An almighty force made me consolidate, or a welcome beneficial construction of s 205-70(6) of the ITAA 1997!
The following article was written by Peter Donovan, Tax Director at Toohey Reid. It was published in the Thomson Reuters Weekly Tax Bulletin on the 21st of February 2017.
A corporate tax entity is liable to pay franking deficit tax (“FDT“) if its franking account is in deficit at the end of an income year or the entity ceases to be a franking entity at a time when its franking account is in deficit pursuant to s 205-45 of the ITAA 1997.
In a consolidations context, under s 709-60 of the ITAA 1997, when an entity joins a consolidated group and its franking account is in deficit just prior to the joining time, the joining time is treated as the end of the entity’s year of income and a liability to FDT arises.
The amount of tax payable by the corporate entity will be the amount of the entity’s franking deficit at that time.
In circumstances where a corporate entity has a franking account deficit at the time of joining a consolidated group, a question arises as to whether the head company is entitled to claim the full tax offset arising from the joining member’s FDT liability.
It appears that the answer to this question is yes. Curiously, it seems that the Commissioner will generally not impose the 30% FDT offset reduction under s 205- 70 as the act of consolidation is considered to be an “event outside the control of the relevant entity”, despite the fact that the act of consolidation is necessarily premeditated.
Tax offset arising from FDT liability
A corporate tax entity is entitled to a tax offset under s 205-70 if it satisfies the residency requirement and any one of the following applies:
- it incurred a FDT liability for the year;
- it incurred an FDT liability in a previous year during which it failed to satisfy the residency requirement and that liability has yet to be taken into account for tax offset purposes; or
- it has an unapplied s 205-70 FDT tax offset entitlement from a previous income year.
The quantum of the tax offset is calculated under s 205-70(2), which may be reduced by 30% where an entity’s FDT liability exceeds 10% of its franking credits for the income year.
The 30% tax offset reduction
The Commissioner’s discretion to not impose the 30% tax offset reduction is contained in s 205-70(6), which states as follows: “(6) The 30% reduction in steps 1 and 2 of the method statement in subsection (2) do not apply in working out the amount of the tax offset to which the entity is entitled for the relevant year if the Commissioner determines in writing, on application by the entity in the approved form, that the excess referred to in those steps was due to events outside the control of the entity.”
Naturally, the questions for consideration are what is the meaning of “events outside the control of the entity” and what species of events potentially qualify for a positive exercise of this discretion?
Guidance on the interpretation of s 205-70(6)
The Explanatory Memorandum to the legislation which introduced s 205-70(6) (the Tax Laws Amendment (2006 Measures No 2) Act 2006, Act 58 of 2006) provides the following example of the intended operation of s 205-70(6), at para 5.15:
“. . . the entity pays a fully franked dividend part way through an income year (with a resulting debit to its franking account) in the reasonable expectation that its future quarterly PAYG instalment payments in the income year would be sufficient to ensure that it would not have a deficit in its franking account at the end of the income year. An unexpected downturn in business results in the company’s future quarterly PAYG instalments being less than expected”.
Examples of the application of s 205-70(6) can be found in a number of the Commissioner’s Private Binding Rulings. For example, in PBR 80653, circumstances that the Commissioner considers to be outside of the control of an entity are listed as follows:
- a downturn in business that is linked to the reduced offset. There must be evidence of behavior on the part of the taxpayer that there was an attempt at mitigation, but in the end, that it was unavoidable;
- unusual events which interrupt the ordinary course of business such as:
- protracted audits undertaken by the Tax Office which may hinder the preparation, lodgment and payment of income tax which defers the generation of franking credits in the franking account until after the reduced franking deficit tax offset is incurred at the end of the financial year;
- international reviews or objections in relation to specific taxation issues which cause unexpected or unavoidable refunds resulting in large franking debits to the franking account which then trigger the reduced franking deficit tax offset;
- situations which may result in unexpected or unavoidable refunds resulting in franking debits to the franking account which then trigger the reduced franking deficit tax offset;
- substituted accounting periods which have the effect of shortening the income year and hence shortening the period within which sufficient franking credits can be generated;
- liquidations, whether voluntary or not, which may shorten the income year and hence shorten the period within which sufficient franking credits can be generated;
- takeovers or consolidation of entities that trigger the consolidation rules which oblige the joining entity to determine and pay any outstanding franking deficit tax at the joining time. In most instances, this selection happens retrospectively and more often than not triggers a franking deficit tax liability and the reduced franking deficit tax offset. This is usually attributed to a shortened income year which results in a shorter period which disregards any franking credits that were generated in its franking account after the joining time.
A close examination of the examples cited above appears to indicate that the Commissioner will take a broad construction of s 205-70(6). For example, a voluntary liquidation is by its very nature “voluntary” as it is instituted by the directors of the ailing company. However, it could be argued that the decision to liquidate was forced upon the directors in order to avoid a breach (or further breach) of directors’ duties under the Corporations Act 2001 hence it was an event that was effectively beyond the control of the entity.
The act of consolidation, however, appears to stand apart from many of the examples cited above.
The act of consolidation
Notably, the Commissioner has indicated that an act of consolidation is considered to be an act outside of the control of an entity. Whilst the Commissioner notes that such an act may occur retrospectively, this is not necessarily always the case.
The act of consolidation results from an election made by the respective entity itself. One might surmise therefore that an act of consolidation arguably cannot be an event that is outside the control of an entity. However, a takeover that triggers a consolidation could be considered outside the control of the entity. Similarly, it would not be unreasonable to conclude that an entity in a group that is consolidated has no choice in the matter.
The result it would seem is that, as I mentioned above, the Commissioner appears to take a wide pragmatic view of the application of the provisions. Taxpayers would welcome that. It appears not to be black and white enough for a hard and fast rule concerning consolidations. But this is not a one size fits all situation.
On one construction, any tax downside suffered by the respective entity, including the inability of the head entity to utilise 100% of the tax paid by the joining entity by way of FDT pursuant to the operation of s 205-70, could be framed as an example of “ignorance of the law is no excuse”.
No doubt taxpayers are thankful for the Commissioner’s beneficial construction of the operation of s 205-70(6) in a consolidations context.
While some may consider it arguable that such a position is not supported by a proper construction of the provision itself, practitioners should be alert to see if the Commissioner sees fit to alter his view in future.
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