Private ruling: The churning measure
Date of advice: 2 October 2018
Published: November 2018
Ruling period: 1 July 20xx to 30 June 20xx
Date scheme commenced: Financial year ending 20xx

Ruling: Q1: Is the Australian resident company a ‘subsidiary’ member of a ‘consolidated’ group at a time for the purposes of paragraph 716-440(1)(a) of the Income Tax Assessment Act 1997? | A1: Yes.

Relevant facts and circumstances: Background A foreign resident company (FR1) is the parent company of a multinational group of corporations, which operates throughout the world. FR1 operates through separate legal / operating structures for each division, including Australia and New Zealand. Simplification of global legal structure and Australia / New Zealand restructure Over the past years, FR1 decided to simplify its global structure and to amalgamate its businesses into a single legal entity in each of the countries it operates in. FR1 decided to restructure its Australian and New Zealand legal structure to be left with one single legal entity in each country. The Australia and New Zealand legal structure comprised two Australian resident incorporated companies, AUS1 and AUS2 which conducted businesses in Australia with each company conducting business in New Zealand through separate branches. The restructure to simplify the Australia and New Zealand structure decided upon involved the following steps which were implemented as follows: ● Under an agreement, FR2 sold its shares in AUS2 to AUS1. ● Under separate agreements, AUS1 and AUS2, sold their respective New Zealand branch assets and business liabilities to a newly incorporated New Zealand company. ● AUS1 elected to form a tax consolidated group consisting of itself and AUS2 and provided the appropriate notification to the ATO. ● Immediately following the election of tax consolidation grouping, AUS2 sold its remaining assets and liabilities to AUS1. ● Following the transfer of assets and undertaking by AUS2 to AUS1, AUS2 undertook to make a distribution of retained earnings and share capital to AUS1. The capital reduction was made in accordance with subsection 256C(3) of the Corporations Act 2001 (Cth). It is noted that FR2 was not subject to Australian capital gains tax on the sale of shares in AUS2 on the basis that the disposal of shares did not constitute taxable Australian property. In that regard, the value of shares in AUS2 were not principally attributable to Australian real property.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 703-15(1) | Income Tax Assessment Act 1997 Subsection 703-15(2) | Income Tax Assessment Act 1997 Section 703-10 | Income Tax Assessment Act 1997 Section 703-20 | Income Tax Assessment Act 1997 Section 703-50 | Income Tax Assessment Act 1997 Section 703-58 | Income Tax Assessment Act 1997 Section 703-60 | Income Tax Assessment Act 1997 Subsection 703-50(2) | Income Tax Assessment Act 1997 Subsection 716-440(1) | Income Tax Assessment Act 1997 Subsection 716-440(2) | Income Tax Assessment Act 1997 Subsection 716-440(3) | Income Tax Assessment Act 1997 Subsection 716-440(4) | Income Tax Assessment Act 1997 Subsection 716-440(5) | Income Tax Assessment Act 1997 Division 855 Assumption(s) | The stated assumptions of the taxpayer are that all requirements contained in paragraphs 716-440(1)(b) to 716-440(1)(g) have been satisfied. | AUS2 satisfies the requirements under section 703-15 item 2 to become a subsidiary member.

Reasons for decision: Summary: AUS2 became a ‘subsidiary’ member of the AUS1 consolidated group on <a specified date>. As a result, the condition in paragraph 716-440(1)(a) of the Income Tax Assessment Act 1997 was satisfied. | Detailed Reasoning - Detailed reasoning: The consolidation regime allows for wholly-owned groups of companies (together with eligible trusts and partnerships) to consolidate as a single entity for income tax purposes. A consolidated group comes into existence when the head company of a consolidatable group, together with its wholly-owned resident subsidiaries, make the relevant choice under section 703-50 to consolidate. | Detailed Reasoning - Head Company: The head company is the relevant taxpayer for income tax purposes in a tax consolidated group. To be a ‘head company’, a company: ● must be an Australian resident (but not a prescribed dual resident); ● must have some or all of its income (if any) taxed at the corporate tax rate (or equivalent); ● must not be an excluded entity under s703-20, and ● must not be a wholly-owned subsidiary of another entity that meets the above requirements or, if it is, it must not be a subsidiary member of a consolidated group. | Detailed Reasoning - Subsidiary member: An entity is a subsidiary member of a consolidated group where: ● it is: ● an Australian resident company (but not a prescribed dual resident) that has all or some of its taxable income taxable at the corporate rate; ● a partnership; or ● an Australian resident trust ● it is a wholly-owned subsidiary (directly or indirectly) of the head company of the group; and ● some or all of its income is taxable income must be taxable at a rate at or equal to the corporate tax rate, and must not be a non-profit company. Forming a consolidated group A consolidated group is formed when the head company makes a choice specifying the day from which the consolidatable group is consolidated. The choice takes effect from the earliest point in time that a consolidatable group exists on that day (Taxation Determination TD 2006/74). A consolidatable group consists of a single head company and all the subsidiary members of the group (section 703-10). Once the choice to form a consolidated group is made, the choice is irrevocable and the specified date cannot be changed (subsection 703-50(2)). The choice to form a consolidated group must be made in writing no later than the day the head company lodges the first consolidated income tax return or, if a return is not required, the day it would have otherwise been due. The head company must notify the Commissioner of the choice made in the approved form within the same time frame (section 703-58). AUS1 notified the Commissioner the group would be consolidated from <a specific date>. | Detailed Reasoning - Subsidiary member of a consolidated group: To become a subsidiary member of a consolidated group, an entity must satisfy all the requirements in item 2 of the table in section 703-15. This section provides: 703-15(1) An entity is a member of a consolidated group or a consolidatable group while the entity is: (a) the head company of the group; or (b) a subsidiary member of the group. 703-15(2) At a particular time in an income year, an entity is: (a) a head company if all the requirements in item 1 of the table are met in relation to the entity; or (b) a subsidiary member of a consolidated or consolidatable group if all the requirements in item 2 of the table are met in relation to the entity: | Detailed Reasoning - Ownership requirements: 1 Head company The entity must be a company (but not one covered by s703-20) that has all or some of its taxable income (if any) taxed at a rate that is or equals the corporate tax rate The entity must be an Australian resident (but not a prescribed dual resident) The entity must not be a wholly-owned subsidiary of another entity that meets the requirements in columns 2 and 3 of this item or, if it is, it must not be a subsidiary member of a consolidatable group or a consolidated group 2 Subsidiary member The requirements are that: (a) the entity must be a company, trust or partnership (but not one covered by s703-20); and (b) if the entity is a company – all or some of its taxable income (if any) must be taxable apart from this Part at a rate that is or equals the corporate tax rate; and (c) the entity must not be a non-profit company (as defined in the Income Tax Rates Act 1986 ) The entity must: (a) be an Australian resident (but not a prescribed dual resident), if it is a company; or (b) comply with s703-25, if it is a trust; or (c) be a partnership The entity must be a wholly-owned subsidiary of the head company of the group and, if there are interposed between them any entities, the set of requirements in s703-45, s701C-10 of the Income Tax (Transitional Provisions) Act 1997 or s 701C-15 of that Act must be met When the membership requirements have been satisfied and choice to form a consolidated group has been made, part 3-90 operates to treat the head company as a single entity for income tax purposes, with all the subsidiary members as being part of the head company. The head company retains its existing tax values for its assets, except for membership interest assets in the joining entities which instead of being reset, the cost of it contributes to the allocable cost amount calculation that is then allocated to the joining entity’s underlying assets in accordance with the rules in subdivision 705-A. Subdivision 705-A sets out the basic case in the tax cost setting process where a single entity joins an existing consolidated group. This basic position is then modified for the formation of a consolidated group under subdivision 705-B. The cost of membership interests in a subsidiary member is allocated to the assets of that subsidiary member in order to align the tax costs of the subsidiary member’s assets with the cost of its membership interests to the joined group. The tax cost of the assets of the subsidiary member will depend on whether they are either retained cost base assets or reset cost base assets. The tax cost setting process involves: ● determining the allocable cost amount of the joining entity; ● allocating an amount of the allocable cost amount to the subsidiary member’s retained cost base assets; ● apportioning the balance of the allocable cost amount to the subsidiary member’s reset cost base assets in proportion to their market values. The 8 steps for calculating the allocable cost amount are set out in section 705-60: ● Step 1: Start with the cost of membership interests in the joining entity ● Step 2: Add liabilities of the joining entity ● Step 3: Add adjustments for certain undistributed frankable profits of the joining entity ● Step 3A: Adjust for any pre-joining time rollover from a foreign resident company to a resident ● company ● Step 4: Subtract certain distributions by the joining entity ● Step 5: Subtract the joining entity’s losses accruing to the head company ● Step 6: Subtract certain tax losses transferred by the joining entity to the head company ● Step 7: Subtract certain inherited deductions ● Step 8: Allocable cost amount result Subdivision 705-B determines the tax cost setting process for the assets of an entity if the assets of that entity become assets of the head company as a result of the formation of a consolidated group. When a consolidated group forms, the tax cost setting process is applied separately to each entity that becomes subsidiary member by modifying the rules in Subdivision 705-A. The modifications are necessary, for example, where one of the entities has membership interests in another entity that joins the group at the same time. Where the tax cost setting rules apply to an entity becomes a subsidiary member, whether by way of the basic case (subdivision 705-A) or a group formation (subdivision 705-B), the tax cost setting outcome may be switched off if the churning measure in section 716-440 applies. The effect of this measure is to switch off the entry tax cost setting rules when an entity (often referred to as the joining entity for tax cost setting purposes) becomes a subsidiary member of a consolidated group in circumstances where: ● a foreign resident entity ceased to hold membership interests in: ● the joining entity, or ● a higher level entity which holds membership interests in the joining entity directly or through one or more interposed entities and which becomes a member of the consolidated group at the same time within the test period starting 12 months before the joining time and ending immediately after the joining time (test period). ● a capital gain or capital loss (if any) made by the foreign resident entity would be disregarded because of the operation of Division 855, and ● there has been no change in the majority economic ownership of the joining entity throughout the test period. The purpose of the churning rules is to prevent the tax cost setting process from applying to a joining entity where no tax is payable by a foreign resident owner when it ceases to hold membership interests, in circumstances where there has been no change in the majority economic ownership of the joining entity for a period of at least 12 months before the joining time. | Detailed Reasoning - The churning measure: Section 716-440 applies if a number of conditions are met. These are: | Detailed Reasoning - 716-440(1): Subsection (3) applies if: (a) an entity (the joining entity) becomes a subsidiary member of a consolidated group at a time (the joining time); and (b) another entity (the disposing entity) ceased to hold membership interests in the joining entity during the period that: (i) started 12 months before the joining time; and (ii) ended immediately after the joining time; and (c) a CGT event happened because the disposing entity ceased to hold the membership interests; and (d) either: (i) a capital gain or capital loss of the disposing entity from the CGT event was disregarded because of the operation of Division 855; or (ii) if there had been a capital gain or capital loss of the disposing entity from the CGT event, the capital gain or capital loss would have been disregarded because of the operation of Division 855; and (e) section 701-10 (cost to head company of assets of joining entity) applies to the joining entity’s assets in respect of the joining entity becoming a subsidiary member of the group (disregarding subsection (2) of this section); and (f) it is reasonable to conclude that, throughout the period mentioned in paragraph (b), the sum of the total participation interests held by an entity (the control entity) and its associates in the joining entity was 50% or more; and (g) in a case where the control entity is not the disposing entity – it is reasonable to conclude that the sum of the total participation interests held by the control entity and its associates in the disposing entity was 50% or more at the time the CGT event happened. | Detailed Reasoning - 716-440(2): For the purposes of paragraphs (1)(f) and (g), in working out the sum of the total participation interests held by the control entity and its associates in another entity, take into account: (a) a particular direct participation percentage interest; or (b) a particular indirect participation percentage interest; held in the other entity only once if it would otherwise be counted more than once because the entity holding it is an associate of the control entity. | Detailed Reasoning - 716-440(3): The following provisions do not apply to the joining entity’s assets in respect of the joining entity becoming a subsidiary member of the group: (a) section 701-10 (cost to head company of assets of joining entity); (b) subsection 701-35(4) (setting value of trading stock at tax-neutral amount). Note: This subsection does not affect the application of subsection 701-1(1) (the single entity rule). | Detailed Reasoning - 716-440(4): Subsection (5) applies if: (a) an entity (the higher level entity) holds membership interests in the joining entity (whether directly or through one or more interposed entities) at a time during the period mentioned in paragraph (1)(b); and (b) the higher level entity becomes a subsidiary member of the consolidated group at the joining time; and (c) the requirement in paragraph (1)(b) is not satisfied (disregarding subsection (5)); and (d) the requirement in paragraph (1)(b) would be satisfied if the reference in paragraph (1)(b) to membership interests of the joining entity included a reference to membership interests in the higher level entity. | Detailed Reasoning - 716-440(5): Treat the reference in paragraph (1)(b) to membership interests in the joining entity as including a reference to membership interests in the higher level entity. | Detailed Reasoning - Paragraph 716-440(1)(a): The first condition that must be satisfied for the churning measure to apply is described in paragraph 716-440(1)(a). That condition requires an entity (labelled as the joining entity) to become a subsidiary member of a consolidated group at a time (labelled as the joining time). The question to be answered is whether AUS2 becomes a member of the AUS1 consolidated group when AUS1 elected to form a consolidated group with effect from <a specific date>. As a result of the disposal of AUS2 by FR2 to AUS1 a consolidatable group commenced to exist, consisting of AUS1 as head company and AUS2 as a subsidiary member (section 703-10). From this disposal date the consolidatable group, consisting of AUS1 as the head company and AUS2 as the subsidiary member, can choose to form a consolidated group by providing the approved notification. Once the choice to form a consolidated group is made, specifying the date from which the group is to be consolidated from, the head company and its eligible subsidiary members are treated as a single entity for income tax purposes. At any time while the consolidated group is in existence the group consists of the head company and all of the subsidiary members (if any) of the group at that time. On <the specific date> AUS2 become a subsidiary member of the AUS1 consolidated group, and is a joining entity for the purposes of the consolidation rules that refer to either a subsidiary member or a joining entity. It follows that, from the start date, AUS2 becomes a subsidiary member of the AUS1 consolidated group. The condition in paragraph 716-440(1)(a) is therefore satisfied. The phrase ‘becomes a subsidiary member’ or ‘the joining entity’ in paragraph 716-440(1)(a), while not dissimilar to its use elsewhere in part 3-90, must be considered in the context of the legislative provision it is used. In the context of section 716-440, the first condition in paragraph 716-440(1)(a) defines the entities to which the provision may apply; that is, to those entities that become a subsidiary member of a consolidated group. Consolidated group in the context is derived from the application of the membership rules in section 703-15. The ATO has consistently interpreted the phrase ‘an entity (the joining entity) becomes a subsidiary member’ guided by its use in the particular section, and generally as being satisfied when an entity satisfies the eligibility requirements to be a subsidiary member of a consolidated group as a result of the head company of the group making a choice to form a group. In the current legislative context it is section 716-440. The interpretation of paragraph 716-440(1)(a) together with the eligibility requirements to form a consolidated group results in an entity that becomes a wholly-owned subsidiary at the group formation time satisfying ‘an entity (the joining entity becomes a subsidiary member’. It is considered that such an interpretation is clearly in accordance with the legislative intent of those conditions. That is, those conditions are intended to be satisfied when a consolidation joining event happens because of an acquisition and when a consolidation joining event happens because of an election to form a consolidated group. | Detailed Reasoning - Conclusion: Paragraph 716-440(1)(a) operates where an entity becomes a subsidiary member of a consolidated group. This joining can be by way of an acquisition (where an existing consolidated group acquires all the membership interests in the joining entity) or as a result of a group formation whereby a subsidiary member becomes a member of the group. With effect from <a specific date>, AUS2 became a subsidiary member of the AUS1 consolidated group (being the joining time ). It is at that time the condition in paragraph 716-440(1)(a) of the churning measure is satisfied.