On 25 November 2011 the Assistant Treasurer announced changes to the rules relating to tax consolidated groups and residual tax cost setting and rights to future income (‘RFI’).  The changes follow a review of the rules undertaken by the Board of Taxation. The Board concluded that the scope of the rules were broader than intended, allowing for preferential tax treatment towards consolidated groups.

The Government has moved to retrospectively amend tax law in an obvious effort to return of Federal Budget to surplus by 2013 by plugging the otherwise significant revenue leak posed by the existing law.  

Interestingly, consolidated groups that acted quickly to have their amended tax returns processed or have received a favourable private binding ruling or advance compliance agreement (in relation to the retrospective application of the existing law) will not be adversely impacted by the retrospective change.  One might question just how equitable this is in the overall policy framework of the law change –especially since most of these taxpayers are likely to represent the larger end of town

Background

Broadly, when an entity joins a tax consolidated group, the tax cost setting rules apply to allocate a tax cost to the assets of the joining entity.  This tax cost is then used by the head company in working out the tax consequences in dealings with the asset (e.g. depreciation).  The nature of the asset determines the tax cost. Where there is no specific tax provision to allocate the cost, the residual tax cost setting rules will apply to determine the tax cost.

The current rules relating to residual tax cost setting and RFI were introduced in June 2010, though their application was backdated to 1 July 2002; the start of the consolidations regime. They apply to allocate a tax cost setting amount for a tax consolidated group in relation to a joining entity’s interest in assets that qualify as RFI.
 
The law as it currently stands suggests that an RFI asset will include rights to payment under:

• long term construction contracts; 
• perpetual or annual service contracts; 
• unbilled income.

Where a consolidated group acquires an entity that holds an RFI asset the current rules allow a consolidated group to claim a deduction (over a maximum period of 10 years) equal to the tax cost amount of the asset. In this way the deduction that is claimed by the consolidated group should offset the income that is expected to arise under the future income right.

Proposed Changes

In essence, the proposed changes will undo the amendments that were introduced in June 2010. 
The changes include a number of alternatives that apply depending on the timing of the acquisition or arrangement giving rise to the joining a tax consolidated group. 

Prospective Period

For entities joining a consolidated group under an arrangement made on or after 31 March 2011, the following changes are proposed:

The tax cost setting rules will apply only to assets already recognised for tax purposes
Where an entity joins a consolidated group, only assets that are recognised for tax will have their costs set. This will predominately be capital gains tax assets.  It follows that assets such as non-contractual customer relationships will be excluded.

• Residual tax cost setting rules modified to apply a business acquisition approach
   A head company will be treated as having acquired the assets of a joining entity as if they were  acquired as part of a business acquisition. The characterisation of an asset as  revenue or capital will  be determined as if the assets were acquired as part of a business acquisition.
• The reset tax costs for assets that qualify as work in progress or are consumable stores will be deductible
   The general tax provisions will be amended to ensure that a deduction is available for work in  progress amounts or consumable stores held by a joining entity.
• Entitlements to future income under contracts to be treated as retained cost base assets
   Contracts giving rise to a right to future income assets (i.e. these are assets that are currently treated as RFI) will be treated as retained cost base  assets. This will prevent the tax cost of such assets being reset upon consolidation.
• Rights to future income deduction to be repealed
   Significantly, the existing provisions that allow a deduction for rights to future income of  joining entities will be repealed.  

Transitional Arrangements

For arrangements entered into between 12 May 2010 and 30 March 2011, transitional arrangements will apply.

For the transitional period, the current provisions will be retained with some amendments: 

• Certain assets will be included as goodwill;
• Exclusion of mine site improvements from the residual tax cost setting rules; and
• Amendments to ensure that no value is attributed to certain contractual RFI.

Importantly consolidated groups that did acquire an entity that held rights during this transitional period (embedded in a contract) for work to be performed or goods to be provided (excluding rights contingent on contract renewal) may have an entitlement to reset the tax cost of such rights and claim a deduction equal to the tax cost.

Arrangements prior to 12 May 2010

Where an entity joined a consolidated group prior to 12 May 2010 or where an arrangement was entered into prior to 10 February 2010, the tax cost setting rules prior to the 2010 amendments will apply with some significant amendments, including:

• Rights to future income deductions will be limited to unbilled work in progress amounts and consumables.
• The amendment period for claiming a deduction for RFI will be limited to the ordinary amendment period – for most affected groups this will be four years from the date of the lodgement of their tax return.

We note that whilst limited deductions may be available to some consolidated groups – the proposed amendments represents an unreasonable reduction in the deductions that are currently available. 

Next Steps

The retrospective application of the proposed changes means that there will be considerable impact on consolidated groups that have not had their amendment request processed or do not have a private binding ruling or Advance Compliance Agreement in place.

The Government will undertake a public consultation on draft legislation. Moore Stephens will be involved in this process, and will provide updates as the process evolves. 

If you wish to discuss the proposed changes further please contact one of the authors or your Moore Stephens Relationship Partner.

Authors: Stephen O’Flynn, Simon Tucker & Angela Sagoe-Crentsil, Moore Stephens Melbourne.

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