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Tax Consolidation

The Single Entity and Entry History Rules

Grant Cathro

Partner, Allens Arthur Robinson

1. Introduction

Faced with the prospect of digesting and understanding 400 pages of

consolidation legislation, it may no doubt come as a surprise to many that the key

operative provisions which operate once a consolidated group has been formed

are, in reality, very short. The vast bulk of the consolidation legislation is

concerned primarily with entry and exit issues, the utilisation of losses and specific

issues which arise for particular taxpayers or MEC groups.

Once a consolidated group has been formed and the cost to the head entity of its

various assets has been established, the modification to the tax laws required to

ensure that the taxable income of the group is computed on a combined basis with

only one tax return, is achieved through the operation of the single entity rule.

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The single entity rule requires subsidiary members of a consolidated group to be

treated, in effect, as if they were parts of (akin to divisions of) the head company of

the group, rather than as separate entities. This rule is expressed to apply only for

certain limited purposes.

Application of the consolidation regime to transactions entered into by a

consolidated group will require a clear understanding of the scope and effect of the

single entity rule. Its application will affect the analysis to be undertaken in

characterising many transactions and will have a significant impact on the

treatment of assets created within a group that are subsequently transferred out of

the group. Despite the single entity rule, there are likely to be circumstances in

which it is appropriate to have regard to the separate ownership and operations of

individual entities within the consolidated group.

The formation of the new consolidated group, or addition of another entity to a

consolidated group adds another dimension to the application of the single entity

rule. In that context, the operation of the single entity rule is modified by the entry

history rule in section 701-5.

2. Single Entity Rule

The single entity rule is to be found in section 701-1 of the Income Tax

Assessment Act 1997 (Cth) (the 1997 Act). It provides:

(1) If an entity is a subsidiary member of a consolidated group for any period,

it and any other subsidiary member of the group are taken for the

purposes covered by subsections (2) and (3) to be parts of the head

company of the group, rather than separate entities, during that period.

In effect, the single entity rule deems an entity which is a subsidiary member of a

consolidated group to be part of, or in effect something similar to a division of, the

head company of the group, rather than a separate entity. This deeming applies

only for the 'head company core purposes' and 'entity core purposes' specified in

section 701-1(2) and (3). It only applies in respect of the period that the subsidiary

member is part of that consolidated group.

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The head company core purposes are:

(a) working out the amount of the head company's liability (if any) for income

tax calculated by reference to any income year in which any of the period

occurs or any later income year; and

(b) working out the amount of the head company's loss (if any) of a

particular sort for any such income year. (s.701-1(2))

The entity core purposes are:

(a) working out the amount of the entity's liability (if any) for income tax

calculated by reference to any income year in which any of the period

occurs or any later income year' and

(b) working out the amount of the entity's loss (if any) of a particular sort for

any such income year. (s.701-1(3))

The single entity rule is central to the operation of the consolidation regime. It

ensures that, for the purposes of working out the amount of the liability for income

tax (or the amount of any tax loss) of both the head company and the subsidiary

members, a subsidiary member is treated as part of the head company. This in

turn has a number of implications during the period of consolidation. It means

that:

(a) a subsidiary member can have no separate liability for income tax (although

it may be jointly and severally liable for the head company's income tax

under Division 721);

(b) in computing the liability of the head company for income tax, the head

company must take into account the activities of the subsidiary members as

if they were part of the head company; and

(c) all intra-group transactions between members of the consolidated group do

not produce amounts of income or expenses, nor result in a CGT disposal,

as transactions between parts of an entity cannot do so.

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A single entity rule is also incorporated into Part 2.10 of the Taxation

Administration Act (TAA) by section 45-710 of that Act. That rules applies for the

purposes of Part 2.10 which deals with the payment of Pay As You Go (PAYG)

instalments.

It is far from clear that the rule operates such that for all purposes, one must

ignore the fact that members of the group are separate legal entities. The

Explanatory Memorandum to the New Business Tax System (Consolidation) Bill

(No. 1) 2002 (Cth) asserts, at paragraph 2.11, that a 'key feature of the new law' is

that 'a consolidated group is treated as a single entity for all income tax purposes'.

This statement will only be relevant if the legislation is ambiguous.

It is clear that the single entity rule operates only for 'head company core

purposes' and 'entity core purposes'. It does not, for example, operate for the

purposes of determining the tax treatment of a shareholder in the head company,

nor for the purpose of other taxes such as FBT and withholding tax. A taxpayer's

liability for income tax is worked out under Division 4 of the 1997 Act by reference

to the entity's 'taxable income'. The single entity rule applies to the process of

determining that taxable income and the income tax payable by applying the

applicable tax rate to it.

The key question is whether the rule requires one to go so far as to ignore

completely all intra-group transactions and treat them as if they did not occur, on

the basis that an entity cannot deal or transact with itself. As a matter of factual

reality, different members of a consolidated group do transact with one another.

Does the single entity rule require us to create a complete fiction which assumes

that those transactions had never occurred, or does it simply require us to

recognise that such dealings between parts of an entity do not result in any

immediate tax consequences, as dealings between parts of an entity cannot

produce amounts of income, deductions or result in CGT Events?

Even where the issue under consideration forms part of calculating the taxable

income of the head company, it appears there will be some circumstances in

which the fact that separate assets or activities are held or conducted by separate

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entities will nonetheless be relevant and have some influence on the determination

of the taxation outcome.

For example, specific issues might arise in the context of the characterisation of

particular transactions entered into by a member of a consolidated group, in the

context of the application of Part IVA, or where an asset created within the group

is subsequently transferred out of it.

The operation of the single entity rule is likely to be confined to the specific

purposes enumerated in section 701 of the 1997 Act and 45-710 of the TAA. To

use the words of AH Slater QC in the paper which he recently presented at the

Leura Conference1:

Outside the purpose specified in section 701-1 and the effect provided for by the

other provisions of Part 3-90, the consolidation of the head company and its

subsidiaries into a 'consolidated group' does not alter 'factual and legal

realities' … Section 701-1 does not require subsidiary members of the group to

be treated as part of the head company for the purpose of other provisions,

whether deeming provisions or otherwise of the Assessment Acts.

A number of cases are examined by AH Slater QC in his paper, which

demonstrate that deeming provisions are likely to be construed narrowly by the

courts. I would commend Tony's paper to you. One of the many cases referred to

in that paper is FC of T v Comber2. In that case the court held that the operation

of section 109 of the Income Tax Assessment Act 1936 (Cth) (1936 Act) which

deemed a director's retiring allowance to be a dividend paid by a company, did not

in so doing, give the payment the qualities of being paid to a shareholder and paid

out of profits as was necessary to make it taxable under section 44. The court

stated:

It is improper in my view to extend by implication the express application of a

statutory fiction. It is even more improper to do so if such an extension is

unnecessary, the express provisions (section 109) being capable by itself of

1 General Consolidation Regime – Key New Tax Concepts?, Tony Slater QC, Taxation Institute of Australia, First NationalConsolidation Symposium, Leura, New South Wales, February 2003.

2 (1986) 64 ALR 451, 458.

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sensible and rational application … in determining whether (the company) has

made a sufficient distribution of its profits.

In practice, the courts are concerned with the application of the law to the actual

facts. A statutory fiction asks them to ignore the true facts and recast them in a

different way. This inherently requires the courts to first examine the true facts in

the context of the legal question which they are dealing with, and then ask

themselves how those facts should be recast, given the deeming provisions. They

will only be inclined to recast them, to the extent that they are convinced that the

deeming provision requires them to do so.

For example, a common issue before the courts is whether or not a profit made on

the sale of an investment is one made in the ordinary course of business, or is on

capital account. If it is clear that, viewed on its own, the company holding the

investment had only entered into one isolated transaction, the court will no doubt

need to be convinced the single entity rule requires it to have regard to the other

activities of the other members of the group, before it will take them into account in

characterising the relevant business.

3. The Entry History Rule

A company joining a consolidated group, either upon formation or at a later date,

will hold assets and liabilities, the treatment of which will be dependent upon

events which occurred prior to the time at which the entity joined the group.

Likewise, there will be transactions which have been entered into by entities

joining the group which have tax consequences after the time of joining.

While earlier versions of the consolidation legislation treated the head company as

if it acquired all of the assets of the subsidiaries upon formation, the consolidation

legislation, as finally introduced, does not take that approach. Instead, it treats the

head company as inheriting the history of the subsidiary members of the group.

Section 701-5 contains the entry history rule. It provides:

For the head company core purposes in relation to the period after the entity

becomes a subsidiary member of the group, everything that happened in relation

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to it before it became a subsidiary member is taken to have happened in relation

to the head company.

The entry history rule, like the single entity rule, operates 'subject to any other

provision of … (the) Act that so requires, either expressly or impliedly (see section

701-85).

It will be recalled that section 701-1(2) identifies head company core purposes to

be working out the amount of the head company's liability for income tax … and

the amount of the head company's losses (if any). After entry into consolidation, a

subsidiary member is thus taken to be part of the head company rather than a

separate entity (during the period of consolidation) and the head company is taken

to inherit the history of the subsidiary member in the sense that everything that

happened in relation to … (the subsidiary member) … before it became a

subsidiary member is taken to have happened in relation to the head company.

Left unchecked, the entry history rule might well have meant that the head

company inherited the assets of the subsidiary member with their existing tax

costs (as is indeed achieved by the entry history rule where the subsidiary

member is a chosen transitional entity to which section 701-15 of the Income Tax

(Transitional Provisions) Act 1997 (Cth) (the TP Act) applies), and inherited the

subsidiary's losses. Many of the provisions of the consolidation legislation which

apply on entry, operate to modify in certain respects what otherwise might have

been the effect of the entry history rule.

The Explanatory Memorandum to the New Business Tax System (Consolidation)

Bill (No. 1) 2002 suggests that the entry history rule will reduce the compliance

costs which would have resulted had the previous history been ignored and a

'clean slate' approach reflected in the February 2002 Exposure Draft adopted. It

suggests that the entry history rule should ensure that:

the mere act of consolidation is not expected to change the character of

transactions, where assets continue to be held by a consolidated group in the

same manner as held by a member of the group prior to consolidation (paragraph

2.27).

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The Explanatory Memorandum makes the following comments about the entry

history rule:

What history is inherited?

2.32 As a consequence of the entry history rule a head company may be

entitled to certain deductions for expenditure incurred by a joining entity prior to it

joining the group. Examples are entitlements to deductions for expenditure on

borrowing expenses, gift deductions (where the entitlement to the deduction is

spread), water facilities, connecting power or telephone lines, certain business

related costs and expenditure allocated to a project pool. A head company may

also be entitled to a deduction for a debt that is brought into a consolidated group

which subsequently goes bad.

2.33 A head company may also need to include assessable income as a

consequence of something that happened to a joining entity prior to

consolidation. For example, an entity may have received a prepayment for which

the assessable income is included over the period of the provision of the

services. A head company may also be assessable on the receipt of a

recoupment of expenditure made by a subsidiary member prior to its entry into

the group. Also, an entity before joining a group may have elected to defer tax on

the profit from the disposal or death of livestock or elected to defer the inclusion

of the profit on a second wool clip.

…

Other consequences of the inherited history rules

2.47 Some examples of the effect of the inherited history rules are:

• The pre-CGT status of assets that are brought into a

consolidated group by an entity that becomes a subsidiary

member will be inherited as a consequence of the entry history

rule. Likewise, the exit history rule will ensure that the pre-CGT

status of assets that an entity takes with it when it leaves a

consolidated group will be inherited by that entity. This maintains

the current law's treatment of pre-CGT asset transfers within

wholly-owned groups. However, any acquisition of membership

interests in the entity would still cause pre-CGT status in the

asset to be lost if it resulted in the ultimate owners not continuing

to hold majority underlying interest in the asset.

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• Private income tax rulings issued to an entity before it becomes a

member of a consolidated group will apply to the head company

insofar as the relevant facts have not changed either by reason of

consolidation (e.g. because they relate to intra-group

transactions, which are ignored) or otherwise. Private income tax

rulings that relate to particular assets, liabilities or businesses

that a leaving entity takes out of a group will apply to the leaving

entity insofar as the relevant facts have not changed either by

reason of the entity creasing to be a member of a consolidated

group or otherwise.

4. Characterisation of Transactions within a Consolidated

Group

The Explanatory Memorandum to the New Business Tax System (Consolidation)

Act (No. 1) 2002 suggests that consolidation should not affect the characterisation

of assets.

At paragraphs 2.27 to 2.29 it states:

Characterisation of assets and transactions

2.26 Following an election to consolidate, the single entity rule has the effect

that for the purposes of assessing the income tax position of the head company,

the head company is taken to hold all the assets and liabilities of its subsidiaries

and to enter into the transactions of its subsidiaries. This is because the

subsidiary members are treated as if they are parts of the head company for

income tax purposes.

2.27 With the exception of intra-group dealings, the mere act of consolidation

is not expected to change the character of transactions, where assets continue to

be held by a consolidated group in the same manner as held by a member of the

group prior to consolidation.

2.28 As is the situation under current law, it may be relevant to consider the

nature of a transaction undertaken by a subsidiary member of a wholly owned

group in the context of the activities of the group as a whole, in order to determine

the income tax character of a particular act or transaction in an assessment of the

consolidated group. The income tax character of a transaction undertaken by a

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consolidated group will continue to be a question of fact to be determined in the

light of all the relevant circumstances.

2.29 It is possible for assets of the same type to be held for dual purposes

within one wholly-owned group. For example, at any point in time one piece of

land may be held as trading stock (e.g. for the purposes of land development)

while another may be held as a capital asset (e.g. for the purposes of housing

business premises) by a group. If that wholly-owned group chooses to

consolidate, the current law will apply using existing principles and case law.

Transactions under consolidation are subject to the same scrutiny for the

purposes of characterisation as those involving a single taxpayer.

While the comments in the Explanatory Memorandum are of some comfort, there

is still significant doubt whether circumstances may arise where consolidation may

affect the characterisation of a transaction. At the very least, the single entity rule

will change the analysis which must be undertaken to characterise many future

transactions.

The UK case of Customs and Excise Commissioners v Kingfisher plc3 provides an

interesting illustration of the way in which a rule like the single entity rule can affect

the tax treatment of a transaction.

In that case, the taxpayer, Kingfisher, was the holding company of a group of retail

companies. There was also a finance company in the group, which provided the

Time credit card to consumers for use in the retail outlets of the group. The

Commissioner assessed Kingfisher on the basis that the daily gross takings of the

retail outlets included all payments made using the Time credit card as if cash had

been received for the purchases. Kingfisher appealed on the grounds that it

should be treated as carrying on both a credit business and a retail business.

Therefore, the credit sales should be treated as self-financed, to be accounted for

when payments were received from the customer.

The UK VAT law provided that where "any bodies corporate are treated as

members of a group any business carried on by a member of the group shall be

treated as carried on by the representative member…". It was held that the

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purpose of this provision was to enable a group to be treated as if it were a single

taxable entity, taxable through its representative member. Consequently,

Kingfisher was deemed to be carrying on both a credit and retail business such

that sales paid for with the Time credit card were regarded as self-financed credit

sales and were only accounted for on receipt of payment.

4.1 Capital v Revenue

In the past it has not been uncommon for groups to acquire particular

assets in a separate legal entity in the hope that doing so may provide a

better tax outcome, or at least a clearer tax outcome than that which would

have been obtained if the same assets were held in a single entity.

Whether, within a consolidation environment, the separation of assets in

different entities will have any influence on the characterisation of assets

may be open to debate.

Example 4.1

In the past, a group which carried on a business as a property developer,

might have acquired its head office building, which it expects to hold on

capital account, in a separate subsidiary.

Assuming this happened within the consolidation environment, the tax

position of the head company would be determined on the basis that the

head company:

(a) conducted a property development business, and

(b) acquired and owned the head office.

In such a case the single entity rule should not change the tax treatment of

the head office. It is clearly possible for one taxpayer to hold a portfolio of

real estate assets which are held on revenue account and at the same time

hold a real estate asset which is held on capital account (see National Bank

3 [1994] STC 63.

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of Australasia Limited v Federal Commissioner of Taxation4). Given the use

of the asset as the head office of the group, it should be possible to

demonstrate that this asset is separate and distinct from the portfolio of

assets held for development purposes – it is held for long term use.

Assuming that the facts are clear, and that the holding of separate entities

did not change the initial answer, the consolidation environment would not

make any difference to the answer.

Example 4.2

However, the position does become a little more complex when we consider

a situation like that in AGC (Investments) Limited v FC of T (AGC

(Investments) case)5. In that case, the taxpayer was a wholly-owned

subsidiary of insurance company, AGC. It was a vehicle for the investment

of funds provided to it by its parent company. It acquired a portfolio of

shares in listed public companies which it held for many years. Over that

time, the total sales of those share were a small percentage of the total

value of the portfolio. In 1987, it commenced selling the portfolio and

reinvesting the proceeds in fixed interest securities. The net profit of over

$45m realised on the sale of shares was held to be on capital account.

In the normal course, profits derived by an insurance company from the

sale of investments is on revenue account.

…, an insurance company is undoubtedly carrying on an insurance

business and the investment of its funds is as much a part of that

business as the collection of the premiums. The purpose of investing the

funds of the … (insurance company) … is to obtain the most efficient

yield of income. (Colonial Mutual Life Insurance Company Limited v

Federal Commissioner of Taxation, 73 CLR 604, at 619-620).

In many cases, investments made by insurance company subsidiaries have

likewise been held to be on revenue account, on the basis that the

4 (1969) 118 CLR 529, 538-539

5 (1992) 92 ATC 4239.

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companies in question were investing moneys which represented part of the

insurance reserves of the parent and were part of the circulating capital of

the parent's business. By contrast, in the AGC (Investments) case, the

amounts in question were held to be on capital account, on the basis that

there was clear evidence that the funds in question were surplus, were not

needed to maintain liquidity and the shares were acquired with a view to

holding for the long term.

The better view would appear to be that consolidation would not change the

outcome in the AGC (Investments) case. While the single entity rule might

require the issue of characterisation to be approached on the basis that the

investments were undertaken by part of AGC, that rule does not change the

factual evidence which showed that the investments were not held with a

view to making a profit by turning over the assets, nor held for the purposes

of facilitating the insurance business.

While the fact that the assets are held in a single entity might be

disregarded in some respects by the single entity rule, it is still necessary to

determine the purpose for which the shares were held. The single entity

rule does not require the head company to attribute the purposes of its

insurance business to the activities of the subsidiary member. The holding

of the shares in a separate entity would still be of some assistance in

demonstrating that the shares were distinct from those shares held as part

of the insurance business.

Cases like AGC (Investments) Limited are rare. Other cases, where

insurance companies have invested surplus funds that were part of their

circulating capital, have come to a different conclusion.6 While it may be

correct to state that the single entity rule should not, strictly speaking,

change the outcome in a case like this, in practice it may just impose yet

another hurdle to cross.

6 R A C Insurance Pty Ltd v FCT (1990) 90 ATC 4737; GRE Insurance Ltd v FCT (1992) 92 ATC 4089

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Example 4.3

In the past, someone who intended to undertake a series of similar

transactions over a period of time, each of which viewed alone might have

been an isolated transaction producing a gain on capital account, might

have established a new entity to undertake each transaction, it being hoped

that the activities of each entity would be viewed separately, assisting in the

characterisation of the transactions as transactions on capital account. In a

consolidation environment there is a real risk that the head company will be

seen to have entered into each of these transactions, with the result that the

transactions would, collectively, be seen to constitute a business of the

head company, with the result that any profits made from the transactions

are on revenue account.

It might be suggested that consolidation would not change the outcome in

this case. There may be scope to debate whether or not, outside

consolidation, the making of investments in separate entities necessarily

achieves the desired result7. The characterisation of a transaction will,

however, often involve matters of degree. In most instances, the single

entity rule will not change the characterisation of transactions. In some, the

single entity rule might make the argument that the gain is on capital

account just that little bit more difficult.

4.2 Characterisation of expenses

It is likely that consolidation will change the analysis which applies to

determine whether or not some expenses incurred by a group company are

deductible.

Example 4.4

In a pre-consolidation environment Group Company A which borrowed

money to acquire a property which was then be leased to another Group

7 see Example 8 in Income tax Ruling TR 92/3.

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Company would be entitled to a deduction for the relevant interest incurred

and required to return the rent as assessable income, even if the other

Group Company used the property for the purpose of producing exempt

income. In a consolidation environment, the deductibility of the interest

expense to the group will be determined by looking at the benefit which the

Group obtained from incurring that expense. Viewed from the perspective

that the two subsidiaries are part of the head company, it is likely that what

the head company will be taken to have done is to have borrowed money to

acquire a property which it then used to produce exempt income. In that

scenario the interest expense will not be deductible.

Example 4.5

Consolidation is also likely to change the analysis applying to the Total

Holdings8 and Spassked9 scenarios. In the past the deductibility of interest

on moneys borrowed to make an interest-free loan to a subsidiary, or to

acquire shares in another member of the group might have been dependent

upon the expectation of the receipt of dividends from the subsidiary. Now,

the deductibility of such moneys will no doubt depend upon the use to which

the group ultimately puts the moneys borrowed. Viewed from the

perspective that each member of the consolidated group is merely a

division of the head company, the use of which the subsidiary puts the

funds borrowed is imputed to the head company.

4.3 Finance Companies

Traditionally, many Australian groups have established a separate entity to

act as the group financier. This has provided the group with a number of

advantages. Characterisation of the business of the group member as a

finance company has often been largely dependent upon significant lending

activities made by that entity to other members of the group.

8 Federal Commissioner of Taxation v Total Holdings (Australia) Pty Ltd 79 ATC 4279.

9 Spassked & Ors v Federal Commissioner of Taxation 2003 ATC 4184.

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In a consolidation context, as a matter of fact, it will still be the case that the

individual entity will be carrying on a business as a financier. However, it

seems likely that transactions entered into with external third parties for the

purpose of providing funds to the consolidated group, will be viewed from

an income tax perspective as if the head company had borrowed the funds,

not for the purpose of on-lending it, but for the purpose to which the group

ultimately applies those moneys.

A more interesting issue arises where the group's finance company has

also traditionally made loans to external third parties, or entities which do

not form part of the consolidated group. Can the head company be

regarded as carrying on a number of businesses, one of which is a finance

business? As a matter of principle, there would seem no reason why the

head company's business could not include a finance business. What then

is the impact of the single entity rule on the characterisation of the head

company's business? When determining whether or not the head company

carries on the finance business, is it appropriate to look only at the

transactions which it enters into with entities outside the group, or is it also

permissible to have regard to the transactions within the group which, as a

matter of fact, are carried on by the finance entity?

4.4 Characterisation of receipts

There are a number of cases in which a payment made to a company for

the termination of a contract has been held to be on capital account, on the

basis that the payment resulted in the recipient abandoning the only

business which they conducted and so was not an incident of carrying on

the company's business.

What then happens under consolidation where one company receives a

payment for the cancellation of an agency arrangement, on which its entire

business is based, but viewed from a group perspective, that business is

but one of a number of similar businesses carried on by the group? At the

very least, it would seem that the single entity rule complicates any analysis

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of the treatment of the payment received. It is clearly possible for one

company to carry on several businesses and a payment received for the

termination of one of those businesses would be on capital account. As

such, characterisation may largely depend on the degree of separation

between the different businesses conducted by the group. If the different

businesses are conducted from different locations and by different staff,

there is a real likelihood that the single entity rule will not change the

outcome. If, on the other hand, the group has rationalised and/or

centralised a lot of the activities of the businesses conducted by different

entities under some form of shared services arrangement, it is more likely

that the single entity rule changes the outcome.

In other cases like Federal Coke Co Pty Ltd v FC of T (Federal Coke)10, the

treatment of an amount received has depended very much upon the entity

in the group it was paid to. In Federal Coke, the taxpayer was a subsidiary

of a holding company which produced coal, which the taxpayer then

converted into coke on behalf of the holding company in return for the

payment of a service fee. A customer of the holding company sought to

terminate a contract for the purchase of coke from the holding company.

Initially it was proposed that the customer should pay a sum to the holding

company in return for the variation of the contract. Ultimately, payment was

made to the taxpayer, as the taxpayer had closed down its coke works as a

consequence of the variation.

At first instance, the payment received by the taxpayer was held to

be on revenue account, with the trial judge 'appeared':

… to have considered that he could approach the characterisation of the

receipts in the hands of the taxpayer by treating them as if they were a

receipt by Bellambi (the holding company) or the Bellambi Group'11.

10 (1977) 77 ATC 4255

11 at page 4263.

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On appeal, the court indicated that 'it is not legitimate to disregard the

separateness of different corporate entities or to decide liabilities to tax

upon the basis of the substantial economic or business character of what

was done'12.

In the present case, regarding the matter from … (the taxpayer's) point of

view, it is seen that the two receipts were part of one large and

unprecedented sum; that they were received without any consideration

passing from the company; and that they were in no sense the product of

any business or income producing activities which it carried on13.

It is quite likely that if a situation like that in the Federal Coke case came up

in the consolidation context, the single entity rule would result in a different

outcome. In a consolidation environment, the payment made will be likely

to be seen to be made in return for the variation of the contract for the sale

of coke, since that was the arrangement which the group had with the third

party.

5. Impact of the Entry History Rule on Characterisation

5.1 Capital v revenue

The passage from the Explanatory Memorandum quoted earlier suggests

that the mere act of consolidation should not change the characterisation of

a gain as revenue or capital.

The question of characterisation of a gain on disposal of an asset, where

the asset was acquired before entry into consolidation, does however, raise

slightly different issues to those arising where the asset was acquired in a

consolidation context.

As Examples 4.1 and 4.2 demonstrate, it will very often be the case that

consolidation will not change the characterisation of the gain arising on the

12 at page 4263.

13 at page 4265.

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disposal of an asset, although there is a possibility that there may be some

instances, at the extreme, where it may do so. Where an asset was

acquired by an entity before entry into consolidation, it would seem that the

entry history rule will often ensure that the characterisation of any gain

arising on the asset does not change.

Ultimately, however, the impact of the entry history rule in a given situation

will depend upon a careful analysis of the transaction giving rise to the gain

and the tests which apply to determine whether that gain is of a revenue or

capital nature. In many instances it is the purpose for which a transaction is

entered into which stamps the transaction with its character. The fact that

an investment is acquired for long term holding will often stamp any profit

later arising on sale with the character of a capital gain. Where a subsidiary

company holds a long term investment which would produce a gain on

capital account if sold by that subsidiary company, and the subsidiary

company becomes part of a consolidated group, it would seem that the

entry into consolidation should not change the character of any gain later

arising.

In the context of Example 4.1, the entry history rule only serves to make it

clearer that the head office is held as a long term capital investment. Given

the conclusion in Example 4.1, the entry history rule will not change the

outcome.

In the context of the AGC (Investments) scenario, the entry history rule

would appear to support the conclusion that any gain later made on

disposal would be on capital account, by attributing to the head company

the act of acquisition and thus the purpose of acquisition of the subsidiary,

being one of long term capital investment, not one for the purpose of

carrying on a business

The position might of course be different if, after consolidation, there was

some change in the way in which the investments were managed, held or

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administered, which suggested that the purpose for which they were held

had changed.

An example, like Example 4.3, is somewhat more problematic. Much may

depend on the precise nature of the transactions which are actually being

undertaken by each of the individual entities. The better view would seem

to be that one would approach the analysis by looking at what a particular

subsidiary member had done up to the point of consolidation, and what

occurred after consolidation. Assuming that the entry history rule doesn't

require the head company to aggregate the history of all of its subsidiaries,

when looking at the tax treatment of something inherited from one

subsidiary, characterisation might be approached by treating the head

company as if its only activity up to the point of consolidation were the

activities that had been undertaken by the individual subsidiary member up

to that point in time, and then assuming that from the point of consolidation

onwards, the head company commenced activities which involved all of the

activities undertaken from that point forward by it and its subsidiary

members.

5.2 Characterisation of Expenses

In the scenario discussed in Example 4.4 above, the fact that the

transaction may have been entered into prior to consolidation would not

appear to change the conclusion that within a consolidation environment,

deductibility of moneys borrowed by the group to acquire the property

depends upon the use to which the property is put by the group. The fact

that the moneys were borrowed to acquire a property which was originally

used for income producing purposes, does not guarantee that interest on

the borrowings will remain deductible throughout the term of the loan. Upon

consolidation, the single entity rule would appear to have the effect of

treating the group as if the property were now put to a different purpose. It

is no longer used by the subsidiary on a stand alone basis to produce rent,

but is used by the group to produce exempt income.

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A similar analysis would apply to Example 4.5 above.

5.3 Finance Companies

It does seem likely that there will be circumstances in which the treatment of

an arrangement entered into by the group finance company prior to

consolidation differs from the treatment of a similar transaction entered into

by the same company, after consolidation, particularly if the single entity

rule makes it difficult or impossible to characterise the activities as those of

a finance company after consolidation.

Example 5.1

Assume that a group finance company places moneys on deposit with a

third party prior to consolidation. The group then consolidates and

subsequently the third party becomes insolvent and the deposit is written off

as a bad debt.

It would seem that there is little doubt that the entry history rule will ensure

that the head company satisfies the test for deductibility of the bad debt

under section 25-35 on the basis that it was money that you lent in the

ordinary course of your business of lending money. This conclusion would

appear to stand, even if a similar deposit made after consolidation would

not similarly be regarded as one made 'in the ordinary course of …

business of lending money'.

6. Assets Created by Intra-group Transactions

Assets which are created by one member of a group and held by another (such as

a debt, or a lease of land or building) raise a number of difficult issues in the

consolidation environment.

The consolidation legislation contains a number of particular provisions to deal

with:

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• The accrual of income and deductions on intra-group transactions upon

entry or exit from a group (sections 701-70 and 701-75).

• The tax cost of assets held by a subsidiary member when it ceases to be a

member of the group (sections 701-20 and 701-45).

• The amount taken into account in respect of intra-group assets when

determining the cost to the head company of shares in a departing

subsidiary member (sections 711-5, 711-20 and 711-40).

• Adjustments to the amounts of intra-group liabilities taken into account

when calculating the ACA on entry and on exit (sections 705-75(2) and 711-

20).

There is however considerable uncertainty about the extent to which assets

created by one group member in favour of another group member can be

recognised when determining the tax treatment of any dealing with those assets

by the group. This uncertainty is compounded in the case of assets existing at the

time of formation or entry, to which a tax cost will be allocated under Division 705.

Example 6.1

Assume that prior to the entry into consolidation, Subsidiary A has made a loan to

Subsidiary B of an amount of $100. Post-consolidation Subsidiary A sells the loan

to a third party for an amount of $85.

Section 701-10(2) indicates that section 701-10 applies in relation to each asset

that becomes an asset of the head company because of the single entity rule.

Section 701-10 requires that each such asset's tax cost is set at the asset's tax

cost setting amount, which in the case of a debt is normally its existing tax cost.

It seems to be assumed that an asset of this type is one to which part of the

allocable cost amount will be allocated upon formation although, interestingly, it is

debatable whether or not the single entity rule has the effect of treating the head

company as owning the asset being the loan as may be required by section 701-

10(2). Assuming for the present that it is correct to treat the loan as an asset to

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which a tax amount is allocated, the loan is a retained cost asset which will retain

its tax cost of $100. One might expect that the tax treatment of the sale of the loan

would simply involve a comparison of the cost of $100 with the proceeds of sale of

$85.

The single entity rule directs however that, for the purposes of calculating the

company's liability for income tax and therefore its taxable income, Subsidiaries A

and B are treated as if they were part of the head company. Does this mean that,

as one company cannot make a loan to itself, the loan is taken not to exist during

the time the companies are consolidated? If so, how is the transaction with the

third party to be characterised? Does the head company receive $85 for the

creation of an asset? Does that asset have a cost base, given that the head

company will have to pay $100 later, or should the entire transaction be recast as

a loan of $85 on which $100 is to be repaid later? (The latter possibility making it

necessary to consider whether the sale might be treated as resulting in the

creation of a qualifying security to which Division 16E might apply.)

It would seem that an approach which ignores the fact that the loan has always

existed ignores the factual realities and leads to the kind of error in applying a

deeming provision which has been identified in cases such as Woodlock v CC of

LT14 and Galibal Pty Ltd v CC of LT15. Failure to recognise the factual realities will

introduce a significant element of fiction to the consolidation regime. It will create

enormous difficulties in recharacterising transactions and often result in taxation

outcomes which are far from intuitive or obvious (this is not of course to suggest

that tax is intuitive or obvious).

The better view, I would suggest, is that the loan has always existed with a tax

cost set by Division 705. This 'better view' is not however without its difficulties.

Example 6.2

14 [1974] C NSWLR 411, 414

15 (1996) 96 ATC 4143

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Assume that the loan made by Subsidiary A to Subsidiary B in Example 6.1 had

been made after the group had consolidated.

An approach which recognises that the loan has always existed creates difficulties

even in this scenario, as it may be difficult to impute to the head company an

appropriate cost base for the loan sold.

Example 6.3

The difficulties associated with an approach which does not recognise the factual

realities, could be illustrated by many examples.

Another obvious example involves the provision by the head company of financial

accommodation to a subsidiary by way of loan, for a period of 12 years on terms

which would result in the financial accommodation being treated as a non-share

equity interest if the debt/equity rules in Division 974 were applied at the time of

issue.

Three years later, the head company sells this financial instrument to a third party.

Assume that, because of the difference between the present value calculation and

nominal calculation, the instrument would be classified as a debt interest if the

loan had been issued with a term of nine years, but in all other respects has the

same terms.

Is the character of the instrument held by the third party to be determined by

applying the debt/equity test at the time that the instrument was issued by the

subsidiary to the head company, or by applying the debt/equity test at the time that

the instrument was acquired by the third party?

The debt/equity rules are drafted in terms which, arguably, do not work unless the

relevant instrument is analysed at the time of its initial creation. Section 974-15

(meaning of 'debt interest') and section 974-70 (meaning of 'equity interest in a

company') both look at the time the scheme comes into existence to determine if

the interest is a debt interest or an equity interest. They both apply to financing

arrangements, being arrangements under which the issuer of the instrument

wgcm M0111347067v2 150630 22.7.2003 Page 25

receives some form of financial benefit. Both compare the financial benefits

received by the issuer with those provided in return.

Any attempt to focus on the time of sale of the instrument out of the group and

treat the payment by the third party as a loan to the group in return for the

payments promised on the instrument, will not work. Not only does it require the

creation of a complete fictional set of circumstances which do not appear to be

justified by the single entity rule, but the provisions themselves will not work.

The single entity rule does not operate for the purposes of determining the tax

treatment of the instrument in the hands of a third party. Thus, from the third

party's perspective, the instrument should be viewed at the time of issue. How is a

third party to know that some intervening event has occurred, so that the tax

treatment of the instrument cannot be judged by simply looking at its terms? That

in itself should be enough to tell us that we should not focus on the time of sale out

of the group. Were we to do so, when the third party pays the head company for

the instrument, it makes payment to the head company and gets a return from the

subsidiary. It is stretching the single entity rule to suggest that it requires us to

treat the head company as the issuer of the instrument as it both receives a

financial benefit and it pays a return. The debt/equity rules operate on the basis

that a person has entered into an instrument which involves that person receiving

a financial benefit and paying a return. The single entity rule should not change

the factual reality. This is simply not what is occurring.

7. Limitations on the Single Entity Rule

It is important to remember that the single entity rule only operates for head

company core purposes and entity core purposes. The entry history rule only

operates for head company core purposes. The rules do not apply in relation to

issues which do not form part of the process of determination of the amount of

income tax payable or the amount of a tax loss. With the exception of Part 2.10 of

the TAA which has its own single entity rule in section 45-710, the single entity rule

does not apply for the purposes of the payment and recovery provisions. It also

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does not apply in relation to the determination of the tax treatment of any taxpayer

other than the head entity or its subsidiary members.

The single entity rule would not, for example, apply to determine the tax treatment

of a shareholder receiving a distribution from a company. It will still be very

important in the consolidation environment to make sure that any company which

is making a distribution to a shareholder which is intended to be dividend, actually

has profits available from which that distribution can be made. Otherwise the

payment in question will not be a dividend and will not be capable of being

franked. It will not be enough that the consolidated group as a whole has profits.

Great care will also need to be taken to avoid thinking that the single entity rule

really means that we can ignore everything which goes on within a consolidated

group when considering the tax consequences of what we are doing. There will

be occasions on which the structure of the transactions and the arrangements

entered into, even within a group, will have a bearing on the eventual tax outcome.

8. Specific Issues Arising from the Entry History Rule

As we all know, most taxpayers are currently preoccupied with entry into

consolidation. Very few have, as yet, worked through all the issues which arise for

them in applying the income tax laws to their activities within a consolidated group.

A number of issues have arisen in relation to the inter-action between the single

entity rule, entry history rule and the normal provisions of the Tax Act. Many more

will no doubt arise. I have set out below some brief comments in relation to a

number of the issues of which I am aware.

8.1 CGT Timing Issues

Differences between the CGT timing rules, and the timing rules which apply

to determine when a subsidiary member ceases to be a member of a

consolidated group, can create some fairly interesting and unexpected

outcomes in relation to the recognition of income or gains arising from the

wgcm M0111347067v2 150630 22.7.2003 Page 27

sale of assets, where the sale of assets straddles a move by the subsidiary

in or out of the consolidated group.

By way of example, assume that a subsidiary in a consolidated group has

entered into a contract to sell certain assets. That contract is entered into

on 1 June 2003 and settles on 1 August 2003. In the meantime, the head

company of the group contracts to sell the shares in the subsidiary

company. That contract is entered into on 30 June 2003 but completes on

30 July 2003. Who is it that accounts for any capital gain arising on the sale

of the asset and what is it that the purchaser of the shares in the subsidiary

is actually buying?

The answer to this question requires a careful analysis of the basis on

which the CGT timing provisions operate and the operation of the entry

history rule. As we all know, the CGT provisions will deem the relevant

asset to have been disposed of with effect from the date of the contract.

That deeming will not however happen unless, and until, the relevant assets

are actually disposed of. When settlement of the sale of assets occurs, the

CGT rules then operate retrospectively back to the date of the contract.

By contrast, the consolidation rules look at the date on which the beneficial

ownership in shares in the subsidiary passes and will generally focus on the

time at which the purchaser is entitled to be registered as the owner of

those shares, which would generally be completion. At completion of the

purchase of the shares, the subsidiary entity still owned the assets, albeit

that it was subject to an executory contract of sale.

8.2 Multiple Elections

There are a number of provisions in the law which allow a taxpayer to make

an election to obtain a particular type of treatment. One example is the

election which can be made by an insurer with respect to reinsurance of

non-residents under section 148. These provisions tend to operate on the

basis that a taxpayer can only have one election.

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Difficulties arise where two or more or entities within a group have taken a

different approach in relation to the election and the entry history rule

deems both to apply. A legislative fix may be required.

8.3 Different Methods of Accounting

It is possible that different entities within a group may have used different

methods of accounting. One may have used cash, and one may have used

accruals, or given the different nature of their businesses, they may have

been used different bases for the recognition of income, because of the

different nature of the businesses of the entities.

In Income Tax Ruling TR 98/1 it is acknowledged, at paragraph 22, that

different methods of accounting can exist within the same entities. Those

different methods of accounting may still be appropriate for different parts of

the head company's business.

8.4 The application of Division 243 where there was a forgiveness prior to

consolidation

Division 243 applies where limited recourse debt has been used to fund

depreciable assets. It takes a slightly different approach to a debt

forgiveness, to that taken in the debt forgiveness rules in Schedule 2C.

Division 243 can apply to reduce a taxpayer's future deductions. It does

not, however, do so by reducing the adjustable value of the relevant asset.

Can Division 243 apply to reduce a head company's deductions where

there was a forgiveness in a subsidiary entity to which the Division applied,

prior to entering into consolidation? It might be suggested that the entry

history rule would cause the Division to apply.

Application of Division 243 or the debt forgiveness rules to the subsidiary

after joining would appear to provide an inappropriate outcome. The tax

cost of the head entity of all of the assets in the subsidiary will have been

reset having regard to the head company's cost of shares in the subsidiary

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and the amount of the subsidiary's liabilities. It seems inconsistent with this

resetting of the tax cost, that provisions of the Act should operate to claw

back some of the deductions, based on events which occurred prior to

consolidation.

8.5 Present entitlement as to trust income in Section 97

Section 97 requires a beneficiary who is presently entitled to a share of the

income of a trust's estate to include that amount in assessable income.

Can the section apply where the beneficiary is a subsidiary member of a

consolidated group? I would suggest that the answer is that it can. The

single entity rule requires us to treat the subsidiary as if it were a part of the

head company. As such, the head company is treated as if it (not the

subsidiary) held the subsidiary's assets, when calculating the taxable

income of the head company. Those assets include the interest in the trust

held by the subsidiary. If that beneficial interest carries a present

entitlement to income, it would seem that the head company is treated as

holding the beneficial interest which carries the present entitlement to

income. Consequently, section 97 would require the head company to

include the relevant share of income in the head company's assessable

income.

8.6 Subdivision 170-D – linked groups

Particular difficulties arise in applying the single entity rule where the Act

requires amounts to be included in a subsidiary's assessable income, a

capital loss to be recognised, or provides rollover relief, based on events

which occurred prior to consolidation, or based upon the ownership of

certain assets which appear not to be recognised within the consolidated

group (for example, the holding of shares in a subsidiary company).

The provisions of Subdivision 170-D apply where there has been a transfer

of an asset from one member of a linked group to another, to defer the time

of recognition of any capital loss arising on the transfer until the asset exits

the linked group. When the asset does so, the loss is recognised.

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There has been some suggestion that the provisions of Subdivision 170-D

cannot apply properly, where what has been transferred in the past are

shares in a subsidiary company which is part of a wholly-owned group.

Basically, the perceived problem arises because it is suggested that the

shares in a subsidiary entity are not recognised within consolidation. It

might however be suggested that as a matter of fact the shares do still exist

within consolidation. It is simply that transactions between entities within a

consolidated group are treated as transactions between parts of the one

entity, with the result that we are required by the single entity rules to treat

those transactions as if they did not have a tax effect.

8.7 Demergers

Questions have been raised about the application of the demerger

provisions in the context of consolidation. The suggestion being that as

subsidiary entities are not recognised while they are part of a consolidated

group but are treated as part of the head company, there can be a head

entity within a consolidated group, but cannot be a demerger subsidiary.

Perhaps the answer to this issue lies, at least in part, in the purposes for

which the single entity rules operate. The demerger rules exist to provide

owners of equity with a rollover. At the same time they may ensure that a

capital gain or loss that a demerging entity makes from certain events is

disregarded.

It is clear that when looking at the tax treatment of a shareholder in a

company, that the single entity rule has no application whatsoever. To that

extent at least it would seem that the relief made available by the demerger

provisions still applies and that the entities within the group are to be treated

as if they were separate entities.

The analysis becomes more complex when we apply the demerger

provisions to the entities in the group themselves. The single entity rule is

clearly not intended to apply to deem a subsidiary member to be part of a

wgcm M0111347067v2 150630 22.7.2003 Page 31

consolidated group in the context of the sale or the degrouping of that

subsidiary member. To the extent that the demerger provisions deal with

the disregarding of any gain arising, their operation would not appear to be

inconsistent with the single entity rule.

Where a difficulty may arise with the demerger rules is that those rules

focus on the particular entity within a group which disposes of shares in the

demerged entity. They deem that particular taxpayer not to make a capital

gain. Given the focus on that particular taxpayer in the provisions, it is

unclear whether they work properly in the consolidation environment.

Fortunately it seems that, in order to provide relief to the head company for

any capital gain under section 125-155, all that needs to be concluded is

that the head company is the entity which disposes of shares in the

demerged entity and is therefore the demerging entity within section 125-

70(7). Such a conclusion may not be difficult to reach if either the head

company actually owns the shares in the demerged entity itself, or a

subsidiary of the head company owns the shares in the demerged

company, in which case as that subsidiary is part of the head company, the

head company is treated as if it owned the shares.

8.8 Other statutory provisions

If there are any provisions within the Act which only operate where certain

circumstances exist within a group, which distinguish between different

entities within the group, those provisions may not work satisfactorily in the

consolidation environment without some amendment. Their application, in

effect, requires us to have regard to the separate activities of the different

entities in the group, so that particular circumstances can then be deemed

for an entity within the group. On the one hand, if all the subsidiary

members are treated as part of the head company, the conditions for the

operation of these sections won't work, yet on the other hand if the

subsidiary companies are not treated as part of the head company, all the

sections will do is to deem a particular tax consequence for a subsidiary

member.

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The single entity rule does not allow us to then treat any consequence

imposed by the Act on the subsidiary, as a consequence for the head

company. That approach would be appropriate if we had a consolidation

regime based on the entity-based model which required us to calculate the

taxable income for each entity and added up. To my mind, the single entity

rule does not justify that approach. It does not justify one saying that if the

Act deems particular tax consequences for the subsidiary, those tax

consequences must flow to the head company. All that it does is allow us

to analyse what is occurring and apply the Act to the head company, on the

basis that all of the activities are occurring within the head company as if, in

a sense, the activities of each subsidiary were the activities of a separate

division of the head company.

9. Conclusion

At first brush, the single entity rule sounds like a fairly simple concept. It gives the

impression that we can simply ignore intra-group transactions completely – they

don't exist for tax purposes and treat the head company as if it were the

subsidiary.

Unfortunately, however it seems unlikely that this is the case. While in a great

many instances, intra-group transactions will not affect taxation outcomes and in

most instances the head company will get the same treatment as the subsidiary

entity itself would have got, there will be exceptions.

There will no doubt be a number of areas in which the current drafting of the TaxAct is inappropriate to deal with a consolidated group and in which amendmentsmay be required to the existing laws.