Issue
Can incidental costs of the type described in paragraph 110-35(1)(b) and subsection 110-35(2) of the Income Tax Assessment Act 1997 (ITAA 1997) that is: (a) incurred by the head company of a consolidated group, (b) by a transaction with an entity outside the group before a subsidiary member leaves the consolidated group (and which relate to the disposal of that head company's shares in the subsidiary member to an entity outside the group),
be included in the cost base and reduced cost base of those shares and as such be precluded from deductibility by paragraph 40-880(5)(f) of the ITAA 1997, if the expenditure (to the extent it is also business capital expenditure) otherwise satisfies the requirements of section 40-880 of the ITAA 1997?
Decision
No. In the circumstances described, such incidental costs cannot be included in the cost base and reduced cost base of the head company's shares in the subsidiary member that are worked out when the subsidiary leaves the group. Therefore paragraph 40-880(5)(f) of the ITAA 1997 will not operate to preclude a deduction under that section if its requirements are otherwise met.
Facts
Head Co owns all the shares in Sub A, Sub B and Sub C. All four entities formed a consolidated group with effect from 1 July 2003.
On 1 February 2007 Head Co incurred a liability to pay legal and accounting fees of $100,000 in negotiating the sale of its shares in Sub C and in drawing up the contract for that sale, to an entity outside the group.
On 1 May 2007 Head Co sold all the shares it owned in Sub C to an entity outside the group with the result that Sub C left the consolidated group.
Reasons for Decision
For head company core purposes and entity core purposes, the single entity rule (SER) deems subsidiary members of a consolidated group to be parts of the head company rather than separate entities during the period they are members of the consolidated group (section 701-1 of the ITAA 1997, 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 ).
One effect of the SER is that the existence of shares in a subsidiary member of a consolidated group is disregarded for the head company's core purposes during the period the shares are held by members of the group. Part 3-90 contains an elaborate legislative scheme, the purpose of which is to prevent the double taxation (or double tax benefits) that arise when the income tax law taxes the single economic gain or loss that is reflected in the value of the assets of companies and the value of shares in the company holding the assets.
The proper approach to the operation of capital gains tax (CGT), in a consolidation context, in relation to the CGT event that happens as a consequence of the sale of these shares when a member leaves a consolidated group, is to bring to tax the gain or loss on the underlying CGT assets held by the leaving entity on the basis of their tax cost, rather than the gain or loss in respect of the shares sold on the basis of what would otherwise be their CGT cost base.
The head company's capital gain or capital loss in respect of such a CGT event is calculated by reference to the cost base which is set under the tax cost setting process just before the entity (the leaving entity) ceases to be a subsidiary member of the consolidated group at a particular time (the leaving time). None of the actual elements of what, but for the SER, would be the cost base of the shares in the leaving entity if they were recognised before the cost setting process, have a role to play in computing the head company's capital gain or capital loss in respect of the CGT event that happened when the head company sold those shares to an entity outside the consolidated group.
However, incidental costs incurred at or after the subsidiary's leaving time may be included in the cost base and reduced cost base of the head company's shares in the leaving subsidiary.
Based on the facts in this case, Sub C is taken to be a part of Head Co, and the shares in Sub C are for core purposes disregarded, because of the SER, until just before the leaving time, when Sub C leaves the consolidated group.
In these circumstances the incidental costs incurred by Head Co to an entity outside its consolidated group before Sub C left the group and which relate to the disposal by Head Co of its shares in Sub C to an entity outside the group cannot be included in the cost base and reduced cost base of Head Co's shares in Sub C that are worked out when Sub C leaves the group.
This decision means that, in the context of section 40-880 of the ITAA 1997, the exclusion in paragraph 40-880(5)(f) of the ITAA 1997 will not apply to limit to any extent the amount of any deduction that is otherwise available under section 40-880 of the ITAA 1997 for the incidental costs that are the subject of this ATO ID.