General Value Shifting Rules & Capital Losses

1. General Value Shifting Rules& CapitalLosses By David Eley

2. Taxation Advanced 569, Semester2, 2012 Item 1 Item 2 Item 3 Tutorial Presentation The Discussion ProblemQuestion 4.6 Capital LossesGeneral Application Other OptionsWhat they could have done Division 723Its effect on the Loss Item4

3. The Discussion Problem ABC Co owns an asset (an underlying asset) with a cost base (and reduced cost base) of $40 million and a market value of $50 million. ABC Co grants a right to an associate (B Co) allowing B Co unrestricted and exclusive use of the underlying asset for a period of 5 years. No charge is made by ABC Co to B Co, whether on the initial granting or the right or during the period for which the right was granted. Existing tax rules do not impute a market value consideration to the creator of the right in this situation. The existence of the right reduces the market value of the underlying asset by $15 million to $35 million. ABC Co sells the underlying asset sometime thereafter for $33 million; the further decrease in market value is attributable to the existence of the right in a changed economic environment. Please calculate the loss with and without Division 723. e

4. Capital Losses General Application Firstly, are we dealing with a CGT asset and a CGT event? This question is important, because in order to have a capital loss or capital gain, we need to have a CGT event. [ITAA97 s.100-20(1)] By reference to Divisions 100, 104 and 108 of the ITAA, we are dealing with leases, land and buildings – which would fall into the categorisation as CGT assets and events. So yes, we are dealing with CGT assets and a CGT event. The relevant CGT event for the purposes of determining any capital gain orloss is the sale of the asset by ABC Co for the amount of $33 million,which is assumed to be an arms length transaction for full market value.

5. Capital Losses General Application To determine the value of the loss, we need to firstly determine the asset’s reduced cost base (“RCB”). [ITAA97 s.100-40(2)] Division 110 of the ITAA provides information on how to calculate the cost base and reduced cost base of a CGT asset – cost base is used for a capital gain and reduced costs base is used for a capital loss. [ITAA97 s.110-10] From our Discussion Problem we are given an RCB of $40 million . The Capital Loss is defined in the ITAA as “You make a capital loss if yourtotal costs associated with the CGT event exceed the capital amounts youreceive (or are entitled to receive) from the event.” [ITAA97 s.100-35]

6. Capital Losses General Application The difference between the RCB of $40 million and the market value sale price of$33 million , is $7million. As the amount received for the CGT asset is less than the costs associated with the CGT asset (the RCB) ABC Co has a Capital Loss.

7. Division 723 Its effect on the loss CGT Asset Value (CB or RCB) CGT Asset Sale Price Capital Loss or Gain The above diagram shows the usual way that a capital gain or loss is calculated. The difficulty thatcan arise from having a simple procedure as outlined, is the potential for taxpayers to manipulatethe losses or gains, for the purpose of avoiding or deferring tax obligations. As a consequence changes were made to the Taxation Laws and specificallythe ITAA to introduce, amongst other changes, Division 723 which dealswith value shifting and sets out the General Value Shifting Rules, asthey are applied by Division 723.

8. Division 723 Its effect on the Loss Division 723 applies where: • a right is created over a non-depreciating asset in favour of an associate [as defined in ITAA36 s.318] and that right is created for less than market value or for no consideration at all; • the market value of the right is not properly accounted for upon its creation; • after the creation of the right and while the right still exists, the unencumbered non-depreciating asset is realised, partially or fully, at a LOSS, and • the loss on the realisation of the non-depreciating asset is attributableto the creation of the right which encumbers the non-depreciating asset. [ITAA97 s.723.10]

9. Division 723 Its effect on the Loss Applying Division 723 to the facts of our situation, we get the following: the right created is a lease interest, which is a non-depreciating asset; the right was created in favour of an associate; the right was created for less than market value, being no consideration at all; the right was not accounted for upon its creation; the asset was sold while the right was still in place and an encumbranceon the asset; the asset was sold at a loss from its RCB; and the loss was attributable to the existence of the right.

10. Division 723 Its effect on the Loss The outcome of the application of Division 723 is to deny the loss to ABC Co with the result that the loss of $7 million on the sale of the asset, is not an allowable capital loss for the purposes of ABC Co’s taxation.

11. Other Options What they could have done In order to avoid the application of Division 723 and lose the ability to access the capital loss on the sale of the asset, ABC Co could have done the following: • waited until the term of the lease had expired and it was no longer an encumbrance on the asset; • grant the lease to someone who was not defined as an associate under ITAA36; or • grant the lease at market value and account for the value received fro the grant of the lease.

12. Legislation referred to Legislation referred to an abbreviated in this presentation was: Income Tax Assessment Act 1936 (Cth) referred to as ITAA36; and Income Tax Assessment Act 1997 (Cth) referred to as ITAA97.