Compendium

We question the appropriateness of the ATO position that incidental costs incurred before the leaving time are disregarded in determining the cost base of shares due to the application of the tax cost setting rules just before the leaving time.

In our opinion a more appropriate position under the SER is that the Head Entity has incurred expenses to sell some of its assets (that is those that are legally owned by the leaving entity while it is part of the consolidated group) and those expenses should be included in the tax cost of the relevant assets - which then feeds back into the cost base of the shares in the leaving entity.

In other words, as under the SER the tax consolidation provisions are based on the recognition of the underlying (non-intra-group) assets held by the members of a tax consolidated group, any expenses incurred to sell the (only) assets that are recognised under consolidation as being held by the Head Entity should form part of the tax cost of those assets - they are incurred to get the assets into the position/state where they can be sold.

This view is supported in the explanatory memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006, [2] the Bill that introduced the current section 40-880. It discusses the consolidation interaction with that section as follows: 2.87 In order to determine whether business capital expenditure incurred by a head company is deductible under section 40-880, the nature of the expenditure must be characterised in the hands of the head company, taking into account the effect of the single entity rule . 2.88 The expenditure must be characterised at the time it is incurred by the head company . That is , a head company is not required to anticipate whether or not the expenditure is related to an asset that may become recognised for tax purposes at some time in the future . For example, expenditure incurred by a head company in relation to membership interests in a subsidiary member will be deductible under section 40-880 despite the fact that the expenditure is in relation to an asset that may at some point in the future become recognised for tax purposes (eg, immediately before the subsidiary member exits the consolidated group ). [ emphasis added ]

Accordingly, under the SER it is necessary to look at the assets held by the Head Entity at the time of 'incurrence'. This is made clear in the example provided in the EM where the expenditure is incurred by the Head Entity at a time that a company is not a member of the group : Example 2.17 - A consolidated group incorporates a new subsidiary company, which becomes a subsidiary member of the consolidated group. The capital expenditure the head company incurs in doing so [ i.e. to form/incorporate the new company] is deductible under paragraph 40-880(2 )( a ) as it does not relate to an [ intra-group ] asset that is held by the head company [ at the time it is incurred ].

We submit that just because (for example) no balancing adjustment event will actually arise for the Head Entity regarding depreciable assets when the entity that legally owns those assets exits the group, should not prevent the expenses incurred by the Head Entity from forming part of the tax cost of those assets. The tax cost of the assets that is used to 'build up' the cost base of the shares in the leaving entity should reflect all of the expenses that the Head Entity has incurred regarding the (only) assets that exist up until the leaving time.

(As an aside, we note that focusing on the only assets that exist under the SER will allow a consistent approach to be taken to the tax cost of the underlying assets in both joining and leaving cases. That is, expenses incurred to acquire shares prior to an entity joining a group will go into the cost base of the shares (and hence be 'pushed down' into the tax cost of the underlying assets under the allocable cost amount process) while similar expenses incurred after the joining time will go straight into the tax cost of underlying assets - being the only assets that exist at that time under the SER).

The ATO reasoning in the draft Determination is that the tax cost setting process determines the first element of the cost base of the shares at the leaving time (consistent with the approach taken in ATO ID 2004/238) plus it resets to nil all the other elements of the cost base at the leaving time. Incidental costs in the circumstances described in the draft Determination would not be taken into account in determining the exit allocable cost amount for the leaving subsidiary and would not otherwise be taken into account in determining the tax cost setting amount which is recognised for CGT purposes via section 701-55(5).