3-90. TR 2005/17 recognises that the High Court in Murry v Federal Commissioner of Taxation 4 supported the conventional accounting residual method as a valid method for identifying and determining the value of goodwill in cases where a business is profitable and expected to continue to be profitable, and explains that for the purposes of consolidation, goodwill is generally valued using a residual value approach. This means that the value of goodwill of a joining entity is determined by "finding the difference between the market value of each business of the joining entity and the value of the net identifiable assets of each of those businesses…" This residual valuation approach applies when a business is profitable and expected to continue to be profitable. TR 2005/17 advises that the following points be considered when working out the value of goodwill using a residual value approach: In valuing the businesses, the market value of each of the businesses of the joining entity is found using accepted business valuation methods and includes consideration of the non-current assets employed in the business together with any working capital items. Two such methods are the discounted cash flow method and the capitalisation of future maintainable profits method. In identifying and valuing assets, it is the commercial values of the assets (rather than the accounting book values of those assets) that are relevant to working out the value of goodwill under the residual value approach. In identifying and valuing liabilities, it is the commercial values of the liabilities that are relevant to working out the value of goodwill under the residual value approach, and may include liabilities that have not been taken into account in working out the amount of liabilities in the ACA calculation. As Company A is not a chosen transitional entity, when it was acquired by Partnership A and joined MEC Group 2, section 705-35 required that the TCSA of each of Company A's reset cost base assets be determined following the allocation of the ACA to Company A's retained cost base assets. In accordance with TR 2005/17 and the residual value approach endorsed therein, as a profitable business, the value of Company A's goodwill should be determined as the excess of the market value of Consolidated Group 1 (the joining group) over the market value of Consolidated Group 1's identifiable assets net of its liabilities. This value then forms the basis for allocating the ACA in accordance with subsection 705-35(1). Company A's goodwill was treated as a residual asset and its value determined as the excess of the market value of Australian Business 1 and Australian Business 2 over the market value of those businesses' net identifiable assets at the joining time. The market value of Australian Business 1 and Australian Business 2 was taken from a valuation report, the valuations of which were undertaken using a discounted cash flow method and the capitalisation of future maintainable profits method. Finally, in determining the market value of those businesses' identifiable assets net of their liabilities the assets and liabilities were valued at their commercial values. As such, the TCSA of Company A's goodwill was correctly set using a residual method in accordance with section 705-35 and TR 2005/17, despite the fact that the value of Company A's goodwill as determined via this residual value approach resulted in a different amount to the value of Company A's goodwill as per the valuation report. | Detailed Reasoning - Question 5: Have the accrued trade rebates been appropriately treated as a reduction to trade receivables for the purposes of the tax cost setting process in accordance with section 705-25 of the ITAA 1997? | Summary: The accrued trade rebates were appropriately treated as a reduction to trade receivables for the purposes of the tax cost setting process in accordance with section 705-25 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 701-10 explains that when an entity becomes a subsidiary member of a consolidated group, the tax cost of each asset of the entity is set at the asset's TCSA as worked out under Division 705. Section 705-25 provides what the TCSA is for a retained cost base asset. A retained cost base asset is defined in subsection 705-25(5) and includes (by virtue of paragraph 705-25(5)(b)) a right to receive a specified amount of Australian currency (other than trading stock or collectables), other than a right that is a marketable security within the meaning of section 70B of the Income Tax Assessment Act 1936 (ITAA 1936). According to subsection 705-25(2), if the retained cost base asset is covered by paragraph 705-25(5)(b), its TCSA is equal to the amount of the Australian currency concerned. The policy objective for treating certain assets which fall under paragraph 705-25(5)(b) as retained cost base assets is so that the cost of such assets is set equal to the joining entity's cost for those assets - which therefore avoids compliance costs which would arise if the cost of such assets was set at an amount different to their nominal value. This policy objective is achieved by the operation of subsection 705-25(2), whereby the TCSA for assets covered by paragraph 705-25(5)(b) is set at the amount of the Australian currency concerned. Taxation Ruling TR 2005/10 (TR 2005/10) provides the Commissioner's view on when an asset of a joining entity will be a retained cost base asset under, inter alia , paragraph 705-25(5)(b) and what the TCSA will be for such an asset in accordance with, inter alia , subsection 705-25(2). TR 2005/10 explains that 'a right to receive a specified amount of Australian currency' refers to an indefeasible, present right to the actual or constructive receipt of a fixed, nominal amount of Australian currency. This definition points to a right to receive a specified amount of Australian currency where: · the performance of the corresponding obligation is not contingent; and · the right is legally enforceable in the event of no-performance of the corresponding obligation to pay the specified amount. Example 5.5 in the Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 1) Bill 2010 recognises that an Australian dollar trade receivable is a right to receive an amount of Australian currency, and is therefore a retained cost base asset under paragraph 705-25(5)(b). When Company A was acquired by Partnership A and joined MEC Group 2, the balance sheet of Company A included a credit balance that related to accrued trade rebates and was disclosed as a reduction to the face value of trade receivables. These trade rebates primarily relate to volume rebates provided to customers and are utilised by these customers to reduce the amount payable to Company A for future sales. Company A normally receives the net trade receivable amount from customers. As such, the trade receivables and the trade rebates are expected to be realised at the same time. Sample invoices show that the amount receivable by Company A is a discounted amount representative of the trade receivable reduced by the applicable trade rebate. In allocating the ACA, the TCSA for Consolidated Group 1's trade receivables was set at an amount which represented trade receivables reduced by trade rebates. As stated above, subsection 705-25(2) provides that the TCSA of an Australian currency trade receivable (i.e. retained cost base asset is covered by paragraph 705-25(5)(b)) is equal to the amount of the Australian currency concerned, that is, the specified amount of that receivable. TR 2005/10 clarifies that in order to 'specify' an amount, it must be named specifically or definitely or stated in detail. The ruling goes on to confirm that this means that 'the amount of Australian currency concerned' referred to in subsection 705-25(2) is the "specific or definitive amount which there is a right to receive." In the case of Company A's trade receivables, the specific amount to which there is a right to receive is the amount of the trade receivable reduced by the relevant trade rebate. Sample invoices evidence this, and as such the net trade receivable amount is "a fixed, nominal amount that can be identified for the purposes of applying subsection 705-25(2) to arrive at a TCSA." Provided that the discounted amount of Company A's trade receivables represents an amount equal to the joining entity's cost for those assets (i.e. the market value of the relevant assets), setting the TCSA of these assets as the reduced amount falls squarely within the policy objective of paragraph 705-25(5)(b) - which is to set the TCSA of retained cost base assets as their nominal value. Accordingly, trade rebates were appropriately treated as a reduction to trade receivables for the purposes of the tax cost setting process in accordance with section 705-25. | Detailed Reasoning - Question 6: Has the deferred income in relation to supplier incentive payments disclosed as liabilities on the balance sheet of Company A been appropriately excluded from step 2 in determining the allocable cost amount for Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997? Have the lease incentive payments received and disclosed as liabilities on the consolidated balance sheet of Company A been appropriately included at step 2 in determining the allocable cost amount for Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997? | Summary: The deferred income in relation to supplier incentive payments disclosed as liabilities on the balance sheet of Company A has been appropriately excluded from step 2 in determining the allocable cost amount for Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997. The lease incentive payments received and disclosed as liabilities on the consolidated balance sheet of Company A have been appropriately included at step 2 in determining the allocable cost amount Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: The steps for working out a group's ACA for a joining entity are set out in the table in section 705-60. Step 2 of this calculation, which ensures that the joining entity's liabilities at the joining time are reflected in the ACA as part of the acquiring group's cost of acquiring that entity, is set out in further detail at section 705-70. Subsection 705-70(1) provides that: For the purposes of step 2 in the table in section 705-60, the step 2 amount is worked out by adding up the amounts of each thing (an accounting liability) that, in accordance with the joining entity's accounting principles for tax cost setting, is a liability of the joining entity at the joining time. TR 2006/6 provides guidance on recognising and measuring liabilities of a joining entity under subsection 705-70(1) where an entity joins a consolidated group. | Detailed Reasoning - Accounting liability & the accounting construct: The term 'accounting liability' refers to a liability at the joining time that can or must be recognised in a statement of financial position (balance sheet) in accordance with the accounting standards or statements of accounting concepts issued by the AASB. The Explanatory Memorandum to Tax Laws Amendment (2010 Measures No. 1) Bill 2010 also confirms a matter is 'in accordance with a joining entity's accounting principles' if it is in accordance with: · accounting standards; or · if there are no accounting standards applicable to the matter, · authoritative pronouncements of the AASB that apply to the preparation of financial statements. For this purpose, accounting standards or statements of accounting concepts includes double entry accounting conventions, Australian accounting standards, UIG Interpretations, statements of accounting concepts, the Framework and other authoritative pronouncements of professional bodies and, where relevant, other national accounting standards setting bodies, that apply to the preparation of financial reports. Paragraph 31 of TR 2006/6 explains that the meaning of the word 'liability' is defined in paragraph 49 of the Framework as "a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits", and that a liability should be recognised if: · it is probable that any future economic benefits associated with the item will flow to or from the entity; and · the item has a cost or value that can be measured with reliability. Except where required by an Australian accounting standard, if a liability does not meet the definitions and recognised criteria as outlined in the Framework, joining entities should not include those liabilities or obligations at Step 2 of the ACA calculation. Liability of the joining entity at the joining time that can or must be recognised in the entity's statement of financial position Subsection 705-70(1) requires the adding up of the amounts of each thing that is an accounting liability of the joining entity at the joining time. That is, that the accounting liability can or must be recognised in the entity's statement of financial position. 'At the joining time' is not legislatively defined, however for the purposes of subsection 705-70(1) the phrase should be interpreted as if the single entity rule did not apply to cause the accounting liability to be that of the head company at that time. Furthermore, the 'joining time' represents an event that takes place at a particular time and triggers the act of joining, from which point in time the single entity rule applies (and all that this entails). As such, treating the particular time referred to as the joining time in the consolidation legislation as if the single entity rule did not apply (for the purposes of subsection 705-70(1)), enables the pre-joining time accounting liabilities of a joining entity to be determined for the purposes of Step 2 of the ACA calculation. This particular time (the joining time) is considered to be a reporting date. As such, this date will define which standards, authoritative pronouncements and statements of accounting concepts are applicable to the recognition and measurement of liabilities at the joining time. Where joining entities have previously produced statements of financial position (balance sheets) in accordance with accounting standards and other authoritative statements, the accounting policies adopted at the joining time would usually be expected to be consistent with those previous statements or balance sheets (with some limited exceptions). Paragraph 90 of the Framework provides that a liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. | Detailed Reasoning - Incentive payments: The balance sheet of Company A when it was acquired by Partnership A and joined MEC Group 2 included credit balances that related to: · prepaid 'sign on' incentive payments from suppliers for a member of MEC Group 1 (which was acquired by Company A) entering into a long term supply contracts (supplier incentive payments); and · upfront lease incentives (in the form of a capital contribution to premises fit-outs and a rent free period) received upon entering into a lease agreement for premises. These amounts were treated as assessable in the year they were received. As stated above, the Framework broadly defines a 'liability' as a "present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits." The applicant submits that in respect of each incentive received there was a present obligation to be settled by future outflow of economic benefits. That is, Company A's obligation to buy the supplier's products or to continue to lease premises represented a present obligation that would be settled by the future outflow of economic benefits in the form of making payments to the supplier for future purchases or making lease payments for the use of the leased premises. Both of these incentives were initially included at Step 2 of the ACA calculation undertaken upon Partnership A's acquisition of Company A, on the basis that they were both disclosed in the accounts under the liabilities section and demonstrated characteristics of liabilities. The ACA calculation however, excludes the supplier incentive payments from the Step 2 amount. | Detailed Reasoning - Supplier incentive payments: In the absence of a specific accounting standard to determine the accounting treatment of a supplier incentive payment from a supplier for entering into a long term supply contract, the Commissioner must rely on the Framework's definition of 'liability' in order to determine if such amounts should be recognised as a liability for the purposes of subsection 705-70(1). As stated above, only a present obligation, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits will be recognised as a liability for the purposes of Step 2 of the ACA calculation, provided, · it is probable that any future economic benefits associated with the item will flow to or from the entity; and · the item has a cost or value that can be measured with reliability. Furthermore, paragraph 60 of the Framework explains that this essential characteristic of having 'a present obligation' means that there is a duty or responsibility to act or perform in a certain way. This paragraph goes on to explain that "obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received." | Detailed Reasoning - Terms of the payments: The supplier incentive payments relate to two agreements entered into by a member of MEC Group 1. The agreements required the purchase of any products of a particular type exclusively from the particular supplier for the term of the agreements. Under each of these agreements: · the relevant subsidiaries of Company A were required to purchase any products of a particular type from the supplier for the term of the agreements (i.e. preferred supplier rights); · the supplier must pay the relevant subsidiary an up-front sign on incentive a specified amount under each agreement; · the incentive payments are for preferred supplier rights granted to the supplier; · the incentive payments are non-refundable under the terms of the contract; and · the agreements can be terminated if either party commits a material breach of its obligations under the contracts. The terms and conditions of the agreements listed above do not evidence that a present obligation exists in respect of the supplier incentive payments. The obligation to purchase all relevant products required from the supplier for the term of the agreements (i.e. the preferred supplier rights created) must be distinguished from the obligation to make payment for those products (i.e. the expected outflow of resources embodying economic benefits) which is an obligation that arises when the purchases are made. The supplier incentive payments are consideration for entering into the two contracts and the creation of the preferred supplier rights granted under those contracts. The incentive payments themselves do not give rise to an obligation for Company A to make payment for all relevant products from the supplier for the term of the agreements. The future outflow of economic benefits in the form of Company A making payments to the supplier for future purchases is related to the legal obligation that arises when the purchases of products are made by Company A. Furthermore, the non-refundable nature of the incentive payments means that Company A does not have a contractual obligation to repay the amount received. The non-refundable nature of the payments is not changed by the expectation of Company A's management that remedies would be sought (including legal action to recover a portion of the incentive payments) should the supply contracts be terminated by Company A prior to the termination date. Even if it could be argued that there is a present obligation in relation to the incentive payment received and there will be a future outflow of economic benefits to continue purchasing products from the supplier (which the Commissioner does not concede), the incentive payment cannot be treated as a liability as it fails the recognition criteria stated in the Framework. While it is probable that future outflows of resources embodying economic benefits will occur when the obligation to purchase all relevant products required from the supplier for the term of the agreements is settled (i.e. when the purchases take place), the amount at which the settlements will take place cannot be measured reliably at the time the agreement is entered into. The agreement does not specify the quantity of the products that Company A is required to buy and the price at which those products will be acquired throughout the term of the agreements. Therefore, the amount to settle the obligation cannot be quantified and measured reliably. Based on this reasoning, the non-refundable incentive payment should not be recognised as a liability in the financial statement of Company A. On this basis, the deferred income in relation to supplier incentive payments disclosed as liabilities on the balance sheet of Company A has been appropriately excluded from Step 2 in determining the allocable cost amount for Company A to MEC Group 2 in accordance with section 705-70 of the ITAA 1997. | Detailed Reasoning - Lease incentives: Paragraph 2 of the Framework states that: This Framework is not an Australian Accounting Standard and hence does not define standards for any particular measurement or disclosure issue. Nothing in this Framework overrides any specific Australian Accounting Standard. Paragraph 3 of the Framework goes on to say that: The AASB recognises that in a limited number of cases there may be a conflict between the Framework and an Australian Accounting Standard. In those cases where there is a conflict, the requirements of the Australian Accounting Standard prevail over those of the Framework. It is therefore clear that in considering whether a thing is recognised as an accounting liability, priority is given to the application of specific accounting standards in precedence to the Framework and its definition of a 'liability'. Furthermore, AASB and UIG Interpretations are listed in AASB 1048, giving them authority under the Corporations Act 2001 alongside the Standards. TR 2006/6 reinforces this position, stating: Where an accounting standard or other authoritative pronouncement of the AASB does deal with transactions and events then those standards and pronouncements are mandatory. Transactions and events not dealt with in those standards and pronouncements may be recognised as assets, liabilities and equity in the statement of financial position (balance sheet) where they meet the relevant recognition and measurement criteria used in the Framework. | Detailed Reasoning - AASB Interpretation 115 & AASB 117: 'AASB Interpretation 115 - Operating Leases - Incentives' (Interpretation 115) explains that in negotiating an operating lease, the lessor may provide incentives for the lessee to enter into the agreement. Such incentives can take the form of up-front cash payments to the lessee, the lessor's reimbursement or assumption of the lessee's costs (such as relocation costs, leasehold improvements and costs associated with a pre-existing lease commitment of the lessee), or initial rent-free or rent-reduced periods. As stated above, in the present case the relevant lease incentives were received as a capital contribution to the leased premises' fit-out and a rent-free period. Therefore, prima facie, Interpretation 115 applies in this case. However, this Interpretation only applies to operating leases. 'Operating leases' are defined in 'AASB 117 - Leases' (AASB 117) as a lease other than a finance lease. A 'lease' is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. A 'finance lease' is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. AASB 117 goes on to explain that situations that individually or in combination would normally lead to a lease being classified as a finance lease are: · the lease transfers ownership of the asset to the lessee by the end of the lease term; · the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised; · the lease term is for the major part of the economic life of the asset even if title is not transferred; · at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and · the leased assets are of such a specialised nature that only the lessee can use them without major modifications. On this basis, Company A's lease of premises constitutes an operating lease. As such, AASB Interpretation 115 applies to determine the accounting treatment of any associated lease incentives received by Company A. The Interpretation provides that incentives in an operating lease are recognised as an integral part of the net consideration agreed for the use of the leased asset. As such, the lessee (in this case, Company A) shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term, on a straight line basis (unless another systematic basis is representative of the time pattern of the lessee's benefit from the use of the leased asset). Essentially then, a lease incentive is not 'free', but will be paid for or paid back by the lessee over the term of the lease. In other words, the incentive can be seen as part of the payment of rent over the lease period. Indeed, upon entering into the lease, Company A has a legal obligation to remain in the leased premises and continue to pay rent in respect of that premises. This creates a present obligation that can be expected to be settled by the outflow of economic benefits in the form of future measurable rent payments. As such, the upfront incentives received by Company A upon entering into the lease agreement are correctly recognised as accounting liabilities when received. Consequently, the lease incentives received and disclosed as liabilities on the consolidated balance sheet of Company A constitute accounting liabilities for the purposes of Step 2 of the ACA calculation, and therefore have been appropriately included at Step 2 in determining the ACA for Company A to MEC Group 2. | Detailed Reasoning - Question 7: Will losses made on amounts borrowed by MEC Group 2 as part of the Australian integration steps be deductible in accordance with section 230-15 of the ITAA 1997, assuming that MEC Group 2 does not exceed the thin capitalisation safe harbour limit? | Summary: Losses made on amounts borrowed by MEC Group 2 as part of the Australian integration steps will be deductible in accordance with section 230-15 of the ITAA 1997, assuming that MEC Group 2 does not exceed the thin capitalisation safe harbour limit. | Detailed Reasoning - Detailed reasoning: Division 230 provides for the taxing of gains and losses arising on certain financial arrangements taxpayers start to have in income years commencing on or after 1 July 2010 and operates in priority to other tax provisions. Under subsection 230-15(2) losses from financial arrangements are deductible to the extent that they are made in gaining or producing a taxpayer's assessable income or are necessarily made in carrying on a business for the purposes of gaining or producing assessable income. | Detailed Reasoning - Financial arrangement: Broadly, a taxpayer has a financial arrangement under subsection 230-45(1) if it has, under an arrangement a: · cash settlable legal or equitable right to receive a financial benefit; or · cash settlable legal or equitable obligation to provide a financial benefit; or · a combination of one or more such rights and/or one or more such obligations, · unless the taxpayer also has, under the arrangement, one or more legal or equitable rights to receive or obligations to provide something which is not a financial benefit, or is not cash settlable, and the one or more rights or obligations are not insignificant in comparison with the cash settlable rights and obligations under the arrangement. In order to determine whether an arrangement is a financial arrangement under section 230-45, the rights and obligations that constitute the arrangement for the purposes of Division 230 must be determined having regard to subsection 230-55(4). Subsection 230-55(4) provides the following matters relevant to determining what rights and/or obligations constitute particular arrangements and whether a number of rights and/or obligations are themselves an arrangement or are 2 or more financial arrangements: · the nature of the rights and/or obligations; · their terms and conditions (including those relating to any payment or other consideration for them); · the circumstances surrounding their creation and their proposed exercise or performance (including what can reasonably be seen as the purposes of one or more of the entities involved); · whether they can be dealt with separately or must be dealt with together; · normal commercial understandings and practices in relation to them (including whether they are regarded commercially as separate things or as a group or series that forms a whole); and · the objects of Division 230. A contract often defines the boundaries of an arrangement, especially where the form of the contract is consistent with its substance. To this end, paragraph 2.47 of the Explanatory Memorandum to the Taxation Laws Amendment (Taxation of Financial Arrangements) Bill 2008 states: … [T]he contract is typically viewed on a 'stand alone' basis. In this context, the contract is neither aggregated with another contract (or contracts), nor disaggregated into component parts, when determining the relevant arrangement to be considered under Division 230. Note 1, Note 2 and Note 3 were drawn down by various subsidiary members of MEC Group 2. Having regard to each of the factors listed in subsection 230-55(4) to the facts provided including the following: · the notes are in different currencies; · while all notes were drawn down on the same day, each note was drawn down separately; · the settlement date for final payment of Note 3 differs to that of Notes 1 and 2; · the interest payable in respect of each note was calculated using different rates; · the funds were used for separate and distinct acquisitions; and · each note was treated separately for accounting and commercial purposes, Note 1, Note 2 and Note 3 each constitute a separate 'financial arrangement' under subsection 230-55(4). | Detailed Reasoning - Extent of deductibility: The extent to which the losses made are deductible under subsection 230-15(2) depends on whether such losses are made in gaining or producing assessable income or are necessarily made in carrying on a business for the purposes of gaining or producing assessable income. In the present case, the deductibility of interest on funds borrowed must be determined taking into account the effect of the SER in section 701-1. The principle underlying the SER is to treat a consolidated group as a single entity, with the head company being that entity for income tax purposes 5 . This ensures that the income tax laws will apply to a consolidated group (or a MEC group) on the basis that the group is a single entity with all of the actions and transactions undertaken by the subsidiary members of the group being imputed to the head company. This means that the actions and transactions of the relevant subsidiary members of MEC Group 2 in respect of Notes 1, 2 and 3 are treated as having been undertaken by MEC Group 2 Head Co as head company of MEC Group 2. | Detailed Reasoning - Note 1: After receiving funds from Overseas Co 3, Overseas Co 4 lent cash to Partnership A in exchange for Partnership A issuing two interest bearing notes (being Note 1 and Note 2). Partnership A used the funds from Note 1 to subscribe for shares in Company A. Company A then used the funds to partly refinance a previous borrowing used by it to acquire shares in Company B. As a result of this acquisition by Company A, Company B (along with all of the assets of Australian Business 2) became a subsidiary member of Consolidated Group 1. In order for the interest payable on Note 1 to be deductible under subsection 230-15(2), it must be incurred in gaining or producing MEC Group 2 Head Co's assessable income or necessarily incurred in carrying on MEC Group 2 Head Co's business for the purposes of gaining or producing assessable income. As stated above, the funds from Note 1 were ultimately used by Company A to refinance its borrowing used to acquire Australian Business 2 (via its acquisition of Company B). Taxation Ruling TR 95/25 confirms that interest on a new borrowing is deductible if this new loan is used to repay an existing borrowing which, at the time of the second borrowing, was being used in an assessable income producing activity or in a business activity which is directed to the production of assessable income. Company A acquired Company B in order to produce assessable income from Australian Business 2. As such, the interest on Note 1 (which refinanced the borrowing used by Company A to acquire Company B and produce assessable income) is deductible under subsection 230-15(2). | Detailed Reasoning - Note 2: The funds obtained in exchange for the issuance of Note 2 were contributed to Company A and subsequently lent to Overseas Co 9 to acquire certain overseas businesses. MEC Group 2 will therefore receive interest income from Overseas Co 9 on the loaned amount. This interest payable is therefore deductible under subsection 230-15(2) because it is incurred in gaining or producing assessable interest income of MEC Group 2. | Detailed Reasoning - Note 3: Investment Holdings Co issued Note 3 and used the funds obtained in exchange for issuing this note to acquire Overseas Investments from Finance Co. The funds paid by Investment Holdings Co for Overseas Investments were ultimately used to partly refinance the borrowing of Company A used to acquire Company B. As stated above, Company A's acquisition of Company B was undertaken in order to produce assessable income from Australian Business 2, therefore the interest on Note 3 (which partly refinanced the borrowing used by Company A to acquire Company B and produce assessable) is deductible under subsection 230-15(2). | Detailed Reasoning - Question 8: Will partnership distributions made by Partnership A be treated as dividends in accordance with section 94L of the Income Tax Assessment Act 1936 (ITAA 1936) and be frankable in accordance with Division 202 of the ITAA 1997? | Summary: Partnership distributions made by Partnership A will be treated as dividends in accordance with section 94L of the ITAA 1936 and will be frankable in accordance with Division 202 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: For limited partnerships that are 'corporate limited partnerships' (as defined by section 94D of the ITAA 1936) the income tax law has effect subject to the changes set out in Subdivision C of Division 5A of the ITAA 1936. 6 The result of these changes is to essentially treat such corporate limited partnerships as companies for tax purposes. Some of the specific modifications contained in Subdivision C of Division 5A of the ITAA 1936 are: · that a reference in the income tax law (other than the definitions of 'dividend' and 'resident' and 'resident of Australia' in section 6 of the ITAA 1936) to a company or a body corporate includes a reference to the partnership; and · that a reference in the income tax law to a dividend or to a dividend (within the meaning of section 6 of the ITAA 1936) includes a distribution made by the partnership, whether in money or in other property, to a partner in the partnership (provided that such a distribution is not attributable to profits or gains arising during a year of income in relation to which the partnership was not a corporate limited partnership). Therefore in order for partnership distributions made by Partnership A to be treated as dividends by virtue of section 94L of the ITAA 1936: · Partnership A must be a corporate limited partnership in relation to the relevant income year; and · any distributions made by Partnership A must not be attributable to profits or gains arising during a year of income in relation to which Partnership A was not a corporate limited partnership. | Detailed Reasoning - Corporate limited partnership: For the purposes of Division 5A of the ITAA 1996, subsection 94D(1) of the ITAA 1936 provides that a limited partnership will be a corporate limited partnership in relation to a year of income of the partnership if: the year of income is the 1995-96 year of income or a later year of income; or the partnership was formed on or after 19 August 1992; or both: (i) the partnership was formed before 19 August 1992; and (ii) the partnership does not pass the continuity of business test set out in section 94E of the ITAA 1936; or all of the following apply: (i) the partnership was formed before 19 August 1992; (ii) a change in the composition of the partnership occurs during the period: (A) beginning on 19 August 1992; (B) ending at the end of the year of income; (iii)the partners do not elect, in accordance with section 94F, that the partnership is not to be treated as a corporate limited partnership in relation to the year of income. A partnership cannot however be a corporate limited partnership if it is: · a venture capital limited partnership (VCLP) within the meaning of subsection 118-405(2) of the ITAA 1997; · an early stage venture capital limited partnership (ESVCLP) within the meaning of subsection 118-407(4) of the ITAA 1997; · an Australian venture capital fund of funds (AFOF) within the meaning of subsection 118-410(3) of the ITAA 1997; or · a venture capital management partnership (VCMP) as defined by subsection 94D(3) of the ITAA 1936. Furthermore, a limited partnership that is a foreign hybrid limited partnership in relation to a year of income (per subsection 830-10(1)) is not a corporate limited partnership in relation to a year of income. | Detailed Reasoning - Limited partnership: In order for a partnership to be a corporate limited partnership under section 94D of the ITAA 1936, it must firstly be a 'limited partnership'. Section 995-1 of the ITAA 1997 defines a 'limited partnership' as: · an association of persons (other than a company) carrying on a business as partners or in receipt of ordinary income or statutory income jointly, where the liability of a least one of those persons is limited; or · an association of persons (other than one referred to in paragraph (a) above) with legal personality separate from those persons that was formed solely for the purpose of becoming a VCLP, ESVCLP, AFOF or VCMP. The table at paragraph 18 of Taxation Ruling TR 97/11 (TR 97/11) sets out the indicators the Commissioner considers relevant in determining whether activities constitute the carrying on of a business. No one indicator is decisive 7 and indicators must be considered in combination and as a whole. Paragraph 16 of TR 97/11 states that, Whether a business is being carried on depends on the 'large or general impression gained' ( Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' ( Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). Partnership A holds shares in Company B, manages the distribution or reinvestment of dividend income from this investment and services the borrowings to fund the acquisition of the investment. In terms of the indicators in TR 97/11, the Partnership Agreement confirms that the there is a purpose and intent for the parties to carry on a business and that this business will be carried on as partners in common with a view to a profit. Furthermore, in Federal Commission of Taxation v Total Holdings (Australia) Pty Limited the taxpayer was incorporated for the purpose of acquiring and holding shares in an entity and its principal activities were holding of shares in and the making of loans to that entity. Whilst the main issue in this case was whether a nexus existed between the taxpayer's income producing activities and certain expenditure, it was recognised by Lockhart J and the Commissioner that the taxpayer's principal activities constituted the carrying on of a business. The Partnership Agreement also specifies that there is a limited partner. As such, Partnership A is a limited partnership for tax purposes. | Detailed Reasoning - VCLPs, ESVCLPs, AFOFs & VCMPs: If a limited partnership satisfies the definitions of a VCLP, an ESVCLP, or an AFOF or a VCMP, it is treated as an ordinary partnership for tax purposes rather than a corporate limited partnership consequently governed by the modifications in Subdivision C of Division 5A of the ITAA 1936. For tax purposes, a limited partnership is a VCLP, ESVCLP or AFOF if, at a particular time, the partnership's registration as a VCLP, ESVCLP or AFOF under Part 2 of the Venture Capital Act 2002 is, or is taken to have been, in force. A VCMP is a limited partnership that is a general partner of one or more of the following: · one or more VCLPs; · one or more ESVCLPs; or · one or more AFOFs · and carries on activities that are related to being such a general partner. 8 Partnership A has not at any time been registered as a VCLP, an ESVCLP, or an AFOF under Part 2 of the Venture Capital Act 2002 , nor is Partnership A a general partner in one or more of the one or more VCLPs, ESVCLPs or AFOFs. As such, it is not excluded as a corporate limited partnership on the basis that it is a VCLP, an ESVCLP, an AFOF or a VCMP. | Detailed Reasoning - Foreign Hybrid Limited Partnership: Division 830 essentially ensures that foreign hybrids that would otherwise be treated as companies for Australian tax purposes, are in fact treated as partnerships. Instead of being treated as corporate limited partnerships however (subject to the modifications in Subdivision C of Division 5A of the ITAA 1936), Foreign Hybrid Limited Partnerships (FHLPs) are treated as ordinary partnerships for tax purposes. In order to be an FHLP, a limited partnership must, amongst other things articulated in subsection 830-10(1), be formed in a foreign country. Partnership A was not formed in a foreign country and consequently will not meet the definition of a FHLP. As such, Partnership A is not excluded from being a corporate limited partnership on the basis that it is a FHLP. | Detailed Reasoning - Formation date: Finally, subsection 94D(1) of the ITAA 1936 provides that a limited partnership will be a corporate limited partnership if the partnership was formed on or after 19 August 1992. Partnership A was formed after 19 August 1992, and therefore satisfies this requirement. | Detailed Reasoning - Conclusion: Based on the above, Partnership A is a corporate limited partnership under section 94D of the ITAA 1936 because it: · is a limited partnership; · is not a VCLP, an ESVCLP, an AFOF or a VCMP; · is not a FHLP; and · was formed after 19 August 1992. As a consequence of being a corporate limited partnership (and therefore essentially treated as a company for tax purposes), distributions made by Partnership A will be dividends for income tax purposes to the extent that such distributions (whether in money or in other property), to the partners are not attributable to profits or gains arising during a year of income in relation to which the partnership was not a corporate limited partnership. | Detailed Reasoning - Frankable dividends: Section 200-10 explains that when an Australian corporate tax entity distributes profits to its members, the entity has the option of passing to those members, credits for income tax paid by the entity on the profits, and that this is done by franking the distribution. In order to frank a distribution, section 202-5 provides that the following requirements must be satisfied: · the distributing entity must be a franking entity; · the franking entity must satisfy residency requirements; · the distribution must be a frankable distribution; and · the entity must allocate a franking credit to the distribution. | Detailed Reasoning - Franking entity: Under section 202-15, a franking entity includes a 'corporate tax entity'. A corporate limited partnership is defined as a corporate tax entity under section 960-115. Accordingly, Partnership A, as a corporate limited partnership will also be a 'franking entity'. | Detailed Reasoning - Residency: In the case of a corporate limited partnership, section 202-20 provides that the partnership satisfies the residency requirements if it is an Australian resident at the time it makes a distribution. Partnership A is an Australian resident, and provided it remains an Australian resident at the time it makes distributions to the partners in the partnership, it will satisfy the requirement in paragraph 202-5(a). | Detailed Reasoning - Frankable distribution: Subsection 202-40(1) provides that a distribution is a 'frankable distribution' to the extent that it is not 'unfrankable' under section 202-45. A 'distribution' for the purposes of this subsection includes a distribution made by the corporate limited partnership, whether in money or in other property, to a partner in the partnership, other than a distribution attributable to profits or gains arising during an income year in which the partnership was not a corporate limited partnership. Therefore, provided distributions made by Partnership A are not 'unfrankable' and are not attributable to profits or gains arising during an income year in which it is not a corporate limited partnership, such distributions will be frankable. Section 202-45 provides that the following are unfrankable: · a distribution to which paragraph 24J(2)(a) of the ITAA 1936 applies that is taken under section 24J to be derived from sources in a prescribed Territory (i.e. distributions by certain corporate tax entities from sources in Norfolk Island); · where the purchase price on the buy-back of a share by a company from one of its members is taken to be a dividend under section 159GZZZP of the ITAA 1936 - so much of that purchase price as exceeds what would be the market value of the share at the time of the buy-back if the buy-back did not take place and were never proposed to take place; · a distribution in respect of a non-equity share; · a distribution that is sourced directly or indirectly, from a company's share capital account; · an amount that is taken to be an unfrankable distribution under section 215-10 (i.e. certain non-share dividends by ADIs) or section 215-15 (i.e. non-share dividends if profits are unavailable); · an amount that is taken to be a dividend for any purpose under any of the following provisions: Division 7A of Part III of the ITAA 1936 (i.e. distributions to entities connected with a private company), unless subsections 109RB(6) or 109RC(2) of the ITAA 1936 apply in relation to the amount; Section 109 of the ITAA 1936 (i.e. excessive payments to shareholders, directors and associates deemed to be dividends); Section 47 of the ITAA 1936 (i.e. distribution benefits - CFCs); an amount that is taken to be an unfranked dividend for any purpose under section 45 of the ITAA 1936 (i.e. streaming of bonus shares and unfranked dividends) or because of a determination of the Commissioner under section 45C of the ITAA 1936; a demerger dividend; and a distribution that section 152-125 (i.e. payments to company's or trust's CGT concession shareholders) or section 220-105 (i.e. unfrankable distributions by NZ franking companies) says is unfrankable. Partnership distributions made by Partnership A do not satisfy the circumstances outlined in section 202-45 as described above. Partnership A's distribution will therefore not be considered unfrankable distributions. As Partnership A: · is a corporate limited partnership and therefore a franking entity; · satisfies the residency requirements in section 202-20; and · makes distributions that are frankable distributions (by virtue of not being unfrankable distributions under section 202-45); · its partnership distributions are treated as dividends in accordance with section 94L of the ITAA 1936 (to the extent that such distributions are not attributable to profits or gains arising during a year of income in relation to which the partnership was not a corporate limited partnership), and are frankable in accordance with Division 202. | Detailed Reasoning - Imputation issues in relation to MEC groups: Subdivision 719-H deals with some imputation issues in relation to MEC groups. Subsection 719-435 applies such that Part 3-6 (provisions dealing with the imputation system) operates as if a frankable distribution made by an eligible tier-1 company that is a member of a MEC group and is not the provisional head company of the group had been made by the provisional head company to a member of the provisional head company. Taxation Ruling TR 2006/21 explains that the provisional head company is therefore responsible for meeting the imputation obligations arising in relation to frankable distributions made by the eligible tier-1 company members of the group from the day specified as the day chosen to consolidate a potential MEC group. As Partnership A is an eligible tier-1 company of MEC Group 2, any frankable distributions made from the time it was a member of the group will be taken, by virtue of subsection 719-435(1), to have been made by the provisional head company of MEC Group 2. | Detailed Reasoning - Question 9: Will any capital gain made by Overseas Co 7 on the transfer of Company B to Overseas Partnership be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 5 on the transfer of Company A to Overseas Co 6 be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 6 on the transfer of Company A to Overseas Co 3 be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Partnership on the transfer of Company B to Overseas Co 3 be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 3 on the transfer of Company B to Company A be disregarded under Division 855 of the ITAA 1997? Will any capital gain made by Overseas Co 3 on the transfer of Company A to Partnership A be disregarded under Division 855 of the ITAA 1997? | Summary: Any capital gain made by Overseas Co 7 on the transfer of Company B to Overseas Partnership will be disregarded under Division 855 of the ITAA 1997. Any capital gain made by Overseas Co 5 on the transfer of Company A to Overseas Co 6 will be disregarded under Division 855 of the ITAA 1997. Any capital gain made by Overseas Co 6 on the transfer of Company A to Overseas Co 3 will be disregarded under Division 855 of the ITAA 1997. Any capital gain made by Overseas Partnership on the transfer of Company B to Overseas Co 3 will be disregarded under Division 855 of the ITAA 1997. Any capital gain made by Overseas Co 3 on the transfer of Company B to Company A will be disregarded under Division 855 of the ITAA 1997. Any capital gain made by Overseas Co 3 on the transfer of Company A to Partnership A will be disregarded under Division 855 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Division 855 provides that a foreign resident can disregard a capital gain or loss unless the relevant CGT asset is a direct or indirect interest in Australian real property, or relates to a business carried on by the foreign resident through a permanent establishment in Australia. Subsection 855-10(1) provides that a capital gain or loss from a CGT event is disregarded provided: · the taxpayer is a foreign resident just before the CGT event happens; and · the CGT event happens in relation to a CGT asset that is not taxable Australian property. During the Australian integration, the following transfers occurred: · Overseas Co 7 transferred Company B to Overseas Partnership; · Overseas Partnership transferred Company B to Overseas Co 3; · Overseas Co 5 transferred Company A to Overseas Co 6; · Overseas Co 6 transferred Company A to Overseas Co 3; · Overseas Co 3 transferred Company B to Company A; and · Overseas Co 3 subsequently transferred Company A to Partnership A. · Overseas Co 7, Overseas Partnership, Overseas Co 5, Overseas Co 6 and Overseas Co 3 were all foreign residents at the time of the relevant transfer. | Detailed Reasoning - CGT asset & CGT event: Subsection 108-5(1) explains that a CGT asset is any kind of property or legal or equitable right that is not property. Note 1 to subsection 108-5(2) confirms that this includes shares in a company. As such, the shares in Company B and Company A (the transferred companies) constitute CGT assets. Upon entering into the contract for each of the transfer of shares described above (or if no contract existed, when the change in ownership of the shares occurred), CGT event A1 occurred as each relevant transferor disposed of a CGT asset in accordance with subsection 104-10(2). According to subsection 104-10(4), the relevant transferor makes a capital gain if the capital proceeds from the disposal are more than the asset's cost base. Alternatively, a capital loss is made if those capital proceeds are less than the asset's reduced cost base. | Detailed Reasoning - Taxable Australian property: As stated above, if a capital gain was made upon the transfers described above, such a gain is disregarded unless the shares in Company B and Company A (the relevant CGT assets) constitute taxable Australian property (TAP). Section 855-15 explains that there are 5 categories of CGT assets that are TAP: · taxable Australian real property (as per section 855-20); · an indirect Australian real property interest (as per section 855-25) that is not also covered by item (e) below; · an asset used in carrying on a business through a permanent establishment in Australia that is not also covered by items (a), (b) or (e); · an option or right to acquire any of the CGT assets in items (a) to (c); or · a CGT asset that is deemed to be Australian taxable property where a taxpayer, on ceasing to be an Australian resident, makes an election under section 104-165. The shares in Company B and Company A do not constitute TAP under categories (a), (c), (d) or (e) above. | Detailed Reasoning - Indirect Australian real property interest: Section 855-25 provides that a membership interest held by an entity (the holding entity) in another entity (the test entity) at a time constitutes an 'indirect Australian real property interest' at that time if the membership interest: · passes the non-portfolio interest test (in section 960-195) at that time or throughout a 12 month period beginning no earlier than 24 months before that time and ending no later than that time; and · passes the principle asset test in section 855-30 at that time. | Detailed Reasoning - Non-portfolio interest test: According to section 960-195 the non-portfolio test is passed at a time if the sum of the direct participation interests held by the holding entity (and its associates) in the test entity at that time is 10% or more. At the time of the relevant transfers each transferor held 100% of the shares in the transferred entity (i.e. Company B or Company A as the test entity), therefore the non-portfolio test is satisfied. | Detailed Reasoning - Principle asset test: The purpose of the principle asset test in section 855-30 is to define when an entity's underlying value is principally derived from Australian real property. Subsection 855-30(2) provides that a membership interest held by the holding entity in the test entity satisfies the principle asset test if the sum of the market values of the test entity's assets that are taxable Australian real property (its TARP assets) exceeds the sum of the market values of its assets that are not taxable Australian real property (its non-TARP assets). Basically, the principle asset test is passed if the total market values of a test entity's TARP assets constitute more than 50% of the total market values of all of the test entity's assets. Based on valuations, at no stage during the Australian integration did the sum of the market values of Company A's and Company B's TARP assets exceed the sum of the market values of their non-TARP assets. As such, the principle asset test is not satisfied. Accordingly, the shares in Company A and Company B do not constitute indirect Australian real property interests. | Detailed Reasoning - Conclusion: Based on the above analysis, shares in Company A and Company B are not: · taxable Australian real property; · indirect Australian real property interests; · assets used in carrying on a business through a permanent establishment in Australia; · options or rights to acquire any of the CGT assets; or · CGT assets that are deemed to be Australian taxable property where a taxpayer, on ceasing to be an Australian resident, makes an election under section 104-165 As the shares in Company A and Company B are therefore not TAP, any capital gains arising from: · Overseas Co 7's transfer of Company B to Overseas Partnership; · Overseas Partnership's transfer of Company B to Overseas Co 3; · Overseas Co 5's transfer of Company A to Overseas Co 6; · Overseas Co 6's transfer of Company A to Overseas Co 3; · Overseas Co 3's transfer of Company B to Company A; and · Overseas Co 3's transfer of Company A to Partnership A are disregarded under Division 855. | Detailed Reasoning - Disclaimer: You cannot rely on the rulings in the Register of private binding rulings in your tax affairs. You can only rely on a private ruling that we have given to you or to someone acting on your behalf. The Register of private binding rulings is a public record of private rulings issued by the ATO. The register is an historical record of rulings, and we do not update it to reflect changes in the law or our policies. The rulings in the register have been edited and may not contain all the factual details relevant to each decision. Do not use the register to predict ATO policy or decisions. 1 New Business Tax System (Consolidation Measures) (No. 2) Bill 2002, Explanatory Memorandum, paragraph 2.14. 2 Paragraph 16. 3 TR 2005/17, paragraphs 4 and 22. 4 193 CLR 605; 98 ATC 4585; (1998) 39 ATR 129. 5 Taxation Ruling TR 2004/11, paragraph 17. 6 Section 94H of the ITAA 1936. 7 TR 97/11, paragraph 15. 8 Subsection 94D(3) of the ITAA 1936.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Question 1: Will Subdivision 705-C of the ITAA 1997 apply to set the tax cost setting amounts of the assets of Company B when it is acquired by Company A?