Adjusting Consolidation, Again 1. Background

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1 Tax Brief 9 October 2012 Adjusting Consolidation, Again The Board of Taxation has released another Discussion Paper in its ongoing review of the consolidation regime. One special focus of this paper is the way liabilities are handled on entry into, and exit from, a consolidated group. This Tax Brief outlines the issues that the Board is examining and some of the implications of the Board s reform proposals for the future. 1. Background During the last 3 years, work on reforms to consolidation has been happening in several projects. In 2009, the government asked the Board of Taxation to undertake a postimplementation review of the consolidation system. The Board decided to focus on three issues: the single entity rule, the entry history rule and the interaction between consolidation and the rest of the tax law. The Board circulated a Discussion Paper in late 2009 and held consultation meetings in early A Position Paper was released in late 2010 and further consultations occurred. The Board s report on these topics was delivered to the government in June 2012 but has not yet been released to the public. Meanwhile, in March 2011, the government asked the Board to revisit the rights to future income amendments which had been enacted in June 2010 (without the benefit of any prior review by the Board). The Board s report in May 2011 led to changes to the rights to future income rules which were enacted in June 2012 (see our Tax Briefs at and The Board s May 2011 report also recommended that the government examine further the treatment of liabilities and caps on the cost setting process. In November 2011, the government announced it would proceed with those recommendations. The current Discussion Paper arises from that project and deals principally with the treatment of liabilities on entry into, and exit from, a consolidated group, and some other aspects of the tax cost setting process. The Assistant Treasurer s Press Release in November 2011 announced a third proposal this time for changes to the operation of the taxation of financial arrangements (TOFA) rules for consolidated groups [to ensure] that, for consolidated groups, the TOFA Stages 3 & 4 provisions operate as intended and

2 that the tax treatment of financial arrangements that are liabilities is appropriate. Those amendments were enacted in June 2012 (see our Tax Briefs at and It was not clear at the time just how this third project about liabilities that were also TOFA financial arrangements related to the wider review of all liabilities, which was being announced at the same time. 2. The problems The Discussion Paper examines a collection of discrete problems. Most of the Paper focuses on the treatment of liabilities on entering a group although some other issues are also addressed. 2.1 Deductible liabilities that enter a group According to the Board s Paper, the current rules for handling the liabilities of subsidiary members that join a consolidated group disclose a number of problems. The Paper notes that the tax cost of liabilities owed by a subsidiary member is not generally reset at the time of entry, and this can lead to doublecounting and to an inaccurate tax outcome, when compared to the commercial result. Liabilities raise two problems that have to be managed: ensuring symmetry of treatment between sellers and buyers, and preventing doublecounting by buyers ie, ensuring that the same amount is not both added to the cost of assets and then separately claimed as a tax deduction on settlement. Although the demonstration of these points in the Paper leaves something to be desired, it is indisputable that the relevant rules are difficult and obscure. The Paper proposes four possible alternative ways of remedying the problems: deeming all deductible liabilities to be assumed by the head entity at their accounting value, at the time a subsidiary member joins a consolidated group; denying a deduction for deductible liabilities after the subsidiary member has joined the consolidated group; disregarding deductible liabilities in calculating the tax cost of assets on entering a group; or deeming the acquiring consolidated group to have realised a capital gain at the joining time equal to the amount of deductible liabilities entering the group. 2.2 Non-deductible liabilities that enter a group The Paper then examines the special case of a deferred tax liability entering a group with a subsidiary member. Again, the Board takes the view that the current rules can lead to double-counting and in this case pose an integrity risk. The solution proposed by the Board is to remove deferred tax liabilities as a component in the tax cost setting process for exit cases and entry cases. 2 Adjusting Consolidation, Again

3 2.3 Differing tax cost for liabilities The Paper notes a third problem under the legislation. Where the amount of a liability would have to be recorded at a different figure when it appears in the accounts of the head entity, rather than those of the joining entity, the rules employ the revised amount in determining the tax cost setting amount. The Paper proposes removing this adjustment largely on the basis that its original intent was to deal with deferred tax liabilities, and this issue would be dealt with by removing a deferred tax liability from the tax cost setting process. 2.4 Adjusting liabilities for timing differences Another problem in the legislation arises from the attempt to handle the differing times at which an item might be recorded for tax and accounting purposes. Complex adjustments are required when a liability is taken into account earlier in the financial accounts than it is for tax purposes, and the impact of the timing difference is to change other elements in the cost setting calculation (typically, the entries dealing with pre-acquisition profits and losses). Again, the Paper proposes removing this adjustment, but only in cases where the head entity is acquiring 100% of the subsidiary member. In staged acquisition cases, the adjustment may survive. 2.5 Which rules decide whether an asset or liability exists? Under the current rules, the existence of a liability is determined by the requirements of the accounting standards a liability is each thing that, in accordance with the joining entity s accounting principles for tax cost setting, is a liability of the joining entity. On the other hand, as a result of amendments made in June this year, the tax cost is reset for anything that is an asset for tax law purposes. The ATO had previously issued a Ruling that an asset was anything of commercial value, and would include both assets for tax purposes and assets recognised under accounting standards. The June 2012 amendments which confine asset just to tax assets were made as a result of a recommendation in the Board s 2011 Report but it now appears that this has created, or at least exacerbated, the disjunction between the concepts of asset and liability in the consolidation context. Some rules in consolidation link liabilities and assets, but the Paper is concerned about potential problems arising from the broader disjunction that the liability may be recognised but not the associated asset and vice versa, because law and accounting differ in what they recognise. This kind of problem is, perhaps, to be expected given the equivocal reliance by tax law on using accounting standards. The Paper proposes a tentative solution to this issue to create a liability for tax purposes where an asset exists but no accounting liability, and to disregard the liability for tax purposes where no asset exists but an accounting liability does. The Paper asks for comments on this proposal. 3 Adjusting Consolidation, Again

4 2.6 Capping the tax cost setting amount Under the current cost setting rules, when a subsidiary member joins a group, the cost of some of its assets is not reset, the cost of other assets is reset but capped (generally to the higher of cost and market value), and the cost of other assets is reset without an upper limit. The Board had proposed in its 2011 Report that the tax cost of all reset assets should be capped at the higher of cost and market value, and where the head entity has paid a premium (ie, the available allocable cost exceeds the market value of the reset cost assets) the surplus should be treated as paid for goodwill, or else give rise to an immediate capital loss. The 2012 Paper repeats that proposal and solicits comments on it. (Not surprisingly, there is no proposal to remove CGT event L5 which happens where the converse situation arises). 2.7 Rollovers and other provisions The last topic addressed in the Paper is the perennial problem of making the rest of the legislation work properly when one party to a transaction is a consolidated group. Rules that make sense in isolation will often not give full effect to the outcome that consolidation would imply. The examples used in the Paper involve the CGT rollover rules which dictate that an acquirer inherits as its cost in shares the transferor s cost in the shares. While these provisions preserve the deferred tax not collected from the transferor and make it the acquirer s liability, the prescriptive nature of the rules means they will sometimes omit some of the other elements which the acquirer should be entitled to add when calculating its allocable cost amount. Similar problems can arise when the acquirer s cost is derived from the target s costs in its assets. A circular process seems to result the acquirer uses the cost of the assets to derive the cost in the shares which is then pushed down as the cost of the assets. The Paper proposes a range of discrete solutions to the miscellaneous problems identified but the discussion is principally directed at soliciting suggestions about how to handle the issue. 3. Some comments Two taxpayers handling one liability asymmetrically. The issues surrounding the treatment of deductible liabilities on entering consolidation are not intractable, but the discussion of them in the Paper is confused and confusing. Outside consolidation, when liabilities pass with an asset they are treated as additional proceeds for a seller (making any gain higher), and additional cost for a buyer (which will matter when the asset is sold). This treatment makes sense in a tax system where the seller s cost in an asset includes amounts it borrowed to acquire the asset, even though the seller hasn t yet repaid the debt. The logic of the consolidation entry and exit calculations is intended to get to the same result, albeit in a different manner. When a seller sells a company with a 4 Adjusting Consolidation, Again

5 liability in its accounts the seller is required to reduce its cost in the company by an amount representing the liability (ie, Step 4 in the exit calculation) (which has the same effect as adding an amount for the liability to the seller s proceeds) and the buyer acquires cost of an amount representing the liability (step 2 in the entry calculation) (which will matter when the asset is sold). In the long term it should not matter to the government if the liability in the company is handled in this way or is simply disregarded for both parties, although the decision will clearly affect the time at which tax is collected (ie, more tax at time of sale of the company v. more tax at the time of the sale of the company s assets) and the division of the total tax debt between the parties. Unfortunately, the discussion of how best to handle liabilities in the Paper is confused. The Paper uses a prolonged Example which is said to show a number of problems the value of liabilities are not reset and there is double recognition of liabilities first by the vendor and then in the hands of the target. The Example does not demonstrate this. It shows and is driven entirely by asymmetrical treatment. In the Board s interpretation of the relevant provisions (provisions which are very difficult and may not always lead to the asserted treatment), the seller does not trigger a higher gain by being relieved of the liability, but the buyer does increase its costs by an amount for the liability arriving in the company. So it is not surprising that the Example shows a problem, but that problem is not a structural one the problem is that the legislation does not execute a clear, consistent policy. Double-counting liabilities, by the same taxpayer. On the other hand, there is a real double-counting problem which requires a solution, but it is a problem that arises where the same amount is for the buyer both (i) cost in an asset and (ii) an allowable deduction. (Unfortunately, when the Paper talks about doublecounting it is often describing the previous problem where both the buyer and seller are benefiting from the same liability.) But the real double-counting problem which requires a structural solution is the double counting that would happen if the same amount were treated for the buyer as both cost and a deduction. The four solutions to this problem in the Paper are all complex and come at the issue rather obliquely. One would require tracking liabilities over time and another could trigger capital gains at the time of buying a company. But the most obvious solution to the issue is a rule which, at the moment of consolidation, makes a demarcation and determines which parts of the amount paid by the buyer are to be treated as deduction and which go to cost. Again, this is not canvassed in the Paper. Which liabilities will be affected? The Paper does not discuss how its proposals would fit with the very significant amendments made in June 2012 by Tax Laws Amendment (2012 Measures No 2) Act This Act introduced highly elaborate amendments adjusting the tax cost of liabilities that are financial arrangements governed by TOFA. Since most groups that have elected to consolidate will probably also be sufficiently large that they are obliged to apply 5 Adjusting Consolidation, Again

6 TOFA to their financial arrangements, it is not obvious how the proposals in the Paper and the recent amendments are intended to fit. 4. Next steps There is no indication in the Paper about the likely start date for the measures being canvassed whether they will be back-dated or will be prospective only. This is an important project and could well have significant impacts in merger and acquisition transactions. Greenwoods & Freehills has been engaged by the Board of Taxation to help its work on this project. The Board is seeking submissions on the Paper by 12 October Greenwoods & Freehills is available to assist clients who wish to make a submission. For further information, please contact: Sydney Richard Hendriks richard.hendriks@gf.com.au phone Joshua Cardwell joshua.cardwell@gf.com.au phone Daniel Sydes daniel.sydes@gf.com.au phone Melbourne Ken Spence ken.spence@gf.com.au phone Richard Buchanan richard.buchanan@gf.com.au phone G&F document ID _3.DOC These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney Level 39 MLC Centre Martin Place Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax Adjusting Consolidation, Again