mafm M0111385988v1 150630 9.9.2003
Mergers and Acquisitions – Some
Current Issues
Taxation Institute of Australia
42nd Victorian State Convention
11-13 September 2003
Martin FryPartner
Allens Arthur Robinson
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Table of Contents
1. Buy/Selling the Assets or the Company 3
2. Dealing with the Acquisition of Consolidated Entities 4
2.1 Summary of the Joint and Several Liability Issue 5
2.2 Guidelines for Purchasers 7
2.3 Quantify the Risk 8
2.4 Responses to the Joint and Several Liability Risk 11
3. Current Problems and Opportunities 14
3.1 Losing Cost Base on Wasting Assets 14
3.2 Purchase Price Strategies 16
3.3 Issues for Foreign Bidders 18
3.4 Using Demerger Relief 20
Appendix A 22
Tax Cost Setting On Exit 22
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Mergers and Acquisitions - Some Current Issues
42nd Victorian State Convention
Taxation Institute of Australia
The topic 'Mergers and Acquisitions' is an extremely broad one and, as such, the objective is to
identify aspects of this broad topic which are most relevant in the current context.
With this objective in mind, this paper addresses the following:
(i) a brief and limited comment on the choice between buying/selling a company or the assets
of a business in the post consolidation environment – refer 1;
(ii) an analysis of the 'joint and several liability' issue. When a purchaser acquires a targetentity from a consolidated group it must come to terms with the potential for the target to be
jointly and severally liable for unpaid tax of the entire vendor group. At 2. below I have
sought to define the boundaries of this risk from a practical or realistic perspective. I
have also briefly commented on responses to this risk, ie vendor warranties, de-grouping
etc.
(iii) a summary of technical and practical issues that are arising in current M&A transactions as
a consequence of recent law change. Specifically:
• the problem of 'losing' cost base on the wasting assets of the target entity, which
arises from the calculation of the target entity's ACA upon exit – refer 3.1 below;
• various strategies designed to extract value out of the target entity prior to its exit,
including the treatment of pre-exit dividends, pre-exit liabilities, CGT Event L5 –
refer 3.2 below;
• issues for foreign bidders wishing to avail themselves of the tax consolidation rules
– refer 3.3 below;
• current issues arising under the demerger tax rules – refer 3.4 below.
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1. Buy/Selling the Assets or the Company
One of the fundamental questions posed in M&A transactions is whether to buy/sell the
assets of a company or the company itself.
The advent of tax consolidation has introduced a powerful new factor into this question.
Specifically, as it is now essential to at least contemplate (if not assume) that acquisitions
and disposals will occur between corporate groups that are or will become consolidated,
the potential for the target entity to be liable for the tax obligations of the entire vendor
group is a new factor which the purchaser must feed into the price of acquiring the target
entity.
When this potential liability of the target entity is added to the fact that the target entity will
leave its tax losses, franking credits and foreign tax credits behind in the vendorconsolidated group, some commentators have suggested that acquisitions/disposals will
now almost always occur by way of an asset sale.
This is clearly not the case. The acquisition/disposal of corporate entities will continue to
be a feature of the M&A landscape for a number of reasons, including:
(a) stamp duty – an asset acquisition will often trigger a higher stamp duty cost than a
share acquisition;
(b) complexity – if a business is highly regulated and/or involves highly complex or
restrictive contracts, the complexity of 'unscrambling the egg' can lead a purchaser
to prefer a share acquisition. This is particularly so if the purchaser wants to
execute the acquisition quickly;
(c) regulatory – asset acquisitions can involve a higher regulatory hurdle than share
acquisitions. For example, under each of the State Mining Acts the transfer of
mining and exploration tenure requires Ministerial consent and in some cases may
not be permitted. By contrast, in most jurisdictions of Australia the sale of an entity
which holds such tenures does not require Ministerial consent.
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2. Dealing with the Acquisition of Consolidated Entities
As suggested above, in my view it cannot be doubted that the acquisition of corporate
entities (as opposed to assets) is 'here to stay'. Hence, players in the M&A market will
have to come to grips with the special issues that arise under tax consolidation where a
corporate entity is acquired.
Obviously the tax consolidation rules have enormous implications in this context, the most
striking of which is the ability of the bidder to push the price paid to purchase a company
into the assets owned by the company via the ACA steps.
The costs and benefits of the ACA 'push down' have been dealt with comprehensively at
this and other conferences and I do not wish to develop that theme.
Rather I wish to focus on the 'joint and several liability' issue. As we know, a subsidiary
member of a consolidated group can be jointly and severally liable for unpaid tax
obligations of its consolidated group: Division 721, Tax Act 1997. When a purchaser
acquires a target entity from a consolidated group, it must evaluate that risk and factor it in
to its analysis of the acquisition.
In this section of the paper I will attempt to define the boundaries of that risk and provide
guideline for evaluating the extent of the risk. I will also comment on some of the
responses to the risk that have arisen in M&A transactions thus far.
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2.1 Summary of the Joint and Several Liability Issue
The 'joint and several liability' issue has been the subject of conference papers in recent
times – see for example Grant Cathro's paper at the Taxation Institute of Australia's First
National Consolidation Symposium, Leura NSW, February 2003.
The following is a summary of the effect of Division 721 for the purchaser of a target entity
that is sold by a consolidated group.
(a) The first relevant risk for the purchaser arises from the fact that elections to
consolidate can operate retrospectively.
Specifically, the vendor group can elect for consolidation to apply with effect from
1 July 2002 or a later time (the Start Date), and the vendor group is not required to
actually lodge the election until it lodges its income tax return for the income year in
which Start Date occurs.
(b) As a consequence of the single entity rule, the head company of the vendor group
must pay the tax liabilities of the consolidated group (section 701-1, Tax Act 1997).
However, if the head company has not paid in full any of the group liabilities of
the vendor group by the time due and payable, then the head company and the
entities that were subsidiary members of the group at any time during the period to
which the group liabilities relate are jointly and severally liable to pay the unpaid
group liability (section 721-15, Tax Act 1997). This joint and several liability arises
just after the time that the group liability was due and payable, and the liability of aparticular subsidiary member becomes due and payable 14 days after the
Commissioner gives notice of the liability.
The group liabilities are defined to include the liability for income tax (section 204,
Tax Act 1936), PAYG Instalments, general interest charges and penalties, franking
deficit tax (section 160ARV, Tax Act 1936), untainting tax (section 160ARDZ, Tax
Act 1936).
(c) However the joint and several liability for unpaid group liabilities does not arise if
the group liability is covered by a Tax Sharing Agreement (or if a particular
subsidiary member is precluded by law from entering arrangements which give rise
to joint and several liability – this category has not been prevalent in my
experience): section 721-15(2), (3), Tax Act 1997.
(d) A group liability is covered by a Tax Sharing Agreement if, just before the liability
became due and payable (section 721-25, Tax Act 1997):
(i) an agreement existed between the head company and one or more
subsidiary members of the group;
(ii) under the agreement, a particular amount (the contribution amount)
could be determined for each subsidiary member in relation to the group
liability;
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(iii) the contribution amount for each subsidiary member represented areasonable allocation of the total group liability among the head company
and the subsidiary members; and
(iv) the agreement complied with requirements set out in regulations (there are
no regulations at present).
However a group liability is not covered by a Tax Sharing Agreement if:
(i) the Agreement was entered into as part of an arrangement the purpose of
which was to prejudice the recovery by the Commissioner of the group
liability; or
(ii) the Commissioner gives the head company a written notice requiring it to
give the Commissioner a copy of the Agreement within 14 days after thenotice is given, and the Commissioner does not receive a copy of the
Agreement within that time.
(e) Where a group liability is covered by a Tax Sharing Agreement, subject to (f) next
each subsidiary member is liable to pay to the Commonwealth an amount equal to
the contribution amount determined under the Agreement (section 721-30, Tax Act
1997).
(f) A subsidiary member is not liable to the Commonwealth for its contribution amount
if the subsidiary member left the group clear of the group liability, meaning
(section 721-35 Tax Act 1997):
(i) the subsidiary member exited the consolidated group before the group
liability became due and payable;
(ii) the exit was not part of an arrangement the purpose of which was to
prejudice the recovery by the Commissioner of group liabilities; and
(iii) before its exit, the subsidiary member paid to the head company its
contribution amount in respect of the group liability or, if that cannot be
determined, a reasonable estimate thereof.
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2.2 Guidelines for Purchasers
The purchaser of a target entity clearly needs to think carefully about the potential for the
target to be liable for taxes relating to its time as a member of the vendor group.
In evaluating the extent of the joint and several liability issue, the purchaser of the target
entity can draw the following relevant conclusions.
(a) The potential for the target entity to be liable for taxes of the vendor group is onlyrelevant to the extent that the head company has or will default on payment of a
group liability which relates to the period during which the target entity was a
member of the vendor group (whether for all or part of that period).
(b) Where the head company of the vendor group has defaulted on payment of a
group liability, the target entity's potential liability is to pay the entire group liability.
(c) The target entity's potential liability will be mitigated if the unpaid group liability is
covered by a Tax Sharing Agreement that satisfies section 721-25 – that is:
(i) the Agreement existed when the unpaid group liability became due and
payable;
(ii) the contribution amount of each subsidiary member can be determinedunder the Agreement in respect of the unpaid group liability;
(iii) the contribution amount is a reasonable allocation of the unpaid group
liability amongst the head company and subsidiary members;
(iv) the purpose of entering the Agreement was not to prejudice theCommissioner's recovery; and
(v) the Commissioner has or will receive a copy of the Agreement within
14 days of requesting a copy in a written notice relating to the unpaid group
liability;
Where these requirements are met:
(i) the target entity's potential liability is mitigated in that it is not jointly and
severally liable for the entire unpaid group liability;
• however, the target entity is liable to the Commonwealth for payment of its
contribution amount under the Agreement (even if it has in fact paid an
amount to the head company under tax funding arrangements which may
exist between the head company and the target entity).
(d) The target entity's potential liability to the Commonwealth for its contribution
amount is eliminated if the target entity pays its contribution amount (or a
reasonable estimate thereof) to the head company of the vendor group before the
target entity exits the group.
However this is only effective in respect of the target entity's liability for contribution
amounts which relate to group liabilities which are due and payable after the
target entity exits the vendor group.
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2.3 Quantify the Risk
Based on the conclusions drawn at 2.2 above, where a purchaser acquires a target entity
from a consolidated group, it could apply the following rules in attempting to quantify the
risks associated with 'joint and several liability' issue.
The first rule is that the target entity can only be liable for taxes of the vendor group to the
extent that:
• the head company of the vendor group fails to pay a group liability when due and
payable; and
• that unpaid group liability relates to a period during which the target entity was amember of the vendor group.
We can call this Solvency Risk .
The subsequent rules are as follows, and they apply on the assumption that the head
company of the vendor group fails to pay a group liability which relates to a period during
which the target entity was a member of the vendor group.
(a) Where the vendor group has a Tax Sharing Agreement that 'covers' the unpaid
group liability (ie it satisfies section 721-25), then the Solvency Risk is mitigated.
That is:
(i) in respect of unpaid group liabilities which were due and payable before
the target entity's exit – target entity is liable to the Commonwealth for itscontribution amount;
(ii) in respect of unpaid group liabilities which are due and payable after the
target entity's exit, and only those which relate to a period during which the
target entity was a member of the vendor group – target entity is liable to
the Commonwealth for its contribution amount, unless the target entity paid
its contribution amount (or a reasonable estimate thereof) to the head
company of the vendor group prior to its exit from the group (in which case,
target entity has no liability to the Commonwealth for that amount).
(b) Even if the vendor group has a Tax Sharing Agreement that satisfies
section 721-25, there is a Prior Year Amendment Risk , which manifests itself as
follows:
(i) if the head company of the vendor group has not defaulted on a group
liability relating to a period during which the target entity was a member of
the vendor group, there is a risk that an amended assessment will issue
relating to that period and the head company defaults on the amendedliability. This is probably just another example of Solvency Risk;
(ii) there is a risk that an amended assessment will issue relating to a period
during which the target entity was a member of the vendor group and, as a
consequence:
(A) the Commissioner takes the view that the calculation of the
contribution amounts under the Tax Sharing Agreement was not
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reasonable (eg because under the Agreement the contributionamount of members was defined such that a member was not
required to contribute towards an amended assessment that arose
from that member's business) in which case the Agreement is not
effective; or
(B) the Commissioner takes the view that the target entity's
contribution paid prior to exit was not reasonable, in which case a
clean exit is not achieved in respect of unpaid liabilities which are
due and payable after exit.
(c) There is a TSA Compliance Risk , which is the risk that:
(i) the Tax Sharing Agreement did not exist when the unpaid liability became
due and payable;
(ii) the Agreement is not sufficiently well drafted to ensure both that the
contribution amounts of subsidiary members for the unpaid group liability
can be determined, and that the amount determined represented a
reasonable allocation amongst the head company and the subsidiary
members;
(iii) the Commissioner does not receive a copy of the Agreement within
14 days of making a written request for a copy. This risk lives on after
target entity's exit, but only in respect of a written request by theCommission in respect of an unpaid group liability relating to the period
during which target entity was a member of the vendor group;
(iv) a purpose of entering the Agreement was to prejudice the Commissioner's
recovery of group liabilities.
(d) Finally there is a Clean Exit Compliance Risk , which is the risk that:
(i) the target entity did not pay its contribution amount (or a reasonable
estimate thereof) to the head company of the vendor group prior to target
entity's exit;
(ii) a purpose of the target entity's exit from the vendor group was to prejudice
the Commissioner's recovery of group liabilities.
Conclude
The fact is that the overwhelming majority of M&A transactions are conducted between
parties who do not default on payment of their tax obligations.
With this in mind, it is clear that in the majority of cases the 'joint and several liability issue'
has not materially altered the risks associated with purchasing a target entity, even though
it would now generally be prudent for purchasers to assume that the target entity is being
sold from a consolidated group (whether or not the election has yet been made).
There is one highly technical qualification to this proposition. Although it is true to say that
the majority of corporate groups do not default on payment of their tax obligations, as a
technical matter it should be noted that the joint and several liability of group companies isinvoked if the head company falls to pay or otherwise discharge a group liability by the time
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it was due and payable (section 721-10). Hence as a strict technical matter it is invoked ifthere is non-payment of a group liability by the time it is due and payable,
notwithstanding that non payment by the due time may have resulted from an
administrative oversight and may have been rectified very shortly thereafter.
Of course, in the less common cases where a purchaser is acquiring a target entity from a
vendor group that has a history of insolvency or otherwise may have difficulty in paying its
tax debts at present or in the near future, then the risk of the 'joint and several liability
issue' must be taken seriously by the purchaser. This is particularly so if the target entity
represents a significant proportion of the vendor group's assets or cash flows.
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2.4 Responses to the Joint and Several Liability Risk
Thus far I have witnessed three responses to the joint and several liability risk in M&A
transactions. I will comment briefly on each.
No Concessions
The first response has been for the vendor group to refuse to give the purchaser any
concessions to mitigate the joint and several liability risk.
This response arose out of the early stages of the transition period, where vendor groups
had not yet decided the date from which they would elect to enter consolidation and
purchasers requested the vendor group to warrant that they would not enter consolidation
until after completion of the sale of the target entity. Vendor groups refused (quite
reasonably) to give any such warranty and purchasers were required to live with the
inherent risks.
Vendor groups have also refused to provide the purchaser with copies of Tax Sharing
Agreements, generally because very few Agreements have yet been drafted. Indeed,
some corporate groups take the view that they may not enter into a Tax Sharing
Agreement as it is only relevant in the case of default on tax obligations and default is not
considered to be a realistic risk by some groups. Again, in my experience purchasers have
had to live with this.
Clearly the question of whether the no concession stance will prevail in an M&A transaction
will depend on the characteristics and relative bargaining power of the vendor andpurchaser.
Representations and Warranties
The more typical response has been for purchasers to seek warranties and indemnities as
a means of mitigating the joint and several liability risk (acknowledging that the risk only
arises where the vendor group has failed to pay its group liabilities and that, as such, thevalue of warranties and indemnities from a vendor group which has been unable to meet its
tax obligations may be limited).
A purchaser may wish to seek the following to mitigate the joint and several liability risk
(this list is not exhaustive, as each transaction is different and each purchaser has a
different view of the joint and several liability risk; note also that the list relates only to the
joint and several liability risk):
(a) a warranty that the head company of the vendor group has not failed to pay any
group liability when due and payable;
(b) a warranty that the vendor group will not fail to pay a group liability which is not yet
due and payable and which relates to the period during which the target entity was
a member of the vendor group;
(c) a warranty that the vendor group has a Tax Sharing Agreement that satisfies
section 721-25. The purchaser will want to view the Agreement and:
(i) attempt to form a view on whether the methodology for determining
contribution amounts represents a reasonable allocation;
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(ii) identify the liability (if any) of the target entity under the Agreement forcontribution amounts relating to amended assessments;
(iii) identify the time from which the Agreement existed (as the Agreement is
only effective to the extent that it existed at the time there was default on
payment of a group liability);
(iv) attempt to identify whether, as a minimum, the main subsidiary members ofthe vendor group are parties to the Agreement;
(d) a warranty that the vendor group has not failed to provide the Commissioner with a
copy of the Agreement within 14 days of the Commissioner making a written
request in respect of a group liability, and that the vendor group will not fail to do so
in the future to the extent a written request is made in respect of a group liability
relating to a period during which the target entity was a member of the group;
(e) a warranty that the target entity has paid its contribution amount (or a reasonable
estimate thereof) for group liabilities that become due and payable after the target
entity's exit and that relate to a period during which the target entity was a member
of the vendor group;
• a warranty that neither the Tax Sharing Agreement nor the target entity's exit from
the vendor group were part of an arrangement a purpose of which is to prejudice
the Commissioner's ability to recover group liabilities.
Degroup Target Entity
A third response that has been used in this transition period into consolidation has been to
degroup the target entity. This is obviously not a long term strategy and is only available if
the vendor group had pre existing plans to sell the target entity and had the foresight to
cause the target entity to issue one or more degrouping shares prior to the group's
consolidation start date.
There are a few points to make here.
• First, where the degrouping of the target entity is effected prior to the vendor
group's consolidation start date, then for the purposes of determining the taxable
gain or loss from the sale of the target entity for the vendor group, the cost base of
the shares in target entity will be determined by the traditional CGT rules and not
by the ACA push down.
• Second, the de-grouping shares create both practical and legal difficulties because
the vendor group wants to achieve two outcomes which can be at odds with each
other. Specifically, it wants to establish that no member of the vendor group is the
beneficial owner of the shares (sections 703-15, 703-30), but it also wants to
ensure that it controls the shares in every respect and, in particular, that it is able to
deliver those shares to the purchaser of the target entity. The need to control the
shares leads to the creation of put and call options and other contractual devices,which can undermine the original objective of de-grouping the target entity.
• Finally, in my experience purchasers have not been comfortable with the types of
structures that are necessary to de-group the target entity. This seems to have
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arisen from the purchaser's concern that it may be acquiring a target entity with alatent exposure under Part IVA arising from the de-grouping structure. Although
the technical basis for this concern is questionable it has been a real consideration.
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3. Current Problems and Opportunities
The purpose of this section of the paper is to summarise the problems and opportunities
which are cropping up in current M&A activities as a consequence of recent law change.
3.1 Losing Cost Base on Wasting Assets
One of the key issues to have arisen for a consolidated group that is selling the target
entity is the propensity for cost base to be 'lost' on wasting assets. The issue is bestillustrated by example. Refer also to the summary of the rules for calculating tax costs on
exit of a subsidiary member, set out in Appendix A.
(a) Vendor group paid $200 to acquire all of the shares in the target entity. The target
entity held a truck and a printing press, each with a market value of $100.
(b) When vendor group acquired the target entity, the target entity was a joining entityand, in accordance with Division 705 of the Tax Act 1997, the tax costs of the truck
and printing press were set at $100 each ie vendor group 'pushed down' the $200
cost of equity in the target entity into the assets of the target entity.
(c) Five years later, vendor group is approached by a purchaser wishing to acquire the
target entity. As a consequence of target entity's business success, the purchase
price is $200. However, at this time the adjustable values of the truck and printing
press have been written down under Division 40 to $30 each.
(d) Pursuant to Division 711, the cost base of vendor group's shareholding in the
target entity will be $60, despite the fact that it paid $200 to acquire the target entity
five years previously. This is because Step 1 in calculating the ACA of a leaving
entity is to aggregate the terminating value of, broadly speaking, all assets of the
leaving entity (sections 711-20, 711-25, 711-30 of Tax Act 1997). This amount is
then spread across the membership interests in the leaving entity to determine the
cost base of those membership interests for the vendor group (ie for the purposes
of calculating the vendor group's gain/loss on sale of the target entity). There are
other steps in calculating the ACA of the leaving entity, but they are not relevant for
the purpose of demonstrating the problem of 'losing' cost base on wasting assets.
There are a few points to be made on this issue:
(i) First, the fact that vendor group's cost base is 'lost' on the target entity's
wasting assets is broadly in line with the intended policy outcome of the tax
consolidation rules – that is, the same tax outcome would apply regardless
of whether the vendor group sold the target entity itself or the assets of the
target entity.
(ii) Second, although $140 of the vendor group's cost base is not available
when it sells the target entity in year 5, the vendor group has claimed
Division 40 deductions for that cost base over the 5 year period. As such,
there was a double loss to the Revenue under the pre-consolidation
position, as the vendor group would have claimed the $140 Division 40
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deductions and it would have offset the $140 cost base against the capitalproceeds from the sale of the target entity.
(iii) Third, goodwill has an interesting role to play in this situation.
Many commentators highlight the fact that, in the ACA push down for a
joining entity, the value of goodwill can act as an 'ACA sponge', in that it
'soaks up' tax cost and, in so doing, it draws tax cost away from itemswhich yield deductions (eg Division 40 assets, trading stock). This is
obviously viewed as detrimental.
However it is worth remembering that Step 1 in calculating the ACA of a
leaving entity includes the head company's cost base of goodwill that is
'taken away' from the vendor group by reason of the target entity's exit
(subsection 711-25(2), Tax Act 1997). Hence, where there was goodwill
recognised upon the target entity joining the vendor group and ACA tax
cost was allocated to that goodwill (in the manner described above), then
the tax cost allocated to the goodwill is recognised in the cost base of the
shares held in the target entity for the vendor group in calculating again/loss on the sale of the target entity.
However if the goodwill arose after the target entity joined the vendor
group, it will only be recognised as cost base if actual expenditure of the
vendor group can be attributed to the goodwill.
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3.2 Purchase Price Strategies
Vendor groups often seek to extract value out of the target entity prior to its exit and recent
law changes mean that the various strategies are producing interesting results.
(a) One strategy is for the target entity to take on a new borrowing which is used to
fund a pre-exit dividend to the vendor group and which has the effect of
suppressing the sale price of the target entity.
There are two points to be made here.
First, Step 4 in calculating the ACA of the leaving entity is to subtract the face value
of the leaving entity's accounting liabilities (sections 711-20, 711-45, Tax Act 1997;
refer Appendix A for a summary of tax cost setting on exit of the target entity).
Hence, the new borrowing will reduce the cost base of the vendor group's shares in
the leaving entity on a dollar-for-dollar basis.
Second, it is important to be aware of CGT Event L5 (section 104-520, Tax Act
1997). Under CGT Event L5, the vendor group is taken to make a capital gain to
the extent that the leaving entity's ACA upon exit is negative (refer Appendix A,
Step 5). Hence, a capital gain will arise if the new borrowing taken on by the
leaving entity exceeds the tax value of the assets of the leaving entity.
(b) Another strategy is for the target entity to declare a dividend in favour of the vendor
group which is not paid until after exit of the target entity. The unpaid dividend
creates a liability of the target entity at the time of exit, so the cost base reductionunder Step 5 of the exit ACA and CGT Event L5 mentioned at (a) above needs to
be considered here.
In addition, the removal of the intercorporated dividend rebate from 30 June 2003
(subject to the transitional rules) means that there must be a real risk of the
dividend being fully taxed on receipt by the vendor group unless it is franked. It is
not at all clear whether the single entity rule in section 701-1 is broad enough for
the dividend to be ignored for tax purposes on the basis that it was declared and
derived while the target entity was a member of the consolidated group. Of course
if the dividend were not paid and the purchase price were to be increased by an
equivalent amount the extra purchase price would also be taxable. However thevendor group may have revenue losses to offset the unfranked dividend.
(c) Another strategy is for the vendor group to revalue the assets of the target entity
and for the target entity to pay an asset revaluation dividend prior to its exit.
Prior to consolidation this strategy would not have been effective as the asset
revaluation dividend would be fully taxable – it would be excluded from theintercorporate dividend rebate (sections 46E and 46G to 46M, Tax Act 1936); it
would not be frankable (section 202-45, Tax Act 1997); and the Commissioner may
assert that it created an exposure under the dividend stripping provisions
(section 177E of the Tax Act 1936). See also TD 2003/3 on whether Part IVA
generally may apply.
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However, post consolidation the effect of the single entity rule is that transactions,distributions etc between the target entity and the vendor group are ignored whilst
the target entity is wholly owned by the vendor group for the purpose of
determining the liability to tax of the head company of the vendor group
(section 701-1, Tax Act 1997). As such, it is difficult to see how the dividend
stripping provisions can apply and, obviously, the removal of the dividend rebate
from 1 July 2003 is of no consequence.
The answer to this conundrum may be that the correct amount of tax will ultimately
be paid, as the vendor group will ultimately pay the asset revaluation dividend out
to shareholders as an unfranked dividend. However, if the vendor group is wholly
owned by a UK company and is therefore able to avail itself of the exemption fromdividend WHT under the Australia/UK DTA, there would appear to be a permanent
loss to the revenue.
Of course the asset revaluation dividend needs to be funded. If it is funded from
the target entity's cash reserves, the tax value of the cash asset is not available in
constructing the target entity's ACA for the purposes of determining the cost base
of the vendor group's shares in the target entity (section 711-25, Tax Act 1997). If
it is funded by the target entity taking on a new borrowing then the issues
discussed at (a) above need to be considered. Refer Appendix A for a summary of
how the exit ACA is constructed.
(d) Note that the treatment of pre-exit dividends in the pre-consolidation environment
is addressed by the Commissioner in TD 2003/3, where it is asserted that Part IVA
can apply.
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3.3 Issues for Foreign Bidders
Where the purchaser of a target entity is a non-resident, the non-resident purchaser has
the choice of acquiring the target entity directly or using an Australian resident subsidiary to
make the acquisition.
(a) If the non-resident purchaser uses an Australian resident subsidiary to make the
acquisition then the subsidiary can elect to form a consolidated group and push the
purchase price paid for the target entity into the assets of the target entity. If the
non-resident purchaser acquires the target entity directly then the cost base push.
down is not available (clearly, in the latter case the target entity can form a
consolidated group with its wholly owned subsidiaries (if any) but the purchase
price paid to acquire the target entity does not get reflected in the tax cost of itsassets in these circumstances.)
In this context the foreign bidder will need to have regard to the Commissioner's
recent statement on the application of Part IVA to consolidated groups (it is titled
'The application of Part IVA to elections to consolidate', has not yet been posted on
the ATO website and is undated. It was made available to the public on
1 September 2003). Specifically, the paper addresses structures which are
established to create the factual circumstances necessary for an entity to elect to
form a consolidated group.
The paper addresses 19 scenarios and scenarios 1 to 4 involve structures in which
an Australian resident company is inserted by a non-resident group so as to
become the head company of a consolidated group. None of the scenarios apply
directly to a non-resident purchaser's decision to utilise an Australian resident bid
vehicle, and in my experience non resident purchasers will utilise an Australian
resident bid vehicle for commercial reasons. Nevertheless it would be prudent for
the non-resident purchaser to ensure that its commercial rationale for using an
Australian resident bid vehicle is well documented.
(b) Another issue for a non-resident purchaser is the requirement that its Australian
resident bid vehicle not be a 'prescribed dual resident' as defined in section 6 of the
Tax Act 1936. If the bid vehicle is a prescribed dual resident it is not eligible to be
the head company of a consolidated group (section 703-15, Tax Act 1997). In
broad terms, the Australian resident bid vehicle will be a prescribed dual resident if
it is:
(i) a resident of Australia and a resident of the foreign jurisdiction (ie under the
tax laws of the foreign jurisdiction) and, under the terms of a dual residenttie breaker provision in a DTA with the foreign jurisdiction, the bid vehicle is
taken to be a resident of the foreign jurisdiction. For example, if a bid
vehicle was incorporated in Australia but had its effective management
located in Indonesia, the bid vehicle would likely be a prescribed dual
resident as a consequence of Article 4(4) of the Indonesia/Australia DTA;
or
mafm M0111385988v1 150630 9.9.2003 Page 19
(ii) a resident of Australia by reason only that it has its central managementand control in Australia and it has central management and control in
another country.
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3.4 Using Demerger Relief
The demerger tax rules contained in Division 125 of the Tax Act 1997 have become a
regular feature in M&A transaction, principally because they provide an avenue for a
successful purchaser to spin out entities which are owned by the target entity at the time of
purchase but which are not wanted by the purchaser.
The demerger tax rules have thrown up some interesting issues on recent M&A
transactions.
(a) The first issue that arises is whether a consolidated group can satisfy the
pre-conditions for demerger tax relief to apply.
A 'demerger' is defined in section 125-70 to be something that happens to a
'demerger group', and a demerger group is defined in section 125-65 to consist of a
head entity and one or more 'demerger subsidiaries'. A demerger subsidiary is
defined to be a company (or trust) in which, in broad terms, other members of the
demerger group hold ownership interests of more than 20%. As such, where the
entity to be spun out is a wholly owned member of a consolidated group, the effect
of the single entity rule in section 701-1 makes it very difficult to establish that ademerger subsidiary exists.
Under a qualifying demerger, tax relief is available at both the shareholder level
and the corporate group level.
The technical problem created by the single entity rule is probably confined toeligibility for tax relief at the corporate group level, as the single entity rule applies
only for the head company core purposes and the entity core purposes, and not for
the purpose of determining the shareholder's liability to tax.
(b) Another issue that has arisen in the context of M&A transactions arises from the
definition of the 'head entity' of a demerger group, and the fact that the demerger
rules are seen as a means of exit from an unsuccessful acquisition. Consider the
following example.
• Bidder makes an offer for all of the shares in Target, which is the head
entity of a group of companies. One of Target's subsidiaries is Jewell Co,which operates the business that Bidder wants most.
• Bidder's strategy is to offer up to $5 for Target. If the offer succeeds in
Bidder acquiring control of Target but not 100% ownership (eg 70% of
Target's shareholders accept the offer), Bidder's strategy is that it will
cause Target to demerge Jewell Co and will then make an offer to acquire
the minority shareholding in Jewell Co (ie the proportionate interest
requirement in section 125-70(2) of the demerger rules will require Jewell
to be demerged from Target pro rata to Bidder (70%) and the
non-accepting shareholders (30%) ).
• Under section 125-65, Jewell Co can only be demerged from Target if
Target is the head entity of a demerger group, which in turn means that
mafm M0111385988v1 150630 9.9.2003 Page 21
there must be no other company or trust which owns 20% or more ofTarget.
Bidder's 70% shareholding in Target means that Target is prima facie
unable to be the head entity of a demerger group and, as such, Jewell Co
cannot be demerged within the meaning of Division 125.
If Target is a listed entity, it can elect to ignore Bidder's shareholding whilstit remains less than 80% (section 125-65(5)). However if Bidder's
shareholding reaches 80%, then it is in the difficult position of being unable
to demerge Jewell Co but also being short of the 90% threshold for
compulsory acquisition of the minority shareholders.
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Appendix A
Tax Cost Setting On Exit
These notes are a brief summary of the rules which apply to determine the tax cost setting amount
of assets when an entity leaves a consolidated group (CG).
These notes do not cover other aspects of an entity leaving a CG, such as the liability for taxes
(see Division 721), the tax recognition of intra-group transactions which are on foot at the time of
exit (section 701-75), or the timing rules for the legal event of exit (section 703-33).
Concept
(a) While an entity is a member of a CG, the assets owned by the entity are treated as being
assets of the head company (HC).
(b) Also, the membership interests owned by the HC in the entity are effectively ignored (or
‘temporarily suspended’) for the period that the entity is a member of the CG.
(c) Therefore, when an entity ceases to be a member of a CG, for tax purposes (in particular,
for the HC core purposes of determining the taxable income of the HC of a CG: section
701-1(2) and 711-5(1)), it is necessary to reinstate and recognise the following:
(i) assets in fact owned by the leaving entity;
(ii) membership interests in the entity owned by the HC (or other member of the CG);
(iii) liabilities owed by the entity to the HC (or other members of the CG), and liabilities
owed to the entity by the HC (or other members of the CG);
(iv) other relevant contractual relationships between the HC and the leaving entity.
In other words, it is necessary to unravel the fiction that the leaving entity is a part of the
HC for tax purposes.
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Relevant Core Rules
When an entity leaves a CG, the Core Rules effectively distinguish between the following:
(a) first, sections 701-15, 701-20, 701-45 and 701-50 provide that the tax costs of the assets
and liabilities specifically identified in those sections are the ‘tax cost setting amounts’
prescribed in the table in section 702-60;
(b) second, for all other assets and liabilities (ie, those which are not specifically identified inthe sections noted in (a)), the tax costs will be determined by the exit history rule (which is
found in section 701-40).
An alternative way of viewing the tax cost setting rules is to say:
(a) when an entity leaves a CG, the HC needs to calculate: the tax costs of the membership
interests it held in the leaving entity at the time of exist (in which case the tax cost is set bysections 711-15 and 711-55, per section 701-60), the tax cost of any liabilities owed by the
leaving entity to the HC, being assets of the HC (in which case the tax cost is the market
value of the liability per section 701-60); and
(b) equally, when an entity leaves a CG, the leaving entity needs to calculate the tax cost of
membership interests it holds in other entities which also leave the CG as a consequence
of the leaving entity’s exit (in which case the tax cost is set by section 711-55, per section
701-60); the tax cost of liabilities owed by members of the CG to the leaving entity, being
assets of the leaving entity (in which case the tax cost is the market value of the liability,
per section 701-60); and the tax cost of all other assets, liabilities and businesses of theleaving entity (in which case the tax cost is set by the exit history rule, per section 701-40).
Core Rule (under whichthe tax cost is set)
Asset Tax Cost Setting Amount
s.701-15 membership interests held by the HC in theentity leaving
the amount calculated unders.711-15 or s.711-55 (per s.701-60)
s.701-20 liabilities owed by the leaving entity to the HC(ie, an asset of the HC)
market value (per s.701-60)
s.701-45 liabilities owed by a member of the CG to theleaving entity (ie, an asset of the leavingentity)
market value (per s.701-60)
s.701-50 membership interests held by the leavingentity in another entity which leaves the CGas a consequence of the leaving entity’s exitfrom the CG (eg, a wholly owned subsidiaryof the leaving entity)
the amount calculated unders.711-55 (per s.701-60)
s.701-40 (the exit historyrule)
subject to the above, any asset, liability,business or R & D registration of the leavingentity
the tax cost ‘carried over’ by theexit history rule, including anyprior application of the entryhistory rule (s.701-5) (refer noteto s.701-45(3))
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Section 701-40: Exit History Rule
Where an entity ceases to be a member of a CG, then (section 701-40 and paras 2.30 to 2.47 of
the Explanatory Memorandum):
(a) for the purposes of determining the taxable income etc of the leaving entity after exit from
the CG (but subject to other relevant rules, eg section 701-45, section 701-50);
(b) everything that happened in relation to the following while these things were held by theCG is taken to have happened to the leaving entity in relation to these things:
(c) this covers:
(i) any asset;
(ii) any liability or other thing which is a liability under accounting standards (note – this
is broader than the concept of liability in Step 2 of the ACA under the cost setting
rules for a joining entity: refer paragraph 2.41 of the Explanatory Memorandum);
(iii) any business;
(iv) any R & D registration which the leaving entity takes with it upon exit.
Hence, the leaving entity inherits the history of the assets, liabilities and business that it takes away
from the CG on exit. This covers both:
• things done while the assets etc were held by the HC, and assets etc acquired after the
leaving entity joined the CG; and
• the history of assets etc which the HC inherited when entities joined the CG.
The ‘history’ of assets etc refers to:
• the tax cost of the assets etc (including, for example, additional incurred by HC to upgrade
depreciable plant):
• deductions or assessable income which has accrued but not yet been recognised for tax
purposes (eg prepayments);
• private tax rulings (but not if the intra-group dealings which become recognised after exit
cause there to be a relevant change in the factual basis of the ruling).
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Division 711: Cost of Membership Interests in Leaving Entity
The rules for determining the tax cost setting amount of membership interests held in the leaving
entity by the HC are found in Division 711.
The rules distinguish between two scenarios (section 711-10(a) and (b)):
• first, where a single entity leaves the CG (section 711-15 ) – see next;
• second, where an entity (the first entity) leaves the CG and it owns membership interests
in other entities which also leave the CG as a consequence of the exit by the first entity.
Section 711-15: Single Entity Leaves the CG
Where a single entity leaves a CG, the tax cost setting amount of membership interests in the
leaving entity held by members of the old CG is determined as follows (section 711-15):
(a) first, calculate the old CG’s ACA for the leaving entity in accordance with section
711-20 – see below;
(b) second, if there is more than one class of membership interests in the leaving
entity: allocate the ACA to each class in proportion to the total market value of
each class;
(c) third, if there is only one class of membership interests: allocate the ACA pro-rata
to each membership interest; if there is more than one class: allocate the portion of
the ACA for each class (determined under (b)) pro-rata to each membership
interest in the class;
(d) fourth, if the leaving entity is a trust: not applicable.
Where, at the leaving time:
• a member of the old CG holds a right or option to acquire a membership interest in the
leaving entity (including a contingent right or option); and
• the right or option was created or issued by the leaving entity,
then the right or option is treated as a membership interest, and as a separate class of membership
interest (section 711-15(2)).
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Section 711-20: ACA of the Leaving Entity
There are five steps in calculating the ACA of the leaving entity (section 711-20):
ACA of Leaving Entity: Section 711-20
Step 1 add the terminating value of all assets of the leaving entity.
Note: the amount is increased for goodwill of the HC which is
referrable to assets or business of the leaving entity.
Step 2 add deductions that the leaving entity inherits from the HC when it leaves
the CG
Step 3 add liabilities owed to the leaving entity by members of the old CG (which
are assets of the leaving entity)
Step 4 subtract the value of all liabilities of the leaving entity, but note:
• not include liabilities which attach to assets
• use tax effect if the discharge of the liability will be a deduction
• use a ‘terminating value’ for liabilities which have accrued for
accounting but which are not yet recognised for tax, eg
unrealised FX gains/losses, accrued employee entitlements
• increase for employee shares in the leaving entity which were
ignored for the leaving entity to join the CG
• increase for anything which is equity for accounting but which
satisfies the debt test (ie, it is a ‘debt interest’ for tax but not for
accounting)
Step 5: Outcome
If the amount is:
• Positive: this is the ACA of leaving entity
• Nil or Negative: the leaving entity’s ACA is nil
• Negative: the HC makes a capital gain of this amount: CGT Event L5 (see section 104-520,
Sch. 21, No. 2 Bill).
But note special rules for:
• Division 715: interaction with value shifting rules and loss integrity rules (Division 165-CC,
Division 165-CD, Division 170-D);
• concessions for transitional groups for over-depreciated assets and pre-CGT assets (section
701-40 and section 701-45 of Transitional Provisions Act);
• pre-CGT assets (section 711-65).
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Section 711-20: The Five Steps
Step 1: Add terminating values
Add up the terminating values for the HC of the assets which the leaving entity takes with it when it
leaves the old CG – ie assets which are in fact owned by the leaving entity (section 711-25).
Per sections 711-30 and 705-30, the terminating value of the leaving entity’s assets is the ‘carrying
value’ of each asset for tax purposes. Hence, it is:
• for depreciable assets – the adjustable value;
• for qualifying securities – the amount necessary to ensure no gain or loss would be
triggered;
• for trading stock – cost or value as appropriate;
• for CGT assets – the cost base (note – this is changed to be the reduced cost base forpurposes of determining whether the HC realises a capital loss: section 711-20(2));
• for any other assets – the amount that would be the cost base if the asset were a CGT
asset.
Goodwill
Where (section 711-25(2)):
• the ‘loss of control and ownership of the leaving entity by the HC would decrease the
market value of goodwill associated with assets or businesses of the old group (other than
those of the leaving entity),
• then the Step 1 amount is increased by the cost base to the HC of the goodwill held by the
HC at the leaving time because of that ownership and control of the leaving entity.
In other words, where the leaving entity ‘takes goodwill away from the CG’, the Step 1 amount is
increased by the cost base to the HC of that goodwill.
Step 2: Add Inherited Deductions
Add an amount for deductions that the leaving entity inherits from the HC when it leaves the CG
(section 711-35). That is:
• the sum of deductions that the leaving entity will claim after leaving the CG which arise
from expenditure incurred while the leaving entity was a member of the CG (refer section
711-35(2)(a): this does not include depreciation deductions available to the leaving entity
after exit); and
• the tax value of deductions that the leaving entity inherits from the HC which relate to
expenditure incurred by an entity prior to it joining the CG (and which were brought in to the
CG by the entry history rule).
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Refer paras 5.120 to 5.121 and 5.98 to 5.101 of the Explanatory Memorandum. Examples ofrelevant amounts are expenditure allocated to software development pool (section 40-450), UCA
project pools (Division 40-1), borrowing expenses (section 25-25).
Step 3: Add Liabilities Owed by the CG to the Leaving Entity
Add the market value of each asset of the leaving entity which is a liability owed to the leaving
entity by members of the old CG (section 711-40).
Note:
1. It is necessary to add this amount here because it is not included in the Step 1 amount.
The Step 1 amount captures only assets which are assets of the HC as a consequence of
the fiction that the leaving entity is a part of the HC, as such the Step 1 amount will not
recognise an asset created by a liability owed by a member of the CG to the leaving entity.
2. Broadly, this amount is reduced to cost for CGT purposes of an asset of the leaving entity
created by a member of the old CG incurring a liability in favour of the leaving entity,
where:
(a) the incurring of the liability would have been a CGT event, eg Event D1 of F1; and
(b) the cost is less than the market value of the liability.
(Refer paragraph 5.123 of the Explanatory Memorandum.)
Step 4: Subtract Liabilities Owed by the Leaving Entity, and Employee Shares, andOthers
(a) Subtract the following (section 711-45) - each thing that, in accordance with accountingstandards, is a liability of the leaving entity, and which can or must be identified in the
leaving entity’s statement of financial position;
Note:
• This does not include a liability which arises because of the ownership of an asset
by the leaving entity, where the liability attaches to the asset and would transfer to
the purchaser upon sale of that asset – eg liability to rehabilitate a mine site, which
a purchaser of the mine becomes subject to because the liability effectively
attaches to the asset itself. (The rationale here is that a liability which attaches to
the asset is considered to suppress the market value of the asset itself, whichmeans that a lower amount of ACA is allocated to the asset at joining time or (if
acquired by the HC after joining time) a lower amount is paid to acquire the asset;
as such the liability must be excluded to avoid double counting.)
• To the extent the liability will give rise to a deduction for the leaving entity when it is
discharged, we multiply this amount by the company tax rate (minus a double
counting adjustment).
• To the extent the liability is an asset of a member of the old group, we use the
market value of the asset.
mafm M0111385988v1 150630 9.9.2003 Page 29
• If the tax recognition of the liability is deferred to a point in time after the accounting
recognition of the liability, then we use the amount that would be necessary to
discharge the liability and that would trigger no gain or loss for tax purposes (refer
paragraph 5.128 of the Explanatory Memorandum).
For example – accrued employee leave entitlements or FX gains and losses –
these are recorded as an accounting liability when the liability or FX gain/loss
accrues, but are only recognised for tax when the liability is incurred or the FX
gain/loss is realised. See example below.
(b) Increase the amount to be subtracted for – the market value of employee shares in the
leaving entity which were ignored at the joining time under section 703-35 so that theleaving entity could be a ‘wholly owned subsidiary’ of the HC.
(c) Increase the amount to be subtracted for – the market value of each thing that is recorded
as equity under the accounting standards, but which satisfies the debt test in Division 974.
Example of Unrealised Gain/Loss: section 711-45(5)
While the leaving entity was a member of the old CG, it borrowed US$100 and, at the time that it
incurred this liability, the A$ value of the liability was A$140. At the leaving time, the US$ loan
remains outstanding (repayment is not required for another two years) and the A$ has depreciated
such that the A$ value of the liability is A$180 – the leaving entity has an unrealised foreign
exchange loss of A$40, which is recognised for general accounting purposes at the leaving time
but is not recognised tax purposes under current law until the loss is realised.
Accordingly, the value of the US$100 liability under Step 4 is A$140, being the A$ value of the
amount that would discharge the liability and would not realise a taxable gain or allowable
deduction.
Step 5: Outcome
If the amount is:
• Positive: this is the ACA of leaving entity
• Nil or Negative: the leaving entity’s ACA is nil
• Negative: the HC makes a capital gain of this amount: CGT Event L5 (see section 104-520,
Schedule 21, No. 2 Bill).
But note special rules for:
• Division 715: interaction with value shifting rules and loss integrity rules (Divisions 165-CC,
165-CD and 170-D);
• concessions for transitional groups for over-depreciated assets and pre-CGT assets
(sections 701-40 and 701-45 of Transitional Provisions Act);
• pre-CGT assets (section 711-65).
mafm M0111385988v1 150630 9.9.2003 Page 30
Other Aspects
• Refer section 711-55 for the tax cost setting amount of membership interests where
multiple entities leave the old CG – eg where the wholly owned subsidiaries of the leaving
entity also leave the old CG as a consequence of the sale of the leaving entity.
• Refer sections 711-65 and 711-70 for rules dealing with pre-CGT assets.
