Tax Consolidation. The Single Entity and Entry History Rules

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1 Tax Consolidation The Single Entity and Entry History Rules Grant Cathro Partner, Allens Arthur Robinson 1. Introduction Faced with the prospect of digesting and understanding 400 pages of consolidation legislation, it may no doubt come as a surprise to many that the key operative provisions which operate once a consolidated group has been formed are, in reality, very short. The vast bulk of the consolidation legislation is concerned primarily with entry and exit issues, the utilisation of losses and specific issues which arise for particular taxpayers or MEC groups. Once a consolidated group has been formed and the cost to the head entity of its various assets has been established, the modification to the tax laws required to ensure that the taxable income of the group is computed on a combined basis with only one tax return, is achieved through the operation of the single entity rule. wgcm M v Page 1

2 The single entity rule requires subsidiary members of a consolidated group to be treated, in effect, as if they were parts of (akin to divisions of) the head company of the group, rather than as separate entities. This rule is expressed to apply only for certain limited purposes. Application of the consolidation regime to transactions entered into by a consolidated group will require a clear understanding of the scope and effect of the single entity rule. Its application will affect the analysis to be undertaken in characterising many transactions and will have a significant impact on the treatment of assets created within a group that are subsequently transferred out of the group. Despite the single entity rule, there are likely to be circumstances in which it is appropriate to have regard to the separate ownership and operations of individual entities within the consolidated group. The formation of the new consolidated group, or addition of another entity to a consolidated group adds another dimension to the application of the single entity rule. In that context, the operation of the single entity rule is modified by the entry history rule in section Single Entity Rule The single entity rule is to be found in section of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act). It provides: (1) If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period. In effect, the single entity rule deems an entity which is a subsidiary member of a consolidated group to be part of, or in effect something similar to a division of, the head company of the group, rather than a separate entity. This deeming applies only for the 'head company core purposes' and 'entity core purposes' specified in section 701-1(2) and (3). It only applies in respect of the period that the subsidiary member is part of that consolidated group. wgcm M v Page 2

3 The head company core purposes are: (a) working out the amount of the head company's liability (if any) for income tax calculated by reference to any income year in which any of the period occurs or any later income year; and (b) working out the amount of the head company's loss (if any) of a particular sort for any such income year. (s.701-1(2)) The entity core purposes are: (a) working out the amount of the entity's liability (if any) for income tax calculated by reference to any income year in which any of the period occurs or any later income year' and (b) working out the amount of the entity's loss (if any) of a particular sort for any such income year. (s.701-1(3)) The single entity rule is central to the operation of the consolidation regime. It ensures that, for the purposes of working out the amount of the liability for income tax (or the amount of any tax loss) of both the head company and the subsidiary members, a subsidiary member is treated as part of the head company. This in turn has a number of implications during the period of consolidation. It means that: (a) (b) (c) a subsidiary member can have no separate liability for income tax (although it may be jointly and severally liable for the head company's income tax under Division 721); in computing the liability of the head company for income tax, the head company must take into account the activities of the subsidiary members as if they were part of the head company; and all intra-group transactions between members of the consolidated group do not produce amounts of income or expenses, nor result in a CGT disposal, as transactions between parts of an entity cannot do so. wgcm M v Page 3

4 A single entity rule is also incorporated into Part 2.10 of the Taxation Administration Act (TAA) by section of that Act. That rules applies for the purposes of Part 2.10 which deals with the payment of Pay As You Go (PAYG) instalments. It is far from clear that the rule operates such that for all purposes, one must ignore the fact that members of the group are separate legal entities. The Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002 (Cth) asserts, at paragraph 2.11, that a 'key feature of the new law' is that 'a consolidated group is treated as a single entity for all income tax purposes'. This statement will only be relevant if the legislation is ambiguous. It is clear that the single entity rule operates only for 'head company core purposes' and 'entity core purposes'. It does not, for example, operate for the purposes of determining the tax treatment of a shareholder in the head company, nor for the purpose of other taxes such as FBT and withholding tax. A taxpayer's liability for income tax is worked out under Division 4 of the 1997 Act by reference to the entity's 'taxable income'. The single entity rule applies to the process of determining that taxable income and the income tax payable by applying the applicable tax rate to it. The key question is whether the rule requires one to go so far as to ignore completely all intra-group transactions and treat them as if they did not occur, on the basis that an entity cannot deal or transact with itself. As a matter of factual reality, different members of a consolidated group do transact with one another. Does the single entity rule require us to create a complete fiction which assumes that those transactions had never occurred, or does it simply require us to recognise that such dealings between parts of an entity do not result in any immediate tax consequences, as dealings between parts of an entity cannot produce amounts of income, deductions or result in CGT Events? Even where the issue under consideration forms part of calculating the taxable income of the head company, it appears there will be some circumstances in which the fact that separate assets or activities are held or conducted by separate wgcm M v Page 4

5 entities will nonetheless be relevant and have some influence on the determination of the taxation outcome. For example, specific issues might arise in the context of the characterisation of particular transactions entered into by a member of a consolidated group, in the context of the application of Part IVA, or where an asset created within the group is subsequently transferred out of it. The operation of the single entity rule is likely to be confined to the specific purposes enumerated in section 701 of the 1997 Act and of the TAA. To use the words of AH Slater QC in the paper which he recently presented at the Leura Conference 1 : Outside the purpose specified in section and the effect provided for by the other provisions of Part 3-90, the consolidation of the head company and its subsidiaries into a 'consolidated group' does not alter 'factual and legal realities' Section does not require subsidiary members of the group to be treated as part of the head company for the purpose of other provisions, whether deeming provisions or otherwise of the Assessment Acts. A number of cases are examined by AH Slater QC in his paper, which demonstrate that deeming provisions are likely to be construed narrowly by the courts. I would commend Tony's paper to you. One of the many cases referred to in that paper is FC of T v Comber 2. In that case the court held that the operation of section 109 of the Income Tax Assessment Act 1936 (Cth) (1936 Act) which deemed a director's retiring allowance to be a dividend paid by a company, did not in so doing, give the payment the qualities of being paid to a shareholder and paid out of profits as was necessary to make it taxable under section 44. The court stated: It is improper in my view to extend by implication the express application of a statutory fiction. It is even more improper to do so if such an extension is unnecessary, the express provisions (section 109) being capable by itself of 1 General Consolidation Regime Key New Tax Concepts?, Tony Slater QC, Taxation Institute of Australia, First National Consolidation Symposium, Leura, New South Wales, February (1986) 64 ALR 451, 458. wgcm M v Page 5

6 sensible and rational application in determining whether (the company) has made a sufficient distribution of its profits. In practice, the courts are concerned with the application of the law to the actual facts. A statutory fiction asks them to ignore the true facts and recast them in a different way. This inherently requires the courts to first examine the true facts in the context of the legal question which they are dealing with, and then ask themselves how those facts should be recast, given the deeming provisions. They will only be inclined to recast them, to the extent that they are convinced that the deeming provision requires them to do so. For example, a common issue before the courts is whether or not a profit made on the sale of an investment is one made in the ordinary course of business, or is on capital account. If it is clear that, viewed on its own, the company holding the investment had only entered into one isolated transaction, the court will no doubt need to be convinced the single entity rule requires it to have regard to the other activities of the other members of the group, before it will take them into account in characterising the relevant business. 3. The Entry History Rule A company joining a consolidated group, either upon formation or at a later date, will hold assets and liabilities, the treatment of which will be dependent upon events which occurred prior to the time at which the entity joined the group. Likewise, there will be transactions which have been entered into by entities joining the group which have tax consequences after the time of joining. While earlier versions of the consolidation legislation treated the head company as if it acquired all of the assets of the subsidiaries upon formation, the consolidation legislation, as finally introduced, does not take that approach. Instead, it treats the head company as inheriting the history of the subsidiary members of the group. Section contains the entry history rule. It provides: 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 wgcm M v Page 6

7 to it before it became a subsidiary member is taken to have happened in relation to the head company. The entry history rule, like the single entity rule, operates 'subject to any other provision of (the) Act that so requires, either expressly or impliedly (see section ). It will be recalled that section 701-1(2) identifies head company core purposes to be working out the amount of the head company's liability for income tax and the amount of the head company's losses (if any). After entry into consolidation, a subsidiary member is thus taken to be part of the head company rather than a separate entity (during the period of consolidation) and the head company is taken to inherit the history of the subsidiary member in the sense that everything that happened in relation to (the subsidiary member) before it became a subsidiary member is taken to have happened in relation to the head company. Left unchecked, the entry history rule might well have meant that the head company inherited the assets of the subsidiary member with their existing tax costs (as is indeed achieved by the entry history rule where the subsidiary member is a chosen transitional entity to which section of the Income Tax (Transitional Provisions) Act 1997 (Cth) (the TP Act) applies), and inherited the subsidiary's losses. Many of the provisions of the consolidation legislation which apply on entry, operate to modify in certain respects what otherwise might have been the effect of the entry history rule. The Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002 suggests that the entry history rule will reduce the compliance costs which would have resulted had the previous history been ignored and a 'clean slate' approach reflected in the February 2002 Exposure Draft adopted. It suggests that the entry history rule should ensure that: the mere act of consolidation is not expected to change the character of transactions, where assets continue to be held by a consolidated group in the same manner as held by a member of the group prior to consolidation (paragraph 2.27). wgcm M v Page 7

8 The Explanatory Memorandum makes the following comments about the entry history rule: What history is inherited? 2.32 As a consequence of the entry history rule a head company may be entitled to certain deductions for expenditure incurred by a joining entity prior to it joining the group. Examples are entitlements to deductions for expenditure on borrowing expenses, gift deductions (where the entitlement to the deduction is spread), water facilities, connecting power or telephone lines, certain business related costs and expenditure allocated to a project pool. A head company may also be entitled to a deduction for a debt that is brought into a consolidated group which subsequently goes bad A head company may also need to include assessable income as a consequence of something that happened to a joining entity prior to consolidation. For example, an entity may have received a prepayment for which the assessable income is included over the period of the provision of the services. A head company may also be assessable on the receipt of a recoupment of expenditure made by a subsidiary member prior to its entry into the group. Also, an entity before joining a group may have elected to defer tax on the profit from the disposal or death of livestock or elected to defer the inclusion of the profit on a second wool clip. Other consequences of the inherited history rules 2.47 Some examples of the effect of the inherited history rules are: The pre-cgt status of assets that are brought into a consolidated group by an entity that becomes a subsidiary member will be inherited as a consequence of the entry history rule. Likewise, the exit history rule will ensure that the pre-cgt status of assets that an entity takes with it when it leaves a consolidated group will be inherited by that entity. This maintains the current law's treatment of pre-cgt asset transfers within wholly-owned groups. However, any acquisition of membership interests in the entity would still cause pre-cgt status in the asset to be lost if it resulted in the ultimate owners not continuing to hold majority underlying interest in the asset. wgcm M v Page 8

9 Private income tax rulings issued to an entity before it becomes a member of a consolidated group will apply to the head company insofar as the relevant facts have not changed either by reason of consolidation (e.g. because they relate to intra-group transactions, which are ignored) or otherwise. Private income tax rulings that relate to particular assets, liabilities or businesses that a leaving entity takes out of a group will apply to the leaving entity insofar as the relevant facts have not changed either by reason of the entity creasing to be a member of a consolidated group or otherwise. 4. Characterisation of Transactions within a Consolidated Group The Explanatory Memorandum to the New Business Tax System (Consolidation) Act (No. 1) 2002 suggests that consolidation should not affect the characterisation of assets. At paragraphs 2.27 to 2.29 it states: Characterisation of assets and transactions 2.26 Following an election to consolidate, the single entity rule has the effect that for the purposes of assessing the income tax position of the head company, the head company is taken to hold all the assets and liabilities of its subsidiaries and to enter into the transactions of its subsidiaries. This is because the subsidiary members are treated as if they are parts of the head company for income tax purposes With the exception of intra-group dealings, the mere act of consolidation is not expected to change the character of transactions, where assets continue to be held by a consolidated group in the same manner as held by a member of the group prior to consolidation As is the situation under current law, it may be relevant to consider the nature of a transaction undertaken by a subsidiary member of a wholly owned group in the context of the activities of the group as a whole, in order to determine the income tax character of a particular act or transaction in an assessment of the consolidated group. The income tax character of a transaction undertaken by a wgcm M v Page 9

10 consolidated group will continue to be a question of fact to be determined in the light of all the relevant circumstances It is possible for assets of the same type to be held for dual purposes within one wholly-owned group. For example, at any point in time one piece of land may be held as trading stock (e.g. for the purposes of land development) while another may be held as a capital asset (e.g. for the purposes of housing business premises) by a group. If that wholly-owned group chooses to consolidate, the current law will apply using existing principles and case law. Transactions under consolidation are subject to the same scrutiny for the purposes of characterisation as those involving a single taxpayer. While the comments in the Explanatory Memorandum are of some comfort, there is still significant doubt whether circumstances may arise where consolidation may affect the characterisation of a transaction. At the very least, the single entity rule will change the analysis which must be undertaken to characterise many future transactions. The UK case of Customs and Excise Commissioners v Kingfisher plc 3 provides an interesting illustration of the way in which a rule like the single entity rule can affect the tax treatment of a transaction. In that case, the taxpayer, Kingfisher, was the holding company of a group of retail companies. There was also a finance company in the group, which provided the Time credit card to consumers for use in the retail outlets of the group. The Commissioner assessed Kingfisher on the basis that the daily gross takings of the retail outlets included all payments made using the Time credit card as if cash had been received for the purchases. Kingfisher appealed on the grounds that it should be treated as carrying on both a credit business and a retail business. Therefore, the credit sales should be treated as self-financed, to be accounted for when payments were received from the customer. The UK VAT law provided that where "any bodies corporate are treated as members of a group any business carried on by a member of the group shall be treated as carried on by the representative member ". It was held that the wgcm M v Page 10

11 purpose of this provision was to enable a group to be treated as if it were a single taxable entity, taxable through its representative member. Consequently, Kingfisher was deemed to be carrying on both a credit and retail business such that sales paid for with the Time credit card were regarded as self-financed credit sales and were only accounted for on receipt of payment. 4.1 Capital v Revenue In the past it has not been uncommon for groups to acquire particular assets in a separate legal entity in the hope that doing so may provide a better tax outcome, or at least a clearer tax outcome than that which would have been obtained if the same assets were held in a single entity. Whether, within a consolidation environment, the separation of assets in different entities will have any influence on the characterisation of assets may be open to debate. Example 4.1 In the past, a group which carried on a business as a property developer, might have acquired its head office building, which it expects to hold on capital account, in a separate subsidiary. Assuming this happened within the consolidation environment, the tax position of the head company would be determined on the basis that the head company: (a) (b) conducted a property development business, and acquired and owned the head office. In such a case the single entity rule should not change the tax treatment of the head office. It is clearly possible for one taxpayer to hold a portfolio of real estate assets which are held on revenue account and at the same time hold a real estate asset which is held on capital account (see National Bank 3 [1994] STC 63. wgcm M v Page 11

12 of Australasia Limited v Federal Commissioner of Taxation 4 ). Given the use of the asset as the head office of the group, it should be possible to demonstrate that this asset is separate and distinct from the portfolio of assets held for development purposes it is held for long term use. Assuming that the facts are clear, and that the holding of separate entities did not change the initial answer, the consolidation environment would not make any difference to the answer. Example 4.2 However, the position does become a little more complex when we consider a situation like that in AGC (Investments) Limited v FC of T (AGC (Investments) case) 5. In that case, the taxpayer was a wholly-owned subsidiary of insurance company, AGC. It was a vehicle for the investment of funds provided to it by its parent company. It acquired a portfolio of shares in listed public companies which it held for many years. Over that time, the total sales of those share were a small percentage of the total value of the portfolio. In 1987, it commenced selling the portfolio and reinvesting the proceeds in fixed interest securities. The net profit of over $45m realised on the sale of shares was held to be on capital account. In the normal course, profits derived by an insurance company from the sale of investments is on revenue account., an insurance company is undoubtedly carrying on an insurance business and the investment of its funds is as much a part of that business as the collection of the premiums. The purpose of investing the funds of the (insurance company) is to obtain the most efficient yield of income. (Colonial Mutual Life Insurance Company Limited v Federal Commissioner of Taxation, 73 CLR 604, at ). In many cases, investments made by insurance company subsidiaries have likewise been held to be on revenue account, on the basis that the 4 (1969) 118 CLR 529, (1992) 92 ATC wgcm M v Page 12

13 companies in question were investing moneys which represented part of the insurance reserves of the parent and were part of the circulating capital of the parent's business. By contrast, in the AGC (Investments) case, the amounts in question were held to be on capital account, on the basis that there was clear evidence that the funds in question were surplus, were not needed to maintain liquidity and the shares were acquired with a view to holding for the long term. The better view would appear to be that consolidation would not change the outcome in the AGC (Investments) case. While the single entity rule might require the issue of characterisation to be approached on the basis that the investments were undertaken by part of AGC, that rule does not change the factual evidence which showed that the investments were not held with a view to making a profit by turning over the assets, nor held for the purposes of facilitating the insurance business. While the fact that the assets are held in a single entity might be disregarded in some respects by the single entity rule, it is still necessary to determine the purpose for which the shares were held. The single entity rule does not require the head company to attribute the purposes of its insurance business to the activities of the subsidiary member. The holding of the shares in a separate entity would still be of some assistance in demonstrating that the shares were distinct from those shares held as part of the insurance business. Cases like AGC (Investments) Limited are rare. Other cases, where insurance companies have invested surplus funds that were part of their circulating capital, have come to a different conclusion. 6 While it may be correct to state that the single entity rule should not, strictly speaking, change the outcome in a case like this, in practice it may just impose yet another hurdle to cross. 6 R A C Insurance Pty Ltd v FCT (1990) 90 ATC 4737; GRE Insurance Ltd v FCT (1992) 92 ATC 4089 wgcm M v Page 13

14 Example 4.3 In the past, someone who intended to undertake a series of similar transactions over a period of time, each of which viewed alone might have been an isolated transaction producing a gain on capital account, might have established a new entity to undertake each transaction, it being hoped that the activities of each entity would be viewed separately, assisting in the characterisation of the transactions as transactions on capital account. In a consolidation environment there is a real risk that the head company will be seen to have entered into each of these transactions, with the result that the transactions would, collectively, be seen to constitute a business of the head company, with the result that any profits made from the transactions are on revenue account. It might be suggested that consolidation would not change the outcome in this case. There may be scope to debate whether or not, outside consolidation, the making of investments in separate entities necessarily achieves the desired result 7. The characterisation of a transaction will, however, often involve matters of degree. In most instances, the single entity rule will not change the characterisation of transactions. In some, the single entity rule might make the argument that the gain is on capital account just that little bit more difficult. 4.2 Characterisation of expenses It is likely that consolidation will change the analysis which applies to determine whether or not some expenses incurred by a group company are deductible. Example 4.4 In a pre-consolidation environment Group Company A which borrowed money to acquire a property which was then be leased to another Group 7 see Example 8 in Income tax Ruling TR 92/3. wgcm M v Page 14

15 Company would be entitled to a deduction for the relevant interest incurred and required to return the rent as assessable income, even if the other Group Company used the property for the purpose of producing exempt income. In a consolidation environment, the deductibility of the interest expense to the group will be determined by looking at the benefit which the Group obtained from incurring that expense. Viewed from the perspective that the two subsidiaries are part of the head company, it is likely that what the head company will be taken to have done is to have borrowed money to acquire a property which it then used to produce exempt income. In that scenario the interest expense will not be deductible. Example 4.5 Consolidation is also likely to change the analysis applying to the Total Holdings 8 and Spassked 9 scenarios. In the past the deductibility of interest on moneys borrowed to make an interest-free loan to a subsidiary, or to acquire shares in another member of the group might have been dependent upon the expectation of the receipt of dividends from the subsidiary. Now, the deductibility of such moneys will no doubt depend upon the use to which the group ultimately puts the moneys borrowed. Viewed from the perspective that each member of the consolidated group is merely a division of the head company, the use of which the subsidiary puts the funds borrowed is imputed to the head company. 4.3 Finance Companies Traditionally, many Australian groups have established a separate entity to act as the group financier. This has provided the group with a number of advantages. Characterisation of the business of the group member as a finance company has often been largely dependent upon significant lending activities made by that entity to other members of the group. 8 Federal Commissioner of Taxation v Total Holdings (Australia) Pty Ltd 79 ATC Spassked & Ors v Federal Commissioner of Taxation 2003 ATC wgcm M v Page 15

16 In a consolidation context, as a matter of fact, it will still be the case that the individual entity will be carrying on a business as a financier. However, it seems likely that transactions entered into with external third parties for the purpose of providing funds to the consolidated group, will be viewed from an income tax perspective as if the head company had borrowed the funds, not for the purpose of on-lending it, but for the purpose to which the group ultimately applies those moneys. A more interesting issue arises where the group's finance company has also traditionally made loans to external third parties, or entities which do not form part of the consolidated group. Can the head company be regarded as carrying on a number of businesses, one of which is a finance business? As a matter of principle, there would seem no reason why the head company's business could not include a finance business. What then is the impact of the single entity rule on the characterisation of the head company's business? When determining whether or not the head company carries on the finance business, is it appropriate to look only at the transactions which it enters into with entities outside the group, or is it also permissible to have regard to the transactions within the group which, as a matter of fact, are carried on by the finance entity? 4.4 Characterisation of receipts There are a number of cases in which a payment made to a company for the termination of a contract has been held to be on capital account, on the basis that the payment resulted in the recipient abandoning the only business which they conducted and so was not an incident of carrying on the company's business. What then happens under consolidation where one company receives a payment for the cancellation of an agency arrangement, on which its entire business is based, but viewed from a group perspective, that business is but one of a number of similar businesses carried on by the group? At the very least, it would seem that the single entity rule complicates any analysis wgcm M v Page 16

17 of the treatment of the payment received. It is clearly possible for one company to carry on several businesses and a payment received for the termination of one of those businesses would be on capital account. As such, characterisation may largely depend on the degree of separation between the different businesses conducted by the group. If the different businesses are conducted from different locations and by different staff, there is a real likelihood that the single entity rule will not change the outcome. If, on the other hand, the group has rationalised and/or centralised a lot of the activities of the businesses conducted by different entities under some form of shared services arrangement, it is more likely that the single entity rule changes the outcome. In other cases like Federal Coke Co Pty Ltd v FC of T (Federal Coke) 10, the treatment of an amount received has depended very much upon the entity in the group it was paid to. In Federal Coke, the taxpayer was a subsidiary of a holding company which produced coal, which the taxpayer then converted into coke on behalf of the holding company in return for the payment of a service fee. A customer of the holding company sought to terminate a contract for the purchase of coke from the holding company. Initially it was proposed that the customer should pay a sum to the holding company in return for the variation of the contract. Ultimately, payment was made to the taxpayer, as the taxpayer had closed down its coke works as a consequence of the variation. At first instance, the payment received by the taxpayer was held to be on revenue account, with the trial judge 'appeared': to have considered that he could approach the characterisation of the receipts in the hands of the taxpayer by treating them as if they were a receipt by Bellambi (the holding company) or the Bellambi Group' (1977) 77 ATC at page wgcm M v Page 17

18 On appeal, the court indicated that 'it is not legitimate to disregard the separateness of different corporate entities or to decide liabilities to tax upon the basis of the substantial economic or business character of what was done' 12. In the present case, regarding the matter from (the taxpayer's) point of view, it is seen that the two receipts were part of one large and unprecedented sum; that they were received without any consideration passing from the company; and that they were in no sense the product of any business or income producing activities which it carried on 13. It is quite likely that if a situation like that in the Federal Coke case came up in the consolidation context, the single entity rule would result in a different outcome. In a consolidation environment, the payment made will be likely to be seen to be made in return for the variation of the contract for the sale of coke, since that was the arrangement which the group had with the third party. 5. Impact of the Entry History Rule on Characterisation 5.1 Capital v revenue The passage from the Explanatory Memorandum quoted earlier suggests that the mere act of consolidation should not change the characterisation of a gain as revenue or capital. The question of characterisation of a gain on disposal of an asset, where the asset was acquired before entry into consolidation, does however, raise slightly different issues to those arising where the asset was acquired in a consolidation context. As Examples 4.1 and 4.2 demonstrate, it will very often be the case that consolidation will not change the characterisation of the gain arising on the 12 at page at page wgcm M v Page 18

19 disposal of an asset, although there is a possibility that there may be some instances, at the extreme, where it may do so. Where an asset was acquired by an entity before entry into consolidation, it would seem that the entry history rule will often ensure that the characterisation of any gain arising on the asset does not change. Ultimately, however, the impact of the entry history rule in a given situation will depend upon a careful analysis of the transaction giving rise to the gain and the tests which apply to determine whether that gain is of a revenue or capital nature. In many instances it is the purpose for which a transaction is entered into which stamps the transaction with its character. The fact that an investment is acquired for long term holding will often stamp any profit later arising on sale with the character of a capital gain. Where a subsidiary company holds a long term investment which would produce a gain on capital account if sold by that subsidiary company, and the subsidiary company becomes part of a consolidated group, it would seem that the entry into consolidation should not change the character of any gain later arising. In the context of Example 4.1, the entry history rule only serves to make it clearer that the head office is held as a long term capital investment. Given the conclusion in Example 4.1, the entry history rule will not change the outcome. In the context of the AGC (Investments) scenario, the entry history rule would appear to support the conclusion that any gain later made on disposal would be on capital account, by attributing to the head company the act of acquisition and thus the purpose of acquisition of the subsidiary, being one of long term capital investment, not one for the purpose of carrying on a business The position might of course be different if, after consolidation, there was some change in the way in which the investments were managed, held or wgcm M v Page 19

20 administered, which suggested that the purpose for which they were held had changed. An example, like Example 4.3, is somewhat more problematic. Much may depend on the precise nature of the transactions which are actually being undertaken by each of the individual entities. The better view would seem to be that one would approach the analysis by looking at what a particular subsidiary member had done up to the point of consolidation, and what occurred after consolidation. Assuming that the entry history rule doesn't require the head company to aggregate the history of all of its subsidiaries, when looking at the tax treatment of something inherited from one subsidiary, characterisation might be approached by treating the head company as if its only activity up to the point of consolidation were the activities that had been undertaken by the individual subsidiary member up to that point in time, and then assuming that from the point of consolidation onwards, the head company commenced activities which involved all of the activities undertaken from that point forward by it and its subsidiary members. 5.2 Characterisation of Expenses In the scenario discussed in Example 4.4 above, the fact that the transaction may have been entered into prior to consolidation would not appear to change the conclusion that within a consolidation environment, deductibility of moneys borrowed by the group to acquire the property depends upon the use to which the property is put by the group. The fact that the moneys were borrowed to acquire a property which was originally used for income producing purposes, does not guarantee that interest on the borrowings will remain deductible throughout the term of the loan. Upon consolidation, the single entity rule would appear to have the effect of treating the group as if the property were now put to a different purpose. It is no longer used by the subsidiary on a stand alone basis to produce rent, but is used by the group to produce exempt income. wgcm M v Page 20

21 A similar analysis would apply to Example 4.5 above. 5.3 Finance Companies It does seem likely that there will be circumstances in which the treatment of an arrangement entered into by the group finance company prior to consolidation differs from the treatment of a similar transaction entered into by the same company, after consolidation, particularly if the single entity rule makes it difficult or impossible to characterise the activities as those of a finance company after consolidation. Example 5.1 Assume that a group finance company places moneys on deposit with a third party prior to consolidation. The group then consolidates and subsequently the third party becomes insolvent and the deposit is written off as a bad debt. It would seem that there is little doubt that the entry history rule will ensure that the head company satisfies the test for deductibility of the bad debt under section on the basis that it was money that you lent in the ordinary course of your business of lending money. This conclusion would appear to stand, even if a similar deposit made after consolidation would not similarly be regarded as one made 'in the ordinary course of business of lending money'. 6. Assets Created by Intra-group Transactions Assets which are created by one member of a group and held by another (such as a debt, or a lease of land or building) raise a number of difficult issues in the consolidation environment. The consolidation legislation contains a number of particular provisions to deal with: wgcm M v Page 21

22 The accrual of income and deductions on intra-group transactions upon entry or exit from a group (sections and ). The tax cost of assets held by a subsidiary member when it ceases to be a member of the group (sections and ). The amount taken into account in respect of intra-group assets when determining the cost to the head company of shares in a departing subsidiary member (sections 711-5, and ). Adjustments to the amounts of intra-group liabilities taken into account when calculating the ACA on entry and on exit (sections (2) and ). There is however considerable uncertainty about the extent to which assets created by one group member in favour of another group member can be recognised when determining the tax treatment of any dealing with those assets by the group. This uncertainty is compounded in the case of assets existing at the time of formation or entry, to which a tax cost will be allocated under Division 705. Example 6.1 Assume that prior to the entry into consolidation, Subsidiary A has made a loan to Subsidiary B of an amount of $100. Post-consolidation Subsidiary A sells the loan to a third party for an amount of $85. Section (2) indicates that section applies in relation to each asset that becomes an asset of the head company because of the single entity rule. Section requires that each such asset's tax cost is set at the asset's tax cost setting amount, which in the case of a debt is normally its existing tax cost. It seems to be assumed that an asset of this type is one to which part of the allocable cost amount will be allocated upon formation although, interestingly, it is debatable whether or not the single entity rule has the effect of treating the head company as owning the asset being the loan as may be required by section (2). Assuming for the present that it is correct to treat the loan as an asset to wgcm M v Page 22

23 which a tax amount is allocated, the loan is a retained cost asset which will retain its tax cost of $100. One might expect that the tax treatment of the sale of the loan would simply involve a comparison of the cost of $100 with the proceeds of sale of $85. The single entity rule directs however that, for the purposes of calculating the company's liability for income tax and therefore its taxable income, Subsidiaries A and B are treated as if they were part of the head company. Does this mean that, as one company cannot make a loan to itself, the loan is taken not to exist during the time the companies are consolidated? If so, how is the transaction with the third party to be characterised? Does the head company receive $85 for the creation of an asset? Does that asset have a cost base, given that the head company will have to pay $100 later, or should the entire transaction be recast as a loan of $85 on which $100 is to be repaid later? (The latter possibility making it necessary to consider whether the sale might be treated as resulting in the creation of a qualifying security to which Division 16E might apply.) It would seem that an approach which ignores the fact that the loan has always existed ignores the factual realities and leads to the kind of error in applying a deeming provision which has been identified in cases such as Woodlock v CC of LT 14 and Galibal Pty Ltd v CC of LT 15. Failure to recognise the factual realities will introduce a significant element of fiction to the consolidation regime. It will create enormous difficulties in recharacterising transactions and often result in taxation outcomes which are far from intuitive or obvious (this is not of course to suggest that tax is intuitive or obvious). The better view, I would suggest, is that the loan has always existed with a tax cost set by Division 705. This 'better view' is not however without its difficulties. Example [1974] C NSWLR 411, (1996) 96 ATC 4143 wgcm M v Page 23

24 Assume that the loan made by Subsidiary A to Subsidiary B in Example 6.1 had been made after the group had consolidated. An approach which recognises that the loan has always existed creates difficulties even in this scenario, as it may be difficult to impute to the head company an appropriate cost base for the loan sold. Example 6.3 The difficulties associated with an approach which does not recognise the factual realities, could be illustrated by many examples. Another obvious example involves the provision by the head company of financial accommodation to a subsidiary by way of loan, for a period of 12 years on terms which would result in the financial accommodation being treated as a non-share equity interest if the debt/equity rules in Division 974 were applied at the time of issue. Three years later, the head company sells this financial instrument to a third party. Assume that, because of the difference between the present value calculation and nominal calculation, the instrument would be classified as a debt interest if the loan had been issued with a term of nine years, but in all other respects has the same terms. Is the character of the instrument held by the third party to be determined by applying the debt/equity test at the time that the instrument was issued by the subsidiary to the head company, or by applying the debt/equity test at the time that the instrument was acquired by the third party? The debt/equity rules are drafted in terms which, arguably, do not work unless the relevant instrument is analysed at the time of its initial creation. Section (meaning of 'debt interest') and section (meaning of 'equity interest in a company') both look at the time the scheme comes into existence to determine if the interest is a debt interest or an equity interest. They both apply to financing arrangements, being arrangements under which the issuer of the instrument wgcm M v Page 24

25 receives some form of financial benefit. Both compare the financial benefits received by the issuer with those provided in return. Any attempt to focus on the time of sale of the instrument out of the group and treat the payment by the third party as a loan to the group in return for the payments promised on the instrument, will not work. Not only does it require the creation of a complete fictional set of circumstances which do not appear to be justified by the single entity rule, but the provisions themselves will not work. The single entity rule does not operate for the purposes of determining the tax treatment of the instrument in the hands of a third party. Thus, from the third party's perspective, the instrument should be viewed at the time of issue. How is a third party to know that some intervening event has occurred, so that the tax treatment of the instrument cannot be judged by simply looking at its terms? That in itself should be enough to tell us that we should not focus on the time of sale out of the group. Were we to do so, when the third party pays the head company for the instrument, it makes payment to the head company and gets a return from the subsidiary. It is stretching the single entity rule to suggest that it requires us to treat the head company as the issuer of the instrument as it both receives a financial benefit and it pays a return. The debt/equity rules operate on the basis that a person has entered into an instrument which involves that person receiving a financial benefit and paying a return. The single entity rule should not change the factual reality. This is simply not what is occurring. 7. Limitations on the Single Entity Rule It is important to remember that the single entity rule only operates for head company core purposes and entity core purposes. The entry history rule only operates for head company core purposes. The rules do not apply in relation to issues which do not form part of the process of determination of the amount of income tax payable or the amount of a tax loss. With the exception of Part 2.10 of the TAA which has its own single entity rule in section , the single entity rule does not apply for the purposes of the payment and recovery provisions. It also wgcm M v Page 25

26 does not apply in relation to the determination of the tax treatment of any taxpayer other than the head entity or its subsidiary members. The single entity rule would not, for example, apply to determine the tax treatment of a shareholder receiving a distribution from a company. It will still be very important in the consolidation environment to make sure that any company which is making a distribution to a shareholder which is intended to be dividend, actually has profits available from which that distribution can be made. Otherwise the payment in question will not be a dividend and will not be capable of being franked. It will not be enough that the consolidated group as a whole has profits. Great care will also need to be taken to avoid thinking that the single entity rule really means that we can ignore everything which goes on within a consolidated group when considering the tax consequences of what we are doing. There will be occasions on which the structure of the transactions and the arrangements entered into, even within a group, will have a bearing on the eventual tax outcome. 8. Specific Issues Arising from the Entry History Rule As we all know, most taxpayers are currently preoccupied with entry into consolidation. Very few have, as yet, worked through all the issues which arise for them in applying the income tax laws to their activities within a consolidated group. A number of issues have arisen in relation to the inter-action between the single entity rule, entry history rule and the normal provisions of the Tax Act. Many more will no doubt arise. I have set out below some brief comments in relation to a number of the issues of which I am aware. 8.1 CGT Timing Issues Differences between the CGT timing rules, and the timing rules which apply to determine when a subsidiary member ceases to be a member of a consolidated group, can create some fairly interesting and unexpected outcomes in relation to the recognition of income or gains arising from the wgcm M v Page 26