Private ruling: Cost of the membership interests in the entry allocable cost amount
Date of advice: 6 July 2017
Published: November 2017
Ruling period: Year ending 31 December 20YY

Ruling: Q1: For the purposes of step 1 in subsection 705-65(1) of the Income Tax Assessment Act 1997 (ITAA 1997), in working out the cost of the membership interests in the joining entity, is the cost base of the Entity’s membership interests in the joining entity calculated in accordance with the general rules in section 110-25 of the ITAA 1997? | A1: Yes | Q2: Does section 855-45 of the ITAA 1997 apply to the Entity’s membership interests in the joining entity to treat the cost base of the membership interests as being the market value of the joining entity’s shares at the time the joining entity joins the Entity’s tax consolidated group? | A2: No

Relevant facts and circumstances: The Entity is listed on the Australian Stock Exchange and operates internationally including through wholly-owned non-resident subsidiaries and permanent establishments. The Entity is the head company of the tax consolidated group and has a substituted accounting period. The joining entity is a wholly-owned subsidiary of the entity. It was incorporated overseas and was a Controlled Foreign Company from the incorporation date. The joining entity’s principal activity is the provision of shared services to the members of the Entity’s tax consolidated group. It also procures services at a global level on behalf of the group. The joining entity is not a prescribed dual resident company. Central management and control of the joining entity In 20YY, there was a change in the composition of directors of the joining entity whereby several non-Australian resident directors resigned and additional Australian directors were appointed. The change resulted in the majority of the joining entity’s directors being Australian residents. From this point in time, all the joining entity’s board meetings occurred in Australia with a majority of Australian directors present. The joining entity’s Board provides oversight and strategic guidance, ensuring alignment to the entity’s strategy and requirements. Matters reserved for the Board have been documented. Operations of the joining entity The joining entity was created to support the Entity’s business. The joining entity operates a captive business process outsourcing operation overseas. It provides support for various services and functions. The joining entity has been the signing entity for global contracts, covering global service contracts. The work in relation to the preparation and negotiation of these contracts is carried out in Australia. Acquisition of the joining entity The Entity acquired the joining entity from its associated company in 20XX. The consideration paid was the book value of all the existing shares in the joining entity. On the acquisition date, the Entity also contributed additional equity for new ordinary shares in the joining entity. There was no other property given in respect of acquiring the membership interests in the joining entity.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 110-25, | Income Tax Assessment Act 1997 Section 110-55 | Income Tax Assessment Act 1997 Section 112-20, | Income Tax Assessment Act 1997 Section 112-87, | Income Tax Assessment Act 1997 Section 703-15, | Income Tax Assessment Act 1997 Section 705-65, | Income Tax Assessment Act 1997 Section 855-45 | Income Tax Assessment Act 1997 Subsection 995-1(1), and | Income Tax Assessment Act 1936 Section 6(1).

Reasons for decision: Summary: The joining entity’s entry into the Entity’s tax consolidated group According to section 703-15 of the ITAA 1997, a subsidiary member of an income tax consolidated group is broadly any Australian resident company, partnership or trust that is a wholly owned subsidiary of the head company and is not a prescribed dual resident under section 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936). The Entity is the head company of a tax consolidated group. In 20XX, the joining entity became a wholly owned subsidiary of the Entity on the date the Entity acquired a 100% interest in the joining entity. According to section 6(1) of the ITAA 1936, a resident of Australia means 'a company which is incorporated in Australia, or which, not being incorporated in Australia, carries on business in Australia and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.’ Draft Taxation Ruling TR 2017/D2 provides: 4. To be resident under the central management and control test, a company must carry on business in Australia. 5. If a company has its central management and control in Australia, and it carries on business, it will carry on business in Australia within the meaning of the central management and control test of residency. It is not necessary for any part of the actual trading or investment operations from which its profits are made to take place in Australia. This is because the central management and control of a business is factually part of carrying on that business. It follows that a company carrying on business does so both where its trading and investment activities take place, and where the central management and control of those activities occurs. Central management and control is the control and direction of a company’s operations. The key element is the making of high-level decisions that set the company’s general policies, and determine the direction of its operations and the type of transactions it will enter. Normally, where a company is run in accordance with its constitution and the normal company law rules, its directors will control and direct its operations and the company will be controlled and directed where those making its decisions do so as a matter of fact and substance. Based on the composition of the directors and the Board’s activity, the central management and control of the joining entity is located in Australia. As the joining entity is not a prescribed dual resident as defined in section 6(1) of the ITAA 1936, the joining entity is a resident of Australia and became a subsidiary member of the Entity’s tax consolidated group in 20YY. Cost of acquiring the joining entity Generally, the first element of the cost base of the membership interests in the joining entity is the money that was paid or required to be paid, by the Entity in respect of acquiring those membership interests. It also includes the market value of any other property that was given in respect of acquiring the membership interests at the time of acquisition. The CGT provisions contain market value substitution rules which mean that the first element of the cost base or reduced cost base of an asset will be taken to be the market value of the asset in certain circumstances, rather than the actual amount of consideration paid for the asset. Subsection 112-20(1) of the ITAA 1997 provides: The first element of your *cost base and *reduced cost base of a *CGT asset you *acquire from another entity is its *market value (at the time of acquisition) if: (a) you did not incur expenditure to acquire it, except where your acquisition of the asset resulted from: (i) *CGT event D1 happening; or (ii) another entity doing something that did not constitute a CGT event happening; or (b) some or all of the expenditure you incurred to acquire it cannot be valued; or (c) you did not deal at *arm's length with the other entity in connection with the acquisition. The expenditure can include giving property: see section 103-5. (An asterisk denotes a defined term in the ITAA 1997). Based on the circumstances and the fact that the Entity acquired the joining entity from its associate in 20XX at book value, it is considered that the Entity did not deal at arm’s length with its associate in respect of the acquisition. The definition of 'arm’s length’ in subsection 995-1(1) of the ITAA 1997 provides that in determining whether the parties deal at arm’s length, consider any connection between them and any other circumstances. In Federal Commissioner of Taxation v. AXA Asia Pacific Ltd (2010) 189 FCR 204; 2010 ATC 20-224; (2010) 81 ATR 180, Edmond and Gordon JJ stated at 231 that: Any assessment of whether parties were dealing at arm’s length involves 'an assessment [of] whether in respect of that dealing they dealt with each other as arm’s length parties would normally do, so that the outcome of their dealing is a matter of real bargaining’… We consider that the Entity did not acquire the joining entity at arm’s length for the following reasons: ● the vendor is an associate of the Entity, and ● part of the consideration paid is the book value of the existing shares in the joining entity instead of the market value of those shares at the time of the acquisition. Therefore, in accordance with subsection 112-20(1) of the ITAA 1997, the first element of the cost base of the Entity’s membership interests in the joining entity is the sum of the market value of the 3.6 million shares acquired by the Entity. For the purposes of subsection 112-20(1) of the ITAA 1997, the market value is determined at the date of acquisition. In determining the market value of the membership interests, the Entity may choose to: ● obtain a detailed valuation from a registered valuer, or ● compute their own valuation based on reasonably objective and supportable data. Step 1 in working out allocable cost amount Section 705-65 of the ITAA 1997 provides that the first step in determining the allocable cost amount (ACA) for a joining entity is to add up the costs of the membership interests in the joining entity that are held by members of the consolidated group it is joining. According to subsection 705-65(1) of the ITAA 1997, if at the joining time, the market value of a membership interest is greater than or equal to its cost base, the relevant cost to be used in calculating the ACA is the cost base of those membership interests. Otherwise, the relevant cost is the greater of the market value of the membership interests or the reduced cost based of the membership interests. For the purposes of subsection 705-65(1) of the ITAA 1997, the market value of the Entity’s membership interests in the joining entity is determined at the date the joining entity becomes a member of the Entity’s tax consolidated group. If the market value of the membership interests at that date is greater than the cost base of the membership interests, which under section 112-20 of the ITAA 1997 will include the market value of all the shares in the joining entity on the acquisition date, then the relevant cost is the cost base. If the market value of the membership interests at the date the joining entity joined the Entity’s tax consolidated group is lower than the cost base, then the relevant cost is the greater of the market value of the membership interests at the joining date or the reduced cost base of the membership interests as worked out under section 110-55 of the ITAA 1997. When a company becomes an Australian resident, special cost base and acquisition rules in section 855-45 of the ITAA 1997 apply in respect of each CGT asset owned by the company just before becoming a resident. However, these rules do not apply to pre-CGT assets or assets that are taxable Australian property. Step 1 in the ACA calculation process is about working out the cost of membership interests in the joining entity held by members of the relevant tax consolidated group. In this case, it is the cost of the membership interests that Entity holds in the joining entity. The membership interest in the joining entity is an asset of the Entity. The Entity has always been an Australian resident company since it was incorporated. As such, section 855-45 of the ITAA 1997 will not apply in the calculation of the cost base of the Entity’s membership interests in the joining entity for the purposes of section 705-65.