nsw 9th annual tax forum - amazon s3 · the ip unit trust immediately prior to the acquisition....

© Paul Lyon, EY 2016

Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

NSW 9TH ANNUAL

TAX FORUM

M&A Activity In

The Private Sector

Written by:

Paul Lyon Partner

EY

Presented by:

Paul Lyon Partner

EY

Deborah Gentry-

Rose

Manager

EY

NSW Division

2-3 June 2016

Sofitel Sydney Wentworth

Paul Lyon & Deborah Gentry-Rose M&A Activity in the Private Sector

© Paul Lyon & Deborah Gentry-Rose 2016 2

CONTENTS

1 Introduction .................................................................................................................................... 4

2 Structuring ...................................................................................................................................... 5

2.1 Restructuring and scrip-for-scrip ............................................................................................... 5

2.1.1 The IP Unit Trust ................................................................................................................ 5

2.1.2 Acquisition of a Single Entity ............................................................................................. 7

2.1.3 Other considerations.......................................................................................................... 9

2.2 Separating Business and Personal Assets ............................................................................... 9

2.2.1 Can a discretionary trust be part of a consolidated Group? ............................................ 10

2.2.2 Tax Payable on Trust Income .......................................................................................... 11

2.2.3 Cessation of the tax consolidated group ......................................................................... 11

2.3 Pre-Sale Dividends ................................................................................................................. 12

2.4 Earnouts .................................................................................................................................. 12

3 Consolidation matters ................................................................................................................. 16

3.1 Liabilities ................................................................................................................................. 16

3.2 Churning and the like… .......................................................................................................... 16

3.2.1 Churning .......................................................................................................................... 16

3.2.2 The Like ........................................................................................................................... 17

4 Debt/Equity Implications for M&A Activity ................................................................................ 19

4.1 Financing through a combination of debt and equity .............................................................. 19

4.2 Convertible Notes ................................................................................................................... 20

4.3 Limited Recourse Debt ........................................................................................................... 20

4.4 Subordinated Debt .................................................................................................................. 20

5 Inheriting Tax Risks ..................................................................................................................... 21

5.1 Non-consolidated acquirer and non-consolidated target (target group) ................................. 21

5.2 Target is an entire consolidated group ................................................................................... 21

5.3 Target is a subsidiary or sub-group of consolidated group ..................................................... 22

6 Stamp Duties ................................................................................................................................ 24



6.1 Corporate reorganisation generally ........................................................................................ 24

6.2 Landholder Duty ...................................................................................................................... 24

6.3 State budgets .......................................................................................................................... 24



1 Introduction

We have seen an active mergers and acquisitions market in the last 12 months, principally because

of:

A favourable lending environment;

Historically low interest rates;

Increased corporate/private equity cash; and

An increasing number of companies owned by private equity firms.

With all M&A activity comes tax opportunities and risks. These include opportunities and risks

revolving around:

Structuring;

Re-setting tax cost bases;

Debt or Equity Funding;

Inheriting Tax Risks; and

Minimising Duties.

This paper will provide some private sector flavour to these topics. Often these aspects of taxation are

only considered when the time for planning for a transaction has passed. In the fast paced world of

M&A, advisers to private sector groups should be alive to these issues so they can plan ahead in

preparation of future M&A activity. If nothing else, planning ahead of any future transaction should

assist in mitigating tax risk given the wider application of our general anti-avoidance provisions.

All errors and omissions are those of the authors and not Ernst & Young.

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.



2 Structuring

Structuring for M&A transactions often starts with a client conversation about “What if” or in many

circumstances “We’ve been approached by…”. As their trusted advisor we are often brought in at this

time to dust off the skeletons in the closet and develop, modify or review a structure for the client that

will be ‘deal ready’ for a potential acquirer and does not incur unreasonable tax costs and/or risks in

the process.

Pre-sale dividends, pre-sale restructuring and purchase price earn-outs are familiar terms often heard

at this time and it is these terms that can red flags especially in the private sector. Is a pre-sale

dividend going to form part of the capital proceeds for the vendor? Will any pre-sale restructuring

have Part IVA implications? How does the new legislation impact an earn-out?

While these questions are often seen as a storm cloud they can equally provide opportunities to

rationalise corporate groups and improve their tax effectiveness.

2.1 Restructuring and scrip-for-scrip

2.1.1 The IP Unit Trust

In the private sector, we often encounter structures where growth businesses have been advised to

hold various forms of valuable intangible assets (let’s call it IP for simplicity) in Unit Trust structures,

separating the IP from the trading activities of the main company. Licence fees are charged for the

use of the IP and on a day to day level this functions well for the client who is able to protect their key

asset while maintaining the flexibility of income flowing through a family trust (often the units in the IP

Trust and the shares in the trading company are held in a family trust).

However, on the basis that this IP is often the main or one of the main asset(s) that an acquirer

wishes to purchase the question arises, who wants to purchase a Unit Trust in a ‘structure’

acquisition?

Provided pre-conditions are met a vendor has the ability to “correct” this position pre-divestment using

CGT rollover relief. Further, these same provisions can be used in step by step transactions to

provide a commercially attractive structure, maximising the value of the business and facilitating a

sale.

Diagram 1 – Pre-conversion structure

Trading Co

Owner 3

Licence Fees

Owner 2 Owner 1

40% 30% 30%

IP Holdings Pty Ltd

IP Unit Trust



Subdivision 124-N allows for CGT rollover relief upon the restructure of a unit trust into a company. It

states:

(1) A roll-over may be available for a restructuring (a trust restructure) if:

(a) a trust, or 2 or more trusts, (the transferor) *dispose of all of their *CGT assets to a company limited by *shares

(the transferee); and

(b) *CGT event E4 is capable of applying to all of the units and interests in the transferor; and

(c) the requirements in section 124-860 are met.

Note: A roll-over is not available for a restructure undertaken by a discretionary trust.

(2) For 2 or more transferors, units and interests in each transferor must be owned in the same proportions by the

same beneficiaries.

Applying this to an IP Unit Trust

The Trust would dispose of the IP to a new proprietary company (Newco)

As a result of this disposal, the Trustee of the IP Unit trust (transferor) would ordinarily make a

capital gain, which would be distributed to the unit holders. Instead the unit holders will receive

ordinary shares in Newco and under subdivision 124-N the capital gain is disregarded.

If any of the IP is a Division 40 asset, then s118-24 states that any capital gain is disregarded and

s40-340 allows for any balancing adjustment amount to automatically qualify for rollover relief

when an asset is transferred under subdivision 124-N.

Under section 124-860, to be eligible for the rollover relief Newco must satisfy the following:

It must be a new company with no trading history or losses (i.e. a shelf company or the

trustee company per s124-860(5)).

After the trust restructure Newco’s ownership must reflect the current ownership in the IP Unit

Trust

The market value of the shares in Newco (i.e. the replacement interests) must be substantially

the same value as the units in the IP Unit Trust.

Diagram 2 – Post-conversion structure

IP Newco

Trading Co

Owner 3

Licence Fees

Owner 2 Owner 1

40% 30% 30%

IP Unit Trust

IP Holdings Pty Ltd

Deregistered and Wound up

Unit Trust replaced



Implications for unit holders

A unit holder can choose to apply the roll-over relief where the ownership of all units held in the IP

Unit trust ends under a trust restructure in exchange for shares in Newco.

If the choice is made the cost base of the shares received to replace the units is:

Original asset (Units) cost base as at the date ownership ended

Number of new assets (Shares in Newco)

Implications for the transferor (IP Unit Trust)

Any capital gain or loss on the disposal of the asset is disregarded

The Unit Trust must cease to exist within 6 months of applying the roll-over

If not the roll-over may be reversed

The trust is ordinarily vested immediately following the transfer of IP to Newco

Implications for the transferee (Newco)

The cost base of the IP that is transferred to Newco will be the same as it was for the Trustee of

the IP Unit Trust immediately prior to the acquisition.

2.1.2 Acquisition of a Single Entity

It may be that an acquirer (especially foreign investors) wants to acquire shares in a single entity.

Building on the IP Unit Trust discussion we can further rationalise our private group by using

subdivision 124-M.

Section 124-780(1) allows for CGT rollover relief upon exchange of a share in one company (original

entity) for a share in another (replacement entity). It states:

(1) There is a roll-over if:

(a) an entity (the original interest holder) exchanges:

(i) a *share (the entity’s original interest) in a company (the original entity) for a share (the holder’s replacement

interest) in another company; or

(ii) an option, right or similar interest (also the holder’s original interest) issued by the original entity that gives the

holder an entitlement to acquire a share in the original entity for a similar interest (also the holder’s replacement

interest) in another company; and

(b) the exchange is in consequence of a single *arrangement that satisfies subsection (2) or (2A); and

(c) the conditions in subsection (3) are satisfied; and

(d) if subsection (4) applies, the conditions in subsection (5) are satisfied.



Applying this to our IP Newco:

Family Trust will exchange shares held in IP Newco for new shares issued in Trading Company,

s124-780(1)(a)(i).

As long as all owners of IP Newco were able to participate and Trading Company will have more

than 80% of the voting shares in IP Newco, the exchange will satisfy the requirements of s124-

780(1)(b) above.

S124-780(1)(c) is satisfied if:

The original interest holders have acquired the shares in IP Newco post 20 September 1985

and apart from the roll-over they will make a capital gain, and

If the original interest holder chooses to apply the rollover relief, they advise Trading Company

in writing of their cost base.

S124-780(1)(d) operates to ensure that where the transaction involves a company with less than

300 members and all parties to the transaction are linked the transaction is on arm’s length terms.

Implications for the original interest holder (Family trusts)

Any capital gain or loss on the disposal of the asset is disregarded

Under section 124-785 the cost base of new shares issued in Trading Company will equal the

cost base of the interest in the original entity being IP Newco calculated as:

Original asset (Shares) cost base as at the date ownership ended

Number of new assets (Shares in Trading Company Pty Ltd)

Implications for the replacement entity (Trading Company Pty Ltd)

As there is a significant stakeholder in the transaction the cost base for the acquiring entity is

calculated per section 124-782.

Transfer of cost base

(1) The *cost base of an original interest *acquired by an acquiring entity under the *arrangement from an original

interest holder becomes the first element of the cost base and *reduced cost base of the acquiring entity for the

interest if:

(a) the original interest holder obtains a roll-over; and

(b) the holder is a *significant stakeholder or a *common stakeholder for the arrangement

Any transfer of IP from Newco up to Trading Company will ordinarily be tax-free, if part of a tax

consolidated group.

Newco could, if thought necessary, then be wound up or otherwise deregistered, leaving the

structure clean in preparation for acquisition.



Diagram 3 – Pre and Post Scrip for Scrip

2.1.3 Other considerations

In performing the above “housekeeping” ensuring that dealings are conducted on an arm’s length

basis with commercial objectives is essential. This was an issue with a sale transaction in FCT v

Fabig [2013] FCAFC 99. If consideration is allocated between vendor shareholders on a

disproportionate basis, even though the transaction may be conducted at arm’s length, roll-over relief

may not be available.

Furthermore, the wider application of Part IVA can operate to prevent the obtaining of a tax benefit by

a taxpayer notwithstanding the arrangement has all the hallmarks for a genuine restructure to position

the target group to be deal-ready.

2.2 Separating Business and Personal Assets

Another situation regularly encountered in the private sector is where there are assets held in the

trading entity that are not core or business related where the purchaser wants them extracted from the

group.

With some planning, it may be possible to establish a structure and use the tax consolidation

provisions to restructure these assets into a family trust (a vehicle frequently used to hold personal

assets in a protected environment). This strategy provides a structure to be established at an earlier

time to allow for the rationalisation of the trading entity without triggering immediate tax

consequences.

IP Newco

Trading Co

Owner 3

Licence Fees

Owner 2 Owner 1

40% 30% 30%

100%

Ownership

New shares issued IP Newco

Trading Co

Owner 3

Licence Fees

Owner 2 Owner 1

40% 30% 30%

Acquisition of scrip in IP Newco

Replacement with scrip in Trading Co



The proposed structure is:

In this structure, it allows for non-business/non-core assets to be transferred out of the trading entity

to the trust. Under the single entity rule, this asset transfer is ignored and the tax consolidated group

continues to operate as usual.

Specific queries that this paper considers are:

1. Can a discretionary trust form part of a consolidated group?

2. What tax is payable on the trust income?

3. What happens on cessation of the tax consolidated group?

2.2.1 Can a discretionary trust be part of a consolidated group?

Section 703-15 defines the entities capable of being a member of either a consolidated or

consolidatable group. For a trust to be a wholly-owned subsidiary of a consolidated group all the

membership interests in the trust must be beneficially owned by either the holding entity, and/or one

or more wholly-owned subsidiaries of the holding entity.

Ta

x C

onsolid

ate

d G

roup

Holding Company/Trading

Entity

Discretionary

Investment

Trust

Trustee Company

Beneficiaries

Holding Company and 100% owned Australian subsidiaries.

Trustee has the power to add further class of specified

beneficiaries which are either individuals or trust

Holding company presently entitled to

net income of trust only when trustee

exercises his direction

Mr X Mrs X



Subsection 960-130(1) stipulates that a member of a trust is any beneficiary, unit holder or object of

the trust. Section 960-135 states that a membership interest is:

(a) each interest, or set of interests, in the entity; or

(b) each right, or set of rights, in relation to the entity

by virtue of which you are a member of the entity is a membership interest of yours in the entity.

For the purposes of section 960-135, the mere existence of a power to extend a pre-existing class of

objects of a trust will not confer any rights on persons outside of that class, who may at some future

point in time be added to that class via the powers conferred on the trustee(s).

Therefore, a trust settled pursuant to a Deed that has the existing consolidated group members as

beneficiaries and permits the trustee to add and remove persons to a defined class of objects will be

eligible to be a member of the consolidated group as provided in item 2 of paragraph 703-15(2)(b).

ATO ID 2005/74 confirms that a discretionary trust can be a member of a tax consolidated group.

2.2.2 Tax Payable on Trust Income

As we all know, unless there is no beneficiary made presently entitled to trust income, a trustee does

not pay tax. Therefore, in the context of a consolidated group does the Head Company need to be

made presently entitled to the income of the trust or can the income in the trust accumulate?

This simply raises a question as to whether the trustee is considered part of the group. To mitigate

any concern in this regard the trustee could simply go through the normal present entitlement process

in the ordinary manner.

2.2.3 Cessation of the tax consolidated group

The addition of a beneficiary by the trustee of the trust will result in the exit of the trust from the group

ahead of any sale transaction. Intra-group balances would be ‘cleaned up’ prior to sale.

If the trust leaves the tax consolidated group, care would need to be taken to ensure that the exit

calculation under Division 711 did not result in a negative ACA triggering CGT event L5. However, the

relevant assets and liabilities have exited the private group ahead of any sale transaction.



2.3 Pre-Sale Dividends

Pre-sale dividends are a common mechanism used by private groups to facilitate a number of

objectives prior to a sale including but not limited to:

Extraction of cash prior to sale;

Utilisation of franking credits for the current owner; and

Enabling a more favourable taxation position in the event of a sale.

TR 2010/4 “Income tax: capital gains: when a dividend will be included in the capital proceeds from a

disposal of shares that happens under a contract or a scheme of arrangement”, sets out the

Commissioner’s view on the circumstances in which pre-sale dividends are included as part of the

capital proceeds of a transaction.

If the fact pattern of an M&A transaction includes the following, the ruling treats the dividend as capital

proceeds:

the vendor shareholder is entitled under the contract to refuse to complete the transfer if the

dividend is not declared by the target company or if the dividend is not paid by the target

company; or

the vendor shareholder is entitled to refuse to complete the transfer if a purchaser or third party

does not finance or facilitate payment of the dividend; or

the vendor shareholder has bargained for any other obligation on the part of the purchaser to

bring about the result that the dividend shall be received by the vendor shareholder.

It specifically targets dividends that have been paid a part of negotiations, where the vendor

shareholder has bargained for the receipt of the dividend.

The anti-overlap provisions in s 118-20 operate to reduce any capital gain where as a result of this

ruling a pre-sale dividend would otherwise be included in capital proceeds. In this scenario the

dividend retains its character and is assessable as dividend income. The main issue is the impact on

capital losses which are not affected by the anti-overlap provisions.

2.4 Earnouts

Until the recent change in legislation as enacted by Tax and Superannuation Laws Amendment (2015

Measures No. 6) Bill 2015 (‘the Earn-out Bill’), there was no clear position on how such arrangements

treated for tax purposes.

In 2007 the ATO issued Draft Taxation Ruling TR 2007/D10 (which we are all familiar with) to provide

some guidance regarding earnouts which placed most earnouts in the separate asset category. It

states that an earnout may be either a “standard” earnout or a “reverse” earnout, and were defined as

follows:



A standard earnout arrangement is any transaction in which an income-earning asset (often a business asset) is sold

for consideration that includes the creation of an 'earnout right' in the seller of the asset.

An earnout right is a right to an amount calculated by reference to the earnings generated by the asset for a defined

period following the sale (generally a period of between one and five years).

A reverse earnout arrangement is a contract for the sale of an asset in which the seller of an asset accepts a

nominated sum by way of consideration, but undertakes to pay an amount or amounts (post-sale payments) to the

buyer calculated by reference to the earnings generated by the asset during a specified period after completion of the

sale.

This guidance provided in TR 2007/D10 could be succinctly summarised as follows:

In a “standard” earnout arrangement the seller includes in their capital proceeds the market value

of the earnout right which is considered a separate CGT asset from this time and any adjustment

necessary when the earnout right comes to an end is captured as a capital gain (or capital loss)

under CGT event C2.

Similarly, the buyer includes the market value of the earnout right in their cost base, however,

unlike the sellers position this is not adjusted for the actual monies that do or do not become

payable.

In a “reverse” earnout arrangement the market value of the earnout right is excluded from the

capital proceeds of the sale of the original asset for the seller and any amounts paid to satisfy the

earnout right neither trigger a CGT event nor impact the capital proceeds.

The treatment for the buyer in a “reverse” earnout is similar to that of the seller in a standard

earnout. The right is initially acquired at market value and will form part of the cost base at that

time, however, once the right comes to an end the buyer will instead make the capital gain (or

loss) under CGT event C2.

Commercially this approach provided challenges including:

Obtaining valuations to address uncertainty in the underlying value of the asset

The separate asset approach results in a new asset (being the earnout right) resulting in the

relevant party potentially not being able to access the 12 month CGT discount.

Further, as an earnout right could not be considered an active asset the small business CGT

concessions are not available to payments made once the right comes to an end.

The discrepancy between market value and what payments are actually made under the earnout

results in amounts on which too much tax has been paid by the seller, cannot be recognised as

part of capital proceeds in a reverse arrangement for the seller or forms unrecognised amounts of

cost base for the buyer.

Within section118-565 we now have legislation applying the “look through” approach to earnout rights.

However, those earnouts that do not fall into this specific definition still need to apply the guidance

contained in TR 2007/D10.



Look Through Earnout Rights (LTER’s) are defined as:

s118-565 Look-through earnout rights

Look-through earnout rights—main case

(1) A look-through earnout right is a right for which the following conditions are met:

(a) the right is a right to future *financial benefits that are not reasonably ascertainable at the time the right is created;

(b) the right is created under an *arrangement that involves the *disposal of a *CGT asset;

(c) the disposal causes *CGT event A1 to happen;

(d) just before the CGT event, the CGT asset was an *active asset of the entity who disposed of the asset;

Note: For extra ways to be an active asset, see section 118-570.

(e) all of the financial benefits that can be provided under the right are to be provided over a period ending no later

than 5 years after the end of the income year in which the CGT event happens;

(f) those financial benefits are contingent on the economic performance of:

(i) the CGT asset; or

(ii) a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which

those financial benefits relate;

(g) the value of those financial benefits reasonably relates to that economic performance;

(h) the parties to the arrangement deal with each other at *arm’s length in making the arrangement.

Between s118-575 and s118-580 any gain or loss on the earnout right is effectively disregarded.

Instead it is added to the first element of the cost base for an acquirer or forms part of capital

proceeds for the seller. Further, once the financial benefit is a known quantity the legislation allows for

ATO interest free amendments to be made providing that they are made within the time period. This

effectively removes the commercial problems described above and resets the thinking around

negotiations.

Most earnouts will be classed as LTER’s and there is little reason to structure a transaction that does

not meet the LTER criteria. For the private sector this may lead to a further increase in M&A activity

as often having an earnout in an agreement was a deal breaker. Those taxpayers who were eligible

for Small Business CGT concessions and/or the CGT Discount were discouraged from entering into

earnouts as the separate asset principle meant that a significant portion of their sale proceeds was

effectively assessable as ordinary income.

This new legislation will make the private sector a more appealing M&A environment. Large

organisations can spread their risk between upfront payment on settlement and an earnout and the

private entrepreneur, who is largely motivated by tax outcomes, can sell without unreasonable tax

cost on the earnout portion.



2.5 Date of transaction

Another matter that is not often considered but can have significant ramifications for private groups is

the date at which the relevant transaction takes place for tax purposes. This can change the income

year in which the capital gain is derived and it can also affect the timing for the conditions relevant for

the small business CGT concessions.

Recently, we have encountered the ATO disputing the CGT event date particularly where Heads of

Agreements (HoA) are executed. Whether signing a HoA impacts the date of a CGT event depends

largely on whether it is a binding or non-binding agreement.

In FCT v. Sara Lee Household & Body Care (Aust) Pty Ltd 2000 ATC 4378, the issue was whether

contractual amendments to a purchase and sale agreement alter the date of the transaction. The High

Court found that it was the original contract date that provided the date of the transaction as the

identification of the contract under which the assets were disposed of required “a judgment as to

which of the contracts is properly to be seen as the source of the obligation to effect the disposal”.

In Confidential and Commissioner of Taxation [2013] AATA 76 (15 February 2013) the substance of

the HoA was considered in detail and due to the agreement being legally binding the disposal date

was found to be the date that the HoA was signed. The Tribunal referred to the High Court case of

Master v Cameron (1954) 91 CLR 353 which classified conditional agreements into 3 categories:

1. A binding document detailing all the terms of the agreement

2. A binding document detailing all the terms of the agreement but performance of some of the

terms is conditional on the execution of a formal document

3. A non-binging document subject to a formal contract

In each of the first two categories a formal contract is in place as:

“…in the first case a contract binding the parties at once to perform the agreed terms whether the

contemplated formal document comes into existence or not, and to join (if they have so agreed), in

settling and executing the formal document; and in the second case a contract binding the parties to

join in bringing the formal contract into existence and then to carry it into execution.”

When entering into a HoA often a binding document is used to reduce the risk of the contract not

going ahead. Ideally, both documents fall in the same financial year however it is prudent to ensure

that the intention of the HoA does not affect the intended date of the transaction.

http://law.ato.gov.au/atolaw/view.htm?locid=%27JUD/2000ATC4378%27&PiT=99991231235958



3 Consolidation matters

The Tax Consolidation regime continues to morph as reviews are performed and integrity provisions

are developed. The latest changes were those released in April 2015 in the 2015 Exposure Draft for

the Tax and Superannuation Laws 4 Amendment (2015 Measures No. 4) Bill 5 2015: Consolidation.

Two of the proposed changes in that ED are topical for Private Groups in an M&A situations.

Removing the “double deduction” for liabilities; and

The removal of the ability for a foreign parent with a MEC group to gain a permanent uplift in

their cost base for additional acquisitions (‘churning’)

3.1 Liabilities

The Board of Taxation review in 2013 noted two issues with the treatment of liabilities at step 2.

1. Unlike assets they are not reset on joining, any “wrong” amounts effectively give rise to a

distortion (often an increase in ACA) and there is no requirement to correct these amounts

2. Acquired deductible liabilities (i.e. annual leave provisions) give rise to a double benefit as these

liabilities are added at step 2 (effectively increasing ACA and therefore allowing future deductions

once allocated to assets) and are then deducted from assessable income by the acquirer

Private entities can have unreported deductible liabilities (i.e. Leave Provisions) where the owners

have not taken or booked their Long Service Leave or Annual Leave. This provides opportunity in an

M&A transaction as the acquirer may be purchasing liabilities that may or may not be recognised in

the balance sheet or be held at the correct value. Assuming an Acquirer is consolidated this can

provide an upside to undertaking the transaction, when the private entity joins the tax consolidated

group, the acquirer can benefit from this anomaly and as it can deduct the amount paid to discharge

the liability when it is discharged.

The 2015/16 Budget has proposed amendments to remove the concern around the ‘assessable

income’ issue with effect from 1 July 2016 by now not including any amount in the assessable income

of the head company but removing deductible liabilities from Step 2 calculations.

3.2 Churning and the like…

3.2.1 Churning

Cleaning up private corporate groups post acquisition can also have its challenges. This can be so if

the target group has both domestic and foreign activities where the foreign entity is the target holding

company.

Currently, when an entity is acquired by a consolidated group from a foreign resident, a double benefit

can arise.



When a foreign parent sells a non-TARP entity within a wholly owned group they are able to apply

Division 855 to provide an exemption on any capital gain. If the foreign parent sells this entity to a

consolidated group the entry tax cost setting rules apply to reset the tax costs of the joining entity’s

assets (at market value) even if the foreign resident is exempt from tax on any capital gain made

when it ceases to hold membership interests in the joining entity.

This effectively converts a temporary deferral of capital gain into a permanent deferral.

The churning measure included in the 2015 ED will prevent this double benefit by switching off the

entry tax cost setting rules when there has been no change in the majority economic ownership of the

joining entity for a period of at least 12 months before the joining time.

3.2.2 The Like

What happens if the private group acquirer is forming a tax consolidated group? More interestingly

what happens on formation when one of the entities in the private group has benefitted from a

Division 122 rollover?

Imagine this scenario; a private group established pre-CGT has organically grown over time and now

seeks to restructure into a corporate group.

The interaction between a Division 122 rollover and the tax cost setting provisions in the tax

consolidation regime was explored in Financial Synergy Holdings Pty Ltd v Commissioner of Taxation

[2015] FCA 53 (9 February 2015) where in the initial judgement Justice Pagone held that for the

purposes of Step 1 of an ACA calculation, a Division 122 rollover will preserve both the Pre-CGT

status and provide the relevant timing for determining the cost base of for tax cost setting purposes

for the tax consolidated group.

At first instance, it was held that the time immediately before 20 September 1985 was the relevant

date for determining the cost base for tax consolidation purposes. This was because in the Court’s

view the policy behind the statue dictated that the deeming rules in Division 122 must have

application for cost base purposes such that the value at this time recognises the full pre-CGT value

of the assets brought into the group.

However, on appeal to the Full Federal Court, this decision was overturned and it was held that the

“time of acquisition” and therefore the value at that time was in fact 29 June 2007, which was the time

of the actual restructure transaction.

The reasoning behind the Full Court decision is largely dependent on two key items:

1. The purpose of Division 122 – this is to preserve a Pre-CGT asset’s status and exempt it

from the operation of the CGT provisions. Therefore, any deeming provisions within the

context of Division 122 do not extend beyond this purpose.

2. The object of the consolidation provisions – as stated in s705-10(2) the object of these

provisions is “to recognise the head company’s cost of becoming the holder of the joining

entity’s assets as an amount reflecting the group’s cost of acquiring the entity”. The Full

Court agreed that the recognition of $30 million as the cost base for the purposes of Step 1

by Financial Synergy Holdings agreed with this object.



The same can be said for a Division 615 rollover.

On this basis, the (commercially driven) restructuring of pre-CGT businesses into corporate

structures may attract some further attention.



4 Debt/Equity Implications for M&A Activity

One of the key elements to any M&A transaction is the funding behind it.

It is the debt and equity rules in Division 974 that determine whether the finance to a transaction will

be treated as debt or equity for tax purposes.

Whilst classic legal form debt and equity provides little controversy for the tax adviser, other forms of

financing, such as subordinated debt, limited recourse debt, intra-group loans, convertible notes and

redeemable preference shares can cause interesting and complex interpretational issues to be

addressed. The complex rules in the TOFA regime can also give rise to interesting interpretational

issues but this regime is typically less relevant in a private group setting and beyond the scope of this

paper.

Determining whether the financing arrangement is debt or equity is paramount because returns on

debt interests will, subject to some conditionality, be deductible whilst returns of equity will be non-

deductible and may be frankable.

Other important distinctions arising from the classification include consolidation membership eligibility,

thin capitalisation outcomes and withholding tax exposures.

Debt Test

In order for a financial instrument to be classified as a debt interest, the ‘debt test’ must be satisfied.

The defining characteristic is whether the issuer of the interest has an effectively non-contingent

obligation (ENCO) to provide financial benefits in return that are substantially likely to be at least

equal in value. The obligation need not be a legally enforceable one but must be determined having

regard to the pricing, terms and conditions of the scheme.

Equity Test

A financing arrangement gives rise to an equity interest if it satisfied the ‘equity test’ and is not

characterised (or form part of a wider arrangement that is) as a debt interest. The defining

characteristic here is that the return on the instrument is contingent of the economic performance of

the issuer.

As noted above, ‘vanilla’ financing arrangements are not likely to trouble a competent tax adviser but

some of the more complex financing arrangements that appear in M&A transactions in the private

space can cause issues.

4.1 Financing through a combination of debt and equity

When looking at a financing arrangement that has a combination of debt and equity instruments, it is

important to consider the ‘related schemes’ provisions in Division 974.

In essence, these provisions can group the interests together and treat them as a single interest (the

notional scheme) that is tested against the primary tests.



Based on the broad wording in the test, it will be common for interests which are issued

simultaneously (or close to) to be related. However, consequences of being related will only result if it

is reasonable to conclude that the company intended, or knew that a party to the scheme intended,

the combined economic effects of the constituent schemes to be the same as or similar to the

economic effects of a debt or an equity interest.

Importantly, it is often the case that the financing interests will have a clear, documented purpose

within the capital structure of the entity raising finance and this purpose is not to give rise to the

combined economic effects of either a debt or equity interest.

If there was not a documented and clear purpose, then unintended consequences could arise under

the related scheme provisions (refer ATO ID 2004/430).

4.2 Convertible Notes

Whilst convertible notes are generally well understood from a commercial perspective, it is important

to remember the Commissioner’s views in TR 2009/3 that section 177EA of the 1936 Act can apply to

dent imputation benefits to the holders of convertible notes that can either be redeemed on maturity or

converted to ordinary shares equal to the dollar value of the issue price. It is because the notes can

be converted to ordinary shares on maturity that they fall outside the debt test and are treated as non-

share equity.

4.3 Limited Recourse Debt

In this situation, the lender’s ability to recover its funds are likely to be linked to the economic

performance of the borrower such that their interest may be more akin to equity because of the

contingent nature of the return.

In such arrangements, there is still an effectively non-contingent obligation to make repayments, it is

simply the recourse upon default that is limited.

The equity test is unlikely to be satisfied because the lender’s right to receive repayments is not

contingent on the economic performance of the borrower.

4.4 Subordinated Debt

Typically this is where one lender is precluded from making a repayment demand while other more

senior debt is on foot.

Here there is still a non-contingent obligation to repay the debt but the timeframe is more restricted.

From an equity test perspective, there is likely to be more risk in related party situations where there is

a discretionary element to any repayment.



5 Inheriting Tax Risks

This paper is focussed principally on the acquirer’s position and so this part of the paper will look at

the type of risks that a purchaser of a private group may face and how those risks may be mitigated in

both a practical and contractual sense.

As with prior years, the ATO has, in its 2015 Compliance Program (now part of the Building

Confidence document) drawn attention to CGT (and other M&A) issues surrounding divestments in

privately owned groups. On this basis, extra focus should always be applied to the potential or real tax

risks resulting from M&A activity in the private sector.

The typical fact patterns for acquisitions in the private sector are:

Non-consolidated acquirer and non-consolidated target;

Target is an entire consolidated group; and

Target is a subsidiary or sub-group of a consolidated group;

I will look at each of these scenarios in a little more detail.

5.1 Non-consolidated acquirer and non-consolidated target (target

group)

In this scenario, the target’s losses and franking credits may be available.

The asset cost basis of the subsidiary and/or group members will be inherited without the

consolidation adjustment flowing from the ACA rules.

The tax history and risks of the group will be acquired by the purchaser. This risk is much the same as

occurred prior to the introduction of the tax consolidation regime and therefore would be subject to the

usual tax due diligence processes.

Given the absence of a consolidation election, individual transactions within the target will need to be

assessed from a tax perspective as part of the diligence processes. Given that there is usually pre-

sale reorganisations of target groups, provisions such as the debt forgiveness regime and share value

shifting regime will need to be carefully considered.

5.2 Target is an entire consolidated group

In this instance, the tax attributes will be available in that the franking account and tax losses will

come with the target group and the analysis is much the same as above except the tax risks with

intra-group dealings falls away given the operation of the single entity rule.

If the acquirer is not consolidated, when the target group becomes a wholly owned subsidiary of the

acquirer, this will cause the old consolidated group to cease to exist and there will be a disposal of

assets out of the consolidated target group under the Division 711 exit rules.



Whilst this may not lead to tax risk per se, the complexity of the rebuilding of tax cost bases in the

former group (and reliance on the tax values asserted by the consolidated vendor) and the different

outcomes that may arise (from that experienced in the non-consolidated environment) means that

consideration should be given to creating a consolidated acquirer group ahead of any acquisition.

5.3 Target is a subsidiary or sub-group of consolidated group

In this scenario, the target company or sub-group will have no tax attributes to transfer. However, it

does bring the potential joint and several tax liabilities for the vendor consolidated group.

The due diligence required needs to be modified to deal with the joint and several liability exposures

of the target company or sub-group.

Given the extent to which the tax consolidation regime has been adopted by private corporate groups,

the joint and several liability exposure is a very real risk and is dealt with in more detail below in the

Tax Sharing Agreement section.

The divestment will cause a Division 711 exit event for the vendor group which, in turn, needs to be

understood in the overall context of assessing tax risk that is being inherited.

Importance of Tax Sharing Agreements

It is clear that the Tax Sharing Agreement (TSA) rules in Division 721 do not resolve the commercial

risks in relation to target companies which are acquired from vendor consolidated groups.

Having said that, the TSA concept is attractive and is certainly of assistance in helping to regulate the

risk of inheriting latent tax liabilities from a target group.

The importance of a TSA surrounds the joint and several liability exposure that exists if there is no

TSA in place, and the ‘clear exit’ that can be afforded to an exiting subsidiary if a valid TSA exists.

Does a valid TSA exist?

Broadly, for there to be a valid TSA, the following requirements must be satisfied:

An agreement exists between the head company and one or more contributing members

before the due time for the group liability;

The contribution amount for each contributing member can be determined; and

The contribution amounts must represent a reasonable allocation of the group liability.

A valid TSA is important because it allows for a subsidiary member to leave clear of a consolidated

group’s group liability that falls due after completion (included amended assessments in certain

circumstances) where a valid TSA exists and a range of criteria is satisfied.

Without going into a full technical analysis of Division 721, some of the practical matters that arise

when considering TSA’s in the context of endeavouring to mitigate inheriting tax risk in a private group

acquisition are:



Contention over whether a particular allocation principle under the TSA is reasonable (noting

that this principle has not yet been tested in Court). It is our experience that typically a

pragmatic approach is taken by both sides particularly if the methodology chosen falls within

those listed in the Commissioner’s guidance in PS LA 2013/5;

Whether the failure of a subsidiary member of a consolidated group to accede to a TSA has

caused it to be invalid. What is necessary here is to understand if that entity would have

affected the ‘reasonable allocation’ of the group liability. This can be a problem if the

purchaser does not have visibility over the tax calculations of the wider group;

The existence of two TSA’s that cover the same liability;

Estimating a reasonable clear exit payment in respect of a future amended assessment

where an ATO review or audit is currently in progress. Again, understanding the tax profile

and affairs of the wider group is likely to be necessary in formulating a reasonable outcome.

This scenario is not adequately dealt with in PS LA 2013/5;

Historical clear exit payments not made. This could be an issue if a subsidiary goes on to

leave the acquirer group having not made a clear exit payment from a previous acquired

group. In this case, the acquired subsidiary continues to have joint and several liability in

relation the acquired group as well as future amended assessments.

Tax liabilities that have fallen due and that are outstanding prior to the exit of a subsidiary

need to be identified particularly if the subsidiary has a contribution amount in relation to such

an amount. This is because the subsidiary can still be liable for such a payment (ie no clear

exit) because it relates to a pre-existing liability. Clear exit payments only relate to liabilities

where the due date falls after the exit date.



6 Stamp Duties

6.1 Corporate reorganisation generally

In M&A activities, be it restructuring or transactional, stamp duty is always a key consideration. The

difficulty however is dealing with the state by state interactions as seven different regimes need to be

negotiated. Often the identification of a corporate group is difficult as certain entities (i.e. trusts) may

not be recognised as part of a corporate group in different states. Further, relationships between

entities may create circumstances that disallow exemptions.

When performing such corporate reorganisation the commercial objectives need to be considered in

the context of stamp duty provisions too. The exemption for corporate reorganisations relies heavily

on the purpose of the transaction in each state and these tests often contradict (i.e. you cannot

receive an exemption in one state for the same reason as another). These navigational issues mean

that a stamp duty specialist should be consulted at the beginning of such reorganisation rather than

as an afterthought.

6.2 Landholder Duty

A sneaky stamp duty that needs to be considered when effecting a corporate reorganisation is

landholder duty. Generally, private entities will be assessed on landholder duty when there is an

acquisition of more than 50% of the entity and the entity holds land that meets a minimum value.

In most cases, where corporate reorganisation relief is available this will also be extended to include

any landholder duty, however, where a transaction includes a third party the definition of landholder

duty base needs to be closely considered. A landholder’s duty base is broader than many think and

depending on the state it can extend to include chattels on the land and/or fixtures held in the hand of

the tenant. These additions to the duty base can see de minims thresholds crossed and duty being

payable. It also means that more entities are considered landholders (i.e. retail chains that rent their

floor space).

6.3 State budgets

Stamp duty is always a target in state budgets. As a large source of revenue for states it can be used

to score votes and make promises. This year the Victorian budget has increased duty for foreign

investors of residential land to 12.5% (not doubt a vote scoring item considering recent news reports)

and we wait to see what the other states will do, our own being one of the more interesting ones to

watch as we have duties scheduled for abolition on 1 July 2016 (marketable securities, commercial

fishery shares, mortgage duty, statutory licences and transfer on sale of business assets). Will these

be deferred or will they proceed as legislated?

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