Private ruling: CGT, consolidation and Part IVA
Published: October 2014
Ruling period: Year ending 30 June 2015
Date scheme commenced: 01 July 2014

Ruling: Q1: Will the proposed restructure of Coy A and Coy B cause any Capital Gains Tax (CGT) events to happen? | A1: Yes | Q2: Will the proposed issue of shares in Coy B and the entering into of the Deed cause CGT event D1 to happen? | A2: Yes | Q3: Will the Commissioner seek to apply Part IVA of the Income Tax Assessment 1936 (ITAA 1936) to the identified Scheme? | A3: No

Relevant facts and circumstances: Coy A was registered as a company in 199X. AB holds all of the shares in Coy A. Coy A owns IP. Coy A wants to raise capital from investors to commercialise the IP. Coy A has proposed investors The proposed investors have requested that ownership of the IP be transferred to a new company. AB has proposed the use of Coy B. AB holds all of the shares in Coy B. Coy B has nominal cash assets and no or nominal liabilities. The proposed restructure involves the following steps: • Transfer the current share in Coy B from AB to Coy A for a market value. • Coy A and Coy B form a consolidated tax group. • Coy A transfer the IP to Coy B for equity consideration (shares). • Coy B (owning the IP) will issue, at market value, additional shares to the proposed investors (for money consideration) and consequently exit the tax consolidated group. The shareholders of Coy B will execute an Agreement that will govern their relationship in relation to Coy B The shareholders of Coy B will also execute a Deed. The Deed will include a restrictive covenant.

Relevant legislative provisions: Section 104-35 of the Income Tax Assessment Act 1997 | Income Tax Assessment Act 1997 Section 104-510, | Income Tax Assessment Act 1997 Section 104-520, | Income Tax Assessment Act 1997 Section 116-20, | Income Tax Assessment Act 1997 Section 701-1, | Income Tax Assessment Act 1997 Section 703-50, | Income Tax Assessment Act 1997 Section 705-25, | Income Tax Assessment Act 1997 Section 705-60, | Income Tax Assessment Act 1997 Section 711-20, | Income Tax Assessment Act 1936 Section 177A, | Income Tax Assessment Act 1936 Section 177C and | Income Tax Assessment Act 1936 Section 177CB.

Reasons for decision: Summary: Division 104 of the Income Tax Assessment Act 1997 (ITAA 1997) sets out all of the CGT events for which an entity can make a capital gain or loss. To determine whether any CGT events happen as a consequence of the proposed restructure of Coy A and Coy B it is necessary to consider the acts that make up the proposed restructure. The restructure contemplates the following actions: • Transfer of the share in Coy B from AB to Coy A. • Tax consolidate Coy A and Coy B. • Coy A transfers the IP it owns to Coy B, and Coy B issues shares to Coy A as consideration. • Coy B to exit the tax consolidated group by issuing shares to proposed investors (who will pay money for the shares). Transfer of the share in Coy B It is accepted by the applicant that the transfer of the share in Coy B will cause CGT event A1 to happen, with the capital gain or loss arising to AB. Tax consolidate Coy A and Coy B Subdivision 104-L of the ITAA 1997 contains a number of CGT events that relate to tax consolidated groups. CGT events L1, L2, L3, L4 and L8 may apply in circumstances where an entity becomes a subsidiary member of a consolidated group. Based on the facts and circumstances, CGT event L3 is particularly relevant to the proposed restructure. Subsection 104-510(1) of the ITAA 1997 provides that CGT event L3 happens if: (a) an entity becomes a subsidiary member of a consolidated group or a MEC group; and (b) the sum of the tax cost setting amounts for all retained cost base assets that are taken into account under paragraph 705-35(1)(b) in working out the tax cost setting amount of each reset cost base asset of the entity exceeds the group's allocable cost amount for the entity. Subsection 705-25(5) of the ITAA 1997 provides that a 'retained cost base asset' includes: (a) Australian currency, other than trading stock or collectables of the joining entity; Subsection 705-25(2) of the ITAA 1997 states that the tax cost setting amount for Australia currency is equal to the amount of the Australian currency: If the retained cost base asset is [Australian currency] … and is not covered by another subsection of this section, its tax cost setting amount is equal to the amount of the Australian Currency concerned. Section 705-60 of the ITAA 1997 provides the following formula for determining a joined group's allocable cost amount for the joining entity (all legislative references in the table are to the ITAA 1997): Working out the joined group's allocable cost amount for the joining entity Step What the step requires … 1 Start with the step 1 amount worked out under section 705-65, which is about the cost of membership interests in the joining entity held by members of the joined group … 2 Add to the result of step 1 the step 2 amount worked out under section 705-70, which is about the value of the joining entity's liabilities … 3 Add to the result of step 2 the step 3 amount worked out under: (a) section 705-90, which is about undistributed, taxed profits accruing to the joined group before the joining time; or (b) if the joining entity is a trust (and not a corporate tax entity)section 713-25, which is about undistributed, realised profits accruing to the joined group before the joining time that could be distributed tax free … 3A For each step 3A amount (if any) under section 705-93 (which is about pre-joining time roll-overs): (a) if the step 3A amount is a deferred roll-over loss add to the result of step 3 (as affected by any previous application of this step) the step 3A amount; or (b) if the step 3A amount is a deferred roll-over gain subtract from the result of step 3 (as affected by any previous application of this step) the step 3A amount … 4 Subtract from the result of step 3A the step 4 amount worked out under section 705-95, which is about pre-joining time distributions out of certain profits … 5 Subtract from the result of step 4 the step 5 amount worked out under section 705-100, which is about certain losses accruing to the joined group before the joining time … 6 Subtract from the result of step 5 the step 6 amount worked out under section 705-110, which is about losses that the joining entity transferred to the head company under Subdivision 707-A … 7 Subtract from the result of step 6 the step 7 amount worked out under section 705-115, which is about certain deductions to which the head company is entitled … 8 If the remaining amount is positive, it is the joined group's allocable cost amount. Otherwise the joined group's allocable cost amount is nil. … You advise that at the time Coy B will become a subsidiary member of the consolidated group its only asset will be cash; a retained cost base asset (Australian currency) with a value equal to the amount of the cash. You also advise that it will have either no or nominal liabilities. If the tax cost setting amount for the cash exceeds the group's allocable cost amount for Coy B, the head company will make a capital gain equal to the excess. If the sum of the cash does not exceed the group's allocable cost amount for Coy B, the head company will not make a capital gain or loss from this CGT event. The time of the event will be just after Coy B becomes a subsidiary member of the tax consolidated group. Coy A transfers IP it owns to Coy B Subsection 701-1(1) of the ITAA 1997 contains the single entity rule and states: If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period. Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997 provides the following explanation of the income tax consequences of the single entity rule (SER): 7. For income tax purposes the SER deems subsidiary members to be parts of the head company rather than separate entities during the period that they are members of the consolidated group. 8. As a consequence, the SER has the effect that: (a) the actions and transactions of a subsidiary member are treated as having been undertaken by the head company; (b) the assets a subsidiary member of the group owns are taken to be owned by the head company (with the exception of intra-group assets) while the subsidiary remains a member of the consolidated group; (c) assets where the rights and obligations are between members of a consolidated group (intra-group assets) are not recognised for income tax purposes during the period they are held within the group whether or not the asset, as a matter of law, was created before or during the period of consolidation…; and (d) dealings that are solely between members of the same consolidated group (intra-group dealings) will not result in ordinary or statutory income or a deduction to the group's head company. 9. An example of an intra-group dealing is the transfer of a capital gains tax (CGT) asset from one group member to another. This transfer is not treated for income tax purposes as a disposal or acquisition in the hands of the head company. Although the legal transfer of the CGT asset between the subsidiary members occurs at general law, it has no income tax consequences as the group's head company is taken to be the owner of the asset both before and after the transfer. The transfer of the IP from Coy A to Coy B will be a dealing between members of the same consolidated group (an intra-group dealing). As such, the transfer will not be recognised for any entity within the group (there will be no CGT event). Coy B exits the tax consolidated group Subdivision 104-L of the ITAA 1997 also provides a CGT event (event L5) that may occur in circumstances where an entity ceases to be a subsidiary member of a tax consolidated group. Subsection 104-520(1) of the ITAA 1997 provides that CGT event L5 happens if: (a) an entity ceases to be a subsidiary member of a consolidated group or a MEC group; and (b) in working out the group's allocable cost amount for the entity, the amount remaining after applying step 4 of the table in section 711-20 is negative. Subsection 711-20(1) of the ITAA 1997 provides the following formula for determining the old group's allocable cost amount for the leaving entity (all legislative references in the table are to the ITAA 1997): Working out the old group's allocable cost amount for the leaving entity Step What the step requires … 1 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. … 2 Add to the result of step 1 the step 2 amount worked out under section 711-35, which is about the value of deductions inherited by the leaving entity that are not reflected in the terminating value of the leaving entity's assets just before the leaving time. … 3 Add to the result of step 2 the step 3 amount worked out under section 711-40, which is about liabilities owed by members of the old group to the leaving entity at the leaving time. … 4 Subtract from the result of step 3 the step 4 amount worked out under section 711-45, which is about: (a) the leaving entity's liabilities just before the leaving time; and (b) membership interests in the leaving entity that are not held by members of the old group. … 5 If the amount remaining after step 4 is positive, it is the old group's allocable cost amount for the leaving entity. Otherwise the old group's allocable cost amount is nil. … If, after going through the above formula, Coy B has a negative allocable cost amount, the head company will make a capital gain equal to that amount. If the allocable cost amount for Coy B is nil or positive, the head company will not make a capital gain or loss. The time of the event will be when Coy B ceases to be a subsidiary member of the group Subsection 104-35 (1) of the ITAA 1997 states: CGT Event D1 happens if you create a contractual right or other equitable right in another entity. Example: you enter into a contract with the purchaser of your business not to operate a similar business in the same town. The contract states that $20,000 was paid for this. You have created a contractual right in favour of the purchaser. If you breach that contract, the purchaser can enforce the right. The shareholders of Coy B will execute a Deed (the Deed) that sets out covenants relating to Coy B. One of the covenants will prohibit each of the parties from competing with Coy B. This restrictive covenant will create a contractual right between each party to the Deed (each party will contract with the other parties not to compete with Coy B), and will cause CGT event D1 to happen for each party to the Deed. The time of the event will be when the Deed is entered into. Subsection 104-35(3) provides that a capital gain is made if the capital proceeds from creating the right are more than the incidental costs incurred that relate to the event, and a capital loss is made if the capital proceeds are less than the incidental costs incurred. 'Capital proceeds' is defined in subsection 116-20(1) of the ITAA 1997 as follows: The capital proceeds from a CGT event are the total of: (a) the money you have received, or are entitled to receive, in respect of the event happening; and (b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). The parties to the deed will not receive money in respect to the restrictive covenant. As such, it is necessary to consider the market value of any other property received by the parties in respect of the CGT D1 event. The consideration to be given by each party to the Deed is considered to be the rights forfeited by each party under the restrictive covenant. However, not all rights are considered to be property. Generally, a right will be property where it is capable of assignment. Personal rights, such as rights under a restrictive covenant, are not capable of assignment, and are not propriety rights. Therefore, no party to the Deed will receive property in respect to the CGT D1 event, and there will be no capital proceeds giving rise to a capital gain or loss. Part IVA of the ITAA 1936 will apply where: • there is a scheme as defined in section 177A of the ITAA 1936; and • a tax benefit, as defined in section 177C of the ITAA 1936, would be or might reasonably be expected to be obtained in connection with the scheme, but for subsection 177F(1) of the ITAA 1936; and • having regard to the factors in section 177D of the ITAA 1936, the scheme is one to which Part IVA of the ITAA 1936 applies. Scheme Section 177A of the ITAA 1936 provides the following meaning of 'scheme': "scheme" means: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct. The proposed restructure includes the following steps: • Transfer of the share at market value in Coy B from AB to Coy A. • Tax consolidate Coy A and Coy B. • Coy A transfers the IP it owns to Coy B, and Coy B issues shares to Coy A as consideration. • Coy B will issue, at market value, additional shares to the proposed investors (for money consideration) and consequently exit the tax consolidated group These steps in the proposed restructure are considered to be a scheme under section 177A of the ITAA 1936 and the relevant scheme for the purposes of section 177D. Tax benefit in connection with a scheme Subsection 177C(1) of the ITAA 1936 provides that a tax benefit obtained by a taxpayer in connection with a scheme includes: (a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out; … In deciding whether an amount 'would have been included' or 'might reasonably be expected to be included' in the assessable income of the taxpayer had the scheme not been entered into or carried out, subsection 177CB(1) of ITAA 1936 requires consideration be given to the following: … (2) A decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme). (3) A decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme. (4) In determining for the purposes of subsection (3) whether a postulate is such a reasonable alternative: (a) have particular regard to: (i) the substance of the scheme; and (ii) any result or consequence for the taxpayer that is or would be achieved by the scheme (other than a result in relation to the operation of this Act); but (b) disregard any result in relation to the operation of this Act that would be achieved by the postulate for any person (whether or not a party to the scheme). In the present case, the transfer of the share in Coy B to Coy A and the election by Coy A to form a consolidated group with Coy B will enable Coy A to transfer the IP to Coy B without causing a CGT event A1 (and the likely capital gain) to happen. If it is postulated (option 1) in accordance with subsection177CB(2) that Coy A does not carry out the scheme events, an assessable CGT event would not happen as there would be no disposal of the IP to Coy B. There would be no tax effect (ie no amount would be included in the assessable income of Coy A). Alternatively (option 2), Coy A could retain ownership of the IP and undertake the commercialisation of the IP itself by means of debt capital. In which case there would be no tax effect, ie, no capital gain would be included in Coy A's assessable income. However, taking into account subsection 177CB(4), you advise that the substance and objective or result of the scheme is to enable Coy A to commercialise the IP that it owns by means of capital from investors. This postulate is not a reasonable alternative given that outcome would not be achieved. Another alternative (option 3), taking into account subsection 177CB(4), would involve AB still transferring their shareholding in Coy B to Coy A, but not using the 100% ownership to consolidate. Rather Coy A would merely transfer the IP it owns to Coy B in consideration for Coy B issuing shares to Coy A, with Coy B then also issuing shares to the proposed investors. This would achieve both the scheme's substance and the taxpayer's result by enabling Coy A to commercialise the IP by means of the investors who have agreed to contribute capital. The consequent assessable capital gain to Coy A (from the disposal of the IP to Coy B) would not be relevant (subparagraph 177CB(4)(b)). Perhaps a more reasonable alternative (option 4) that would achieve the substance and outcomes of the scheme (ie Coy A commercialising the IP by means of capital injection by the proposed investors) would involve Coy A and the proposed investors setting up a new company. Coy A providing the IP as capital and the investors providing cash as capital (the shareholding of each would be commensurate to their capital contribution as under the scheme). Again, the consequent assessable capital gain to Coy A, from disposing of the IP to the new company, would not be relevant. The tax benefit for the purpose of section 177C of the ITAA 1936 will be the tax free capital gain to Coy A by virtue of Coy A's election to form a consolidated group with Coy B, and the consequent application of the single entity rule. Paragraph 177C(2)(a)(i) of the ITAA 1936 provides an exclusion to obtaining a tax benefit where the tax benefit relates to the non-inclusion of an amount in assessable income, and the non-inclusion is 'attributable' to an election being made as provided for under the ITAA 1936 or ITAA 1997. The omission of an amount from the assessable income of a member of a consolidated group can be attributed to the election to consolidate. The choice to consolidate is the direct cause of these effects of the statutory fictions of the single entity rule. However, the exclusion will only apply where the scheme was not entered into or carried out for the purpose of creating the circumstance or state of affairs needed to enable the election to be made (subparagraph 177C(2)(a)(ii)). To this end the Consolidations Reference Manual (C9-1-220 Application of Part IVA to elections to consolidate) provides (at p. 4-5): Broadly speaking, then, the circumstances to which subparagraph (ii) [of paragraph 177C(2)(a)] might apply are causing a company to be the beneficial owner of all the shares in at least one other company on a particular day, and for its own shares not to be wholly owned beneficially by another resident company on that date. … Likewise, a company that had no subsidiaries at all, and that acquired a subsidiary dominantly to enable it to make an election to consolidate, or which arranged for itself to be acquired by a head company to enable that head company to make an election to consolidate, might have entered into and carried out a scheme to which Part IVA could apply, since these schemes bring into existence the state of affairs which must exist for the choice to be available. For subparagraph 177C(2)(a)(ii) to apply to the proposed scheme, the scheme must be entered into or carried out for the purpose of enabling the election to consolidate to be made. You advise that the reason for the proposed scheme is to enable Coy A to commercialise the IP that it owns by means of capital from investors; Coy A has investors who have agreed to invest in IP, the investors want to invest in a new company and want the IP to be transferred to such a company, Coy B meets the requirements of the investors. Although the proposed scheme will involve Coy A acquiring a subsidiary (Coy B) to enable it to form a consolidated group, it is considered that the purpose for the scheme is to enable Coy A to raise capital from investors, rather than to enable it to make an election to consolidate. As the proposed scheme will not be entered into for the purpose of enabling an election to be made, paragraph 177C(2)(a)(i) will apply, with the effect that there will be no tax benefit obtained in connection with the scheme. Conclusion Coy A will not obtain a tax benefit in connection with the scheme. As such, Part IVA will not apply to the scheme.