Income tax: consolidation tax cost setting rules: Are distributions paid up a chain of entities sourced from profits in a lower-tier entity that did not accrue to the joined group added at step 3 of the entry allocable cost amount (ACA) of the higher-tier entity?

No. A profit of a higher-tier entity in the group will not be held to have accrued to the group where it has arisen from a dividend paid by a lower-tier entity out of profits that did not accrue to the group. That is, the profits would fail paragraph 705-90(6)(a) of the Income Tax Assessment Act 1997 (ITAA 1997).

This determination will be relevant for calculating the step 3 amount of the entry allocable cost amount (ACA) for groups of entities forming a consolidated group (subdivision 705-B), consolidated group acquired by another consolidated group (subdivision 705-C) or multiple-linked entities joining a consolidated group at the same time (subdivision 705-D).

The term 'profit accrued to the joined group before the joining time' is set out in subsection 705-90(7). This subsection states: 'A profit accrued to the joined group before the joining time if, on the following assumptions: a. that it was distributed to holders of *membership interests as it accrued; and b. that entities interposed between the *head company and the joining entity successively distributed any of it immediately after receiving it; it would have been received by the entity that is the head company at the joining time in respect of membership interests that it held continuously until that time either directly or indirectly through interposed entities'.

Subdivisions 705-B, 705-C and 705-D modify the provisions of the basic case in subdivision 705-A. The policy intent as expressed in the objects clauses of these three subdivisions is to ensure that where on becoming subsidiary members, entities hold assets consisting of membership interests in other subsidiary members joining the group at the same time, the tax cost setting amount (TCSA) of each entity that becomes a subsidiary member, reflects the cost of the group of acquiring the entities.

Where membership interests are acquired indirectly, by acquiring the membership interest of an interposed subsidiary (or Division 149 was triggered after the profits were made), [F1] the value will be reflected in the amount paid by the group for the interposed entity, counted in step 1 of the ACA for that entity, and then pushed down to the lower-tier entity for its step 1 amount (subsection 705-145(2) and subsection 705-225(2)). The profits are effectively counted in the step 1 amount.

It would be incorrect to add at step 3 of the ACA profits that are reflected in the step 1 amount. To add the amount at step 3 of the ACA would result in the profit being counted twice. Once in the price paid for the membership interests reflecting the underlying assets of the higher-tier entity and then again as accumulated retained earnings. This would be the case even if the profit had been distributed to the higher-tier entity after the group acquired the higher-tiered entity. The inflated ACA, when allocated to the assets, would not reflect the true cost to the group of acquiring the entity and would be contrary to the policy intent (see paragraph 4 above). An inflated TCSA may result in a capital loss or reduced capital gain where no economic loss was sustained.

Accordingly, to ensure this double counting does not occur, the profits are treated as retaining their character as acquired profits while being distributed up the chain of ownership.

Where the profits in question have been used to source a dividend paid all the way up the chain to the head company, they will be subtracted only once under step 4, at the level of direct interests held by the head company (see modification rules in sections 705-155 and 705-230). The lower ACA at this level is then pushed down the chain, to achieve the appropriate outcome at all levels. If this subtraction were not made, the step 1 amount would be overstated because it would count the cost of assets that are no longer in the chain of subsidiaries. This implies that in the absence of this modification rule, dividends out of profits that have not accrued to the group retain their character as they flow up the chain of entities, and would be subtracted at step 4 when working out the ACA for each subsidiary in the chain.

HCo acquires all of the membership interests in ACo on 1 July 2001 for $150,000.00. At that time ACo owns all of the membership interests in BCo which has accumulated profits (after tax) of $50,000.00. On 30 June 2002 BCo distributes the profit of $50,000.00 to ACo (fully franked divided). No further profits or losses accrue to either entity and on 1 July 2002 HCo, ACo and BCo form a consolidated group.

ACo's financial position at 1 July 2002 is shown in Table 1. Table 1: ACo - Financial Position at 1 July 2002 ($) Cash 50,000 Equity 100,000 Membership interest in BCo 100,000 Retained earnings (profit after tax) 50,000 150,000 150,000

BCo's financial position at 1 July 2002 is shown in Table 2. Table 2: BCo - Financial Position at 1 July 2002 ($) Cash 0 Equity 100,000 Asset 1 (market value 100,000) 100,000 Retained earnings 0 100,000 100,000

ACo's ACA would be as follows: Table 3: ACA calculation for ACo ($) Step 1 Add cost of membership interests 150,000 Step 3 Add undistributed profits • subsection 705-90(2) undistributed profits: 50,000; • subsection 705-90(3) extent to which undistributed profits could be distributed franked : 50,000; and • paragraph 705-90(6)(a) extent undistributed profits accrued to joined group: 0 0 LESS • paragraph 705-90(6)(b) extent of the undistributed profits accrued to joined group that recouped losses accrued to group: (0) (0) 0 Step 8 ACA 150,000

In the above table the Step 3 amount is $0. The total undistributed profits, and the extent to which these profits could be distributed franked by ACo is $50,000.00. However the profits would fail paragraph 705-90(6)(a) as they would not be profits that accrued to the joined group. If you were to add the profits here at step 3 you would be counting the profits again. HCo paid $150,000.00 for the membership interest of ACo (step 1) which reflects a value for the profits distributed to it by BCo.

The profits retain their character as acquired profits as they are distributed up the chain of ownership. This ensures that duplication does not occur.

The tax cost setting amount for ACo's retained cost base assets (cash) is $50,000.00. The balance of ACA is allocated to ACo's reset cost base asset (membership interests in BCo) of $100,000.00. There is no shortfall or excess of ACA.

BCo's ACA would be as follows: Table 4: ACA calculation for BCo ($) Step 1 Add cost of membership interests 100,000 Step 3 Add undistributed profits 0 Step 8 ACA 100,000

The step 1 amount is the TCSA for the membership interests in BCo, held by ACo. The TCSA becomes BCo's step 1 amount (section 705-145).

The total amount of the ACA is allocated to BCo's reset cost base asset (Asset 1) of $100,000.00. There is no shortfall or excess of ACA. If, for example, the profits were not distributed to ACo, the profits would not be counted at step 3 of the entry ACA calculation for BCo as the profits would not satisfy the requirements of subsection 705-90(6)(a): profit accruing to the joined group before the joining time. The profits would be effectively represented in the TCSA of ($150,000.00) for the membership interests in BCo held by ACo (the step 1 amount for BCo's ACA calculation). If the ACA for BCo is calculated the same result would be achieved for Asset 1.

An alternative view is that, in this example, the dividend received by ACo after ACo was acquired by HCo should be counted at step 3 of the ACA for ACo. The view is that the dividend received by the higher-tier subsidiary did not accrue to the group until that higher-tier subsidiary received the dividend. We think, however, that this interpretation is not consistent with the broad objects of the asset rules because the value of the assets now represented by the dividend in the hands of the higher-tier subsidiary will be counted already in step 1 as the cost of membership interests. If it is counted again at step 3 the profits would be duplicated.

When the final Determination is issued, it is proposed to apply both before and after its date of issue. However, the Determination will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

We invite you to comment on this draft Taxation Determination. Please forward your comments to the contact officer by the due date. Due date: 20 August 2004 Contact officer details have been removed following publication of the final ruling.