Introduced in 2002, the tax consolidation regime is the most fundamental tax change for Australian business since the introduction of the goods and services tax.
Under the regime, qualifying groups of 100%-owned entities are treated as single entities for income tax purposes. Therefore intra-group transactions are ignored and a single tax return lodged for the group. The head company is responsible for the tax liabilities of the group under consolidation. Under the regime there are special rules regarding the treatment of losses and the cost base of assets. Wholly-owned groups could elect to consolidate from July 1 2002.
The new tax consolidation regime was to deliver simplicity and flexibility for business - but a survey by PricewaterhouseCoopers last year found that the environment for corporate transactions has become more, rather than less, complex. Importantly, the survey revealed that almost two-thirds of respondents anticipated that acquisitions and disposals will become more difficult under the regime.
Against this background, this article focuses on the transition into consolidation, highlighting potential trouble spots and hidden opportunities.
For those who have already moved to the new regime, the initial focus on the first tax return has tended to detract from a full understanding of the potential impact of tax consolidation in other areas - among them, transactions.
Businesses still deciding whether or not to consolidate may find themselves negotiating a twin-thought process when approaching transactions - because a different result could ensue under the well-understood old rules than under the still-developing consolidation rules. This has been exacerbated by the announcement that certain elections previously made may be revoked up to December 31 2004. This means that businesses may have the opportunity to change the profile of previous transactions to improve the outcome of future ones.
Consolidation and cost bases: the initial decision to "stick" or "spread"
Australia has chosen the "asset-based model" for tax consolidation, which spreads the acquisition cost (and liabilities) of a joining entity among its assets, so that their costs bases are reset (subject to exceptions). This may require market valuations to be undertaken, as the allocable cost amount is generally spread among assets in proportion to their market value.
A transitional option is available for groups consolidating during the transitional period, under which they may "stick" with the existing cost bases of assets of a particular subsidiary.
Consolidation and disposals |
Consolidated groups will definitely be feeling the impact - good and bad - of the consolidation regime when it comes to disposing of a subsidiary. The calculation of cost bases to establish the opening current values can prove to be problematic. Simply accessing the historical information required to back up some significant cost bases from the past can be a difficult task. Furthermore, there are new complications caused by the fact that the disposal calculation is no longer the domain of tax people - it is now subject to the vagaries of accounting standards as well. This results in an entirely new situation - not experienced under the old rules - in which a subsidiary can have a negative cost base. This generally occurs because a group member has a large intra-group liability compared with the cost base of its assets - liabilities may not be spread around the group in proportion to assets. It is now possible to be assessed on a negative amount that is more than is actually received for the sale, thus attracting a high effective tax rate which will have an impact on the disclosed profit or loss from the transaction. It may be possible with careful planning to avoid this situation, however, in many cases it has been left too late. However, taxpayers may find that the new system brings more equality when it comes to disposing of the business of a subsidiary via assets or shares, as the cost base should now be consistent regardless of which method of disposal is used. Additionally, where the 'spread' method is chosen businesses can now have the inherited goodwill of a company recognized in its cost base - under the old rules this would have been ignored - so there are also potential benefits available in transactions under consolidation. |
The decision to "stick" or "spread" cost bases is one of the more important (and difficult) exercises which a group will need to address before entering into consolidation, particularly when the group is considering a transaction.
Tax losses and franking credits
In the past, if a subsidiary was sold, any losses and franking credits went with it. Depending on the acquisition gearing structure, the value of those losses could be foregone.
Under consolidation, franking credits and losses are not trapped in a subsidiary, but can rise through the group to sit with the head entity. During the transitional pre-consolidation period this can allow a group disposing of an entity to assess whether the purchaser will value the losses, or whether they are more valuable remaining within the group - a consideration which can drive the timing of consolidation.
Losses are usually more valuable to the seller than the acquirer, so businesses may find that the consolidation regime facilitates easier transactions and perhaps greater value for losses.
The use of losses is now governed by a set of additional tests (not only the continuity of ownership and same business tests) and subject to calculation of a fraction so that the use of some losses is likely to be spread over a longer period in comparison to the old law. However, in some cases where there was a risk of losses becoming unavailable due to the failure of the relevant tests, under consolidation these losses become refreshed, therefore some losses that were not transferable to other member can now be used more rapidly.
In addition to these new loss utilization tests, taxpayers are still grappling to understand how the continuity of ownership tests and same business tests will apply in a consolidated environment. The Australian Taxation Office (ATO) and Treasury have recently released a series of discussion papers outlining their views as to the potential operation of these tests going forward, including some proposals that may radically change the application of these tests to larger taxpayers. Further announcements are expected, but until such time as draft legislation is made available, taxpayers still face difficulties over the application of these tests.
Impact of joint and several liability on the due diligence process
In respect of liabilities for group income tax and associated liabilities (for example, franking deficit tax), subsidiary members of a consolidated group are treated as divisions or parts of the head company. The head company is therefore liable, in the first instance, for group liabilities.
Where the head company fails to satisfy a group income tax liability by the time that it becomes due and payable, each subsidiary member then becomes jointly and severally liable with the head company, and each other contributing member, for the amount outstanding at this time unless:
that member is prohibited under an Australian law from entering into arrangements that would subject it to joint and several liability, or
the group liability is covered by a valid Tax Sharing Agreement (TSA) that allocates the liability between the members of the group on a reasonable basis.
Practically this means that the due diligence process will become somewhat extended when considering purchasing a member of a consolidated group - complicated in part by the potential existence of joint and several liability for the post-consolidation group tax liability.
In the past, you could conduct your due diligence process as if it were effectively a stand- alone acquisition. Now you potentially need to consider conducting due diligence on the entity and the entire group.
The result has been an increase in the amount of time devoted to investigating TSAs and a range of warranties now being inserted into sale and purchase agreements specifically in relation to consolidation.
It is important to note that each member of the consolidated group remains separately liable for its tax-related liabilities that do not fall within the scope of the consolidation regime, including pre-consolidation income tax-related liabilities and non-income tax liabilities (for example, goods and sales tax, payroll tax and fringe benefits tax).
Spreading values by the purchaser following an acquisition
When an entity or group is brought into a consolidated group, the purchaser can spread the value of the acquisition down, but businesses should be mindful that this may result in some friction between accounting and tax purposes. This friction may, however, bring the fair value for tax and accounting purposes into alignment.
Keeping tabs on refinancing |
Consolidated groups also need to take great care with their refinancing arrangements, to avoid negative tax consequences. Groups who are refinancing by equity to make an acquisition need to investigate the impact the equity injection will have on any losses. And those who are refinancing by way of hybrid instruments need to take a very careful approach. Hybrid instruments have become increasingly prevalent in the Australian market. They carry the inherent risk of triggering a deconsolidation event if they are issued by a subsidiary in a consolidated group. If the ATO classifies them as a membership interest for tax purposes and does not classify them as a "debt interest", the group can no longer be considered wholly owned. It is extremely important that the hybrid instrument complies with the tax classification of debt or it is not a membership interest. Members of a multiple entry consolidated (MEC) group (or MEC groups with more than one head entity in Australia, with an overseas parent) should also take note, as a similar instrument released by an overseas intermediate parent of the Australian head entities can have the same deconsolidation effect, which the Australian company may not be aware of for some time. Managing this risk may require the financial controller to secure guarantees each year from the foreign parent that no such instrument has been or will be released by an overseas member of the group. On the positive side, under the old grouping rules problems arose with accessing deductions for interest associated with the acquisition of a company where the debt was in a newly-incorporated holding company. Under consolidation, groups have the ability to easily deduct interest costs in the first year of a company's existence. |
What the ATO seeks to know, you should too
The ATO is aware that consolidation has made an impact on restructures and has been raising the issue with companies who have recently undertaken such a transformation.
From our discussions with the ATO and recent information requests sent to some of our clients, we know the ATO is focusing on the impact of consolidations and recent restructure activity on tax payments. The regulator is aware of significant recent group restructure activity - and that some of these restructures have involved increased debt levels. The ATO is seeking to understand whether the tax outcomes from these restructures (for example, asset uplifts and increased debt deductions) represent "unintended consequences of tax reform".
As is the case with any compliance programme, appropriate documentation will be important in supporting the tax outcomes of both the transition into consolidations and transactions undertaken in the consolidation regime.
Internal affairs
Entry into consolidation should lead to simpler internal dealings because under the single entity rule intra-group transactions between members of a consolidated group are treated as transactions between parts of an entity, meaning they do not produce amounts of income or expenses or result in a CGT disposal.
The single entity rule may lead to some headaches for business, as there remains confusion as to whether the rule will override Corporations Lawand accounting principles.
For example, under the old rules, if a new subsidiary borrowed to acquire a business from its parent, which gave rise to a profit in the parent, the interest would be deductible and the parent could generally pay a dividend out of its realized profit. Under the new rules the transaction would be treated as an interdivisional transfer (and will be ignored from a tax perspective) and the borrowing could be seen by the ATO as a borrowing to pay a dividend.
Although a profit will be realized for legal and accounting purposes, it is still unclear whether the ATO will take the same view. That is, they could argue that the profit is unrealized and try to deny a deduction for the interest in certain circumstances. It is considered that the consolidation rules cannot override legal and accounting principles but this needs to be confirmed.
Group members need to remain mindful that for the purposes of the various stamp duties in each state and territory, the transfer of assets between members is still considered a transfer between separate companies - and therefore likely to attract stamp duty. Some concessions are available but these need to be sought before undertaking any reorganization.
Deciding to consolidate
Groups who are seriously considering tax consolidation but have not yet embarked on the process are faced with some complex decisions during the transitional period.
If there are any impending transactions likely for the group, it is vital that the timing of the consolidation event is considered in relation to the impact on the transaction's outcome.
That means looking at what the profit and loss will be on disposal if the group is or is not tax consolidated. The transitional period has certainly added to the complexity of the transaction process, but without considering the different outcomes, businesses can greatly increase their tax liability. Corporate governance will also require that both options are considered to ensure maximum value is obtained for shareholders.
Companies should also be aware that lending banks are significant stakeholders in the process, and it is important to communicate with financing institutions about the group's tax consolidation intentions and the impact on the financing of previous and future transactions.
We have seen situations in which banks have required the group to introduce TSAs and some situations in which the bank has prevented a consolidation because it is not prepared to allow the risk of transferral of losses or interference with the indebted company's cash flow. As a matter of prudence, covenants with the banks should certainly be investigated if consolidation is on the agenda.
Vendors should also expect purchasers to pay close attention to whether the vendor group has in fact consolidated as this will play a significant part in determining what tax liabilities the purchasers will inherit (if any).
With a myriad of areas to consider, there is no doubt that the introduction of the consolidation regime - and the passage through the transitional period - has increased the costs and complexities of transactions for businesses. The system is in evolution and businesses will find help from the ATO slowed by the precedential nature of each response.
Businesses are right to be concerned that transactions will be as, or more, difficult during the transition period than they were under the old rules. However, failure to be proactive and ensure that the proper processes are conducted could mean increased tax liabilities and even cause a de-consolidation event in some cases. It is important to remember that consolidation does provide benefits for taxpayers, and once all the legislation is finalized and the ATO have clarified their interpretations of certain areas, it will not be quite so difficult. For the moment, it is a matter of maintaining momentum and dedicating adequate resources to these processes until the system is bedded down.
Biographies |
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Cath is a director in our tax and legal services practice in Sydney with more than 10 years' experience providing advice to Australian and international groups on their financing and tax strategies. Her experience includes provision of tax due diligence and structuring services on both Australian and international transactions across a range of industries. While working in London, Cath gained valuable expertise across a range of mergers and acquisition services, including tax due diligence, vendor due diligence services, initial public offering and cross-border tax structuring.
Michael Davidson is a tax adviser with more than 18 years' Australian and international experience in the infrastructure, energy and mining and service industries. Before moving to Australia in 1990, Michael was the divisional tax manager of a large publicly listed industrial products company in London. Michael is experienced in advising the public and private sectors on issues such as corporate reorganizations and structuring transactions with tax-exempt entities. He has worked on a range of infrastructure, utility and resource industry projects in recent years and has considerable experience in cross-border transactions. He has worked on a range of infrastructure, utility and resource industry projects, with a focus on cross border transactions. Recent projects include structuring and due diligence on bids for globally recognised corporates.
Michael is a partner in the international tax and transaction services group in Sydney and has over 18 years' experience as a tax adviser. His principal areas of practice are:
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