Consolidation Contractual issues arising for Buyers and Sellers of Companies 1

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1 Consolidation Contractual issues arising for Buyers and Sellers of Companies 1 A paper prepared by Grant Cathro Partner, Allens Arthur Robinson Consolidation raises a number of new issues which need to be considered when buying or selling a company which is a subsidiary member of a consolidatable group. This article explores those issues and their impact on the drafting of a contract of sale 1. Introduction Consolidation effects a significant change in the way in which corporate groups are taxed for income tax purposes. The introduction of consolidation will present a number of new challenges for those involved in commercial transactions, particularly those involving the sale and acquisition of shares and certain project finance transactions, where financiers provide financial accommodation to a consolidated project vehicle on a stand-alone basis. Consolidation may also require arrangements between the head company and the various members of the consolidated group to be documented to enable the head company to pay its income tax liabilities on time (contribution arrangements). Groups will generally require a tax sharing agreement (TSA) which documents the responsibility of each group member to contribute to the payment of taxes on default, so as to avoid all members of the consolidated group being jointly and severally liable for the group s income taxes. Novel issues arise in each of these contexts. In many instances, there is no single way of dealing with the issue and different approaches may be required in different circumstances. In this paper, I have been asked to address contractual issues which arise from the consolidation regime when preparing a share sale agreement. 1 This paper was originally presented at the First National Consolidation Symposium conducted by the Taxation Institute of Australia and the Corporate Tax Association in February It was then an article in The Tax Specialist, Volume 6, No 3, February 2003 edition. wgcm M v Page 1

2 References in this paper to the Act are to the Income Tax Assessment Act 1997 and section and Division references are to that Act unless stated otherwise. 2. Do you Sell the Shares or the Assets? One of the first questions which confronts any vendor and purchaser of a business is whether they should buy/sell shares in the company conducting the relevant business, or the assets of the business themselves. Commercial considerations will usually drive this decision. For example, where the vendor does not have significant assets, the purchaser might be concerned about purchasing a company with its attendant exposure to liabilities. In other cases, regulatory constraints may make it difficult to transfer the business. In the past, the choice between a sale/acquisition of assets or shares has had the potential to produce vastly different tax consequences for the vendor and purchaser. One of the outcomes of consolidation is that, at least where both the vendor and purchaser are consolidated groups, the tax outcomes for the vendor and purchaser of a sale/acquisition of shares in a subsidiary, should produce a similar outcome to a sale/acquisition of assets. That is not, of course, to say that the outcome will always be the same. Importantly: there are still significant differences for a purchaser who is not able to consolidate the acquisition; and if the target company (the Target) is not part of a consolidated group, or is the head entity of a consolidated group, there are still significant differences for: (i) (ii) a vendor in calculating the amount of any gain on sale; and a purchaser, due to the fact that a Target which is purchased will still have the benefit of franking credits, foreign tax credits and losses; (c) Where the Target is a subsidiary of a vendor consolidated group and will be consolidated by the purchaser: (i) (ii) the stamp duty payable on transfer of assets is likely to be much greater than the stamp duty payable on the transfer of shares; while the numerical amount of the gain or loss arising on the sale of shares is likely to be similar to the aggregate amount of any gains or losses arising on sale of all of the assets of a company, the composition of the gain or loss for tax purposes may differ. A gain made on the sale of shares will generally be on capital account. By contrast, certain gains on the sale of some assets (for example depreciable assets) will be on revenue account; (iii) in most instances where a purchaser (being a consolidated group) acquires 100% of the shares in a company, it gets to reset the tax value of the various assets in that company, based on the market value inherent in the price paid for the shares. This provides an outcome which should be very similar, if not identical, to the outcome which would arise if the assets had been purchased themselves. There are however a very limited number of instances in which the tax value of the assets in a company is not able to be reset. Most importantly, the provisions currently do not allow the tax value of a pre-1 July 2001 mining right to be restated. By contrast, wgcm M v Page 2

3 if the purchaser acquired the actual mining right, its full acquisition cost would be recognised as its cost for depreciation purposes; (iv) (v) (vi) there are also important differences in the treatment of accelerated depreciation and the choice of depreciation methods. Where the shares in the Target are purchased, accelerated depreciation can be retained if the tax value of the item is not stepped up (section ), but the method of depreciation must be retained. If assets are purchased, accelerated depreciation is no longer available, but the purchaser can choose which method of depreciation to use; a purchaser acquiring assets does not ordinarily become exposed to liabilities of the vendor. A purchaser acquiring the Target runs the risk that the Target may be exposed to liabilities of which the purchaser is unaware. In particular, a purchaser risks exposure to the consolidated group s liability for income taxes (see 4.4 below); and while a contract of sale of assets would ordinarily set out the allocation of the purchase price between the different assets sold, allocation of the push-down of the allocable cost amount into the Target s assets, is based on the relative market value of those assets. Strictly speaking, it is the product of a mechanical process, providing less flexibility in the allocation. 3. Objectives of the Vendor and Purchaser in drafting a Share Sale Agreement Putting aside the obvious role of the share sale agreement in effecting the sale, setting the price and time of settlement, much of the documentation in the share sale agreement, like the due diligence process itself, is designed to provide a purchaser with assurances that: (c) the purchaser is getting what they are paying for; the purchaser is not buying an entity which is exposed to unexpected liabilities which the purchaser will have to meet; and the Target s business is being conducted in an appropriate manner and nothing has happened which is likely to have an adverse impact on it in the future. Purchasers and vendors approach a share sale agreement from opposing perspectives. The purchaser wants maximum protection and the greatest level of assurance that it has redress against the vendor if it does not get what it expects. The vendor, by contrast, will generally simply want to take the sale proceeds and have nothing further to do with the Target, with no further exposure to the Target s liabilities or performance. 4. Impact of Consolidation Regime The consolidation regime has an impact on the tax attributes of the assets which the purchaser is acquiring through its acquisition of the Target. It also affects the Target s exposure to tax liabilities, both directly through the operation of the tax laws themselves, and indirectly, as a consequence of arrangements which consolidated groups are likely to put in place to fund tax payments. wgcm M v Page 3

4 4.1 Tax Attributes of the Target Where a purchaser acquires a Target from a consolidated group, that Target will have: had the tax cost of its assets reset, based on the vendor group s allocable cost amount at the time of acquisition; 2 and no losses, franking credits or foreign tax credits. Where the purchaser acquires 100% of the shares in the Target and the purchaser is a consolidated group, the tax value of the assets prior to purchase will with limited exceptions be irrelevant 3, as the purchaser will reset the tax cost of the assets, by reference to the purchaser group s allocable cost amount. The comparative position of a purchaser which is part of a consolidated group and buys 100% of the shares in a company is set out in the table below. Table 1 Target is not part of Target is a member Target is head a CG of a CG company of a CG Tax cost of Reset by purchaser Reset by purchaser Reset by purchaser, Assets based on ACA based on ACA based on ACA Franking credits X Losses 4 X 4 FTCs X The position where the purchaser is not part of a consolidated group, or the purchase/subscription is for shares representing less than 100% of the shares in the Target, is slightly different. The main difference arises in relation the tax cost of assets. 2 See section As a transitional measure, certain entities may choose not to reset the tax cost of their assets. See Division 701 of the Income Tax (Transitional Provisions) Act 1997 (Cth). 3 The tax values in the Target prior to acquisition remain relevant for retained cost base assets. There are limits to the extent to which trading stock, revenue assets and depreciable assets can be reset. The tax value in the Target prior to sale can be relevant to the determination of this limit (see section ), although the tax cost to the purchaser can exceed the tax cost in the Target prior to sale, as long as it does not then exceed market value. 4 Availability of losses is subject to modified SBT tests. Utilisation limited by loss factor. wgcm M v Page 4

5 Table 2 Target is not part of Target is a member Target is head a CG of a CG company of a CG Tax Cost of Based on cost Based on earlier Depends whether HC Assets reset by vendor retains status as HC Franking credits X Losses X FTCs X 4.2 Retrospective Elections to Consolidate It will clearly be important for a purchaser who is buying a company, or significant numbers of shares in a company, to understand whether or not consolidation may have an impact on the tax attributes of the Target. It should not be assumed, simply because a vendor group has not yet elected to consolidate, that consolidation will not impact the purchaser. A consolidatable group may elect to consolidate with effect from 1 July 2002 at any time up to the due date for lodgement of the income tax return for the tax year of which 1 July 2002 forms a part. For most corporates which have a tax year ended 30 June 2003, a decision to consolidate effective 1 July 2002 can be made right up until the date of lodgement of the income tax return for the first income year ending after the date chosen as the date for consolidation. This ability of a group to elect retrospectively to consolidate creates particular uncertainties for a purchaser. A vendor group may make an election to consolidate some months after the sale of a subsidiary and do so from a date prior to the date of sale. The one in, all in principle which underlies consolidation requires that all entities which form part of a consolidatable group (section ) on the effective date of consolidation, must be treated as members of that group. No exception has been allowed for entities sold before notice of election to consolidate is given. In practice, few vendor groups are likely to be prepared to tie their hands on an issue as important as consolidation, merely to provide a purchaser with certainty about the treatment of the Target it is purchasing. While hopefully most groups now have some idea of whether they are going to consolidate or not, generally speaking vendor groups will only be prepared to give a purchaser a commitment about whether or not they will consolidate prior to the date of sale where they have already made a decision about their approach to consolidation. It is important to note that a retrospective decision to consolidate affects not only the purchaser as acquirer of the Target, but is also likely to change the calculation of the amount of the gain made by the vendor on sale. The cost base of shares in an unconsolidated Target is based on the normal CGT rules. The cost base of shares in a wgcm M v Page 5

6 consolidated Target will be calculated under Division 711, based on a number of factors, including the terminating value of assets of the Target and its liabilities. Of course, a Target can only form, or be eligible to form, part of a consolidated group, if at some stage after 30 June 2002 all of its shares have been beneficially owned (whether directly or indirectly and whether through one or more interposed entities including certain trusts) by a company which was an Australian resident. The issue is therefore only one which is relevant where a Target has formed part of a wholly-owned group. 4.3 Target s Liability for its own Taxes From a tax manager s perspective, one of the key liabilities which is normally dealt with by this part of the due diligence process and in a share sale agreement, relates to the Target s exposure to tax liabilities relating to events or circumstances arising prior to completion. Historically, the acquisition of a Target entity exposes the purchaser to the possibility that the Target entity might become liable in the future for additional taxes of various types, relating to events or circumstances which occurred prior to completion. Where a Target entity has, prior to the date of acquisition, been a member of a consolidated group (whether by retrospective election or otherwise), that Target entity will continue to have its own individual liability for taxes other than income tax and will continue to be liable for its own income tax for periods other than periods during which it was part of a consolidated group. Amended assessments relating to a period prior to consolidation can still be received by a Target. The Target will retain its own individual liability for those assessments. Under the consolidations regime, individual subsidiary members of a consolidated group do not have any individual income tax liability for the period during which they are part of the consolidated group. Rather, the consolidation regime in effect treats the subsidiary member as if it was part of the head company of the group, rather than a separate entity, during the period of consolidation (see section 701-1). 4.4 Exposure of the Target to Tax Liabilities of the Consolidated Group Superficially, the fact that the target does not have its own tax liability for the period of consolidation would appear to reduce the potential exposure to liability. Unfortunately however, that is not the case consolidation in fact expands the tax liabilities for which the Target could potentially be liable after settlement. The head company of a consolidated group is prima facie liable for all liabilities for income tax, PAYG instalments, franking deficit tax, deficit deferral tax, general interest charges and penalties (group liabilities) see sections and If the head company pays a group liability on time, the potential joint and several liability of other members of the consolidated group in relation to that group liability will not crystallise into a present liability (see sections (4) and (4)). If, however, the head company fails to pay any particular group liability on the due date, all other entities which were subsidiary members of the group for at least part of the period to which the group liability relates (contributing members), other than certain entities excluded by section (2), will be jointly and wgcm M v Page 6

7 severally liable for that group liability (section (1)), unless the group liability is covered by a tax sharing agreement (section (3)). This joint and several liability arises immediately after the time that the head company should have paid the tax and therefore only arises if the head company fails to do so. The liability of a particular member of a consolidated group, becomes due and payable by that member 14 days after the Commissioner gives the member written notice (section (5)). The liability of individual subsidiary members of a consolidated group can be limited by ensuring that each relevant group liability is covered by a tax sharing agreement. Where a group liability is covered by a tax sharing agreement : (c) (d) the head company remains primarily liable for the group liability; where the head company does not pay the group liability by the Head Company s Due Time (section (1)), each subsidiary member of the group which is a party to the TSA (TSA Contributing Member) becomes liable to pay to the Commonwealth an amount determined in accordance with the TSA (their contribution amount) (section (2)); the liability of each TSA Contributing Member arises just after the Head Company s Due Time (section (4)); and the liability does not become due and payable until a date 14 days after the Commissioner gives the relevant group member written notice under section of the liability. 4.5 When is a Group Liability covered by a Tax Sharing Agreement? The circumstances in which a group liability is to be taken to be covered by a TSA are set out in section A particular group liability will be covered by a TSA if: (c) (d) just before the Head Company s Due Time in respect of that group liability there is an agreement in place between the head company of the group and one or more of the entities which were subsidiary members of the group for all or part of the period to which the group liability relates (TSA Contributing Members); the agreement provides for the determination of a particular contribution for each TSA Contributing Member which is the amount for which that TSA Contributing Member is to be liable to the Commonwealth if the head company defaults and does not pay the group liability by the Head Company s Due Time; the contribution amounts for each of the TSA Contributing Members in relation to the group liability, as determined under the agreement, represent a reasonable allocation of the total amount of the group liability among the head company and the TSA Contributing Members ; and the agreement complies with any requirement set out in the regulations. In addition: wgcm M v Page 7

8 (e) (f) the agreement must not have been entered into as part of an arrangement, the purpose of which was to prejudice the recovery by the Commissioner of some or all of the amount of the group liability; and if, at some point in the future, the Commissioner gives the head company a notice requiring the head company to give the Commissioner a copy of the agreement, the head company must provide a copy of that agreement within 14 days, failing which the group liability will be taken never to have been covered by a TSA. It is clear that it would theoretically be possible to have a different TSA to deal with a head company s default in respect of different group liabilities. In practice, it seems likely that groups will seek to put in place an agreement with an enduring life, which covers particular categories of group liabilities, rather than individual group liabilities which might arise. It is however, likely that it may be necessary for the TSA to have a different method of allocating different types of group liability. If an agreement is put in place which is to have an enduring life, it is clear that the agreement will need to be regularly monitored to ensure that the basis of allocation remains reasonable. 4.6 Can it be Assumed that a Tax Sharing Agreement will be Valid? Section sets out a number of requirements which have to be met in order for a TSA to be valid. In practice, any third party dealing with a consolidated group, including a purchaser, will not find it easy to be certain that what is produced to it as a TSA will in fact be valid. The requirement that the head company provide a copy of the agreement within 14 days of request, failing which the group liabilities dealt with in the TSA will be taken never to have been covered by a TSA, is a worrying requirement. There is no way that a purchaser can be certain that if the Commissioner comes along in a couple of years and asks for a copy of the TSA that the head company of the vendor group will comply with that request, particularly if the head company is insolvent. If the head company does not, the relevant group liabilities will be taken never to have been covered by a TSA. Uncertainties also arise as a consequence of the requirement that the contribution amounts for each of the TSA Contributing Members in relation to the group liability, must represent a reasonable allocation of the total amount of the group liability among the head company and the TSA Contributing Members. Ultimately there are likely to be a range of allocation methods which a court would consider to be reasonable. Putting aside issues which arise in determining what mathematically might be a reasonable method of allocating liability between different entities within a group, this test creates a number of uncertainties. the provisions appear to have been drafted on the assumption that there can only be one TSA in respect of a group liability, raising the prospect that if an allocation to any subsidiary member is unreasonable, the relevant group liability will not be covered by a TSA, even if the allocation to the particular entity that we are concerned with is reasonable; and wgcm M v Page 8

9 there is uncertainty as to whether: (i) (ii) a TSA can be valid in circumstances in which members of the group which have significant income or assets, are not actually parties to that agreement, raising the prospect that what appears to be a valid TSA may not be valid, because significant entities in the vendor group are not parties to it; or an agreement which was valid when originally entered into may, with the passage of time, become invalid, if not updated to take account of changes in the key players in the group. I should say that there is considerable scope to debate the issue of whether all significant entities must be a party to the TSA for it to be valid. It is clearly arguable that section does not require that all subsidiary members of the group be a party to the TSA. Importantly, however, once there is a valid and operative TSA, the provision which makes subsidiary members of a consolidated group jointly and severally liable for the group liability no longer operates. It does not operate for any subsidiaries, whether they are parties to the TSA or not. That then raises questions as to whether or not an allocation can be reasonable under section , if the allocation made by a TSA is merely an allocation to one or a limited number of entities in the group. 5. Achieving a Clean Exit As we have already discussed, where there is no TSA, a subsidiary entity will be jointly and severally liable for taxes payable by the consolidated group in respect of the period during which it was a member of the consolidated group. Where the entity leaves part way through a period, it will be liable for the taxes in respect of that period, even if they fall due for payment after the day on which the entity leaves the group. Liability for taxes under amended assessments relates back to the point in time that the original assessment was due and payable, so that amended assessments received in the future may create liabilities for which entities are liable, even after they leave the group. The Act makes specific provision to allow a company which exits the group to limit its liability for taxes in respect of the period of exit if the relevant group liability is covered by a TSA and the exiting entity was a party to that TSA. Section provides for a TSA Contributing Member to leave the group free and clear of a group liability (being a group liability in respect of the period in which exit occurs), if: (c) the TSA Contributing member ceased to be a Member of the group at a time (the leaving time) before the Head Company s Due Time; and the cessation of membership was not part of an arrangement, a purpose of which was to prejudice the recovery by the Commissioner of some or all of the amount of the group liability or liabilities of that kind; and before the leaving time, the TSA Contributing Member had paid to the head company: wgcm M v Page 9

10 (i) (ii) if the contribution amount for that member in relation to the group liability could be determined before the leaving time an amount equal and attributable to that amount; or otherwise an amount that is a reasonable estimate of, and attributable to, that amount. It is important to note that section only applies to a liability which has not yet fallen due for payment. It does not apply to liabilities where the subsidiary entities cease to be a member of the group after the Head Company s Due Time. Section therefore does not provide a clean exit in respect of liabilities for prior periods and, in particular, liabilities which may arise because either: the head company has already defaulted in payment of a group liability; or an amended assessment is received, relating to an earlier period. It does not allow for a clean exit if there is no TSA, if the TSA is not valid (in the sense that the relevant group liability is not taken to be covered by a TSA, given the terms of section ) or if the Target was not a party to the TSA. Where the subsidiary entity leaving the group was a party to a TSA, its responsibility to the Commissioner in respect of these amounts will be dependent upon the terms of the TSA. When the TSA regime was first introduced, many of us might have thought that it would not be unreasonable for a TSA to provide an allocation of liability, which was such that any entity which had left the group no longer remained responsible for the group s income taxes. While it is clearly arguable that such an allocation would be reasonable, this is not a position which is likely to be accepted by the ATO. The ATO does not want to see the Revenue placed in a worse position vis a vis recovery under a consolidation regime, than is the case in the pre-consolidation environment. It would seem that the ATO s view is that: where an amended assessment is received after the sale, and the facts or circumstances giving rise to the amendment relate to the Target, the TSA will only provide a reasonable allocation of the group liability if the Target remains responsible under the TSA for the liability arising from the amendment; and if, as at the date of sale the head company is already in default, in that it has failed to pay taxes which were due and payable under an assessment already received, the Target should remain responsible to contribute its reasonable share of those taxes. In summary, what this all means is that a purchaser who is acquiring a company from a consolidated group, or a substantial number of shares in a company which previously formed part of a consolidated group, will need to: confirm that there is a TSA in existence that covers all relevant group liabilities for the period during which the Target was a member of a consolidated group; check to see that it appears to be valid (ie, it complies with the requirements in section ); (c) seek some assurance that the head company of the vendor group has paid all group liabilities which fell due for payment in the past (it should not be assumed that just because wgcm M v Page 10

11 the Target has paid money to the head company to make payment, the Target is not still exposed to potential liability under any TSA); (d) (e) review the TSA to determine what exposure the Target has in the future for past and present assessments; and ensure that a payment of a reasonable contribution is made up for any group liability relating to the period of exit in accordance with section ; Much of this process is no doubt intended to assist the purchaser is assessing the risk of exposure to the vendor group s tax liability. Ultimately, when it comes time to document the sale agreement, about all that the purchaser can do is to seek an indemnity from one or more members of the vendor group for any liability to taxes relating to the period prior to sale. In extreme circumstances, where the purchaser was concerned about the level of risk and the financial standing of the vendor group, the purchaser might seek to obtain security for that indemnity, although I suspect that this will be very difficult to obtain. 6. Implications of Arrangements put in place by the Head Company to fund Tax Payments A head company will obviously need to put arrangements in place to ensure that it is able to fund its tax payments as and when they fall due. It is up to the head company how it does so. It can choose to use its own funds, rely on dividends from subsidiaries, or to put in place formal arrangements with subsidiaries to allow for the funding of tax payments. It is important to note that a TSA, as referred to in Division 721, deals only with the setting of liabilities which individual group members have to the Commonwealth on default by the head company. It need not provide for the funding of the head company s regular tax payments. It is somewhat confusing to refer to arrangements put in place by a head company to ensure that it has cash to pay its tax liabilities, as TSAs; it is perhaps more appropriate to refer to them as contribution arrangements. While there is no doubt that an agreement which deals with default could also have within it provisions which deal with contributions to the head company to enable the head company to make payment by its due date, there is nothing in the Act which requires there be any particular form of arrangement in place to help the head company fund its regular tax payments. Indeed, an agreement which merely provides for contributions to enable the head company to make payment of tax on time, and does not independently determine an amount for the purposes of section will not be a TSA. It is likely that the accounting standards will encourage head companies not only to put arrangements in place to obtain cash to assist the head company with a payment of its tax liabilities, but to enter into more extensive arrangements which might see individual subsidiary entities paying an amount of money to the head company equal to the tax which the subsidiary would have paid, had it been required to calculate and pay its own income tax on its own activities. These arrangements may even go so far as to permit the head company to recover from its subsidiaries more tax than that actually payable to the ATO, with the head company making notional subvention payments to subsidiaries who would have had a tax loss had the subsidiaries been taxed on a stand alone basis. wgcm M v Page 11

12 Urgent Issues Group Abstract 52 Income Tax Accounting Under the Tax Consolidation System expressly provides that current and future deferred tax amounts are to be recognised by a head entity in a consolidated group as if the relevant transactions, events and balances were those of the head entity. Wholly owned subsidiaries are not permitted to recognise current and deferred tax amounts. Where, however, the head entity and the wholly owned subsidiary have entered into an arrangement under which the subsidiary makes payments to the head company (or vice versa) in respect of tax, assets and liabilities arising out of that agreement must be recognised by the relevant entities as tax related amounts receivable from or payable to the other entities in the group, rather than as tax assets and tax liabilities. The UIG abstract refers to these agreements as tax sharing agreements, although its clear that, in using this term, they are referring to a different type of agreement from that stipulated by Division 721. It will be important for vendors and purchasers to review these agreements and make sure that they do not leave either the vendor group or the Target, exposed to inappropriate liabilities after sale. Implications of the consolidations regime on the value of FITB/Deferred Tax Liabilities It is common in many share sale agreements for the provisional price struck between the vendor and the purchaser as the purchase price, to be adjusted for movements in the net asset position of the Target between the date of accounts made available to the purchaser and completion date. Traditionally, those accounts would have included within them provisions for future income tax benefit or deferred tax liability. In the future it will be important for a purchaser to look carefully and determine whether or not these accounts should have in them assets or receivables relating to tax related liabilities. 7. Issues for the Vendor While consolidation will change the calculation by the vendor of any gain arising on sale of shares in the subsidiary, from a documentation point of view, the vast majority of the issues arising in preparing a contract of sale, arise from the desire of the purchaser to obtain protection against unforeseen consequences or liabilities. There is a potential for TSAs, or contribution agreements, to give the Target an entitlement to payment of moneys from the vendor group in certain circumstances. It will be important for vendors to review these agreements and bring any inappropriate entitlements to an end. The issue of record keeping is also important for the vendor, particularly if the vendor has not yet elected to consolidate and may decide to do so retrospectively. Where a retrospective election is made after the sale of a subsidiary, the vendor group will need access to the records of the Target to allow the vendor group to effect a push-down of the Allocable Cost Amount into the assets of the Target at the effective date of consolidation. If the vendor group does not do this, and elects to stick with the existing tax cost of assets under the transitional relief, the vendor group may well find that the cost base of the shares in the Target which it sold is significantly lower than it might otherwise have been. If the vendor cannot apply the Allocable Cost Amount to the cost base of the Target s assets, there is a real risk that the vendor may make a far higher gain upon sale of the Target than it would have made had the Target been sold prior to consolidation. wgcm M v Page 12

13 Access to records Traditionally, where a vendor sells a company, the vendor gives warranties or indemnities to the purchaser and the purchaser takes the company with its various accounting records. Any dispute which subsequently arises in relation to tax matters would traditionally relate to the tax liability of the Target and would therefore be within the control of the Target which has the accounting records. A vendor, who is liable for any amount payable in relation to such a dispute, would normally seek some level of control over the conduct of the dispute and access to the records. Under consolidation, the head company of the vendor group remains liable for any income taxes relating to the period of consolidation. Superficially one might expect that the head company would have all of the relevant tax records. In practice, however, this may not be the case as many corporate groups will rely upon individual accounting and tax records maintained by individual entities to create their consolidated income tax returns. It will therefore become important for the vendor group to ensure that it has a right of access to the records of the Target and is given assurances that employees of the Target will assist the vendor group if any audit, inquiry or amended assessment arises out of activities undertaken by the Target prior to sale. A vendor group will also need access to the Target s records to complete the vendor group s income tax return for the financial year in which completion of the sale occurs. The head company of the vendor group will be required to include any income arising from the Target s activities up until the date of completion, in the head company s own assessable income. In addition, there is, as mentioned earlier, a need for the vendor group to ensure that it has access to records, where the vendor group may retrospectively elect to consolidate after sale. This is necessary to ensure that the vendor maximises the cost base of the shares sold. 8. Time of Transfer Only entities which are either the head company, or a subsidiary member of a consolidated group, form part of the consolidated group (see section ). An entity will only be a subsidiary member of a consolidated group if it satisfies the requirement set out in item 2 of the Table in s Those requirements include the requirement that all of the membership interests in the subsidiary entity are beneficially owned by the holding entity and/or one or more of its subsidiaries. This wholly owned test is similar, but not identical to, the wholly owned group test in Division 975 of the Act. Section provides: When is one entity a wholly-owned subsidiary of another? (1) One entity (the subsidiary entity) is a wholly-owned subsidiary of another entity (the holding entity) if all the membership interests in the subsidiary entity are beneficially owned by: (c) the holding entity; or one or more wholly-owned subsidiaries of the holding entity; or the holding entity and one or more wholly-owned subsidiaries of the holding entity. wgcm M v Page 13

14 (2) An entity (other than the subsidiary entity) is a wholly-owned subsidiary of the holding entity if, and only if: it is a wholly-owned subsidiary of the holding entity; or it is a wholly-owned subsidiary of a (wholly-owned subsidiary) of the holding entity; because of any other application or applications of this section. In the context of a contract for the sale of a subsidiary member of a consolidated group, or the acquisition of a company which will form a subsidiary member of a consolidated group, the key question is at what point in time does: the vendor group cease to beneficially own the membership interest in the Target; and the purchaser group start to beneficially own the membership interest in the Target. The point in time at which this occurs will define the point in time at which the vendor group ceases to include the Target s activities in the determination of the vendor group s taxable income and at which the purchaser group starts to include the Target s activities in the determination of its taxable income. Importantly, unlike Division 975, the consolidation provisions do not disqualify the subsidiary company from being a member of the group merely because a person is in a position to affect the rights which the holding company or its subsidiaries have in the Target, or will be in such a position in the future. In the consolidation context, a clear policy decision has been taken that the mere existence of an option or some other right over existing shares held by a group in a subsidiary, should not affect the ability of that subsidiary to form part of a consolidated group. There is a considerable degree of uncertainty about the point in time that beneficial ownership passes. It seems that the meaning of the term may vary, depending upon the context in which it is used. It would also seem that the terms beneficial owner and equitable ownership, equitable interest and beneficial interest have at times been used interchangeably, even although they are likely to mean different things. The better view is, it would seem, that where a purchaser and a vendor have entered into a specifically enforceable contract for sale (which is not subject to any conditions) the purchaser obtains an equitable interest in the subject matter of the contract. Once the purchaser has paid the purchase price and is entitled to call for a conveyance of the legal title to the property, the purchaser is the beneficial owner and the vendor is a bare trustee of the property (see Stern v McArthur (1987-8) 165 CLR 489 and the comments of Mason J in Chang v Registrar of Titles (1976) 137 CLR 177 at 185). Before that time, various equitable interests in the property have, to some extent, been transferred to the purchaser. Those interests do not, however, amount to beneficial ownership. (See also the recent decision of the Queensland Court of Appeal in Road Australia Pty Ltd v Commissioner of Stamp Duties (Qld) 99 ATC 4877.) The matter is not, however, free from doubt and it is possible to construct an argument that beneficial ownership passes once the contract becomes capable of specific performance. Such an argument would suggest that, in the case of an unconditional contract of sale, the purchaser should be treated as the beneficial owner from the date of the contract or that, in the case of a conditional contract of sale, the purchaser should be treated as the owner from the point in time that all of the conditions which are not for the benefit of the purchaser, and which the purchaser could not waive, wgcm M v Page 14

15 have been satisfied. In either case, the argument suggests that the purchaser is the beneficial owner before the purchase price has been paid. There is some support for this argument in the comments of the High Court in KLDE Pty Ltd v Commissioner of Stamp Duties (QLD) (1984) 15 ATR 1214, in R v Australian Broadcasting Tribunal; ex parte Hardiman (1981) 44 CLR 13 at 31, Legione v Hately (1983) 57 ALJR 2927, 2928, and in a number of other decisions. In other circumstances, it would seem that the answer to the question When does beneficial ownership pass? may well be influenced by the policy underlying the particular legislation in question (see, for example, J Sainsbury plc v O Connor (1991) 1 WLR 963). It is important to note when considering authorities dealing with this topic, that there may be a difference between beneficial ownership, a beneficial interest and equitable ownership. The point in time at which beneficial ownership passes under a contract of sale determines who pays the tax on the income of a subsidiary. Clearly, it is highly undesirable that there be scope to debate the point in time at which ownership passes for this purpose, or that there be any risk that an entity sold out of one group to another group, moves out of the vendor group at a different point in time to the point in time at which it moves into the purchaser group. Most of us would, I think, feel it sensible in a consolidation context, that a simple vanilla sale of shares, under which the vendor sells the shares in return for a price to be paid at settlement with the share transfer being handed over at settlement and directors being changed at settlement, should result in a transfer which is effective at completion. It is at that point in time that the purchaser takes control of the Target and ought appropriately to be expected to include the income arising from the Target s activities in the purchaser s head company s tax returns. There may however be circumstances in which one or other of the vendor or purchaser might argue that, looking at the particular terms of the contract, it would be more appropriate for the point of transfer to be something other than what we would ordinarily term completion. It might for example be suggested that, where a company is sold based on the price set at the date of contract, with the purchaser getting the benefit of profits or losses based on that date to completion, the purchaser ought to account for those profits or losses for tax purposes. Any approach which takes into account the specific vagaries of the contract in determining when title passes, is however going to create a great deal of uncertainty and scope for considerable debate. The advent of consolidation will clearly make it necessary for vendors and purchasers to look at the appropriateness of the terms of their agreement. Some agreements which might have been entered into in the past may no longer be appropriate. In particular, a vendor who is letting the purchaser have the benefit of all profits from the date of contract may, at the very least, want the target to meet any tax payable on those profits. This is something which the target should be doing to satisfy section Any increase in the net assets of the Target from the date of contract to the date of settlement, will of course increase the tax cost setting amount of the membership interests of the vendor in the Target. Given the uncertainty about the time at which beneficial ownership might pass under a contract of sale, an attempt was made in the fourth batch of the consolidation legislation to provide a greater degree of certainty about the point in time at which title does pass where there is an arm s length sale of shares. wgcm M v Page 15

16 Section provides: Transfer time for sale of shares in company (1) This section applies if: under a contract: (i) (ii) a person (the seller) stops being entitled to be registered as the holder of a share in a company at a time (the transfer time); and another person (the buyer) becomes entitled to be registered as the holder of the share in the company at the transfer time; and (c) (d) as a result of the contract, the seller stops being the beneficial owner of the share, and the buyer becomes the beneficial owner of the share; and the seller and the buyer dealt with each other at arm s length in relation to the contract; and the seller and the buyer were not associates of one another at any time during the period: (i) (ii) starting when the contract was entered into; and ending at the transfer time. (2) For the purposes of subsection (1): the seller is taken to have stopped being the beneficial owner of the share at the transfer time; and the buyer is taken to have become the beneficial owner of the share at the transfer time. The section does make clear that the point in time at which the seller stops being treated as the beneficial owner and the point in time at which the buyer is to be treated as becoming the beneficial owner for section purposes is the same. It is clearly intended that section adopt what in most contracts of sale will be, in effect, a completion test. The point of transfer is meant to be the point in time at which the vendor has done all that needs to be done in order to facilitate the purchaser becoming the registered holder of the shares. As stated in paragraph of the Explanatory Memorandum to the New Business Tax System Consolidation and Other Measures) Bill (No. 2) 2002, the requirement that the purchaser bring the income of the Target into account commences when the vendor and the purchaser have done everything required under the contract to transfer ownership to the purchaser. In effect, the contract must have been performed to the point where the vendor has done all that he needs to do in order to put the purchaser in a position where the purchaser is able to get itself registered as the owner of the shares. 5 It is not intended that all formalities for registration of legal title to the shares must have occurred. Rather, the vendor must be in a position where they have no further interest in the shares and all that remains are for the formalities to be carried out. As stated in paragraph of the Explanatory Memorandum: 5 See, for example Re Rose (deceased); Midland Bank Executor and Trustee Co Ltd v Rose and Others [1948] 2 All ER 97. In Re Rose: Rose v Inland Revenue Commissioners [1952] 1 Ch 499. wgcm M v Page 16

17 Under this rule a member of a consolidated group will be entitled to be registered as the owner of shares in a purchased company, notwithstanding that it has not, for example, paid the relevant stamp duty, or obtained any approval of the transfer that may be required from the directors of the target company. 9. Issues to be considered in documentation At this point, its probably appropriate to summarise some of the issues which actually need to be considered when preparing sale documents. Consolidation, in effect, adds an extra dimension to the drafting of the share sale agreement. Most of the issues which have had to be considered in the past in drafting warranties, indemnities and appeal provisions, continue to be relevant, particularly in relation to taxes other than income tax and the potential exposure of the Target to its own income tax liability for periods during which it was not consolidated. It is therefore likely that we will continue to see many of the provisions which we have previously seen in sale agreements, albeit that they will not apply to income tax liabilities arising during the period of consolidation. Consolidation does raise a number of incremental issues where the Target has been a member of, or could retrospectively become a member of, a consolidated group. They include: (c) (d) (e) (f) (g) the availability of losses, foreign tax credits and franking credits of the Target; are the tax costs of assets of the Target those expected by the purchaser; retrospective elections to consolidate; liability to the Commissioner for consolidated group taxes; termination of liability, entitlement to payments under any contribution agreement for the funding by the head company of tax payments; continued access by the vendor to records of the Target; and the payment of a contribution amount to the head company by the Target at completion in accordance with section There is no clear way in which each of these issues should be dealt with. Vendors and purchasers will have different perspectives. Different issues will assume greater importance in different transactions. In practice, one has to be careful to understand what is important in a particular transaction and where the risks lie. 9.1 Losses, franking credits and foreign tax credits In many instances a purchaser may not be ascribing any value to the entitlement of the Target for losses, franking credits or foreign tax credits. If the purchaser does not, one would not expect the vendor to warrant them. If the Target is part of a consolidated group, but not the head entity, the purchaser knows it will not get losses, franking credits and foreign tax credits and should take that into account in framing the purchase price. wgcm M v Page 17