Income tax: consolidation tax cost setting rules: should distributions of profits accrued to the joined group that recoup losses accrued to the group be counted when determining the step 4 amount of the allocable cost amount on formation of a transitional consolidated group?

Yes. Where a joining entity makes a distribution prior to the joining time out of profits that accrued to the joined group, and those profits recouped losses for income tax purposes that accrued to the joined group, the distribution is subtracted at step 4 of the allocable cost amount (ACA) under subparagraph 705-95(b)(ii) of the Income Tax Assessment Act 1997 (ITAA 1997). This is not changed if the group is a transitional consolidated group.

The purpose of step 4 is to prevent the ACA reflecting a return of part of the amount paid to acquire the membership interests in the joining entity (step 4 column 2 in the table in section 705-60). In particular, subparagraph 705-95(b)(ii) prevents the ACA reflecting an amount paid for membership interests in the joining entity that was later (but before it became a member of the joined group) lost and, following the recoupment of the loss, the profit that recouped the loss was distributed.

HCo incorporates ACo with $100,000.00 on 1 July, 2001. In its first year of operation, ACo makes a tax loss of $50,000.00. ACo makes an accounting loss of $35,000.00 (after creation of a deferred tax asset (DTA) of $15,000.00 in respect of the tax loss). In the second year of operation ACo has an accounting profit of $35,000.00 (after reversing for the DTA). The assessable income of $50,000.00 recouped the tax loss carried forward from the first year. The taxable income (loss) is therefore $nil. ACo paid the profits as an unfranked interim dividend on 30 June 2003. On 1 July 2003 HCo and ACo consolidate.

ACo's financial position at 1 July 2003 is shown in Table 1. Table 1: ACo - Financial Position at 1 July 2003 ($) Cash 65,000 Equity 100,000 Retained earnings (loss) (35,000) 65,000 65,000

The ACA would be as follows: Table 2: ACA calculation for A Co ($) Step 1 Add cost of membership interests 100,000 Step 3 Add undistributed profits 0 Step 4 Less Pre-joining time distributions out of certain profits • Subparagraph 705-95(b)(i) distributions of acquired profits: 0; and • subparagraph 705-95(b)(ii) distributions of profits accrued to the joined group that recouped losses accrued to the group: 35,000 35,000 (35,000) Step 8 ACA 65,000

In the above table, the Step 4 amount is $35,000.00. All of the profits were untaxed as they recouped the prior year tax loss. By subtracting the distribution of profits that accrued to the joined group of $35,000.00 at step 4, we ensure the ACA does not effectively reinstate the tax loss.

The ACA of $65,000.00 will be allocated to the retained cost base asset (that is, cash). There is no shortfall or excess of ACA. Example 2

Assume the same facts as above, but in this example the retained earnings balance is $nil because there was no distribution by ACo of current year profits.

ACo's financial position at 1 July 2003 is shown in Table 3. Table 3: ACo - Financial Position at 1 July 2003 ($) Cash 100,000 Equity 100,000 Retained earnings 0 100,000 100,000

The ACA would be as follows: Table 4: ACA calculation for A Co ($) Step 1 Add cost of membership interests 100,000 Step 3 Add undistributed profits 0 Step 4 Less Pre-joining time distributions out of certain profits (0) Step 8 ACA 100,000

The ACA of $100,000.00 will be allocated to the retained cost base asset (that is, cash). There is no shortfall or excess of ACA.

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.