Private ruling: Consolidation- subsidiary leaving consolidated group- tax treatment of head company's cost to purchase convertible notes in the subsidiary
Published: August 2011
Ruling period: Certain income years after 1 January 2010
Date scheme commenced: A day after 1 January 2010

Ruling: Q1: Has the subsidiary group ceased to be a subsidiary member of the consolidated group for the purposes of section 703-15 of the Income Tax Assessment Act 1997 (the Act) and is this the leaving time for the purposes of Division 711 of the Act? | A1: Yes. | Q2: Are the costs associated with the acquisition of the convertible notes by the head company from a third party and conversion of those notes to shares included when calculating the tax base of membership interests in the subsidiary group companies for the purposes of Division 711 of the Act? | A2: No. | Q4: Are the costs associated with the acquisition of the convertible notes by the head company from a third party and conversion of those notes to shares otherwise taken into account when calculating any capital gain or capital loss on the sale of the shares for the purposes of Part 3-1 of the Act? | A3: No. | Q5: Are the costs associated with the acquisition of the convertible notes by the head company from a third party and conversion of those notes to shares deductible by the head company over five years under section 40-880 of the Act? | A4: No.


Relevant legislative provisions: Part 3-1 of the Income Tax Assessment Act 1997 | Section 6-5 of the Income Tax Assessment Act 1997 | Section 8-1 of the Income Tax Assessment Act 1997 | Section 40-880 the Income Tax Assessment Act 1997 | Subparagraph 40-880(9)(b)(i) of the Income Tax Assessment Act 1997 Section 100-35 of the Income Tax Assessment Act 1997 | Division 104 of the Income Tax Assessment Act 1997 | Subsection 100-40(2) of the Income Tax Assessment Act 1997 | Section 100-45 of the Income Tax Assessment Act 1997 | Section 104-10 of the Income Tax Assessment Act 1997 | Subsection 108-5(2) of the Income Tax Assessment Act 1997 | Section 110-25 of the Income Tax Assessment Act 1997 | Subsection 110-25(2) of the Income Tax Assessment Act 1997 | Subsection 110-25(6) of the Income Tax Assessment Act 1997 | Subsection 110-35(1) of the Income Tax Assessment Act 1997 | Subsection 110-35(2) of the Income Tax Assessment Act 1997 | Subsection 110-35(3) of the Income Tax Assessment Act 1997 | Subsection 110-35(4) of the Income Tax Assessment Act 1997 | Subsection 110-35(5) of the Income Tax Assessment Act 1997 | Section 118-20 of the Income Tax Assessment Act 1997 | Section 701C-10 of the Income Tax (Transitional Provisions) Act 1997 | Section 701-1 of the Income Tax Assessment Act 1997 | Section 701C-15 of the Income Tax Assessment Act 1997 | Section 701-60 of the Income Tax Assessment Act 1997 | Section 703-15 of the Income Tax Assessment Act 1997 | Subsection 703-15(2) of the Income Tax Assessment Act 1997 | Paragraph 703-15(2)(b) of the Income Tax Assessment Act 1997 Section 703-30 of the Income Tax Assessment Act 1997 | Section 703-33 of the Income Tax Assessment Act 1997 | Subsection 703-33(1) of the Income Tax Assessment Act 1997 | Subsection 703-33(2) of the Income Tax Assessment Act 1997 | Section 703-45 of the Income Tax Assessment Act 1997 | Section 705-30 of the Income Tax Assessment Act 1997 | Division 711 of the Income Tax Assessment Act 1997 | Section 711-5 of the Income Tax Assessment Act 1997 | Section 711-25 of the Income Tax Assessment Act 1997 | Section 711-30 of the Income Tax Assessment Act 1997 | Section 711-45 of the Income Tax Assessment Act 1997 | Section 711-55 of the Income Tax Assessment Act 1997 | Section 960-135 of the Income Tax Assessment Act 1997 | Subsection 974-75(1) of the Income Tax Assessment Act 1997

Reasons for decision: Detailed Reasoning - Question 1: Summary The subsidiary group has ceased to be a subsidiary member of the consolidated group for the purposes of section 703-15 of the Act. The time that the subsidiary group ceases to be a subsidiary member of the consolidated group is the leaving time for the purposes of Division 711 of the Act. Detailed reasoning Paragraph 703-15(2)(b) of the Act states that at a particular time in an income year, an entity is a subsidiary member of a consolidated group if all the requirements in item 2 of the table are met in relation to that entity. Column 4 of Item 2 of the table in subsection 703-15(2) of the Act states that for an entity to be a subsidiary member of a consolidated group, it must be a wholly owned subsidiary of the head company of the group. If there are interposed between them any entities, the set of requirements in section 703-45, section 701C-10 of the Income Tax (Transitional Provisions) Act 1997 or section 701C-15 of that Act must be met. Section 703-30 of the Act states that: One entity (the subsidiary entity ) is a wholly-owned subsidiary of another entity (the holding entity ) if all the membership interests in the subsidiary entity are beneficially owned by: a) the holding entity; or b) one or more wholly-owned subsidiaries of the holding entity; or c) the holding entity and one or more wholly-owned subsidiaries of the holding entity. Section 960-135 of the Act provides, in the case of a company, that a membership interest is each interest by virtue of which a person is a member or stockholder of the company. Therefore, a share is a membership interest as it represents membership or stockholding in the company. Prior to the transaction the head company owned all of the shares in W Pty Ltd. Accordingly, for the purposes of section 703-30 of the Act W Pty Ltd was a wholly owned subsidiary of the head company. The subsidiary group consisted of: · W Pty Ltd, · X Pty Ltd, · Y Pty Ltd, and · Z Pty Ltd. W Pty Ltd directly owned all the share capital in X Pty Ltd and Z Pty Ltd. Z Pty Ltd owned all the issued share capital in Y Pty Ltd. Accordingly, W Pty Ltd directly or indirectly owned all of the issued share capital in all three companies in the subsidiary group. Accordingly, for the purposes of section 703-30 of the Act the subsidiary group was a wholly owned subsidiary of the head company. The transaction involved the head company purchasing the notes from the third party on the relevant date. All of the notes were converted by the head company into shares. These newly created shares became membership interests in W Pty Ltd. The head company continued to hold all of the membership interests in W Pty Ltd. As the head company continued to hold all of the issued share capital in W Pty Ltd, W Pty Ltd (and its three subsidiaries in the subsidiary group) continued to be wholly owned by the head company. W Pty Ltd continued to be a subsidiary member of the consolidated group as all requirements in Section 703-15(2)(b) of the Act were still satisfied. Section 703-33 of the Act provides: 703-33(1) This section applies if: a) under a contract: ii) a seller stops being entitled to be registered as the holder of a share in a Company at that time (the transfer time); and iii) the buyer becomes entitled to be registered as the holder of the share in the Company at the transfer time; and a) as a result of the contract, the seller stops being the beneficial owner of the share, and the buyer becomes the beneficial owner of the share, and b) the seller and the buyer dealt with each other at arms length in relation to the contract, and c) the seller and the buyer were not associates of one another at any time during the period: i) starting when the contract was entered into; and ii) ending at the transfer time; 703-33(2) For the purposes of section 703-30(1): a) the seller is taken to have stopped being the beneficial owner of the shares at the transfer time; and b) the buyer is taken to have become the beneficial owner of the share at the transfer time. The transaction involved the head company selling all the issued share capital in W Pty Ltd to the purchaser by entering a sale agreement on the relevant date. The share sale completion and transfer happened at or shortly after on the relevant date. A clause of the sale agreement relates to the passing of ownership interests and has the effect that the legal and beneficial ownership of W Pty Ltd shares passes at this time. As the head company ceased to be the legal and beneficial owner of the W Pty Ltd shares, and the purchaser became the legal and beneficial owner of all the shares in W Pty Ltd then pursuant to subsection 703-33(2) of the Act this is the transfer time for the purposes of section 703-33(1) of the Act. As W Pty Ltd is no longer a wholly owned subsidiary of the head company it no longer meets the conditions at Column 4 of Item 2 of the table at subsection 703-15(2) of the Act. W Pty Ltd then ceased to be a member of the consolidated group at this time. As W Pty Ltd has ceased to be a wholly owned subsidiary of the head company, its three subsidiaries have also ceased to be wholly owned subsidiaries of the head company. Therefore, the subsidiary group has ceased to be a subsidiary member from the consolidated group at the transfer time, being the relevant date. Division 711 of the Act also contains the concept of the leaving time. In relation to the application of the Division section 711-5 states: Application 711-5(1) This Division has effect: (a) for the head company core purposes set out in subsection 701-1(2); and (b) for the entity core purposes set out in subsection 701-1(3); if an entity (the leaving entity ) ceases to be a *subsidiary member of a *consolidated group (the old group ) at a particular time (the leaving time ). Accordingly, the time that the subsidiary group ceases to be a subsidiary member of the consolidated group is also the leaving time for the purposes of Division 711 of the Act. | Detailed Reasoning - Question 2: Summary The tax costs of membership interests held by a head company in a subsidiary member are set just before the member leaves the group under subsection 701-15(3) of the Act. The cost incurred by the head company to acquire the convertible notes, being the notes purchase price, is not included at step 1 of the allocable cost amount (ACA) calculation under section 711-20 of the Act. The cost incurred by the head company will not be taken into account in the remaining steps in the ACA calculation under section 711-20 of the Act. The tax cost of membership interests held by the head company will be the tax cost setting amount, regardless of the previous historical cost base or reduced cost base of the membership interests held by the head company, under subsection 701-55(5) of the Act. The cost to the head company associated with the acquisition of the convertible notes is not included when calculating the tax cost of membership interests in the subsidiary group companies for the purposes of Division 711 of the Act. Detailed reasoning Calculating the tax cost setting amount Section 701-15 of the Act states: | Detailed Reasoning - 701-15(1): If the entity ceases to be a *subsidiary member of the group, this section has effect for the head company core purposes, so far as they relate to the income year in which the entity ceases to be a subsidiary member or any later income year. Object | Detailed Reasoning - 701-15(2): The object of this section is to preserve the alignment of the *head company's costs for *membership interests in each entity and its assets by recognising, when an entity ceases to be a *subsidiary member of the group, the cost of those interests as an amount equal to the cost of the entity's assets at that time reduced by the amount of its liabilities. Setting tax cost of membership interests | Detailed Reasoning - 701-15(3): For each *membership interest that the *head company of the group holds in an entity that ceases to be a *subsidiary member, the interest's *tax cost is set just before the entity ceases to be a subsidiary member at the interest's *tax cost setting amount. As outlined at paragraphs 11 to 15 of Taxation Determination TD 2010/1 Income tax: consolidation: capital gains: does paragraph 40-880(5)(f) of the Income Tax Assessment Act 1997 prevent the deduction, under section 40-880 of the Act, of incidental costs described in subsection 110-35(2) of that Act that the head company of a consolidated group or MEC group occurs, in disposing of shares in a subsidiary member to a non-group entity, before the member leaves the group? 11. The object of the consolidation tax cost setting rules in Part 3-90 that apply when a subsidiary member leaves a consolidated group or MEC group, is to preserve the alignment between the head company's cost for its shares in entities and the entities' assets that is established by the tax cost setting process when entities join the group (that is, become members of the group). Broadly, the alignment is achieved by the cost of the shares reflecting the cost of the leaving subsidiary member's assets reduced by the amount of its liabilities. 12. This has the result that the capital gain or loss on disposal of shares in a subsidiary member reflects the gains or losses in respect of the underlying assets held by the member at the time it leaves the group. The legislation giving effect to this scheme is outlined in the following paragraphs. 13. Under subsection 701-1(1) (the 'single entity rule' or SER), an entity that is a subsidiary member of a consolidated group or MEC group for a period is taken to be part of the head company of the group for that period for the 'head company core purposes' and 'entity core purposes' set out respectively in subsections 701-1(2) and (3). 14. One effect of the SER is that the existence of shares held by group members in the subsidiary member is disregarded for the head company's core purposes during the period it is a member of the consolidated group. The tax costs of the shares held by group members in a subsidiary member are set under subsection 701-15(3) just before the member leaves the group. 15. Subsection 701-15(3) sets the tax cost of each such share to its 'tax cost setting amount'. This amount, worked out under section 701-60 and Division 711, is arrived at (broadly) by reducing the sum of the costs of the leaving subsidiary member's assets by the amount of the liabilities of the member and allocating the result amongst the shares (and any other membership interests). 16. Subsection 701-55(5) then applies so that if the capital gains tax provisions are to apply to the shares, they operate as if the head company's cost base or reduced cost base of each share in the subsidiary member just before it leaves the group is its tax cost setting amount. The cost base or reduced cost base of the shares thus determined is used to work out the amount of any capital gain or capital loss to the head company on disposal of the shares. When W Pty Ltd and its subsidiaries leave the consolidated group the tax cost of the membership interests is set just before leaving time pursuant to subsection 701-15(3) of the Act. This amount, worked out under the table at section 701-60 and Division 711 of the Act, is arrived at (broadly) by reducing the sum of the costs of the leaving subsidiary member's assets by the amount of the liabilities of the member and allocating the result amongst the shares (and any other membership interests). To work out the tax cost setting amount for the purposes of Subsection 701-15(3) of the Act, it is necessary to establish the old group's allocable cost amount for the leaving entity. Section 711-20 of the Act outlines the steps in calculating the allocable cost amount. Is the head company's cost to purchase the notes included in the allocable cost amount: You have submitted in your application that the costs of acquisition and conversion of the notes should be included in step 1 of the calculation of the allocable cost amount. Subsection 711-20(1) of the Act states, 'Start with the step 1 amount worked out under section 711-25, which is about the *terminating values of the leaving entity's assets just before the leaving time.' The purpose of the step is 'to ensure that the allocable cost amount includes the cost of the assets.' The costs incurred by the head company in purchasing the notes is not part of the step one amount. This is because the expense incurred by the head company is not an asset of W Pty Ltd just before the leaving time. On the facts of your case the notes are converted to shares in W Pty Ltd. There are no costs associated with conversion. The cost of acquiring the notes are not, even when the shares are converted, part of the step one amount. This is because the expense incurred by the head company is not an asset of W Pty Ltd just before leaving time. The costs incurred by the head company in purchasing the notes will not be included at any of the remaining steps in the calculation of the allocable cost amount under subsection 711-20(1) of the Act. Interaction with Capital Gains tax provisions It should be noted that the tax cost setting amount determined for each share is then used to determine the consequences for the head company disposing of the share. That is subsection 701-55(5) of the Act applies such that the head company's cost base, or reduced cost base for a share in the company just before the subsidiary leaves is the tax cost setting amount. The head company will use the tax cost setting amount when calculating its capital gain or capital loss on the disposal of the W Pty Ltd shares. Conclusion The cost associated with the acquisition of the notes, being the notes purchase price, is not included when calculating the tax cost of membership interests in the subsidiary group companies for the purposes of Division 711 of the Act. | Detailed Reasoning - Question 3: Summary The costs associated with the acquisition of the notes by the head company from the third party and conversion of those notes for sale to the purchaser is not an incidental cost of the sale of the W Pty Ltd shares for the purposes of section 110-35 of the Act. The costs to purchase the notes are not transfer costs within the ordinary meaning of that term. Further, the amount to purchase the notes are not transfer costs of the sale of the shares within the ordinary meaning of that term. The cost to the head company is not an incidental cost and will not form part of the cost base or reduced cost base of the shares for the purposes of subsection 110-25(3) of the Act. Further, upon the sale of the shares when the subsidiary leaves the group, the cost base or reduced cost base will be set at the tax cost setting amount. Refer to question 2 above. Detailed reasoning The disposal of the shares Section 104-10 of the Act states that CGT event A1 happens if you dispose of a CGT asset: 104-10(1) CGT event A1 happens if you *dispose of a *CGT asset 104-10(2) You dispose of a *CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner. 104-10(3) The time of the event is: (a) when you enter into the contract for the *disposal; or (b) if there is no contract - when the change of ownership occurs. On the relevant date the head company sold the W Pty Ltd shares to a purchaser when the parties entered into the sale agreement. For the purposes of subsection 104-10(2) of the Act the ownership changed when the sale agreement was entered and the purchaser became the legal and beneficial owner of the shares pursuant to a clause of the sale agreement. The sale of the shares is a disposal of a CGT asset and constitutes a CGT event A1. The time of the CGT event A1 is when the sale agreement was entered on the relevant date. Cost base and incidental costs Section 110-25 of the Act provides the general rules about the cost base of a CGT asset. Subsection 110-25(3) of the Act provides that incidental costs that have been incurred are included at the second element of the cost base of a CGT asset. Section 110-35 of the Act outlines the incidental costs you may have incurred in relation to acquiring a CGT asset or that relate to a CGT event. The incidental cost can be included in the cost base or reduced cost base of the CGT asset. Some of the incidental costs are: · Remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser, subsection 110-35(2) of the Act; · Costs of transfer, subsection 110-35(3) of the Act; · Stamp duty or other similar duty, subsection 110-35(4) of the Act; · Costs of advertising or marketing to find a buyer or seller, subsection 110-35(5) of the Act. You have submitted in your application that the cost of acquiring the notes (the notes purchase price) should be considered to be an incidental cost in relation to the sale of the W Pty Ltd shares, and therefore a cost of transfer. The incidental costs recognised at section 110-35 of the Act are all amounts that are incidental to acquiring the CGT asset or incidental to the CGT event. They are all within the scope of being incidental within the ordinary meaning of incidental. The Macquarie Dictionary revised 5 th Edition relevantly defines the word 'incidental' as: 1. happening or likely to happen in fortuitous or subordinate conjunction with something else. 2. incurred casually and in addition to the regular or main amount: incidental expenses. It also defines 'transfer' as: 1. to convey or remove from one place, person, etc., to another. 2. Law to make over or convey: to transfer a title to land. 3. to convey (a drawing, design, pattern, etc.) from one surface to another. The notes purchase price was expenditure for the purchase of the notes. This amount represented the market value of the convertible notes at the time. No additional amount is or was payable in respect of converting the notes to shares. The notes purchase price is not a 'cost of transfer' in relation to acquiring the notes for the purposes of subsection 110-35(3) of the Act. It was the cost of the notes, and not incidental within the meaning in section 110-35 of the Act. The notes purchase price is not a 'cost of transfer' in relation to the conversion of the notes to shares and the disposal of the shares to the purchaser. This is because the amount is not a cost of transfer within the meaning in section 110-35(3) of the Act. The cost of purchasing the notes is not considered to be an incidental cost in relation to the sale of the shares for the purposes of section 110-35 of the Act. The amount would not form part of the cost base of the shares for the purposes of subsection 110-25(3) of the Act. Interaction with Division 711 of the Act If the notes purchase price was an incidental cost of the sale of the shares for the purposes of subsection 110-35 of the Act, any incidental costs that may ordinarily form part of the cost base of the share under section 110-25 of the Act would be disregarded. This occurs because when the subsidiary exits from the consolidated group at the time that the CGT event A1 occurs, the operation of Division 711 of the Act sets the cost base or reduced cost base of the shares to be the tax cost setting amount. Please refer to the reasoning for question 2 above. | Detailed Reasoning - Question 4: Summary The costs associated with the acquisition of the notes by the head company from the third party and conversion of those notes to shares are not otherwise taken into account when calculating the capital gain or capital loss on the sale of the shares for the purposes of Part 3-1 of the Act. This is due to the operation of the cost base and reduced cost base modification in subsection 701-55(5) of the Act. Reasoning Part 3-1 of the Act provides the basis on which to calculate a capital gain or capital loss when a CGT event happens. The head company's conversion of the notes to shares and the sale of those shares by the head company to the purchaser are both CGT events for the purposes of Division 104 of the Act. Per section 100-35 of the Act, for most CGT events: · You make a capital gain if you receive (or are entitled to receive) capital amounts from the CGT event which exceed your total costs associated with that event. · You make a capital loss if your total costs associated with the CGT event exceed the capital amounts you receive (or are entitled to receive) from the event. Under subsection 100-40(2) of the Act for most CGT events, your total costs associated with the event are worked out in 2 different ways: · For the purpose of working out a capital gain, those costs are called the cost base of the CGT asset. · For the purpose of working out a capital loss, those costs are called the reduced cost base of the CGT asset. Section 100-45 of the Act states the method for calculating the capital gain or loss for a CGT event: 1. Work out your capital proceeds from the CGT event. 2. Work out the cost base for the CGT asset. 3. Subtract the cost base from the capital proceeds. 4. If the proceeds exceed the cost base, the difference is your capital gain. 5.If not, work out the reduced cost base for the asset. 6.If the reduced cost base exceeds the capital proceeds, the difference is your capital loss. 7.If the capital proceeds are less than the cost base but more than the reduced cost base, you have neither a capital gain or a capital loss. Section 110-25 of the Act contains the general rules about cost base and provides that the cost base of a CGT asset contains 5 elements. These 5 elements are detailed at subsections 110-25(2) through to paragraph 110-25(6) of the Act and would generally be considered in working out the cost base or reduced cost base of a CGT asset and calculating a capital gain or capital loss. However, as per Question 2, in the case of a consolidated group, the single entity rule (SER) at section 701(1) of the Act applies. Under the SER, an entity that is a subsidiary member of a consolidated group or MEC group for a period is taken to be part of the head company of the group for that period for the 'head company core purposes' and 'entity core purposes' set out respectively in subsections 701-1(2) and (3). Further, subsection 701-55(5) of the Act then operates to provide that if Part 3-1 of the Act is to apply in relation to the asset, the asset's cost base or reduced cost base is equal to the asset's tax cost setting amount. As outlined at paragraphs 14 to 16 of Taxation Determination TD 2010/1 Income tax: consolidation: capital gains: does paragraph 40-880(5)(f) of the Income Tax Assessment Act 1997 prevent the deduction, under section 40-880 of the Act, of incidental costs described in subsection 110-35(2) of that Act that the head company of a consolidated group or MEC group occurs, in disposing of shares in a subsidiary member to a non-group entity, before the member leaves the group? 14. One effect of the SER is that the existence of shares held by group members in the subsidiary member is disregarded for the head company's core purposes during the period it is a member of the consolidated group. The tax costs of the shares held by group members in a subsidiary member are set under subsection 701-15(3) just before the member leaves the group. 15. Subsection 701-15(3) sets the tax cost of each such share to its 'tax cost setting amount'. This amount, worked out under section 701-60 and Division 711, is arrived at (broadly) by reducing the sum of the costs of the leaving subsidiary member's assets by the amount of the liabilities of the member and allocating the result amongst the shares (and any other membership interests). 16. Subsection 701-55(5) then applies so that if the capital gains tax provisions are to apply to the shares, they operate as if the head company's cost base or reduced cost base of each share in the subsidiary member just before it leaves the group is its tax cost setting amount. The cost base or reduced cost base of the shares thus determined is used to work out the amount of any capital gain or capital loss to the head company on disposal of the shares. When W Pty Ltd and its subsidiaries leave the consolidated group the tax cost of the membership interests is set just before leaving time pursuant to subsection 701-15(3) of the Act. The costs associated with the acquisition of the notes by the head company from the third party and conversion of those notes to shares, being the notes purchase price, is not otherwise taken into account when calculating any capital gain or capital loss on the sale of the shares for the purposes of Part 3-1 of the Act. The operation of the cost base and reduced cost base modification in subsection 701-55(5) of the Act override the rules about cost base contained in Part 3-1 of the Act. The means that the tax cost setting amount per share (set just before W Pty Ltd and its subsidiaries leave the consolidated group) is taken to be the cost base or reduced cost base when calculating any capital gain or capital loss on the sale of the shares. | Detailed Reasoning - Question 5: Summary The costs associated with the acquisition of the notes and conversion of those notes to shares are not deductible by the head company over five years under section 40-880 of the Act. This is because when the head company's subsidiary (W Pty Ltd) issues an equity interest to the third party and the head company incurs capital expenditure to purchase the equity interest from the third party (which held the equity interest), the expenditure is an amount that, for another entity, is a return of an equity interest for the purpose of subparagraph 40-880(9)(b)(i) of the Act. Detailed reasoning The object of section 40-880 of the Act is to make certain business capital expenditure deductible over 5 years if: a) the expenditure is not otherwise taken into account; and b) a deduction is not denied by some other provision; and c) the business is, was or is proposed to be carried on for a taxable purpose. However, certain limitations and exceptions exist to prevent a deduction under this section. Subparagraph 40-880(9)(b)(i) of the Act states that: You cannot deduct anything under this section for an amount of expenditure you incur: (b) to the extent that, for another entity, the amount is a *return on or of: (i) *an equity interest In a prior year the head company, its subsidiary W Pty Ltd (a member of the consolidated group at that time), and a third party, entered into an agreement whereby W Pty Ltd issued convertible notes to the third party. On the relevant date the head company incurred capital expenditure of the notes purchase price to purchase the equity interest (convertible notes) from the third party. The third party is 'another entity' for the purposes of subparagraph 40-880(9)(b)(i). The notes were an equity interest in the member held by that third party. It is therefore an equity interest of another entity. The expenditure incurred by the head company to acquire the equity interest is an amount incurred by the taxpayer to acquire another entity's equity interest. In your case the expenditure incurred by the head company to purchase the notes from the third party was less than the amount paid by the third party when the notes were issued. This raises the question of whether, for an amount to be a 'return of' another entity's equity interest, the amount: i) can be incurred by a taxpayer who is not the issuer of the equity interest; and ii) need not exactly correspond with the amount paid by 'another entity' when it acquired the equity interest. The word 'return' is defined in subsection 995-1(1) of the Act to mean: Return on a *debt interest or *equity interest does not include a return of an amount invested in the interest It is clear that this definition does not resolve the meaning of the expression 'return of' for the purposes of subparagraph 40-880(9)(b)(i) of the Act. Recourse must therefore be had to the ordinary meaning of the expression. The Macquarie Dictionary revised 5 th Edition relevantly defines the word 'return' as: 18. the act or fact of returning; a going or coming back; a bringing, sending, or giving back. 20. reciprocation, repayment, or requital: profits in return for outlay The word 'of' is relevantly defined as: 9. objective relation. An amount that, for another entity, is a 'return of an equity interest' is therefore an amount which gives back to that entity their interest in equity. The ordinary meaning of the expression 'return of' does not introduce a requirement that issuer of the equity interest must be the party that incurs the amount that is a return of the equity interest. This is particularly so in the context of subparagraph 40-880(9)(b)(i) of the Act which looks at the amount from the perspective of 'another entity'. It focuses on the entity that held the equity interest and is concerned with 'another entity' being given an amount (by the third party) that is a return of its equity interest. Although it is common for an equity interest to be bought back by the entity which issued the interest this does not mean that subparagraph 40-880(9)(b)(i) of the Act is restricted in its application to only that circumstance. The Explanatory Memorandum to Tax Laws Amendment (2006 Measures No.1) Bill 2006 (the EM) provides some guidance as to the meaning of the expression 'return of' for the purpose of subparagraph 40-880(9)(b)(i) of the Act. Although the EM gives the example of payments made by a company to buy back its own shares as an expenditure which is excluded by subsection 40-880(9) of the Act the EM makes it clear that expenditures excluded by the provision are not limited to the examples given. The relevant paragraphs of the EM state: | Detailed Reasoning - Returns of capital: 2.79 Some capital amounts are not considered legitimate blackhole expenditures as they comprise the transfer or distribution of funds, repayments, or do not give rise to any income tax consequences. As such, the expenditure does not represent an economic loss to the taxpayer and is not deductible. [Schedule 2, item 30, subsection 40-880(9)] 2.80 Expenditures excluded by this provision include, but are not limited to: · dividends paid by companies; · distributions by trustees; · margin calls; · payments made by a company to buy back its own shares; and · repayments of loan principal. Similarly, the ordinary meaning of the expression 'return of' does not introduce a requirement that the amount given to another entity must exactly correspond with the amount paid by that entity when it acquired the equity interest. It is not uncommon for an entity to buy back its shares at market value. The market value will usually differ from the issue price. This would not of itself disqualify the expenditure from being an amount that, for another entity, is a return of an equity interest. Therefore, where the head company subsidiary (W Pty Ltd), issues an equity interest to the third party and the head company incurs capital expenditure to purchase the equity interest from the third party (which held the equity interest), the expenditure is an amount that, for another entity, is a return of an equity interest for the purpose of subparagraph 40-880(9)(b)(i) of the Act. It follows that the costs associated with the acquisition of the notes and conversion of those notes to shares, being the notes purchase price, are not deductible by the head company over five years under section 40-880 of the Act. This is because the amount of expenditure is an amount that, for another entity (the third party), is a return of an equity interest for the purpose of subparagraph 40-880(9)(b)(i) of the Act.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns. | Are the costs associated with the acquisition of the convertible notes by the head company from a third party and conversion of those notes to shares incidental costs of the sale of the converted shares per section 110-35 of the Act and therefore included in the cost base of the converted shares? | Structure: The head company is the head company of a consolidated group. The head company was incorporated in a prior year, and was interposed as head company in the consolidated group in a prior year. | The subsidiary group consists of W Pty Ltd, X Pty Ltd, Y Pty Ltd and Z Pty Ltd. | W Pty Ltd directly owned all of the issued share capital in X Pty Ltd and Z Pty Ltd. Z Pty Ltd owned all of the issued share capital in Y Pty Ltd. Accordingly, W Pty Ltd directly or indirectly owned all of the issued share capital in all three companies (subsidiary group). | X Pty Ltd owned an interest in a Joint Venture. | Prior to the transaction, the head company owned ordinary shares, being all of the issued share capital in W Pty Ltd. These ordinary shares have been held by the consolidated group since incorporation. | Prior to the transaction, a third party held convertible notes (notes) issued in W Pty Ltd. These notes were issued in a prior year. The notes had an original subscription amount. Each note gave the third party (as the holder) the ability to convert the notes into the same number of ordinary shares in W Pty Ltd. | Business Operations: The head company has not derived any non-assessable and non-exempt income (NANE) in the year of the transaction and does not expect to derive NANE in the current or future income years. As a result, the business of the head company is carried on entirely for a taxable purpose. | On a day (the relevant day) the head company acquired the convertible notes from the third party in accordance with documents supplied to the Commissioner for an amount. The total amount paid by the head company to the third party under the documents supplied was the notes purchase price. | On the relevant day the head company converted the notes into fully paid ordinary shares (converted shares) in W Pty Ltd in accordance with the documents supplied. | On the relevant day the head company sold the converted shares and the existing shares (being all the issued share capital in W Pty Ltd) to the purchaser in accordance with the documents supplied for an amount. The total amount received for the share sale was an amount being the share sale proceeds. | The documents supplied provide that legal and beneficial ownership of the shares will remain with the head company until the completion of the share sale, at which time it will pass to the purchaser. | "Costs associated with the acquisition of the convertible notes and conversion of those notes to shares" means the notes purchase price. This amount solely relates to the purchase price of the notes. No additional amount is or was payable in respect of converting the notes to shares. | The head company and the third party dealt with each other at arm's length in relation to the share sale contract. The head company and the third party were not associates at any time during the period starting when the share sale contract was entered into and ending at the transfer time. | The time and date of both the share sale completion and the share transfer time was at or shortly after a specified time on the relevant day. This is the time when a board meeting of W Pty Ltd approved the registration of the share transfers. | The subsidiary group did not have any intra group liabilities just before the share sale completion and share sale transfer times. | The subsidiary group did not have any liabilities to the third party just before the share sale completion and share sale transfer times. | No new rights were created when the head company acquired and converted the notes other than any normal rights of being a shareholder in accordance with the constitution of W Pty Ltd and any incidental contractual rights created by the provided documentation. | The shares held by the head company in W Pty Ltd were held on capital account (although such assets would normally be disregarded given that they are intra group assets in a consolidated group). | The shares held by W Pty Ltd in X Pty Ltd and Z Pty Ltd were held on capital account (which would be considered to be held by the head company, as head company of the consolidated group). | The shares held by Z Pty Ltd in Y Pty Ltd were held on capital account. | The notes are considered to be non share equity in accordance with Division 974 of the ITAA 1997. | The arrangement in respect of which the Ruling applies will be in accordance with the terms of the supplied documents, copies of which were provided to the Commissioner.