mergers and acquisitions in a post-consolidation world · 2.4 impact of sbt ceiling on bad debts in...
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Mergers and Acquisitions
in a
Post-consolidation World
February 2006
Martin Fry
Partner, Allens Arthur Robinson
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Table of Contents
1. Introduction 3
2. Implications of SBT reforms on M&A activity 42.1 Introduction 42.2 SBT Ceiling 42.3 Impact of SBT Ceiling on Losses in Acquisitions 4
2.4 Impact of SBT Ceiling on Bad Debts in Acquisitions 72.5 ACA Implications of Bad Debts 8
3. Some Observations on the Character of Gains on the Sale ofSubsidiary Members 103.1 Quarantining Capital Losses to Capital Gains 103.2 Intra-group Transactions and Facts 11
3.3 Characterisation for Banks and Other Financial Institutions 13
4. Recognising Losses on Disposal 174.1 Background 17
4.2 Operation of Subdivision 165-CD 174.3 Application of Subdivision 165-CD 184.4 Layers of Losses 19
4.5 Effect of Consolidation 204.6 Head Company Choices 214.7 What is the Appropriate Adjustment Amount? 22
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Mergers and Acquisitions
in a
Post-consolidation World
1. Introduction
The purpose of this paper is to provide commentary on the following topical issues
affecting M & A transactions involving tax consolidated groups:
(a) the impact of the SBT Ceiling on the ability of a bidder to acquire the carry-forward
losses of a target entity;
(b) the impact of the SBT Ceiling on the ability of a bidder to claim bad debt
deductions for debts 'inherited' from the acquisition of a target entity;
(c) the characterisation of the sale of membership interests in subsidiary members,
particularly having regard to the quantum of capital losses currently existing in the
tax system;
(d) whether a consolidated group will be denied a loss on the sale of a loss-making
subsidiary member (by operation of Subdivision 165-CD), if 100% of the subsidiary
member is sold to another consolidated group.
Statutory references are to the Income Tax Assessment Act 1997 (Tax Act 1997) and the
Income Tax Assessment Act 1936 (Tax Act 1936).
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2. Implications of SBT reforms on M&A activity
2.1 Introduction
The recent amendments to the COT and SBT rules for loss recoupment will have
significant implications on M&A activity, some of which are discussed below.
As a general statement it can be concluded that the amendments will be strongly pro-
revenue, in that the SBT Ceiling regime will result in the denial of losses as a consequenceof M&A activity over the medium to long term. This is perhaps not entirely unexpected.
Recall that, upon formation of a tax consolidated group, losses which had failed the
continuity of ownership test but were transferred up to the head company of the
consolidated group by satisfying the same business test are effectively freshened up from
a COT perspective. This author has always been perplexed by that outcome.
2.2 SBT Ceiling
Much of the discussion below of the impact of the COT and SBT reforms on M&A activity
focuses on the adverse implications of the SBT Ceiling, which is embodied in new section
165-212A.
It should be noted that the SBT Ceiling is not necessarily a permanent feature of our tax
laws. In November 2005 the Senate Economics Legislation Committee reviewed the Tax
Laws Amendment (Loss Recoupment Rules and Other Measures) Bill 2005 and
recommended that section 165-212A be removed from the Bill.
Unfortunately the Government did not heed the recommendations of the Committee and
the Bill passed through the Senate and was enacted with section 165-212A intact.
However the Government did provide some hope for the possible removal of the SBT
Ceiling, or perhaps SBT rules for large tax payers which are not quite so detrimental to the
SBT Ceiling, when it announced on 7 December 2005 that:
The Government proposes to explore options for improving the operation of the samebusiness test. Business and professional groups are invited to forward their submissions toTreasury by 31 January 2006 for consideration by Government in the Budget context.
2.3 Impact of SBT Ceiling on Losses in Acquisitions
The Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Act 2005
introduced the SBT Ceiling (refer section 165-212A) and fundamentally altered the waythat the continuity of ownership test applies to widely held companies, such as listed public
companies, and other eligible Division 166 companies (refer section 166-5).
Where one consolidated group acquires a single target company or a target consolidated
group the tax losses of the target will only transfer up to the bidder if:
(a) the bidder acquires 100% of the target such that the target becomes a member ofthe bidder's consolidated group; and
(b) the target satisfies the utilisation tests in sections 707-120 and 707-125.
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Broadly, the utilisation tests require the target entity to satisfy COT or SBT in relation to itstax losses at the time of the acquisition.
Where the target entity is widely held (or is otherwise an eligible Division 166 company)
satisfying COT would require the target to prove substantial continuity of ownership at the
relevant testing times (being the end of each year of income and the end of each 'corporate
change' as defined).
An acquisition of 100% of the target would clearly cause the target to experience a
'corporate change' as defined in section 166-175 and the target would obviously fail COT at
that time, or at the end of an income year which occurs before the end of the 'corporate
change'. (The result would be the same if the bidder acquired, say, 60% of the target,
except there would be no prospect of the bidder acquiring access to the target's losses until
such time as the bidder completed a 100% acquisition of the target.)
Having failed COT, the target would then need to satisfy SBT in order for its losses to
transfer up to the bidder upon 100% acquisition of the target.
Specifically, in relation to post 1999 losses of the target, the target would need to be able to
show that:
(a) having regard to the business it carried on immediately before the end of the year
in which it made the loss;
(b) it carried on the same business throughout:
(i) the trail year, which is generally the twelve month period ending
immediately after the completion of the bidder's 100% acquisition of the
target; and
(ii) in general terms, the income year in which the target failed COT if this
income year started earlier than the trial you identified in (i).
Note that there are additional SBT requirements if the target is itself the head company of a
consolidated group and the losses in question were previously transferred to it by an entity
joining that consolidated group and by relying on the joining entity satisfying the SBT (refer
section 707-135).
Pursuant to the new SBT Ceiling the target is deemed to fail the same business test if its
total income for the income year in which the target failed COT exceeds $100m, or if its
total income in the income year which ends during the trail year exceeds $100m (refer
sections 165-212A, 707-120, 707-125 and 716-805).
Accordingly, the key implications of the SBT Ceiling in this context is that, if the SBT
Ceiling applies to the target, the target will be legislatively barred from satisfying the SBT
and its losses will therefore be prevented from transferring up to the 100% purchaser of thetarget, even though the target will join the purchaser's consolidated group as a result of the
acquisition.
In relation to a company's ability to carry forward and utilise its losses (as distinct from the
ability to transfer losses up to the bidder), the application of the SBT Ceiling results in the
taxpayer being unable to utilise the loss in the year in which the Ceiling applies, but it does
not result in the loss being eliminated. For example, if in YE 30 June 2007 a taxpayer
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company which has failed COT wishes to recoup a loss incurred in YE 30 June 2006, thenthe taxpayer will be unable to recoup the loss in the YE 30 June 2007 if its total income
exceeds $100m (by application of the SBT Ceiling) but it may be able to recoup the loss in
a future year in which its income falls below the $100m threshold.
By contrast, if the application of the SBT Ceiling mean that the target company's losses are
not able to be transferred up to the bidder head company, then those losses are eliminated
from the tax system entirely.
Transitional Rules
However, the transitional rules for the SBT Ceiling mean that it is necessary to distinguish
between the following categories of losses in the target.
Pre-1 July 2005
The SBT Ceiling does not apply to (and therefore losses of the target will not be prevented
from transferring up to the bidder in the manner described above) the tax losses and net
capital losses of the target to the extent those losses were incurred in an income year
commencing before 1 July 2005.
Post-1 July 2005
Subject to the following exceptions, the impact of the SBT Ceiling on the tax losses and net
capital losses of the target as described above will apply to:
(a) tax losses incurred by the target in an income year commencing on or after 1 July
2005; and
(b) net capital losses made by the target in an income year commencing on or after 1
July 2005.
Exception: Pre-2005 History
The SBT Ceiling will not apply to a tax loss or net capital loss which was incurred by the
target in an income year commencing on or after 1 July 2005, if:
(a) the loss was transferred to the target at the time as head company of its own
consolidated group as a result of a subsidiary member having joined that
consolidated group; and
(b) that loss was in fact incurred by the subsidiary member or another entity in an
income year commencing before 1 July 2005.
The inclusion of 'or another entity' here means that a loss which was in fact incurred
before 1 July 2005 can be tracked and preserve its pre-1 July 2005 status (ie preserve its
exemption from the SBT Ceiling) even though the loss may be deemed to be incurred by
the head company of more than one consolidated group as the 'real loss maker' becomes
a subsidiary member of successive consolidated groups as a result of successiveacquisitions.
Exception: Unrealised Losses Pre-1 July 2005
The transitional rules for the SBT Ceiling attempt to capture and preserve the pre-1 July
2005 status of unrealised losses in existence at that date.
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This will be relevant where, at the time of acquisition, the target has realised losses whichwere incurred by the target in an income year commencing on or after 1 July 2005 but
which relate to unrealised losses on assets in existence immediately before the income
year commencing on or after 1 July 2005.
In broad terms, the transitional rules provide that a tax loss or net capital loss arising after
1 July 2005 from the disposal of an asset that was owned immediately before the income
year commencing on or after 1 July 2005 will be excluded from the SBT Ceiling to the
extent that there was an unrealised loss on that asset at that time. Hence, in a notional
sense, the assets owned immediately before the income year commencing on or after
1 July 2005 are deemed to be 'tagged assets' for the purposes of tracking and preserving
exemption from the SBT Ceiling.
2.4 Impact of SBT Ceiling on Bad Debts in Acquisitions
Divisions 165-C and 166-C provide the rules under which deductions for bad debts are
made subject to the continuity of ownership test and same business test.
In a tax consolidation environment it is also necessary to have regard to Division 709-D.
It is clear from sections 709-200 and 709-210 that the object of Division 709-D is to modifythe application of the COT and SBT rules to the head company of a consolidated group,
where the head company writes off a debt which arose at a time when the creditor of the
debt was not a member of that consolidated group.
In broad terms, Division 709-D attempts to require the COT and SBT rules to be satisfied in
relation to the separate periods, ie. the period from when the debt arose until immediately
before the creditor became a member of the consolidated group (including perhaps it being
a member of another consolidated group) and, separately, the period from when the
creditor became a member of the 'current' consolidated group until the debt is written off.
The operative provisions of Division 709-D contains such a bewildering array of
assumptions and testing times that taxpayers should only enter Division 709-D at their own
risk! Nevertheless it is possible to draw the following conclusions from the provisions of
Division 709-D.
Acquisition of Head Company
Where a debt becomes owing to a member of the target consolidated group and,
subsequently, a consolidated bidder acquires 100% of the target, then the bidder head
company will be prevented from claiming a deduction when it writes off the debt as bad if
the target head company's total income (on a consolidated basis) exceeds the $100m
threshold.
This is because the second continuity period for the target head company is taken to endjust after it becomes a member of the bidder's consolidated group and the target head
company will therefore fail COT in relation to the second continuity period (refer section
709-215(4)(b), item 3 of the table). As such, the target head company would need to
satisfy SBT in order to preserve the bidder's entitlement to the bad debt deduction, and the
target head company will be prevented from satisfying COT if it's total income exceeds
$100m (refer new section 716-805).
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In broad terms the same analysis will apply if the bidder head company acquires 100% of anon-consolidated company which is owed a debt at the time of the acquisition (refer
Example 6.2 of the Explanatory Memorandum to the Tax Laws Amendment (2004
Measures No. 7) Act).
Acquisition of Subsidiary Member
Where a debt is owed to a subsidiary member (the creditor) of a consolidated group and aconsolidated bidder acquires 100% of the creditor after that debt arose, then the change in
ownership caused by the acquisition will not of itself result in a failure of COT for the
purposes of the bad debt rules. As such, the bidder's entitlement to a deduction when it
writes-off the debt will not be denied by the application of the SBT Ceiling in the manner
described above. This is because the second continuity period of the vendor consolidated
group ends at the time that the creditor exits its consolidated group but does not cross over
into the period from which the creditor becomes a member of the bidder's consolidated
group.
Of course, the bidder would be denied a deduction if, quite apart from the acquisition of the
creditor, the vendor consolidated group failed COT in relation to the period for which thisgroup 'owned' the debt and it exceeded the SBT Ceiling, or indeed if the bidder
consolidated group failed COT in relation to the period that it 'owned' the debt and it
exceeded the SBT Ceiling.
Further, the vendor head company would also need to consider whether Division 165-CD
applied to the sale of the creditor subsidiary (refer Subdivision 715-B, and the discussion at
4.3 below). If Subdivision 165-CD did apply then it should only operate to reduce a loss on
the disposal of the creditor subsidiary. However, as noted below, there are circumstances
in which Subdivision 165-CD can operate to expose a gain to tax.
Transition
The potential application of the SBT Ceiling to bad debt deductions relates only to debts
which arise in an income year commencing on or after 1 July 2005. Item 172 of
Schedule 1 to the Tax Laws Amendment (Loss Recoupment Rules and Other Measures)
Act 2005, uses the phrase 'any deductions in respect of a bad debt that is incurred in an
income year commencing on or after 1 July 2005'. It is reasonably clear from the languageused in Subdivisions 165-C, 166-C and 709-D that this refers to debts arising (or 'incurred')
in an income year commencing on or after 1 July 2005.
2.5 ACA Implications of Bad Debts
It is apparent from the discussion at 2.3 and 2.4 above that the introduction of the SBT
Ceiling will result in an absolute denial of losses and bad debt deductions where a bidder
acquires a target company with, broadly speaking, total annual income exceeding $100m.
Where the SBT Ceiling results in the bidder being denied a bad debt deduction for a debt
'acquired' by it when it acquired the creditor, the ACA implications are perverse. The effect
of section 705-25 is that the ACA allocated to a debt asset acquired by the bidder head
company will be the face value of the debt. As noted by Geoff Lehman in his paper to theTIA Queensland State Convention (8 July 2005), this can result in a curious acceleration of
deductions claimed by the bidder head company. The acceleration arises where the bidder
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writes off a debt and claims a bad debt deduction in relation to a debt which, at the time ofthe acquisition of the creditor, had a face value exceeding its market value (for example, if
the debt asset was doubtful at that time). However, if the bidder's deduction for the bad
debt is denied by application of the SBT Ceiling in the manner discussed at 2.4 above, then
the allocation of 'full face value' ACA to the debt asset results in an even greater distortion.
That is, the 'full face value' ACA allocated to the debt asset will be wasted because the
deduction that would otherwise arise from writing off the debt will be denied by application
of the SBT Ceiling.
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3. Some Observations on the Character of Gains on the Sale ofSubsidiary Members
The characterisation for tax purposes of the sale of membership interests in subsidiary
members from a tax consolidated group is another key issue in the analysis of M&A
transactions in a post-consolidation environment.
3.1 Quarantining Capital Losses to Capital Gains
As was recognised by Jim Killaly, Deputy Commissioner, Large Business and International
(Case Leadership) in February 2005 in his speech to the Australian Taxation Summit, the
formation of tax consolidated groups has resulted in the recognition of an enormous
quantity of new capital losses in the tax system. Killaly said:
We are already seeing major increases in the stock of capital losses being carried forwardby companies, which have increased by over $10 billion for the 2003 financial year. This iscounter-intuitive given the introduction of the loss integrity measures, the extent of mergerand acquisition activity in recent times and the generally strong state of the economy. Thisis emerging in spite of the major focus on losses in our audit program over the last sevenyears.
…
Some of the increase in losses may have arisen due to the more careful analysis of assetmarket values in the context of entering consolidation. Accrued losses may have beencrystallised and the numbers may be reflecting some of that shake-out. However, theincrease in the stock of losses needs to be evaluated against the major overall increase inasset values we are seeing in relation to depreciable assets in the formation cases. Both ofthese aspects will be the subject of ongoing scrutiny in our risk assessment and auditactivity so we can better understand the drivers.
To a large extent the recognition of new capital losses will be a product of CGT Event L1.
That is, capital losses recognised in the head company of a consolidated group as
compensation for the 'cost base push down' process failing to recognise the cost base of
membership interests in subsidiary members to the extent that such cost base reflects an
uplift from the actual cost paid for the membership interests to their deemed market value
at the time of their transition from pre-CGT to post-CGT assets (refer sections 104-500,
705-57 and Division 149 of the Tax Act 1997).
The recognition of new capital losses in the tax system, combined with the quarantining of
capital losses to capital gains, means that there will be a sharp focus on the
characterisation of disposal transactions. If the profit on sale of a subsidiary member is
characterised as a capital profit arising from the disposal of a CGT asset, and not as
income according to ordinary concepts, then the capital losses will be available to shelter
that profit from tax. (This is, of course, subject to satisfying the COT or SBT requirements
for the utilisation of prior year losses. In relation to capital losses arising from CGT Event
L1, it is also subject to the 'five year spreading' of such losses – refer section 104-500(5).)
The issues arising from the characterisation for tax purposes of the sale of membership
interests in subsidiary members are broad and complex. Importantly, questions of
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characterisation in this context require, among other things, an examination of the extent towhich the single entity rule (section 701-1) and entry history rule (section 701-5) have
altered the characterisation that would have applied under general tax law concepts in the
pre-consolidation environment. A detailed examination of these issues would be a
substantial endeavour and is beyond the scope of this paper.
However, it is possible to make some observations at this time and it is important to note
the views of the Commissioner in Tax Determination TD 2005/D31.
3.2 Intra-group Transactions and Facts
Since the advent of tax consolidation taxpayers have been grappling with the question of
whether, in characterising the sale of membership interests in subsidiary members, it is
possible to have regard to the facts which arise from pre-sale transactions and otherdealings between subsidiary members of the consolidated group.
The characterisation of the sale transaction for tax purposes will ultimately require a court
to have regard to all relevant facts in arriving at a determination of whether the membership
interests in the subsidiary member were held by the head company on capital account or
revenue account. In doing so, is the court precluded by the single entity rule from having
regard to the relevant transactions and dealings between subsidiary members of the
consolidated group prior to the sale?
Most tax commentators would be comfortable with the proposition that, in characterising
the sale of membership interests in subsidiary members, it is necessary to lift the veil of the
single entity rule and have regard to the entire relevant factual matrix relating to the sale of
the membership interests. This will involve a consideration of all relevant facts relating to
the acquisition, holding and disposal of the membership interests. It seems that the factual
enquiry will not be limited by the single entity rule, but will bring in, if relevant, facts existing
in the pre-consolidation period (ie if the subsidiary member was in existence prior to
formation of the tax consolidation group), and facts arising from dealings between
members of the consolidated group during the period of tax consolidation and leading up to
the sale.
This line of analysis holds that the single entity rule has done very little to change the way
that we apply tax law principles to characterise the sale of membership interests in
subsidiary members. It is supported by the following:
(a) First, the principle that, as a statutory fiction, the single entity rule is to be applied
strictly in accordance with its terms. This principle is to be found in FC of T v
Comber (1986) 64 ALR 451 at 458, and was restated recently in Ellison Global Ltd
v Healthscope Ltd (No 2) [2006] FCA 18, where Justice Edmonds made thefollowing comment in relation to section 252 of the Tax Act 1936:
But like all deeming provisions, they have to be construed strictly and only for thepurpose to which they are resorted: Ex parte Walton; re Levy (1881) 17 Ch D 746per James LJ at 756; Federal Commissioner of Taxation v Comber (1986) 10 FCR88 at 96 per Fisher J. In other words, it does not operate to deem a person to havethe control of money belonging to a non-resident save where the person is liable topay money to that non-resident. So if a person [A] is liable to pay money to a non-resident [B], and B is liable to pay the same amount of money to another non-
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resident [C], A is not, by virtue of subs 255(2), deemed to have the control ofmoney belonging to C.
(b) Second, the fact that the determination of the tax cost setting amount under
Division 711 of the Tax Act 1997 is nothing more than the determination of an
amount, being the tax cost of the membership interests in the subsidiary member.
Once this amount has been determined it then feeds into whichever of the
subsections of section 701-55 are relevant. In the present context, the question is
whether the tax cost amount (determined in accordance with Division 711) is to be
applied in subsection 701-55(5) (ie for calculating a CGT gain or loss) or
subsection 701-55(6) (ie for calculating a revenue gain or loss from the sale).
However, in order to determine which of subsections 701-55(5) or (6) is to apply it
is necessary to characterise the sale transaction, ie form a view on whether the
sale of membership interests is the sale of capital assets and taxable in
accordance with Part 3-1, or the sale of revenue assets and taxable in accordance
with section 6-5. Relevant case law establishes that the characterisation of the
sale transaction, for the purposes of applying Part 3-1 or section 6-5, is to be
determined by reference to all relevant facts. Section 701-85 provides that the
provisions of Division 701 (including the single entity rule in section 701-1) are
subject to any other provisions of the tax law. Thus section 701-85 supports the
view that the single entity fiction should not stand in the way of characterising the
transaction for the purposes of applying Part 3-1 or section 6-5.
(c) The following discussion in Draft Taxation Determination TD 2005/D31 at
paragraphs 6 to 13:
Characterisation
6. Existing principles in characterising the gross proceeds or profit from atransaction also apply in a consolidated environment. Paragraph 2.28 of theExplanatory Memorandum to the New Business Tax System (Consolidation) Bill(No. 1) 2002 (the EM) states:
The income tax character of a transaction undertaken by a consolidated group willcontinue to be a question of fact to be determined in light of all the relevantcircumstances.
7. Paragraph 2.29 of the EM adds:
Transactions under consolidation are subject to the same scrutiny for the purposesof characterisation as those involving a single taxpayer.
Ordinary income under section 6-5
8. Whether the gross proceeds or the profit from the disposal of the membershipinterests would be assessable as ordinary income under section 6-5 of the ITAA1997 depends on the circumstances of each case.
9. Based on existing principles, where the acquisition and disposal of themembership interests is part of the ordinary business of the head company, thegross proceeds or the profit will be ordinary income and included in the assessableincome of the head company under section 6-5 of the ITAA 1997.
10. Where the acquisition and disposal of the membership interests is not part ofthe ordinary business of the head company, the principles regarding isolated
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transactions outlined in Taxation Ruling TR 92/3 'Income tax: whether profits onisolated transactions are income' provide guidance.
11. TR 92/3 refers to the intention or purpose of the taxpayer in entering into thetransaction. Where the transaction involves simply the acquisition and disposal of
the membership interests, the intention or purpose of the taxpayer in acquiring
the membership interests needs to be determined. Where the membership
interests were not acquired by a group member (for example, where the
head company of a consolidated group incorporates a new subsidiary
member), or where there are substantial changes made to the subsidiary
member prior to the disposal of the membership interests, it is the intention
or purpose of entering into the entirety of the transaction that generated theprofit that will be relevant.
12. Paragraph 7 of TR 92/3 states:
The relevant intention or purpose of the taxpayer (of making a profit or gain)is not the subjective intention or purpose of the taxpayer. Rather it is thetaxpayer's intention or purpose discerned from an objective consideration ofthe facts and circumstances of the case.
13. In determining the head company's intention or purpose, where the headcompany did not itself acquire the membership interests, an objective considerationof all the facts and circumstances may include a consideration of everything thathappened in relation to a subsidiary member that acquired the interest prior towhen it became a member of the group. In determining the head company'sintention or purpose, the SER does not operate to prevent consideration of intra-group transactions or dealings.
3.3 Characterisation for Banks and Other Financial Institutions
Questions of characterisation are particularly relevant for banks and other financial
institutions.
The issue here is, where the head company of a consolidated group is a bank or other
financial institution, does it necessarily follow that a profit from the sale of membership
interests will be a revenue profit or gross income, and not a capital gain?
General Rule
In Colonial Mutual Life Assurance Society Limited v FC of T (1946) 73 CLR 605 (Colonial
Mutual), the High Court stated that, although normally the depreciation or gain in the value
of a security is treated as a capital loss or gain, where that depreciation or gain is made in
the carrying on of the business of the taxpayer, that loss or gain will be on revenue
account, not capital (with California Syndicate v Harris (1904) 5 Tax Cas. 159 being cited
as the leading authority for this proposition). The High Court then held that insurance
companies, including mutual insurance companies, are carrying on the business of
insurance and an investment of its funds is a part of that business. In this case, the
predominant consideration in acquiring the securities was to obtain the most effective yield
for policy holder's funds before those funds reached maturity. Although the insurance
company needed to ensure that it had sufficient accumulated funds to meet its estimated
liabilities (which in this case required an accumulation at 3%), the net surplus in itsinvestments in excess of these liabilities (ie the interest earned above the 3% minus
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expenses) was distributed to policy holders, making the policies more attractive. The HighCourt therefore held that this amount was earned by the insurance company in the course
of business and was therefore assessable income. The High Court also stated (at 620)
that: 'there is no substantial distinction between the business of an insurance company and
that of a bank in this respect'. It is relevant to note that the fact that the funds were
switched from time to time from one security to another (depending on the rise or fall in the
price of the security) provided more evidence that obtaining the highest effective yield was
the predominant consideration in the investment of the funds.
To be contrasted with this are the shares purchased by the National Australia Bank (NAB)
in the National Australia Bank v FC of T (1968) 118 CLR 529. In this case, the shares
were purchased as part of the larger acquisition of the Queensland National Bank (QNB).The shares were purchased in order that the NAB could step into the shoes of the QNB
and not 'by the hope of a profit to be gained by their ultimate sale'. At 538 the Kitto J held:
The purchase of the shares bore no resemblance to an investment of banking funds, madeto earn income pending a need for their deployment in the making of advances and the like;it bore no resemblance to an investment by way of erecting a second or third line of defenceagainst a time of stringency or emergency. It was an acquisition, not of the kind that mightbe repeated in the course of the profit-earning process, but made once and for all for thesake of enhancing, even if only for the time being, the profit earning potential of theenterprise as a whole.
It was therefore held that the profit on the sale of the shares (after some 20 years of
ownership) was a capital profit.
In London Australia Investment Company v FC of T (1977) 138 CLR 106 (London
Australia), the taxpayer was an investment company whose principal object was to invest
in securities for the purpose of producing dividend income which it could distribute to its
shareholders. As with Colonial Mutual, the fact that switching occurred (ie the taxpayerwas systematically reviewing, selling and reacquiring shares in order to maximise the
dividend yields of its investments) was an important factor in the High Court majority's
determination that the net profit made on the sale of those shares (being the difference
between the sale price and the average cost of the shares sold) was made in the course
of carrying on its business. However, in so deciding, the judgement of Jacobs J in
particular appears to take the principle in Colonial Mutual even further. At 4410-4411 he
states:
The nature of banking or insurance business, as part of its putting of money as circulatingcapital to use, involves not only occasional acquisition of property in satisfaction of advances… but also and more commonly the purchase and sale of various kinds of property wherebymoneys which are obtained as part of the business but which form no part of the originalcapital structure of the bank or insurance company, or of the structure enhanced byaccumulated net profits, are put to use short term or long term. All profits arising from thatactivity are profits of the business of banking or insurance …The source of moneys for theactivities of the appellant company is not money of a kind which can be described ascirculating capital. It is essentially investment and reinvestment of moneys which wereoriginally part of, or which were added out of capital profits to, the capital structure of theappellant.
mafm M0111825722v1 150630 3.3.2006 Page 15
However, despite the fact that the source of the funds was the subscribed capital of thecompany, Jacobs J held that (at 4411):
[t]he evidence taken as a whole strongly supports a conclusion that a purpose or intention or
expectation implicit in the carrying into effect of its investment policy was that sharesacquired would be resold if and when an occasion arose which would make it desirable todo so and an element of desirability was that there would be a greater financial benefit indisposing of the shares at an enhanced value than in retaining them.
The most important evidence which Jacobs J relied upon was the scale, continuity and
regularity with which the shares were bought and sold.
Exception
When faced with a similar set of facts, however, in AGC (Investments) Limited v FC of T92 ATC 4239 (AGC Investments) the Full Federal Court unanimously distinguished the
High Court's decision in London Australia. Their primary reasons for doing so was the
findings of fact that the taxpayer, an investment company which was a wholly owned
subsidiary of an insurance company, did not acquire the investments for a profit-making
purpose and that the investments were not held in order to maintain the liquidity of the
insurance business (both of which were findings which over-ruled those of Hill J at first
instance). Crucial to these findings was written evidence setting out the investment
strategy behind AGC Investment's investments and contrasting them with the strategy for
the investments of other members of the AGC group. Influential statements in forming the
above conclusions were:
(a) The AGC group's equity investments were to be carried by AGC Investments.
(b) The AGC group sought long term dividend producing shares from AGC
Investment's investments.
(c) The investments were managed by an independent management company.
(d) The overriding instruction to the management company was that the portfolio of
investments must be managed in such a manner so that AGC Investments
cannot be classed as a trader.
(e) Liquidities trading was to be conducted by a different member of the AGC group.
Unlike Colonial Mutual and London Australia, where the aim of the investments was to
return as high a yield as possible, in the case of AGC Investments, the evidence
established that the aim (at 4252) was to return: 'a reasonable investment yield whilst still
enabling [the AGC group] to operate within the terms of the licence authorisations to which
[they] are subject'. The finding that the shares were not held in order to maintain liquidity
was supported by the fact that, prior to the sale resulting in the disputed profit, the majority
of the investments were held for periods exceeding ten years.
The Full Court also distinguished the fact that AGC Investments still attempted to 'exploit
the cyclical fluctuations' by selling the shares when the market was high and repurchasing
at market lows from the 'switching' which was occurring in London Australia. In addition to
the fact that this buying and selling was not occurring on the continuous basis and large
scale that it was London Australia, the court found it significant that any investments sold
did not have to be immediately reacquired to replace those stocks. At any rate, the court
mafm M0111825722v1 150630 3.3.2006 Page 16
held that such attempts did not over-ride the primary purpose, as clearly established by theevidence, of investing for long term capital growth.
mafm M0111825722v1 150630 3.3.2006 Page 17
4. Recognising Losses on Disposal
Tax consolidation has fundamentally altered the potential application of the loss integrity
rules. To a large extent, when the loss integrity rules were first introduced they were
directed at eliminating the opportunity for the multiple recognition of losses arising from
transactions involving companies within a wholly-owned chain of companies. The single
entity rule in section 701-1 has clearly eliminated such opportunities.
Now, in a post-consolidation environment, a critical issue is how Subdivision 165-CD
applies to a consolidated group when the group sells a subsidiary member for which the
tax cost of membership interests exceeds the price received for the sale. In particular, the
issue is whether Subdivision 165-CD has any role to play where the consolidated group
sells 100% of the subsidiary member to another consolidated group.
4.1 Background
The purpose of Subdivision 165-CD is to prevent the multiple recognition of a company's
losses when equity and/or debt interests held by other corporate entities in the company
are realised and, at the time of realisation, there has been a change in ownership and/orcontrol of the company. Subdivision 165-CD only applies to inter-entity loss duplication. It
does not apply to losses realised by individuals in respect of their equity or debt interests in
a company.
In a tax consolidated environment, it is intended that Subdivision 165-CD will operate
subject to specific modifications. These are set out in Division 715 of the 1997 Tax Act.
In order to understand how Subdivision 165-CD and Division 715 are intended to apply in
these circumstances, it is necessary to first understand how Subdivision 165-CD works
generally and then consider how the modifications set out in Division 715 affect Subdivision
165-CD's operation.
4.2 Operation of Subdivision 165-CD
Generally, before Subdivision 165-CD can apply, three conditions must be satisfied (see
section 165-115K of the 1997 Tax Act):
(a) a company must experience an alteration time;
(b) the company must be a loss company; and
(c) an entity (not an individual) must hold a relevant equity interest or relevant debt
interest in the loss company immediately before the alteration time.
Alteration Time
Typically, a company will experience an alteration time if (see sections 165-115L, 165-
115M and 165-115N):
(a) when compared to its ownership as at 11 November 1999 or the most recentalteration time, the company experiences a more than 50% change in ownership or
change in control; or
mafm M0111825722v1 150630 3.3.2006 Page 18
(b) the liquidator of the company declares there are no reasonable grounds ofexpecting a distribution (as per section 104-145 in the 1997 Tax Act).
Hence, the sale of 100% of a subsidiary member to another consolidated group will be an
alteration time for the subsidiary member.
Loss Company
A company will be a loss company at the alteration time if it has (see section 165-115R):
(c) carried forward losses or current year losses at that time (realised losses); and/or
(d) an adjusted unrealised loss.
The concept of an adjusted unrealised loss is set out in section 165-115U and essentially
means the unrealised losses the loss company has in respect of its underlying assets,
calculated on the basis that the company is deemed to have disposed of its CGT assets at
the alteration time.
Section 165-115U prescribes two methods for calculating whether a company has an
adjusted unrealised loss:
(e) the individual asset method – which deems the loss company to have disposed
of each CGT asset (other than assets acquired for less than $10,000) at the
alteration time and then aggregates the sum of the notional losses arising from the
deemed disposal (without netting off any notional gains); or
(f) the global asset method - which the loss company can elect to use and which
requires it to work out the total market value of all of its CGT assets at the
alteration time using an acceptable valuation method and then compares those
values to the cost bases of the assets.
The sum of a loss company's realised losses and adjusted unrealised loss is called its
overall loss (see sub-section 165-115R(5)).
Relevant Equity and Debt Interest
The final condition that must be satisfied is that an entity, other than an individual, holds
either a relevant equity interest or a relevant debt interest in the loss company at the
alteration time.
An entity will hold a relevant equity interest in the loss company if it has a 'controlling
stake' in the company and its equity interests give it (directly or indirectly) 10% or more of
dividend, capital or voting rights (see section 165-115X).
Similarly, an entity will hold a relevant debt interest in the loss company if it has a
'controlling stake' in the company and is owed debts of $10,000 or more by the company or
by another company that has a relevant equity interest or debt interest in the company (see
section 165-115Y).
4.3 Application of Subdivision 165-CD
Where the above conditions are satisfied, Subdivision 165-CD may apply to reduce the tax
cost of relevant equity interests and/or debt interests held by other corporate entities in the
mafm M0111825722v1 150630 3.3.2006 Page 19
loss company to ensure that the loss company's overall loss is not duplicated by thesestakeholders.
If a reduction is to occur in respect of the relevant interests held by corporate entities in the
loss company, the effect of the reduction will differ depending on how those interests are
characterised for tax purposes. Specifically:
(a) if the relevant shares or debt are held as capital assets - a reduction will be madeto the reduced cost bases of those interests;
(b) if the shares or debt are held as revenue assets - a reduction will be made to the
deductions that would otherwise be allowable on the disposal or acquisition of such
interests (see sub-sections 165-115ZA(4)-(10)).
The amount of the reduction, referred to as the adjustment amount, can be determined inone of two ways (see section 165-115ZB) - a formula method or non formula method.
In the present context it is only relevant to consider the non-formula method. Under this
method, the reduction is to be an amount that is appropriate (see sub-section 165-
115ZB(6)). The legislation does not define what this means. However, the adjustment
must be made by having regard to:
(i) the object of Subdivision 165-CD, as specified in section 165-115J;
(ii) the extent of the affected corporate entity's relevant equity interest or debt interest
in the loss company;
(iii) the circumstances in which the relevant equity interest and/or debt interest wereacquired;
(iv) the loss company's overall loss;
(v) the extent to which the overall loss has reduced the market value of the relevant
equity or debt; and
(vi) to prevent any double counting, the extent of any reductions required by
Subdivision 165-CD in respect of another loss company in which the affected
corporate entity has a relevant equity or debt interest.
4.4 Layers of Losses
The scheme of Subdivision 165-CD recognised the fact that, prior to the advent of tax
consolidation, the losses of a loss company could be reflected at multiple 'layers' within the
tax system.
In conceptual terms, prior to tax consolidation the multiple recognition of losses in the tax
system could be grouped into the following three 'layers' for the purposes of analysing
Subdivision 165-CD (and, in particular, for the purpose of identifying an appropriate
adjustment to cost bases):
(a) the first layer can be described as the 'Shareholder Losses'. These are reflected
in the excess of cost base over market value for shares and loans held indirectly by
individual taxpayers in the loss company;
mafm M0111825722v1 150630 3.3.2006 Page 20
(b) the second layer can be described as 'Interposed Losses'. These are reflected inthe excess of cost base over market value for shares and loans held by companies
that are interposed between the individual shareholders and the loss company.
Clearly, within a tax consolidated group these interposed losses do not exist;
(c) the third layer can be described as the 'Loss Co Losses'. These are the realised
capital and revenue losses of the loss company, and the excess of cost base over
market value for the assets owned by the loss company (ie unrealised losses on
the underlying assets). When looking at a consolidated group, these
Loss Co Losses are recognised as realised losses and unrealised losses of the
head company.
(d) When a loss-making subsidiary member of a consolidated group is sold to an entity
outside the consolidated group, then:
(i) in relation to the realised losses referable to the loss-making
subsidiary: the realised losses remain behind with the vendor head
company and, as such, they cannot be recognised again anywhere else in
the tax system;
(ii) in relation to the unrealised losses referable to the loss-making
subsidiary (ie the excess of tax cost over market value for the assets
legally owned by that subsidiary member): whether or not the
unrealised losses will be recognised elsewhere in the tax system depends
upon whether 100% of the loss-making subsidiary is acquired by a tax
consolidated purchaser -–refer below.
It is clear that Subdivision 165-CD does not operate to deny the Shareholder Losses. It is
also clear that this position is not altered by the modifications to Subdivision 165-CD that
are imposed by Subdivision 715-B under the tax consolidation rules.
In substance, the question of whether Division 165-CD is to apply to the sale of 100% of a
subsidiary member to another consolidated group turns upon whether, in a tax
consolidation environment, the application of Subdivision 165-CD should result in the
Shareholder Losses being the only losses recognised in the tax system. That is, whether
or not it is intended that Subdivision 165-CD should operate, in the context of the sale of aloss company by one consolidated group to another, to deny both the Interposed Losses
and the Loss Co Losses.
4.5 Effect of Consolidation
In a consolidated environment, when an entity leaves a consolidated group, it is intended
that Subdivision 165-CD will broadly have its normal operation, but with some important
modifications (see paragraph 11.87 of the Explanatory Memorandum to the New Business
Tax System (Consolidation and Other Measures) Bill (No. 2) 2002). These modifications
are set out in Subdivision 715-B of the 1997 Tax Act and are intended to have the effect of
ensuring that Subdivision 165-CD appropriately applies to adjust the tax value of the head
company's membership interests in the leaving entity just before the leaving time.
The first modification is set out in section 715-240. This section provides that when
applying Subdivision 165-CD to a company which ceases to be a subsidiary member of a
mafm M0111825722v1 150630 3.3.2006 Page 21
consolidated group (known as the leaving entity), sections 715-245 and 715-255 willaffect how Subdivision 165-CD is to apply.
Significantly, section 715-245 provides that where a leaving entity leaves a consolidated
group and the leaving time is also an alteration time (that is, there has been more than a
50% change of ownership in the leaving entity), then for the purposes of Subdivision 165-
CD, the leaving time will be deemed to be the alteration time, and the leaving entity will be
deemed to be a loss company to the extent that it has an adjusted unrealised loss at
that time. Only the leaving entity's adjusted unrealised loss is taken into account here as
any realised losses remain with the head company. Consequently, the leaving entity's
adjusted unrealised loss is deemed to be its overall loss for the purposes of
Subdivision 165-CD (see sub-section 715-245(3)).
Accordingly, the effect of section 715-245 is that, if a subsidiary member leaves a
consolidated group and the tax cost of the assets legally owned by the subsidiary member
exceed the market value of those assets, then that subsidiary member will be considered
to be a loss company for the purposes of Subdivision 165-CD and the tax value of the head
company's membership interests in the company may be reduced. Section 715-290 sets
out certain assumptions that are to be made here to ensure that the leaving entity and its
membership interests are recognised just before the leaving time (notwithstanding the
operation of the single entity rule) to allow Subdivision 165-CD to properly apply.
4.6 Head Company Choices
Where the above conditions are satisfied, section 715-255 will modify how any
Subdivision 165-CD adjustments are to be made. The section provides that if section 715-
245 applies, the head company of the consolidated group can choose to either:
(a) reduce the tax value of its membership interests in the leaving entity to nil; or
(b) reduce the value of the membership interests by an amount using a modifiedversion of the non-formula method set out in section 165-115ZB.
It is critical to note that if the taxpayer has not made any choice within six months from the
leaving time (or such further period as the Commissioner allows) then the taxpayer is
deemed to have chosen to reduce the tax cost of membership interests to nil.
In relation to membership interests which are CGT assets and not revenue assets, thiswould mean that the reduced cost base is reduced to nil, ie it would result in a denial of any
capital loss. Alarmingly, in relation to membership interests which are revenue assets this
would mean that the tax cost of the membership interests is reduced to nil, ie it would result
in a taxable gain! Refer section 715-255.
The modified version of the non-formula method requires the head company to calculate
an adjustment amount that is appropriate, but by only having regard to:
(a) the object of Subdivision 165-CD, as specified in section 165-115J; and
(b) the loss company's overall loss.
That is, the other four factors set out in section 165-115ZB and referred to above are
specifically excluded.
mafm M0111825722v1 150630 3.3.2006 Page 22
Accordingly, the effect of section 715-255 is to limit the relevant criteria the head companycan have regard to when determining what adjustments should be made to its membership
interests when one of its subsidiary members leaves the group. In particular, section 715-
255 specifies that the head company can only have regard to the object provision in
Subdivision 165-CD and the leaving entity's adjusted unrealised loss in determining the
amount of any reduction in the tax cost of membership interests.
It follows that there are two questions to consider:
(i) what is the object of Subdivision 165-CD?
(ii) does the leaving entity have an overall loss at the time of the sale?
As noted above, the statutory scheme of Subdivision 165-CD proceeds on the basis that
the losses of a loss company may be reflected in the tax system at three layers – ie theShareholder Losses, the Interposed Losses and the Loss Co Losses. Subdivision 165-CD
does not operate to deny the Shareholder Losses.
Therefore, in answering the first question (ie what is the object of Subdivision 165-CD?),
the issue is whether the object of Subdivision 165-CD is to eliminate both the Interposed
Losses and the Loss Co Losses, such that any tax loss arising from the sale is limited to
the Shareholder Losses.
4.7 What is the Appropriate Adjustment Amount?
The following discussion proceeds on the basis that:
(a) a consolidated group has sold 100% of its membership interests in a subsidiary
member to a purchaser which is the head company of a consolidated group (or
other member of a consolidated group);
(b) at the time of the sale, the tax cost of the assets legally owned by the subsidiary
member exceeded the market value of those assets, ie the subsidiary member had
an adjusted unrealised loss which, for Subdivision 715-B purposes, was the overallloss; and
(c) the vendor consolidated group chose to apply subsection 715-255(3); that is, the
tax cost of the membership interests in the subsidiary member is to be reduced by
the adjustment amount that is appropriate having regard to:
(i) the object of Subdivision 165-CD, and
(ii) the quantum of the overall loss.
As for the object of Subdivision 165-CD, section 165-115J simply states that:
The main object of this Subdivision is to make appropriate adjustments to the taxvalues of significant equity and debt interests held directly or indirectly by entitiesother than individuals in a loss company whose ownership or control alters.
The purpose of the adjustments is to prevent the duplication of the company'srealised and unrealised losses when any of those interests are disposed of orotherwise realised. This happens because the company's losses are reflected inthe values of the interests.
mafm M0111825722v1 150630 3.3.2006 Page 23
This section does not provide an unambiguous statement of the object of Subdivision 165-CD.
However, when section 165-115J is read in conjunction with the Review of Business
Taxation's A Tax System Redesigned and Chapter 28 of A Platform for Consultation, it
seems that the object of Subdivision 165-CD is to eliminate the multiple recognition (or
'duplication') of the Loss Co Losses described above (ignoring, the Shareholder Losses,
which are not eliminated by Subdivision 165-CD). Further, it seems that the object of
Subdivision 165-CD is to do no more than eliminate the multiple recognition of the
Loss Co Losses.
It seems reasonable to conclude that if the sale of a loss company does not have the effect
of causing multiple recognition of the Loss Co Losses within the tax system, then
Subdivision 165-CD has no role to play because there is nothing for it to eliminate. This is
because Subdivision 165-CD is intended to eliminate multiple recognition of Loss Co
Losses and no more.
This line of analysis emanates from paragraphs 1.16, 1.18, 1.19, 1.37 and 1.47 of A Tax
System Redesigned, paragraphs 28.4, 28.16, 28.32 and examples 28.2 and 28.3 of APlatform for Consultation. It is also supported by the Explanatory Memorandum to the New
Business Tax System (Miscellaneous) Bill (No. 2) 2000, which introduced Subdivision 165-
CD into the 1997 Tax Act. For example, at paragraphs 1.18, 1.19, 1.37 1.45, 1.47 and
1.48. it is stated that:
1.18 Loss multiplication arises where the taxation system recognises a singleeconomic loss more than once. Inter-entity loss multiplication can occur becauselosses of a company are reflected in the values of direct or indirect interests (e.g.shares and loans) in that company.
1.19 If entities are interposed between individual shareholders and a losscompany, the company’s losses may be multiplied on the realisation of ‘inter-entity’ interests in the loss company.
1.37 The object of the Subdivision is achieved by requiring appropriatereductions to the values for tax purposes of certain interests (inter-entity interests)held by entities that have a controlling stake in the loss company.
1.45 Subdivision 165-CD does not require reductions to be made by individualsholding interests directly or indirectly in the loss company.
1.47 It is appropriate that individuals can effectively realise the underlying netlosses of the loss company by disposing of their interests in it. This isrecognising only once that company’s underlying losses on an interest inthe loss company. Following a change in ownership or control of the losscompany, such losses may also be available to the loss company, but onlyif the same business test is satisfied.
1.48 Subdivision 165-CD limits multiplication of these losses by makingreductions to the tax attributes of relevant ‘inter-entity’ interests in the losscompany.
[Emphasis added]
Here, 100% of the loss-making subsidiary member of the consolidated group is to be
acquired by another consolidated group. This means that, in accordance with Division 705,
the purchaser consolidated group will reset the tax cost of the subsidiary's assets by
mafm M0111825722v1 150630 3.3.2006 Page 24
reference to the arm's length purchase price paid by the purchaser. It follows that theunrealised loss on the subsidiary's assets which exists immediately before the sale cannot
be 'carried over' to or 'replicated' in the purchaser consolidated group.
In other words, the resetting of the purchaser's tax costs by reference to the purchase price
paid for the subsidiary has the effect of eliminating the subsidiary's unrealised loss from the
tax system. This resetting of tax costs is a key design feature of the tax consolidation
regime and is unambiguously embodied in Division 705 of the Tax Act 1997. It is also a
very powerful tool in preventing the multiple recognition of losses in the tax system.
Clearly, the resetting of tax costs under Division 705 is performing a large part of the loss
integrity role that was performed by Subdivision 165-CD in the pre-consolidation
environment.
Of course the analysis would be different if the purchaser of the loss-making subsidiary
was not required to reset the tax cost of the subsidiary's assets by reference to the
purchase price. This would arise if the purchaser is not itself a tax consolidated group, or if
the vendor consolidated group sells less than 100% of the loss-making subsidiary.
Subdivision 165-CD would have a meaningful role to paly in these circumstances because
the tax cost setting process embodied in Division 705 would not operate to eliminate the
subsidiary's unrealised loss from the tax system. In these circumstances, for the purposes
of Subdivision 165-CD it would usually be appropriate for the vendor consolidated group to
reduce the tax cost of membership interests in the subsidiary so as to reduce a tax lossrealised on the sale.
Support for this proposition is illustrated by the fact that, in the Explanatory Memorandum
to the New Business Tax System (Consolidation and Other Measures) Bill (No. 2) 2002, all
the relevant examples in relation to Subdivision 715-B show the continued existence of the
leaving entity's adjusted unrealised loss. In each example, less than 100% of the leaving
entity's membership interests are sold to a third party and therefore, the tax values of the
leaving entity's underlying assets are not reset (see examples 11.4 – 11.8 on pages 293-
300).
It should be noted that the proposition advanced above, that Subdivision 165-CD has no
role to play where one consolidated group sells 100% of a loss-making subsidiary to
another consolidated group, is apparently not supported by Glenn Davies, Assistant
Commissioner of the ATO's Losses and CGT Centre of Excellence, as evident from the
paper presented by Glenn Davies to the TIA/CTA 2nd National Consolidation Symposium in
July 2005.