Consolidation: entry history rule - characterisation of foreign exchange gains and losses

Where: • a finance subsidiary enters into foreign currency denominated borrowings from third-party financiers before the formation of a consolidated group in the ordinary course of carrying on a finance business; • the borrowings were used by the finance subsidiary to fund intra-group loans; and • are repaid after the formation of the consolidated group;

does the entry history rule in section 701-5 of the Income Tax Assessment Act 1997 (ITAA 1997) result in the head company's foreign exchange gains and losses on those borrowings being characterised, for income tax purposes, as though the head company (Head Co) entered into the borrowings in the ordinary course of carrying on a finance business?

Yes. Head Co is taken, under the entry history rule in section 701-5 of the ITAA 1997, to have entered into the borrowings in the ordinary course of carrying on a finance business.

Head Co, together with its wholly-owned subsidiaries, formed a consolidated group on 1 July 2002. After that date, Head Co's business for income tax purposes consisted of manufacturing and construction. Head Co's finance subsidiary, Fin Co, borrowed foreign currency denominated funds from third-party financiers and on-lent the proceeds to Head Co's other wholly-owned subsidiaries who used the funds in their manufacturing and construction businesses.

Before the formation of the Head Co consolidated group, Fin Co was considered to be carrying on the business of a finance company for the purpose of characterising foreign exchange gains and losses on its borrowings.

Some of the borrowings entered into by Fin Co before the formation of the Head Co consolidated group were repaid after the formation time.

The entry history rule is contained in section 701-5 of the ITAA 1997. It provides: 701-5 Entry history rule For the head company core purposes in relation to the period after the entity becomes a *subsidiary member of the group, everything that happened in relation to it before it became a subsidiary member is taken to have happened in relation to the *head company. Note 1 : Other provisions of this Part may affect the tax history that is inherited (e.g. asset cost base history is affected by section 701-10 and tax loss history is affected by Division 707). Note 2 : Section 73BAC of the Income Tax Assessment Act 1936 overrides this rule for the purposes of the research and development incremental expenditure provisions. Note 3 : Section 165-212E overrides this rule for the purposes of the same business test.

In the present case, the carrying on of the finance business was something that 'happened' to Fin Co before the formation time. That history was inherited by Head Co, as the head company of its consolidated group, under the entry history rule which requires the pre-consolidation business of Fin Co to be treated as having been carried out by Head Co itself prior to consolidation.

The entry history rule applies for the purposes of determining Head Co's income tax liability and/or its tax losses, for income years ending after 1 July 2002. Those purposes would include the recognition for income tax purposes of any foreign currency gains and losses made by the group after the formation time.

The Explanatory Memorandum to the New Business Tax System (Consolidation) Act (No. 1) 2002 confirms that the history that is inherited includes both past events and the circumstances which provide those events with a factual context. For example, at paragraph 2.32, it confirms that a consequence of the entry history rule is that a head company is entitled to certain deductions associated with expenditure incurred by a subsidiary member prior to it joining a consolidated group. In doing this, the rule must not only logically explain the expenditure by deeming the head company to have incurred it; it must also explain why that expenditure was incurred. If the rule did not do this, it may not be possible to determine whether the expenditure meets the statutory requirements of the relevant deduction.

Taxation Determination TD 2005/23 addresses the situation where a debt was written off in respect of money lent by a subsidiary member in the ordinary course of its business of lending money before it became a member of a consolidated group. The view is taken that the head company of the consolidated group can satisfy subsection 25-35(1) of the ITAA 1997 in relation to the debt that is written off as bad by a subsidiary member after it has joined the group. The Commissioner concludes that the combined effect of the single entity rule in section 701-1 of the ITAA 1997 and entry history rule in that case is that: (i) the head company is treated as having the debt and as having written it off as bad; and (ii) the head company is treated as having lent the money, in respect of the debt in the ordinary course of its business of lending money.

The question of characterisation addressed by the entry history rule is separate from the question of gain and loss recognition addressed by the single entity rule. The single entity rule and entry history rule apply on their own terms to mutually exclusive points in time. The single entity rule applies during the period that Fin Co is a member of the consolidated group. In contrast, the entry history rule applies to things which happened before Fin Co became such a member.

The single entity rule does not erase the history inherited by the head company in respect of Fin Co's borrowings entered into before the formation of Head Co's consolidated group. For the purposes of characterising any foreign exchange gains and losses on repayment of the borrowings from third-party financiers, Head Co is taken, under the entry history rule, to have entered into the borrowings in the ordinary course of carrying on a finance business.