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The modifications to the basic rules in Subdivision 705-B are

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The modifications to the basic rules in Subdivision 705-B are outlined in the following extract from the
Explanatory Memorandum to the New Business Tax System (Consolidation, Value Shifting, Demergers and
Other Measures) Bill 2002:

Rules for the formation of a consolidated group

1.48     Subdivision 705-B contains the cost setting rules for the formation of a consolidated group. Each entity
that becomes a subsidiary member of a consolidated group at the time it is formed (the formation time) is treated
in the same way, subject to certain modifications, as an entity joining an existing consolidated group. [Schedule
3, item 2, section 705-130]

1.49      The Subdivision applies where one or more entities become subsidiary members of a consolidated
group at the time it comes into existence as a consolidated group. It applies by modifying the basic case rules of
a single entity joining a consolidated group. [Schedule 3, item 2, sections 705-135 and 705-140]

1.50     The modifications to the case of a single entity joining a consolidated group are:
•    order in which tax cost setting amounts are worked out (see paragraphs 1.52 to 1.55);
•    allocable cost amount adjustments where there have been roll-overs from the head company to subsidiaries
before the formation time (see paragraphs 1.56 to 1.66);
•    adjustments for successive distributions of profits (see paragraphs 1.67 and 1.68);
•     allocation of allocable cost amount to membership interests in subsidiary entities with certain losses (see
paragraphs 1.69 to 1.71); and
•    determining pre-CGT factors for assets of subsidiaries (see paragraphs 1.72 and 1.73).

Where a consolidated group forms before 1 July 2004 there are transitional options available that may alter the
treatment under the formation cost setting rules. Those transitional options are explained in paragraphs 1.77 to
1.114.

Order in which tax cost setting amounts are worked out

1.52      Where a subsidiary member of the group (the first subsidiary) holds membership interests in another
subsidiary member of the group (the second subsidiary), it is necessary to first apply the tax cost setting rules to
the first subsidiary. This will set the tax cost of the assets of the first subsidiary, including a cost for the
membership interests in the second subsidiary. [Schedule 3, item 2, subsections 705-145(1) and (2)]

1.53      The amount set for the membership interests in the second subsidiary will then determine the cost base
of those membership interests for the purposes of determining the joined group's allocable cost amount in
relation to the second subsidiary [Schedule 3, item 2, subsection 705-145(3)]. This amount replaces the amount
that would be worked out under subsection 705-65(1) in relation to these membership interests. As such,
subsections 705-65(2) to (4) do not apply in relation to this amount. However, the prevention of the later
operation of the value shifting rules in relation to these membership interests is preserved [Schedule 3, item 2,
subsection 705-145(4)].

1.54     This tax cost setting amount for the membership interests is not used for the purposes of working out the
terminating value of assets consisting of those membership interests. Rather, the terminating value of
membership interests is calculated by reference to the assets the leaving entity takes with it when it leaves the
consolidated group.

1.55       In the basic case of a single entity joining a consolidated group, rights and options to acquire
membership interests are treated as if they were membership interests. Similarly, in the formation case, rights
and options to acquire membership interests are treated as if they were membership interests. [Schedule 3, item
2, subsection 705-145(5)]
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Example 1.2: Order of application of the tax cost setting rules

Head Co owns all the membership interests in T Co. T Co owns all the membership interests in X Co. On 1 July
2002, Head Co forms a consolidated group with the other companies.

First, work out the tax cost setting amounts for T Co's assets according to the rules for an entity joining a
consolidated group. T Co's assets will include the membership interests T Co holds in X Co.

Then work out the tax cost setting amounts for X Co's assets according to the same rules. For this purpose, the
cost base of the membership interests in X Co (step 1 in working out the allocable cost amount) is determined by
the reset costs of those membership interests, the costs for these membership interests having been reset along
with the rest of T Co's assets.

Allocable cost amount adjustments where there have been roll-overs from the head company before the
formation time
1.56    In certain circumstances, where there has been a roll-over from the head company, adjustments need to
be made in working out the allocable cost amounts for subsidiary members.

1.57     One effect of a roll-over within a wholly-owned group (under Subdivision 126-B or section 160ZZO of
the ITAA 1936) is to defer the gain that would otherwise be brought to account as a result of the disposal. The
gain is deferred until the asset leaves the group - either because it is disposed of directly, or it leaves the group
via the disposal of an entity. The deferral takes place by allowing the recipient company to retain the originating
company's cost base for the asset. Another effect that can occur where the originator in a roll-over is the head
company, is that the group's aggregate cost for its assets following consolidation would be different from what it
would have been if the roll-over had not occurred. The purpose of this provision is to offset any effect that a roll-
over would otherwise have in altering a consolidated group's aggregate cost for its assets. [Schedule 3, item 2,
subsection 705-150(1)]

1.58       An adjustment is not required under the basic case of a single entity joining a consolidated group as the
relevant roll-over can only occur within a wholly-owned group. An adjustment is also not required where the
roll-over does not involve the head company. This is because:
•      Division 138 applies to adjust cost bases for membership interests where roll-overs shift value between
`sister' companies or from a wholly-owned subsidiary to its parent; and
•      a roll-over from a parent to its wholly-owned subsidiary will only alter the aggregate cost for assets in a
subsequently formed consolidated group where the originating company in a roll-over within a wholly-owned
group is the head company.

1.59     Allocable cost amount adjustments will need to be considered where all of the following conditions are
met:

•      before the formation time, there is a roll-over under Subdivision 126-B or section 160ZZO of the ITAA
1936 (the head company roll-over event) in relation to a CGT asset (the head company roll-over asset);
•     a member of the consolidated group was the recipient company (the head company roll-over recipient), and
the entity that becomes the head company of the consolidated group was the originating company, in relation to
the roll-over;
•       after the first roll-over but before the formation time there was not a further roll-over from the head
company to a member of the consolidated group (this can only occur if after the first roll-over the same asset was
rolled back to the head company and then rolled-over by the head company again - either to the same entity as
the first roll-over, or to another member of the consolidated group);
•     there was either:
-     no CGT event between the time of the roll-over and the formation time; or
-      if there was a CGT event, then there must have been a roll-over under Subdivision 126-B or section
160ZZO of the ITAA 1936;
•     the CGT asset that was the subject of the roll-over is not a pre-CGT asset at the formation time; and

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•    the sum of the head company's cost bases of all of its CGT assets just before the head company roll-over
event was different to the sum of the head company's cost bases of all of its CGT assets just after the head
company roll-over event.
[Schedule 3, item 2, subsection 705-150(2)]

1.60      The amount of any adjustment is worked out by reference to the head company roll-over adjustment
amount. The head company roll-over adjustment amount is the difference between the head company's cost
bases of CGT assets immediately before the roll-over and the sum of its cost bases of CGT assets just after the
roll-over event.

1.61     If the specified conditions are met (listed in paragraph 1.59), the result from step 3 in working out the
group's allocable cost amount for the recipient company is adjusted. The result from step 3 is reduced (if the
amount worked out for the purposes of this rule is positive) or increased (if the amount is negative) by the
amount worked out as follows:




B                                                                                    B




[Schedule 3, item 2, subsections 705-150(3)]

1.62     The components of the formula are such that, where the sum of the head company's cost bases for CGT
assets does not change as a result of the roll-over event, no adjustments are required. No correction is required
because the roll-over would not alter the group's aggregate cost for its assets after applying the cost setting rules
for consolidation from what that aggregate cost would have been if the roll-over had not occurred.

Example 1.3: Effect of a pre-formation roll-over

Prior to consolidation the head company of a consolidated group (HC) rolls over an asset with a cost base of $10
and market value of $100 to a subsidiary company (SC) for consideration consisting only of the shares issued in
SC. HC's cost base for the consideration shares is the market value of the roll-over asset (i.e. $100). This has the
effect of increasing HC's aggregate cost bases for its CGT assets, which include the membership interests in SC,
by $90. (Before the roll-over it had a CGT asset with a cost base of $10, after the roll-over it had a CGT asset
with a cost base of $100).

If HC and SC were then to form a consolidated group, HC's allocable cost amount for SC would be $100 at step
1, for HC's cost base for membership interests in SC. This amount is reduced under section 705-150 by $90 (the
head company roll-over adjustment amount). Assuming the asset is the only asset held by SC, upon
consolidation, the reduced allocable cost amount of $10 will be pushed down onto the rolled over asset.

Without a rule to reduce the allocable cost amount, after consolidation the roll-over would have increased the
group's cost base for its assets by $90.

1.63      Where the head company holds membership interests in a company interposed between it and the
recipient company, adjustments must be made to the step 3 result in working out the group's allocable cost
amount for the interposed entity.

1.64      The step 3 result is reduced (if the amount worked out for the purposes of this rule is positive) or
increased (if the amount is negative) by the amount worked out as follows:




B                                                                                    B




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[Schedule 3, item 2, subsection 705-150(4)]

1.65     If an adjusted step 3 result after applying these provisions would be negative, the step 3 result is taken to
be nil and the head company makes a capital gain equal to that negative amount. Rules to provide a CGT event
under which the capital gain will arise are to be included in a later bill.

1.66   In applying step 4, the adjusted step 3 result is the amount to be taken into account.
Adjustments for successive distributions of profits

1.67      A modification to step 4 of the allocable cost amount calculation is required on formation of a group to
prevent duplication of reductions in the allocable cost amount for distributions that are effectively a return of the
cost of acquiring membership interests. This duplication can occur if reductions are made separately for the
distribution of the same profits through a chain of 2 or more entities. [Schedule 3, item 2, subsection 705-155(1)]

1.68      The basic case rules are altered on formation so that if a reduction to the allocable cost amount for a
subsidiary member at the formation time is required because of step 4 in respect of a distribution, there is no
further reduction of the allocable cost amount of a second entity that becomes a subsidiary member of the group
at that time if step 4 would otherwise require a reduction for the successive distribution of that amount.
[Schedule 3, item 2, sections 705-155(2) and (3)]

Example 1.4: Successive distributions of pre-acquisition profits

Suppose Sub Co 2 makes a distribution of pre-acquisition profits (i.e. a distribution of profits that accrued to
membership interests before those membership interests came to be directly or indirectly owned by the head
company and which, therefore, would require an amount to be deducted at step 4 in working out the allocable
cost amount for an entity joining a consolidated group) to Sub Co 1 and Sub Co 1 also makes a distribution of
those same profits to Head Co. In this case, without modification step 4 would reduce the group's allocable cost
amount for Sub Co 1 and also reduce the group's allocable cost amount for Sub Co 2. This would result in a
duplicated reduction in allocable cost amounts as a result of the distribution of the same profits.
Therefore, the reduction is only taken into account in relation to the distribution by Sub Co 2, as the distribution
by Sub Co 1 is a successive distribution of the same amount.
Allocation of the allocable cost amount to membership interests in subsidiary entities with certain losses

1.69     The rule for the allocation of the allocable cost amount to reset cost base assets is
modified on formation where a reset cost base asset is a membership interest in a group entity and that group
entity has an amount of losses that will be deducted under step 5 of the allocable cost amount calculation. For the
purpose of allocating the allocable cost amount, the value to be used for that membership interest is its market
value plus the amount of that membership interest's pro-rata share of the losses. [Schedule 3, item 2, subsections
705-160(1) and (2)]

1.70     The amount of that membership interest's share of the losses is calculated under the following formula
(where the loss subtraction amount is the amount that is required to be deducted under step 5 of the allocable
cost amount calculation):
[Schedule 3, item 2, subsection 705-160(3)]

1.71      The purpose of the adjustment is to prevent a distortion in the allocation of the allocable cost amount. In
the absence of section 705-160, the losses of a subsidiary member would reduce both:
•     the amount of the allocable cost amount that is allocated to membership interests, which represent direct or
indirect interests in the subsidiary member with the losses (the unintended effect); and
•      the allocable cost amount for the subsidiary member with the losses (the intended effect of step 5 in
working out the allocable cost amount).

Example 1.5: Allocation to subsidiaries with membership interests in other subsidiaries with certain losses


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Head Company forms a consolidated group with subsidiary members S1 and S2. Assuming that S2 has an
amount of tax losses that will be deducted under step 5, when allocating the consolidated group's allocable cost
amount to the membership interests that S1 has in S2, the market value of those interests will reflect the losses
that S2 has, and will be therefore lower than if S2 did not have losses. The lower market value of these
membership interests will distort the amount of allocable cost amount allocated to those membership interests
and is an unintended consequence.

Therefore, when working out the market value of the membership interests that S1 has in S2, an amount must be
added to that market value to take into account S1's share of S2's losses.

Determining a pre-CGT factor for assets of subsidiaries

1.72      Where a head company's directly held and indirectly held membership interests in a joining subsidiary
entity are pre-CGT assets, the pre-CGT status of those interests is preserved by attaching a pre-CGT factor to the
assets, other than current assets, of the subsidiary. This treatment also applies upon the formation of a
consolidated group. The pre-CGT membership interests to be preserved, by attaching a pre-CGT factor to
underlying assets, are the pre-CGT membership interests held by the head company only. [Schedule 3, item 2,
subsection 705-165(1)]

1.73    If, when a consolidated group is formed, subsidiary members of the group hold membership interests in
another subsidiary member of the group, a pre-CGT factor must first be worked out for the assets of those
members before any pre-CGT factor can be worked out for the assets of the other subsidiary member. The actual
pre-CGT membership interest that the subsidiary member holds in the other subsidiary member is ignored.
[Schedule 3, item 2, subsection 705-165(2)]

Example 1.6: Determining a pre-CGT factor for assets of subsidiaries

Head Co owns all the membership interests in T Co. T Co owns all the membership interests in X Co. On 1 July
2002, Head Co forms a consolidated group with the other companies.

First, work out the pre-CGT factor for T Co's assets, including for the membership interests T Co holds in X Co.

Then work out the pre-CGT factor for X Co's assets. For this purpose, the number of pre-CGT membership
interests in X Co is determined from the pre-CGT factor for those membership interests worked out in
determining the pre-CGT factor for all of T Co's assets.




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Description: The modifications to the basic rules in Subdivision 705-B are