This article was originally published on 1 March 2018.
Long-awaited tax consolidation integrity measures have recently passed the Australian House of Representatives in the form of Treasury Laws Amendment (Income Tax Consolidation Integrity) Bill 2018. So what does the next chapter in consolidation hold and what are the implications for M&A activity?
On 28 February 2018 the Bill passed the House of Representatives without amendment and proceeded to the Senate. The measures broadly apply in the same manner as they did in the Exposure Draft (‘ED’) law that was released in September 2017, but there have also been further changes. Tax consolidated groups now have certainty in relation to the manner in which these integrity measures affect the tax cost setting rules and calculation of allocable cost (‘ACA’) amounts in respect of entities that either join or leave their group, but the changes continue to present complex interactions with many parts of the law and are critical to understand for any future M&A deals.
The six previously announced integrity measures that impact the tax cost setting rules when an entity joins and/or leaves a tax consolidated or multiple entry consolidated (‘MEC’) group are in the Bill and summarized in the table below with their respective start dates.
|1. Deductible liabilities excluded from step 2 of entry ACA||1 July 2016|
|2. Deferred tax liabilities excluded from both entry and exit ACA||15 February 2018|
|3. Securitised assets—related liabilities excluded from both entry and exit ACA||7.30pm (AEST) 13 May 2014 (for ADIs and financial entities)
7.30pm (AEST) 3 May 2016 for all other entities
|4. Foreign resident ‘Churning measure’—assets of joining entity to retain tax cost||14 May 2013|
|5. Alignment of consolidation with Taxation of Financial Arrangements (‘TOFA’)||1 July 2011 (or 1 July 2010 if TOFA early adoption election made)|
|6. Anti-value shifting measure for intra group debt asset leaving the group||14 May 2013|
*Arrangements that start on or after.
The Bill contains various changes made to the proposals in the ED issued in September 2017, which are noted below.
Measure No. 1—Clarification of the deductible liabilities measure
The deductible liabilities measure operates to completely disregard the deductible liabilities from step two of the entry ACA calculation in the same broad manner as was in the ED. And the Bill lists those accounting liabilities of insurance companies that will continue to be recognised in the entry tax cost setting process. Para 1.32 of the Explanatory Memorandum (‘EM’) now clarifies that an amount of an unearned income liability that may be reflected in financial statements is ‘not typically’ a deductible liability.
The EM also includes a new example 1.3 which confirms that the tax-effected amount of the deductible liability is applicable to illustrate the adjustment made to step three of the entry ACA calculation to ensure that a deductible liability that is excluded from step 2 is also not taken into account when working out the accrued undistributed taxed profits of the joining entity to the extent that the profit accrued to the joined group (i.e. in formation or stepped acquisition cases).
As the deductible liability measures will still apply from 1 July 2016, it will disadvantage companies that have been consolidated since this time, which is likely to lead to higher tax outcomes for such consolidated groups. In many cases, particularly for innovative and early stage businesses, the largest liabilities on the balance sheet are deductible in the future (e.g. annual leave liabilities and provisions to do with ‘making good’ leased premises), therefore we expect this measure to have an impact on decisions about the acquisition of such companies.
Measure No. 2—Disregarding all DTLs on exit
The Bill ensures that DTLs are disregarded under the exit tax cost setting rules for all arrangements under which an entity ceases to be a subsidiary member on or after 15 February 2018.
There is no longer the qualification that the leaving entity had its DTLs excluded on entry under the amending law. This is welcome news as it means that existing groups will not have to monitor the time at which a subsidiary member joins the group when seeking to exclude DTLs from the exit calculation.
Measure No. 4—Limited deferral of the anti-churn measure
The foreign resident churning measure, which is one of the most complex of the new integrity measures, and also one that is most widely drafted, continues to apply with retrospective effect from 14 May 2013. It can apply when a joining entity was not 100 percent part of a wholly-owned global group, and therefore potentially apply to transactions that are not merely internal reorganisations involving a foreign parent.
BDO’s submission recommended a modification to allow a partial ACA process be applicable to the proportion of the participation interests in a joining entity that were not previously held by consolidated group members and recommending it not apply where the Division 855 exempt gain is included in the attributable income and assessed to one of the members of the consolidated group.
BDO’s recommendations have not been fully adopted, however the Bill contains a transitional rule that ensures the participation interests of associates are only to be taken into account when determining the control entity in the joining subsidiary in respect of arrangements that commence on or after 15 February 2018. This ensures that taxpayers who have undertaken transactions in the past are not unfairly disadvantaged by what was an unforeseen extension of this provision. The Bill also ensures that there is no double counting of participation interests in working out the requisite level of control in the joining entity.
The measures in the Bill have the potential to reduce some of the complexity in the consolidation regime going forward, but the retrospective nature of most of the measures and the disparate start dates for the application of the measures means, in the short-term, many consolidated groups will have to review their previous consolidation arrangements to ensure they comply with the new rules.
Many of these consolidated groups will have to ask for amended assessments to either increase or decrease their tax liabilities from the past few years. On this note, the ATO has confirmed on its website that no penalties will be imposed where requests for amendments have been made within a short time after the changes are enacted and tax returns have been lodged in accordance to the law at the time or incorrectly in anticipation of the announced but un-enacted new law.
The measures also impact the way in which consolidated groups have and will calculate their ACA and will retrospectively affect many entities' entry and/or exit ACA calculations undertaken over the past few years and possibly as far back as 1 July 2010.
There may also be financial reporting implications as a result of the new measures, in particular deferred tax balances, which will need to be taken into account when preparing financial reports once the measures are substantively enacted.
Practical Implications for M&A
The consolidation integrity measures are critical to understand for any future M&A deals but they also present difficult and complex interactions with many parts of the law and the government has had some trouble drafting these amendments to achieve their goal of closing consolidation ‘loopholes’ without introducing disproportionate effects, which explains why it has taken several years to finalise them. BDO anticipate these changes could have detrimental impact on many companies entering a consolidated group and that the implications for M&A should be considered.
Typically, the initial formation of a tax consolidated group involves an entry ACA calculation for subsidiary members with a negligible (commonly AU$2) step 1 amount, referring to the ‘cost’ of the membership interest. Measure 2 acting to reduce the step 2 amount by the deferred tax liabilities may detriment the cost allocated to tax depreciable assets (among other assets) and could result in the overall deductions for a group decreasing as a direct result of consolidating.
BDO have advised on many matters to be considered before engaging in M&A deals, including where a business is purchased as part of an acquisition and net assets are used as a determination of consideration. Where consideration is determined based on net assets of an acquired company, step 1 of the ACA is in effect reduced for future deductible liabilities and DTLs (as applicable) which are no longer included at step 2.
For M&A deals involving tax consolidated groups, the concept of a ‘net assets for tax’ to determine consideration, which takes into account the impact of these differences can avoid under-allocation of tax cost to the assets of the target entity. Therefore, as part of the negotiation, more thought needs to be given to the value of liabilities acquired. In addition, expert valuations will likely increase in frequency to secure a market value for assets which give rise to future tax deductions to again prevent the unintended under-allocation of tax cost.
The retrospective nature of most of the measures and the disparate start dates for the application of the amendments means that many consolidated groups will have to review their previous consolidation arrangements to ensure they comply with the new rules. It is imperative that all tax consolidated groups that have had an entity join or leave their group in the past few years consider the effect of the rules, and whether there is a need to revisit past tax cost setting calculations and if so, whether any prior year income tax assessments are affected.