NSW 6 TH ANNUAL TAX FORUM

Transcription

1 NSW 6 TH ANNUAL TAX FORUM An Update on the Consolidation Regime (Part 2): Case Study Written by: Craig Marston, CTA Senior Associate Greenwoods & Freehills Julian Pinson Senior Associate Greenwoods & Freehills Presented by: Craig Marston, CTA Senior Associate Greenwoods & Freehills Julian Pinson Senior Associate Greenwoods & Freehills NSW Division 16 May 2013 Hilton, Sydney Craig Marston & Julian Pinson 2013 Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 An Update on the Consolidation Regime (Part 2): Case Study CONTENTS 1 Overview Facts Head Co and Joining Co Joining Co s assets and liabilities Trail Rights WIP Receivable Client list Currency forwards Questions Answers Right to future income assets Introduction Trail Rights WIP Receivable Client list Introduction Tax cost setting Deduction for Head Co? Stationery and other consumables Introduction Tax cost setting Deduction for Head Co? Goodwill Tax cost setting Deduction for Head Co? Currency forwards Introduction Craig Marston & Julian Pinson

3 An Update on the Consolidation Regime (Part 2): Case Study Forwards entered into on 1 August Forwards entered into on 1 August Summary of conclusions Craig Marston & Julian Pinson

4 1 Overview This case study is intended to illustrate the practical implications of recent amendments to the consolidation rules in Part 3-90 of the Income Tax Assessment Act 1997 that affect the treatment of assets and liabilities that a joining entity brings into a group. In particular, this case study focuses on: the treatment of non-cgt assets such as customer relationships; the treatment of right to future income (RTFI) assets; implications for amounts that are allocated to goodwill; and the treatment of accounting liabilities, including the interaction of the consolidation and taxation of financial arrangements (TOFA) regimes. The recent amendments that affect these areas are discussed in detail in the Session 2B: An Update on the Consolidation Regime (Part 1) paper delivered at this conference by Andrew Hirst and Daniel Sydes of Greenwoods & Freehills (Hirst & Sydes Paper). This case study should be read in conjunction with the Hirst & Sydes Paper. This case study only deals with the consolidation rules as they apply to joining events on or after 30 March It does not deal with the different sets of rules that apply to joining events prior to that date, which are discussed in the Hirst & Sydes Paper. All legislative references in this case study are to the Income Tax Assessment Act Craig Marston and Julian Pinson, Greenwoods & Freehills

5 2 Facts 2.1 Head Co and Joining Co Head Co is the head company of a tax consolidated group (TCG). Head Co is a major Australian financial services and wealth management company. On 1 July 2013, Head Co acquires 100% of the shares in Joining Co, which becomes a subsidiary member of the Head Co TCG. Prior to this point, Joining Co was a standalone taxpayer and not a member of another TCG. Joining Co, amongst other things, acts as the operator of an investor directed portfolio service (IDPS) (also referred to in this case study as an investment platform). Broadly, retail investor clients gain access to certain wholesale type investments through the investment platform. In return, the operator charges clients a portfolio administration fee based on the NAV of the particular client s investments held through the investment platform. The administration fees are charged to the client s cash account (within the investment platform) in arrears on the last day of each month. Both Head Co and Joining Co have been subject to the TOFA rules in Division 230 from 1 July Neither company made the TOFA un-grandfathering election (i.e. their pre-1 July 2010 financial arrangements were not brought within Division 230). Neither company has elected into any of the four TOFA elective methods (the fair value, FX retranslation, hedging and financial reports methods). 2.2 Joining Co s assets and liabilities Joining Co s assets and liabilities (as reflected in Joining Co s financial accounts) at the time it joins the Head Co TCG include: rights to receive portfolio administration fees from existing clients for future portfolio administration services to be performed by Joining Co (Trail Rights); a work-in-progress receivable (WIP Receivable); a client list containing the names and contact details of certain high net wealth past and present clients; some stationery and other consumables used in Joining Co s business; and two equal and offsetting non-deliverable currency forwards an in-the-money forward (an asset) and an out-of-the-money forward (a liability) (together the forwards). Further details of these assets and liabilities are set out below. Craig Marston and Julian Pinson, Greenwoods & Freehills

6 2.2.1 Trail Rights Pursuant to a deed poll previously executed by Joining Co and the IDPS Guide, together with the application form attached to the IDPS Guide that is signed by clients when investing through the investment platform, Joining Co (as operator) has the contractual right to charge clients portfolio administration fees on an ongoing basis. Whilst clients can cease investing through the investment platform at any time by requesting that the operator sell their investments and return any remaining cash, as a practical matter, based on past experience, Joining Co can reliably estimate the extent to which existing clients will make future withdrawals from the investment platform. On that basis, Joining Co can reliably estimate its right to receive future portfolio administration fees from existing clients. As at 1 July 2013, there are some 100,000 separate contracts with clients who invested through the investment platform, and therefore 100,000 separate Trail Rights WIP Receivable Joining Co has performed certain consulting services under a contract between Joining Co and a related company that also operates an IDPS. As at 1 July 2013, these services have only been partially performed by Joining Co and not to such an extent that a recoverable debt has arisen Client list Joining Co has previously from time to time allowed certain of its related companies to access Joining Co s client list for a fee Currency forwards Joining Co entered into the forwards on 1 August 2010 and they will settle on 1 August Joining Co entered into one forward with a client and an equal and offsetting forward in the market to hedge its position, such that (outside of consolidation) a gain/loss on one forward should be assessable/deductible and offset by an assessable/deductible gain/loss on the other. On 1 July 2013, the in-the-money forward is recognised in Joining Co s financial accounts as an asset with a fair value of $1m and the out-of-the-money forward is recognised as a liability with a fair value of ($1m). Consistent with expectations at the joining time, the values of the forwards do not change prior to settlement, such that on 1 August 2013, Joining Co pays $1m to settle the out-of-the-money forward and receives $1m on settlement of the in-the-money forward. Craig Marston and Julian Pinson, Greenwoods & Freehills

7 3 Questions Right to future income assets, client list and stationery and other consumables 1. How is the tax cost set in respect of each asset held by Joining Co that is acquired by Head Co? 2. What deductions (if any) are available to Head Co in respect of its acquisition of those assets? Currency forwards 1. How will the tax cost setting rules apply to the in-the-money and out-of-the-money forwards at the joining time (in particular, consider ss (5a) and )? 2. In high level terms, how will Head Co recognise tax gains and losses in relation to the forwards over their remaining periods and on settlement? 3. Would the answers to 1. and 2. differ if Joining Co had entered into the forwards on 1 August 2009 rather than 1 August 2010? Craig Marston and Julian Pinson, Greenwoods & Freehills

8 4 Answers 4.1 Right to future income assets Introduction The right to future income asset examples (i.e. the Trail Rights and the WIP Receivable) are intended to illustrate the application of the Prospective Rules made by the Tax Laws Amendment (2012 Measures No. 2 Act) 2012 (2012 Amendments) to certain so-called right to future income assets. As this acquisition took place after 30 March 2011 the Prospective Rules contained in the 2012 Amendments apply. The general operation of and policy underlying the 2012 Amendments is discussed in detail in the Hirst & Sydes Paper and is not repeated here. In very broad terms: s (5)(d) makes an asset that is a right to future income (other than a WIP amount asset ) a retained cost base asset. A right to future income is defined in s (5) as, broadly, a valuable right to receive an (assessable) amount at a later time where that right forms part of a contract or agreement and has a market value (taking into account related obligations and conditions) that is greater than nil. s (5c) is intended to provide a head company with an immediate deduction under s for the tax cost setting amount allocated to a WIP amount asset. A WIP amount asset is defined in s (6) as, broadly, an asset that is in respect of work (but not goods) that has been partially performed for a third entity but not yet completed to the stage where a recoverable debt has arisen in respect of the completion or partial completion of that work. s is intended to prevent tax cost being allocated to assets that are not ordinarily recognised for income tax purposes. This is done by restricting Part 3-90 (i.e. the consolidation rules) to CGT assets, revenue assets, depreciating assets, trading stock and to a thing that is or is part of a Division 230 financial arrangement Trail Rights Tax cost setting The starting point is to consider whether these are assets to which Part 3-90 applies. In this regard, as noted above, s restricts the assets to which tax cost can be allocated under the consolidation rules. The Trail Rights should be assets in the required sense. In this regard, in Taxation Ruling TR 2004/13, the Commissioner expresses his views on what is an asset for the purposes of the Craig Marston and Julian Pinson, Greenwoods & Freehills

9 consolidation rules. The Ruling states that asset in Part 3-90 is not defined in the income tax legislation, and that this omission is consistent with the word asset being given its ordinary commercial or business meaning. To that end, the Ruling notes (at paragraph 5): Accordingly, an asset for the purpose of the tax cost setting rules is anything recognised in commerce and business as having economic value to the joining entity at the joining time for which a purchaser of its membership interests would be willing to pay. The business or commercial assets of a joining entity would include the things that would be expected to be identified by a prudent vendor and purchaser as having value in the making of a sale agreement in respect of all the membership interests in an entity and its business. These assets would also come within the scope of a due diligence examination undertaken on behalf of a prudent purchaser of such an entity and business. The Trail Rights clearly have economic value to Joining Co. These rights represent the value of Joining Co s expected future income from portfolio administration fees from existing clients (i.e. as at 30 June 2013). In this sense, the Trail Rights are something separately identifiable from the goodwill of Joining Co s business that is valuable from both Head Co (as the purchaser) and the vendor of Joining Co s perspectives. The Trail Rights should be CGT assets on the basis that rights to future portfolio administration fees constitute any kind of property or a legal or equitable right that is not property (refer s which defines a CGT asset ). Absent the application of s it is likely that the Trail Rights would also be revenue assets (as defined in s ). On the basis that the Trail Rights are assets for the purposes of s , then it is necessary to set a tax cost in respect of each Trail Right. This involves pushing down part of Head Co s costs of acquiring Joining Co onto Joining Co s assets that are joining the group. As an incident of the single entity rule in s.701-1, Head Co is taken to hold Joining Co s assets from the time Joining Co joins Head Co's TCG. In this regard, s (4) provides: Each asset s *tax cost is set at the time the entity becomes a *subsidiary member of the group at the asset s *tax cost setting amount. The expression tax cost is set is defined in s Relevantly, in this regard, s (5) provides: If Part 3-1 or 3-3 is to apply in relation to the asset, the expression means that the Part applies as if the asset s *cost base or *reduced cost base were increased or reduced so that the cost base or reduced cost base at the particular time equals the asset s *tax cost setting amount. The Trail Rights tax cost setting amount is worked out using the table in s Item 1 of the table in s provides that if the relevant asset s tax cost is set by s , then the asset s tax cost setting amount is determined in accordance with Division 705. Subsection (2) articulates the object of Division 705: 1 In broad terms, s (2) (introduced as part of the Prospective Rules) provides in relation to each joining asset (to which the residual tax cost setting rule in s (6) applies): [t]reat the *head company as having acquired each of those assets at the joining time as part of acquiring the business of the joining entity as a going concern. The consequence of this provision is that, in many cases, the acquisition of assets (such as Trial Rights) that when viewed separately could arguably be considered revenue assets, must instead be viewed collectively and in the context of the augmentation of the head company s profityielding subject. Viewed in this way, their acquisition is more likely to be on capital account. Craig Marston and Julian Pinson, Greenwoods & Freehills

10 The object of this Subdivision is to recognise the *head company s cost of becoming the holder of the joining entity s assets as an amount reflecting the group s cost of acquiring the entity. That amount consists of the cost of the group s *membership interests in the joining entity, increased by the joining entity s liabilities and adjusted to take account of the joining entity s retained profits, distributions of profits, deductions and losses. The starting point is to consider whether the Trail Rights are retained cost base assets. The definition of this term is in s (5). Of relevance is s (5)(d) which provides that a retained cost base asset is a *right to future income (other than a *WIP amount asset). If the Trail Rights satisfy s (5)(d), then s (4b) is relevant: If the *retained cost base asset is covered by paragraph (d) of the definition of that expression, its *tax cost setting amount is equal to the joining entity's *terminating value for the asset. Discussed below are the meaning of the expressions right to future income and WIP amount asset before considering the consequences for Head Co of s (4b) applying to the Trail Rights. Right to future income Under s (5): A right to future income is a valuable right (including a contingent right) to receive an amount if: (a) the valuable right forms part of a contract or agreement; and (b) the *market value of the valuable right (taking into account all the obligations and conditions relating to the right) is greater than nil; and (c) the valuable right is neither a *Division 230 financial arrangement nor a part of a Division 230 financial arrangement; and (d) it is reasonable to expect that an amount attributable to the right will be included in the assessable income of any entity at a later time. The Trail Rights should satisfy this definition. In particular, the Trail Rights should be valuable rights in the relevant sense. In this regard, the fact that the accounts of Joining Co at the joining time recognise an asset with respect to the Trail Rights indicates that they are of value. The Trail Rights should also satisfy the specific conditions contained in the definition in s (5) for the following reasons: Contract or agreement The Trail Rights should form part of a contract. In this regard, as discussed above, when clients sign the application form accompanying the IDPS Guide, then the combination of the signed application form, the IDPS Guide and the Deed Poll provides the contractual framework for clients investing through the investment platform. In particular, under that contractual framework, Joining Co has rights to charge clients the portfolio administration fee on an ongoing basis. Obligations and conditions Paragraph (b) in s (5) directs that it is necessary to take into account all the obligations and conditions relating to the right when determining whether the market value of the right is Craig Marston and Julian Pinson, Greenwoods & Freehills

11 greater than nil. The scope of this requirement is not free from doubt (as was the case in the context of former s (1)(b) in the ill-fated consolidation amendments introduced in 2010 discussed below). However, for the purposes of this case study it is sufficient to assume that Trail Rights do have a market value greater than nil on the basis that Joining Co has ascribed a value to the Trail Rights in its financial accounts. For completeness, one potential obligation/condition relating to the Trail Rights could be an obligation for Joining Co to pay a client s financial adviser an ongoing commission based on the amount of portfolio administration fees charged to their client. However, as such commissions should generally only represent a percentage of the total portfolio administration fee paid by a client, then, even if such commissions were considered to relate to Trail Rights, the market value of the Trail Rights should nonetheless remain greater than nil. Division 230 does not apply The Trail Rights should be neither a Division 230 financial arrangement nor part of a Division 230 financial arrangement. In this regard, under the arrangement between Joining Co (as operator) and its clients, Joining Co has an obligation to provide administration services to its clients and that obligation is not cash settlable (refer s (1)(e)(ii)) and is not insignificant in the context of the arrangement as a whole (refer s (1)(f)). Future amounts of assessable income It is reasonable to expect that Head Co s assessable income will, at a time after the joining time, include portfolio administration fees (i.e. amounts attributable to the Trail Rights acquired on consolidation). Accordingly, each Trail Right satisfies the definition of a right to future income asset. In this regard, the Explanatory Memorandum to the Bill that introduced the 2012 Amendments notes that the definition of a right to future income in the Prospective Rules is broader than that in the pre-rules and the interim rules. That is, a right to future income is not restricted to rights to receive an amount for the performance of work or services or the provision of goods. Per paragraph of the Explanatory Memorandum: This will ensure that other contractual rights to future income (such as a right to income that arises under an insurance contract or a reinsurance contract) are treated as retained cost base assets. WIP amount asset Even though Trail Rights are a right to future income, they will not be retained cost base assets under s (5)(d) if they are also WIP amount assets. Under s (6): WIP amount asset means an asset that is in respect of work (but not goods) that has been partially performed by a recipient mentioned in paragraph 25-95(3)(b) for a third entity but not yet completed to the stage where a recoverable debt has arisen in respect of the completion or partial completion of the work. Section 25-95(3) provides: An amount is a work in progress amount to the extent that: Craig Marston and Julian Pinson, Greenwoods & Freehills

12 (a) an entity agrees to pay the amount to another entity (the recipient ); and (b) the amount can be identified as being in respect of work (but not goods) that has been partially performed by the recipient for a third entity but not yet completed to the stage where a recoverable debt has arisen in respect of the completion or partial completion of the work. The Trail Rights are not WIP amount assets in the relevant sense. The Trail Rights relate to future portfolio administration services to be performed by Joining Co as the operator of the investment platform in respect of existing clients. It is not the case that Joining Co has partially performed the relevant services. Instead, on the basis that the portfolio administration fees are paid monthly in arrears, then the Trail Rights represent the expectation of income from the provision of future services. On the basis that the Trail Rights are right to future income assets that are not WIP amount assets, then they meet the definition of a retained cost base asset in s (5)(d). Consequently, under s (4b), each Trail Right s tax cost setting amount is equal to Joining Co s terminating value for each Trail Right. Section defines an asset s terminating value. Specifically, s (4) is relevant in the case of the Trail Rights: If an asset of the joining entity is a *CGT asset that is not covered by any of the above subsections, the joining entity's terminating value for the asset is equal to the asset's *cost base just before the joining time. As a practical matter, the Trail Rights are likely to have a nil cost base. In this regard, to the extent Joining Co has incurred any expenses in relation to Trail Rights, those expenses are unlikely to form part of their cost base. In particular, it can be expected that most of the expenses related to the Trail Rights (marketing, operational expenses, etc.) should have been deductible when incurred under s.8-1 as ordinary business expenditure. One advantage of this outcome is that, because valuable allocable cost amount (ACA) is not allocated to these assets, then more ACA can potentially be allocated to Joining Co s reset cost base assets. Deduction for Head Co? As discussed above, on the basis that a nil TCSA is likely to be allocated to the Trail Rights, then Head Co could not claim a deduction for acquiring the Trail Rights. For completeness, it is interesting to contrast this result with the outcome that was (arguably) intended under the former rights to future income provisions enacted by the Tax Laws Amendment (2010 Measures No. 1) Act 2010 (2010 Rules). In very broad terms: Former s (5c) provided that if an asset was covered by (now former) s , then (now former) s applied so that the tax cost setting amount was deductible over a period of up to 10 years. Former s provided certain conditions for that section to cover an asset. In particular, one of these conditions was that that asset needed to be a valuable right covered by former Craig Marston and Julian Pinson, Greenwoods & Freehills

13 s (1). Whilst not elaborated here, for reasons provided above, the Trail Rights should also satisfy the other conditions in former s Former s (1) provided that that subsection covered a valuable right to receive an amount for the performance of work or services or the provision of goods (other than trading stock) if certain conditions were satisfied. Those conditions are the same as those contained in the current paragraphs (a) and (b) in s (5) already discussed (i.e. that the valuable right forms part of a contract or agreement and that the market value of the valuable right is greater than nil). For the reasons outlined above in relation to those paragraphs, the conditions in former s (1) should be satisfied. Having regard to the above, and to the fact that, in the 2010 Rules, the Trail Rights would not have been retained cost base assets, then if the 2010 Rules applied, there are strong arguments to support the proposition that Head Co should have been entitled to deduct the tax cost setting amount allocated to the Trail Rights over a term of up to ten years (depending on the particular circumstances) WIP Receivable Tax cost setting The WIP Receivable should be a commercial or business asset (in the context of TR 2004/13) to which the consolidation provisions apply. In this regard, the WIP Receivable is a CGT asset (either because it is a kind of property or, failing that, a legal or equitable right that is not property ). On the basis that it is a CGT asset, then s (a) applies. Subsection (5C) defines the expression the tax cost is set for WIP amount assets as follows: If: (a) the asset's tax cost is set because an entity becomes a *subsidiary member of a *consolidated group at the particular time; and (b) the asset is a *WIP amount asset; the expression means that section applies as if the *head company had paid a *work in progress amount for the income year in which the particular time occurs equal to the *tax cost setting amount of the asset. The definition of WIP amount asset has previously been stated. The WIP Receivable is clearly a WIP amount asset. Consequently, s (5c) should apply. The tax cost setting amount is determined under Division 705. The WIP Receivable should not be a retained cost base asset under s (5)(d) because it is a WIP amount asset. The WIP Receivable should not satisfy any other condition for a retained cost base asset in s (5). Consequently, the WIP Receivable should be a reset cost base asset with its tax cost setting amount determined under s (1). In broad terms, the amount worked out under s (1) will depend on Head Co s ACA in Joining Co, the tax cost setting amount (if any) allocated to Joining Co s Craig Marston and Julian Pinson, Greenwoods & Freehills

14 retained cost base assets and the market values of all of the reset cost base assets, including goodwill (refer discussion below). Deduction for Head Co? Subsection 25-95(1) provides: You can deduct a *work in progress amount that you pay for the income year in which you pay it to the extent that, as at the end of that income year: (a) a recoverable debt has arisen in respect of the completion or partial completion of the work to which the amount related; or (b) you reasonably expect a recoverable debt to arise in respect of the completion or partial completion of that work within the period of 12 months after the amount was paid. Given that s (5c) applies to the WIP Receivable, then Head Co should be deemed to have paid the tax cost setting amount allocated to that receivable in the 2014 income year. Accordingly, Head Co should be entitled to a deduction for that amount in that year. This conclusion is consistent with the intention articulated in the Explanatory Memorandum to the Bill that introduced the 2012 Amendments (refer paragraphs and 3.103). 4.2 Client list Introduction The client list example is intended to illustrate the application of the Prospective Rules to certain assets that are not ordinarily recognised for tax purposes. As discussed in more detail in the Hirst & Sydes Paper, there were some changes to the accounting standards applying to intangible assets that were made around the same time as the 2010 amendments. In this regard, according to the Board of Taxation 2 : The identification of these types of assets has arisen partly because of changes to the accounting standard for intangible assets (AASB 138) which coincided with the amendments to the consolidation residual tax cost setting rules. The changes to the accounting standards effectively require goodwill to be split into a range of separate assets for accounting purposes. Some taxpayers are using the same approach to identify and deduct the reset tax costs for intangible assets akin to goodwill under the rights to future income rules. As noted above, in response to this concern, the Prospective Rules introduce s which is intended to prevent tax cost being pushed down onto assets that are not ordinarily recognised for tax purposes. 2 Refer to paragraph 4.13 of the Board of Taxation s report Review of the consolidation rights to future income and residual tax cost setting rules, May Craig Marston and Julian Pinson, Greenwoods & Freehills

15 4.2.2 Tax cost setting The starting point is to consider whether the client list is an asset. In the commercial or business context of Joining Co, the client list is something that has economic value to Joining Co at the joining time for which Head Co would be willing to pay (refer paragraph 5 of TR 2004/13). In this regard, the client list has previously generated income for Joining Co from being rented out to other organisations. Despite this, it is likely that this client list will not satisfy any of the conditions in s (in particular, the client list may not be a CGT asset ) with the consequence that Joining Co s client list would not be recognised as a separate asset to which tax cost could be allocated under the consolidation rules. This conclusion appears to be the result intended by the 2012 Amendments. In this regard, paragraph 3.94 of the Explanatory Memorandum notes, relevantly: Examples of assets that may not be CGT assets, revenue assets, depreciating assets, trading stock or Division 230 financial arrangements include: customer related intangible assets such as customer lists, order or production backlogs, and customer relationships; Notwithstanding this intention, as discussed in more detail in the Hirst & Sydes Paper, because there is no separate deeming of these customer related intangible assets to be part of Joining Co s goodwill, then it would still appear open to separately identify and value them, rather than including their value in Joining Co s goodwill. This exercise would effectively reduce the value of goodwill, thus increasing the proportionate value of other reset cost base assets of Joining Co for the purposes of allocating ACA to those reset cost base assets pursuant to s Deduction for Head Co? Given that no tax cost is set for the client list, then Head Co cannot obtain a tax deduction under any provision as a consequence of acquiring this asset. 4.3 Stationery and other consumables Introduction The stationery and other consumables example is intended to illustrate the application of the Prospective Rules to certain types of consumable stores Tax cost setting Stationery and other consumable stores should generally be assets to which s applies. In this regard, such assets are likely to be one or more of a CGT asset, a revenue asset or a depreciating asset. Craig Marston and Julian Pinson, Greenwoods & Freehills

16 Subsection (5D) provides: If: (a) the asset's tax cost is set because an entity becomes a *subsidiary member of a *consolidated group at the particular time; and (b) the asset is consumable stores; the expression means that, for the purposes of section 8-1, the *head company of the group is taken to have incurred an outgoing at the particular time in acquiring the asset equal to the asset's *tax cost setting amount. Stationery and other consumable stores should not meet any of the conditions to be a retained cost base asset. Instead, these assets are reset cost base assets. Their tax cost setting amount will be worked out in the ordinary way under s Deduction for Head Co? Head Co should be entitled to deduct under s.8-1 the full amount of the tax cost setting amount allocated to Joining Co s stationery and other consumables in the 2014 income year. In this regard, by virtue of s (5d), Head Co is deemed to have incurred, on acquiring the stationery and other consumables, an amount equal to their tax cost setting amounts. This conclusion is consistent with the intention of the 2012 Amendments, as expressed in the Explanatory Memorandum to the Bill that introduced the 2012 Amendments (at paragraph 3.106): The modification inserted by the pre-rules to ensure that the head company can apply the general deduction provision to deduct the reset tax costs for consumable stores is retained under the prospective rules. 4.4 Goodwill Tax cost setting Any goodwill acquired by Head Co in Joining Co is an asset of Joining Co. In this regard, the High Court in Federal Commissioner of Taxation v Murry (1998) 193 CLR 605 held: Goodwill is inseparable from the conduct of a business. It may derive from identifiable assets of a business, but it is an indivisible item of property, and it is an asset that is legally distinct from the sources including other assets of the business that have created the goodwill. On the basis that goodwill is a kind of property, then it is a CGT asset and therefore an asset to which the consolidation rules apply (refer ss.108-5(1) and ). On that basis, s (5) applies so that, broadly, the cost base and reduced cost base of that goodwill asset equals the asset s tax cost setting amount. Goodwill does not meet any of the conditions in s (5) to be a retained cost base asset. Accordingly, it is a reset cost base asset and so the asset s tax cost setting amount will be Craig Marston and Julian Pinson, Greenwoods & Freehills

17 determined under s In this regard, as noted above, assets that are not recognised for tax cost setting purposes (such as customer related intangible assets ) are not deemed to be part of goodwill under the Prospective Rules. In this regard, the High Court in Murry also held: That which can be assigned and transferred from the business may, while it is connected to the business, be a source of the goodwill of the business but cannot logically constitute any part of the goodwill of the business. If such assets are valued separately from goodwill, then this has the consequence of reducing the value of goodwill for tax cost setting purposes. In turn, this increases the proportionate value of other reset cost base assets of Joining Co when allocating ACA for the purposes of s Head Co may anticipate certain synergies associated with acquiring Joining Co s business, such as lower operational costs and increased access to Joining Co s clients for cross selling purposes. If that is the case, then s (3) deems such synergistic goodwill that accretes to Head Co at the time of consolidating Joining Co to be a separate asset of Joining Co for the purposes of allocating ACA to that asset. That asset then becomes an asset of Head Co because of the single entity rule. The practical consequence of this, is that, potentially, less ACA is allocated to other reset cost base assets of Joining Co that could better use that tax cost (such as revenue assets and depreciating assets). The 2012 Amendments did not involve changes to s (3). The Commissioner s views on the interpretation of s (3) are set out in Taxation Ruling TR 2005/ Deduction for Head Co? Head Co should not be entitled to a tax deduction in respect of any tax cost allocated to goodwill. 4.5 Currency forwards Introduction The currency forwards example is intended to illustrate the application of the TOFA/consolidation interaction provisions in ss (5a) and , and in particular the impact of the changes to s made by the 2012 Amendments on TOFA liabilities that a joining entity brings into a group. The general operation of and policy underlying ss (5a) and is discussed in detail in the Hirst & Sydes Paper and is not repeated here. In very broad terms: ss (5a) and are intended to apply to assets and liabilities, respectively, of a joining entity if Division 230 will apply to the assets/liabilities in the hands of the head company if Division 230 will apply, then those provisions treat the assets/liabilities as being acquired/assumed by the head company at the joining time and set their tax cost/value; and following the 2012 Amendments, s is also intended to prevent a head company from obtaining a double benefit in respect of deductible TOFA liabilities that a joining entity brings into a group, in the sense of an increase at Step 2 of the ACA calculation at the joining time and a Craig Marston and Julian Pinson, Greenwoods & Freehills

18 subsequent deduction when the liability is discharged. Section only applies to TOFA liabilities; under current law, a head company can still, broadly speaking, obtain such a double benefit in respect of non-tofa liabilities that a joining entity brings into a group. As this example demonstrates, in broad terms, following the 2012 Amendments ss (5a) and work adequately in the context of assets/liabilities that are subject to TOFA in the hands of both the joining entity and the head company (such as the present case where Joining Co entered into the forwards on 1 August 2010). However, there is considerable uncertainty regarding how the provisions operate where a joining entity s assets and liabilities have not been subject to TOFA in its hands (for instance, because they are pre-tofa arrangements) Forwards entered into on 1 August 2010 Financial arrangements subject to Division 230 Section (5A) only applies to an asset If Division 230 is to apply in relation to the asset. As discussed in the Hirst & Sydes Paper, it is generally accepted that this is a test of whether Division 230 is to apply in relation to the asset in the hands of the head company. Similarly, s only applies to a liability if it is or is part of a *Division 230 financial arrangement of the head company at the joining time. A financial arrangement is a Division 230 financial arrangement if Division 230 applies to the taxpayer s gains and losses from the arrangement (s.995-1(1)). Accordingly, ss (5a) and will only apply to the in-the-money and out-of-the-money forwards, respectively, if they (i) are financial arrangements, and (ii) will be subject to Division 230 in the hands of the head company. Financial arrangements The currency forwards are financial arrangements as defined in s : Joining Co has rights to receive and obligations to pay amounts of money and the forwards should not involve not insignificant rights/obligations that are not cash settlable. Division 230 financial arrangements None of the exceptions to the operation of Division 230 for certain financial arrangements as set out in Subdivision 230-H should apply to the forwards. Therefore, subject to the Division 230 transitional rules, the forwards should be subject to Division 230 in the hands of Head Co. Because Head Co did not make the TOFA un-grandfathering election, Division 230 applies to Head Co s financial arrangements that it started to have on or after 1 July When determining whether Division 230 will apply to an asset/liability in the hands of a head company for the purposes of ss (5a) and , it is not entirely clear if: 3 Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (TOFA Act) item 104. Craig Marston and Julian Pinson, Greenwoods & Freehills

19 whether Division 230 will apply must be tested before ss (5a) and apply to deem the asset/liability to have been acquired/assumed at the joining time (in other words, the asset/liability must be subject to Division 230 in the hands of the head company applying the entry history rule and ignoring the effect of the deemed acquisition); or Division 230 must apply to the asset/liability following the head company having been deemed to have acquired/assumed the asset/liability at the joining time. This issue is discussed further in section below. Regardless of which approach is correct, in the present case the forwards would be subject to Division 230 in Head Co s hands and therefore ss (5a) and should apply. This is because Joining Co entered into the forwards on 1 August Therefore, even ignoring the effect of the deemed acquisition at the joining time, the forwards should still be subject to Division 230 in the hands of Head Co because Head Co would be treated (pursuant to the entry history rule) as having entered into the forwards on 1 August Accordingly, Division 230 should apply to the forwards in the hands of Head Co, and their tax cost/value at the joining time should be set under ss (5a) and In-the-money forward s (5a) Head Co has not elected into any of the elective TOFA methods, so s (5a)(b) does not apply. Accordingly, s (5a)(a) should treat Head Co as acquiring the in-the-money forward at the joining time for a payment equal to its TCSA. The determination of the TCSA for the in-the-money forward depends on whether it is a retained cost base asset or a reset cost base asset. Retained cost base asset is defined in s (5). Relevantly, it includes a *right to future income (other than a *WIP amount asset). The definition of a right to future income in s (5) has been stated above. The contingent right to receive an amount on settlement of the in-the-money forward seems to meet the conditions in (a), (b) and (d) of that definition: it is a valuable contingent right under a contract; it has a market value of $1m; and on these facts it seems reasonable to expect that at least an amount attributable to the forward will be included in the assessable income of Head Co upon settlement in one month s time. However, condition (c) is not satisfied as the in-the-money forward is a Division 230 financial arrangement for both Joining Co and Head Co. Therefore, the forward should not be a RTFI. Further, it should not be a retained cost base asset under any of the other categories in s (5). Craig Marston and Julian Pinson, Greenwoods & Freehills

20 Accordingly, it should be a reset cost base asset and its TCSA determined under the ACA pushdown process having regard to the relative market values of Joining Co s assets: s For present purposes, we will assume that under that process the in-the-money forward s TCSA will equal whatever amount is added at Step 2 of the ACA calculation in respect of the out-of-the-money forward. As discussed below, this should be $1m following the 2012 Amendments. Out-of-the money forward s Treatment under the former s Under the former s , where a joining entity brought a TOFA liability into a group, its cost would only be reset if it would be subject to the TOFA fair value, financial reports or FX retranslation methods in the hands of the head company. If one of those elective methods was to apply, broadly speaking, the head company would be taken to have received a payment equal to the amount of the liability at the joining time. However, if the default accruals/realisation methods would apply, the head company would inherit the cost of the liability from the joining entity (for instance, nil in respect of the out-of-the-money forward in this case). Head Co has not elected into any of the TOFA elective methods and the in-the-money forward will be subject to the default accruals/realisation methods. Therefore, under the former s , Head Co would have been treated as starting to have the out-of-the-money forward at the joining time without being deemed to have received any amount in return for assuming that liability. As a result, $700,000 should have been included at Step 2 of the ACA calculation for Joining Co, being the amount of the accounting liability ($1m), adjusted for the value of the deduction that would arise for Head Co when the forward is settled: see ss , and (assuming no adjustment under s was required). Treatment under the new s As discussed in detail in the Hirst & Sydes Paper, under the new s , a head company is treated as starting to have a TOFA liability at the joining time in return for receiving a payment equal to its accounting value, regardless of which TOFA taxing method will apply to the liability in the hands of the head company (i.e. even if the default accruals/realisation methods will apply). Accordingly, under the new s , Head Co is treated as starting to have the out-of-the-money forward at the joining time in return for receiving a payment of $1m, being the amount of the liability recognised in Joining Co s accounts. As a result, $1m would be included at Step 2 of the ACA calculation for Joining Co, being the full amount of the accounting liability (which will not give rise to a deduction for Head Co when settled, as discussed below). Settlement of the forwards Both forwards should be subject to the default accruals/realisation and balancing adjustment methods in Subdivisions 230-B and 230-G. Prior to settlement, there should be no sufficiently certain gains or losses from the forwards for the purposes of the accruals method, because any gains or losses are Craig Marston and Julian Pinson, Greenwoods & Freehills

21 entirely dependent on currency exchange rates on the settlement date. In respect of the in-the-money forward, note that the sufficiently certain test in s is more stringent than the reasonably expected test in s (5)(d)). Head Co will have TOFA balancing adjustments when the forwards settle on 1 August 2013 (s (1)(b)). However, no balancing adjustment gains or losses should arise. Broadly, this is because: in-the-money forward: Head Co will receive $1m on settlement and have a cost of $1m for the forward (being its TCSA set at the joining time); and out-of-the-money forward: Head Co will pay $1m on settlement but will be deemed by the new s to have received $1m at the joining time. Summary Following the 2012 Amendments, Head Co should have no net taxable gain or loss on settlement of the forwards, which is consistent with the result that would arise for Joining Co if it had not joined the Head Co TCG, and the fact that no net commercial gain or loss is made in respect of the forwards. Prior to the 2012 Amendments, the former s would not have deemed Head Co to have received any payment at the joining time. Broadly, on our simplified facts, this would have led to a net deductible loss being claimed on settlement of the forwards (see the table in the Appendix) Forwards entered into on 1 August 2009 A scenario in which the forwards were entered into on 1 August 2009 illustrates the uncertainty regarding the operation of ss (5a) and where a joining entity has assets/liabilities that are not subject to Division 230 in its hands prior to the joining time because they are pre-tofa arrangements and the joining entity has not made the TOFA un-grandfathering election. Financial arrangements subject to Division 230 As discussed above, ss (5a) and only apply at the joining time if Division 230 will apply to the asset or liability in the hands of the head company. Very broadly, and as discussed in detail in the Hirst & Sydes Paper, the ATO s view (based on a strict literal interpretation of ss (5a) and ) appears to be that whether Division 230 will apply to the asset/liability in the hands of the head company is tested on the basis of the entry history rule applying to treat the head company as having acquired/assumed the asset/liability on the date that the joining entity acquired/assumed the asset/liability (i.e. whether Division 230 will apply to the asset/liability must be tested before ss (5a) and apply to deem the asset/liability to have been acquired/assumed at the joining time). The ATO expressed this view at the 25 February 2013 NTLG Finance and Investment Sub-committee TOFA working group meeting, and the view is applied in the edited version of PBR Craig Marston and Julian Pinson, Greenwoods & Freehills

22 In the present scenario, the ATO s view would presumably be that ss (5a) and would not apply to the forwards. This is because Joining Co entered into the forwards prior to 1 July 2010 and neither Joining Co nor Head Co made the TOFA un-grandfathering election, and therefore, absent Head Co being deemed to have acquired the arrangements at the joining time, they would not be subject to Division 230 in its hands. It is not clear that this view is technically correct even on a strict literal interpretation of the provisions. Further, as discussed in the Hirst & Sydes Paper, the extrinsic materials relevant to the TOFA/consolidation interaction provisions suggest the intention was that in all scenarios a head company would be taken to start to have the financial arrangements of a joining entity at the joining time. Nevertheless, we have considered below the implications of ss (5a) and not applying to the forwards at the joining time on the basis of the ATO s interpretation of the provisions. Non-application of Division 230 going forward If the ATO s view is correct, and ss (5a) and do not apply at the joining time, then Division 230 will not apply to the forwards in the hands of Head Co. Accordingly, any gains/losses in respect of the forwards after the joining time should be assessable/deductible under Division 775 (which would take priority over the ordinary assessing provisions). In-the-money forward RTFI In this scenario, the in-the-money forward should be a RTFI as defined in s In particular, s (5)(c) should be satisfied, which requires that the right be neither a *Division 230 financial arrangement nor a part of a Division 230 financial arrangement. In this regard, the inthe-money forward will not be a Division 230 financial arrangement for either Joining Co or Head Co. This is because the forward was entered into on 1 August 2009 (prior to the TOFA start date for Joining Co and Head Co), neither entity made the TOFA un-grandfathering election, and we are assuming that s (5a) would not apply to treat Head Co as acquiring the asset at the joining time. On the basis that the in-the-money forward is a RTFI, its TCSA will be nil because Joining Co has no historic cost for entering into the forward: see ss (6), (4B) and (4). Out-of-the-money forward If s does not apply to the out-of-the-money forward, Head Co should be treated as inheriting the ($1m) value of the forward from Joining Co i.e. it is not treated as receiving any payment for assuming the liability at the joining time. Accordingly, $700,000 should be included at Step 2 of the ACA calculation for Joining Co (i.e. the amount of the accounting liability less the value of the deduction that will arise for Head Co on settlement, as discussed below). Craig Marston and Julian Pinson, Greenwoods & Freehills