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Tax issues: A taxing rule

Every Issue

Cite as: (2003) 77(10) LIJ, p.90

Whether you consolidate or not, the joint and several liability rule has major implications.

The introduction, from 1 July 2002, of the “consolidation regime” represents one of the most significant and complex corporate tax reforms that has taken place in Australia in recent times. The consolidation regime enables a group of wholly-owned resident corporate entities to consolidate and be treated as a single entity for income tax purposes. While consolidation provides wholly-owned groups with a number of significant opportunities, it also creates many new challenges that need to be carefully considered by a range of parties.

This article outlines some of the broad features of the consolidation regime and focuses on one particular aspect of the new measures, namely the “joint and several liability rule”, highlighting some of the key practical issues associated with this rule and the major exception to it, which applies where there is a valid “tax sharing agreement” (TSA).

Choice to consolidate

Consolidation is not mandatory. The group’s resident “head company” may make an irrevocable choice to form a consolidated group. The head company has until it lodges its tax return for the income year in which it wishes the choice to take effect to make this choice. Accordingly, groups with a 30 June balance date will generally have until December 2004 to make a choice to consolidate from a particular date in the 1 July 2003 to 30 June 2004 income year. Once formed, a consolidated group continues to exist until the head company ceases to be a head company (e.g. where it is wound up or taken over by another resident company).

It is likely that most large corporate groups will choose to consolidate, not only because of the opportunities which consolidation provides but also because the various group tax reliefs (e.g. loss transfers and CGT roll-overs) generally ceased to be available from 1 July 2003.

Members of a consolidated group

A consolidated group consists of the “head company” and all its “subsidiary members”. Broadly, a “head company” is a resident company that is not a wholly-owned subsidiary of another resident company and the subsidiary members consist of all resident companies, trust estates and partnerships which are “wholly-owned” by the head company and/or one or more other subsidiary members. Certain entities cannot be members of a consolidated group, such as tax exempt entities, superannuation funds and entities that do not pay tax at the general corporate tax rate (e.g. pooled development funds).

Single entity treatment
One consequence of the single entity rule is that, during the period of consolidation, the assets of subsidiary members are treated as if they were assets of the head company. Unless transitional rules apply, the “tax cost” (e.g. CGT cost base or tax written down value) of these assets is reset according to special rules which are based principally on the group’s cost of acquiring the membership interests (and any liabilities) in the relevant subsidiaries. This may result in a step-up or step-down in the tax cost of such assets for, among other things, CGT and depreciation purposes.

Another important consequence of the single entity rule is that, during the period of consolidation, membership interests held in subsidiaries and intra-group transactions are generally ignored. This means that reorganisations within the group (e.g. liquidations, share buy-backs and cancellations, asset transfers) can generally occur without income tax consequences for the group and only external transactions between the group and third parties will generally have income tax consequences.

Any “tax related liabilities” (i.e. income tax and certain related liabilities) arising from such transactions are treated as tax liabilities of the head company, even if the subsidiaries were actually involved in the relevant transactions. The head company is required to file an income tax return on behalf of the group.

Joint and several liability of contributing members
While primary responsibility for a group’s tax related liabilities lies with the head company, if it fails to satisfy such liabilities by the time they become due and payable, the Commissioner may recover them from the subsidiaries that were members of the group during any part of the period to which the liability relates (“contributing members”). In general, such members become jointly and severally liable with the head company for any unpaid group liability just after the liability became due. Such liability becomes payable 14 days after the Commissioner gives the member written notice of it, which he may do at any time.

Tax sharing agreements

There is an exception to the joint and several liability rule, which operates where the group liability is covered by a valid TSA. A TSA is an agreement entered into between the head company and one or more of the contributing members (TSA contributing members) before the relevant group liability becomes due, under which a “contribution amount” for each TSA contributing member in respect of the group liability can be determined. This must represent a “reasonable allocation” of the total amount of the group liability among the head company and the TSA contributing members.

The effect of a valid TSA is that no contributing member will be jointly and severally liable for the group liability (even if they are not a TSA contributing member) and the liability of contributing members is limited to their respective contribution amounts (if any) under the TSA.

Clear exit rule

There is a also provision for a subsidiary to exit a group clear of a group liability which has not yet become due, where the liability is covered by a valid TSA and the subsidiary pays its contribution amount (or a reasonable estimate thereof) to the head company prior to leaving the group. It would be prudent for purchasers of companies that were formerly subsidiary members of a consolidated group to ensure that these procedures are followed, where possible, in respect of any outstanding group liabilities for which the former subsidiaries could become jointly and severally liable. It is not, however, possible to exit clear of potential liabilities under amended assessments for previous years that might be issued in the future.

ATO guidelines

The Australian Tax Office’s (ATO) policies and guidelines in relation to joint and several liability and TSAs are contained in its Receivables Policy (see: http://www.ato.gov.au). Among other things, these guidelines consider such matters as what is a “reasonable allocation” of a group liability, the form of a TSA and timing issues.

Conclusion

Many important practical issues flow from the joint and several liability and TSA rules. Practitioners advising in the area should note, in particular, the following points:

  • Only income tax and certain related liabilities, such as for PAYG instalments, are covered by these rules. They do not apply to GST, FBT or PAYG withholding liabilities.
  • The rules do not operate in respect of any pre-consolidation tax liabilities of the group members.
  • A subsidiary could be subject to joint and several liability for the entire period to which a group liability relates if it is a member of the group during any part of the period, even if it leaves the group during the period.
  • Purchasers will need to take care in acquiring companies which are, or are potentially (as a consolidation choice can be made retrospectively), subsidiary members of a consolidated group and should ensure that valid TSAs are in place (and that the clear exit procedures are followed where possible) in respect of all unpaid group liabilities for which the subsidiary could be liable, as well as obtaining appropriate warranties and indemnities.
  • Lenders to members of a consolidated group should also probably insist that valid TSAs are in place to protect the member from joint and several liability.
  • TSAs need to be drafted very carefully, in particular to ensure the method of allocation of the group’s tax related liabilities results in a “reasonable allocation”. An inappropriate allocation of a liability to even one member can invalidate the TSA in respect of that liability for all members of the group. TSAs should also be reviewed regularly.
  • While it is not strictly necessary for all members of the group to be parties to the TSA, an allocation may not be “reasonable” if members who are significant contributors to group profits are omitted.
  • A TSA will also be invalidated if the head company does not provide a copy of the TSA in approved form to the ATO when requested to do so.
  • These issues will be relevant for directors of head companies and their subsidiaries in relation to the proper discharge of their directors’ duties and to issues such as solvency.

JANE TRETHEWEY is a partner in the Tax Group of Blake Dawson Waldron, practising in corporate and international tax law.

STEPHEN BARKOCZY is an associate professor, lecturing in taxation law at Monash University, and a consultant with the Tax Group of Blake Dawson Waldron.

tax@liv.asn.au

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