Value Shifting

What is value shifting?

Value shifting is when the value of one asset increases while the value of another decreases as a result of certain actions.

Value shifting rules attempt to prevent taxpayers from deferring or avoiding their tax liabilities. This can occur by manipulating the timing of losses and gains through the transfer of value from assets set to be realized in the short term to assets with longer-term realization prospects. Additionally, taxpayers may use value shifting to potentially evade taxable gains by moving value into assets classified as pre Capital Gains Tax assets.

The General Value Shifting Regime (GVSR) can be applicable to value shifting schemes even if there’s no explicit tax avoidance motive. In such cases, the general anti-avoidance provisions may still be enforced concerning value shifting activities.

The value shifting rules are relevant to entities holding interests in companies and trusts that meet specific control or common ownership criteria. Entities engaging in transactions at arm’s length or based on market value terms are exempt from the value shifting rules. Additionally, value shifts within consolidated groups or MEC groups are not affected by these rules.

The GVSR comprises two primary components: Direct Value Shifting (DVS) and Indirect Value Shifting (IVS) rules. These rules are designed to address value shifts in three main areas:

Direct Value Shifting Involving Equity or Loan Interests in Companies and Trusts
Direct Value Shifting Involving Created Rights in Non-Depreciating Assets
Indirect Value Shifting Involving Non-Arm’s Length Dealings

In most instances, the GVSR leads to adjustments in cost bases or adjustable values of assets. However, it can also result in taxable income or taxable gains in certain cases. It’s essential for affected owners to understand the specific implications for each component of the regime.

Applicability of the value shifting rules

The GVSR exclusively applies to “affected owners,” which include controllers, associates, or active participants in the scheme. If interests are held by entities that do not fall into these categories, the GVSR does not have any implications for them.

It’s worth noting that the rules governing affected owners differ between Direct Value Shifting (DVS) and Indirect Value Shifting (IVS). Affected owners need to be aware of these distinctions to ensure compliance with the GVSR.

Under the GVSR, the following types of transactions may trigger its application:

Issue of Interests at a Discount: This occurs when interests in a company or trust are issued at a price lower than their market value.

Alteration of Rights: It applies when there are changes made to the rights associated with existing equity or loan interests in a company or trust.

Group Financing Restructuring: In cases where there is a reconfiguration of financing arrangements within a group of entities.

Entity Restructuring: This includes situations involving the transfer of assets, issuance, or cancellation of interests within a group of entities.

Debt Forgiveness: When debt is forgiven, potentially leading to value shifts.

Creation of Rights over Non-Depreciating Assets: Particularly relevant when these rights are subsequently sold at a loss.

Non-Arm’s Length Service Arrangements: When service arrangements are established under non-arm’s length terms.

In situations where a single event triggers both the Direct Value Shifting (DVS) and Indirect Value Shifting (IVS) rules, you must remember that the DVS rules may take precedence.

Exclusions from the value shifting rules

The GVSR has specific exclusions in place where its provisions do not apply:

Issuance of Interests at Market Value or Premium: The GVSR doesn’t apply when equity or loan interests are issued at either market value or a premium.
Creation of Rights over Non-Depreciating Assets for Full Market Value: Similarly, the GVSR is not triggered when rights are created over non-depreciating assets in exchange for full market value consideration.
Arm’s Length Transactions: When entities engage in transactions with each other at arm’s length or provide benefits at market value, the GVSR doesn’t come into play.

The GVSR also employs small value exclusions to focus on substantial value shifts, reducing compliance costs for affected taxpayers. These small value exclusions include:

For direct value shifts involving equity or loan interests, the total must be at least $150,000 for the entire scheme.
When creating rights over non-depreciating assets, shortfalls (excess of market value over taxed value) should exceed $50,000.
For indirect value shifts, the cumulative indirect value shifted must exceed $50,000.

Exclusions and Safe Harbors in IVS Rules

The Indirect Value Shifting (IVS) rules encompass several exclusions and safe harbors to provide clarity and minimize compliance burdens. For instance, entities eligible to be considered as simplified tax system taxpayers or those satisfying the maximum net asset value test are exempt from making adjustments under the IVS rules.

Division 725

Under Division 725 of the GVSR, direct value shifting rules come into play when a scheme results in the transfer of value from equity or loan interests in a company or trust to other equity or loan interests within the same company or trust.

Such a direct value shift could occur through various means, such as issuing new shares or trust units at a discounted rate, repurchasing shares at a value below their market worth, or altering the voting rights associated with shares.

Purpose of the rules

These rules are crafted with the aim of preventing losses or gains from arising when these interests are eventually realized. This is achieved by:

Adjusting Interest Values: The rules adjust the value of these interests for income tax purposes, accounting for significant changes in market value attributed to the value shift.
Treating Value Shift as Partial Realization: The value shift is treated as a partial realization to the extent that the value is shifted between interests held by different owners, from assets categorized as post-Capital Gains Tax (post-CGT) to pre-CGT assets, or between interests of different characteristics.

These rules are applicable exclusively to value shifts that involve direct equity or loan interests in companies or trusts meeting the controlling entity test.

Conditions for application of division 725

For Division 725 to be applicable, several conditions must be met:

1. Direct Value Shift: There is a direct value shift within a scheme or arrangement. This involves shifting value from equity or loan interests in a company or trust, referred to as “down interests,” to equity or loan interests in the same company, including those issued at a discount, referred to as “up interests.”

2. Other Conditions for Application

a. There must be one or more controllers in the company or trust at any time from the initiation of the scheme until its execution.

b. The value shift must be reasonably attributable to actions taken under the scheme by the following entities:

The company or trust itself
A controller of the company or trust
An entity associated with the controller, either at or after the scheme’s initiation
An active participant in the scheme.

c. There must be at least one affected owner of both down interests and up interests in the relevant company or trust.

d. Two exceptions should not apply to the value shift:

The direct value shift does not result in a material shift in value (i.e., the total shift in value is less than $150,000).
The value shift is reversed within four years.

It’s worth noting that the direct value shifting rules do not apply to shares issued at a premium above market value because, in such cases, no interests in the company experience a value reduction as a result.

De minimis exemption

This section also contains a de minimis exemption, which means Division 725 applies only if the sum of decreases in the market value of all down interests due to the direct value shift amounts to $150,000 or more. An anti-avoidance provision is also included to prevent taxpayers from using different schemes to exploit this threshold.

Consequences of division 725 application

When all the necessary conditions for Division 725 application are met, the consequences depend on the ownership and character of the interests involved.

Ownership and Character of Interests: Consequences arise only when there is a value shift between down interests and up interests owned by affected owners. No consequences occur when the value shift involves owners of up interests or down interests, or both, who are not affected owners.

Character of Interests: The consequences also depend on whether the interests held by affected owners are categorized as:

CGT assets
Trading stock
Revenue assets

Division 723

Division 723 is designed to prevent tax losses that might occur when an underlying asset, not classified as a depreciating asset, is sold at a loss partly due to the value being shifted out of that asset by creating a right over it for an associate.

The division’s goal is to ensure that the value shifted out of the asset is properly considered in tax calculations, either during the asset’s sale or when the right is created.

Addressing a historical gap

Before the introduction of Division 723, tax rules did not require the consideration of the market value of the right created for an associate when calculating tax consequences. I

In certain scenarios, the act of creating such a right could reduce the asset’s market value, resulting in a lower selling price upon disposal than would have occurred if the right had not been created. This gap in regulation could lead to unexpected tax losses or larger losses than anticipated.

Conditions for the application of division 723

Division 723 is governed by specific conditions that determine when it comes into effect:

Asset Ownership and Type: Division 723 applies when value is shifted from a non-depreciating asset, known as the underlying asset, owned by any entity. This rule is not restricted to companies and trusts.
Associate Involvement: It applies when the value shift occurs to an asset, specifically a newly created right, held by an associate.
Shortfall Threshold: Division 723 comes into effect when a right is established with a value lower than its market worth, and the market value of that right at the time of its creation surpasses the consideration for tax purposes by over $50,000.
The difference between these values is termed the “shortfall on creating the right.”
Loss on Realization: The division applies when the underlying asset is realized, either entirely or partially, by the entity that created the right. This realization must result in a loss that can be partially attributed to the right.

It also applies when the underlying asset is rolled over, and the loss could potentially occur upon the realization of replacement interests. Importantly, just before the time of realization of the underlying asset, the right must still be in existence and held by an associate of the entity that’s selling the underlying asset.

Exemptions from division 723

Conversely, there are situations where Division 723 does not apply:

Market Value Substitution Rule: The division does not apply when a market value substitution rule is used during the creation of the right. This is because there is no shortfall; in other words, there is no difference between capital proceeds and market value.
Partial Disposal or Specific Tax Law Provisions: When the creation of the right results in a partial disposal or realization of the underlying asset, or when a specific provision of tax law treats the granting of the right as a disposal of the underlying asset, Division 723 is not applicable.
Transfers within a Consolidated Group: The division doesn’t apply when transfers of the underlying asset occur within a consolidated group.

Application in CGT scenarios

Division 723 may still apply in situations where the entity selling the underlying asset did not create the right but acquired the asset through a CGT roll-over (or a series of roll-overs) between associates.

Additionally, if a CGT asset is also classified as trading stock or a revenue asset, Division 723 applies to the asset first as a CGT asset and then again based on its character as trading stock or a revenue asset.

De minimis exemption and anti-avoidance provision

In Division 723, there’s a de minimis exemption, which specifies that Division 723 is applicable if certain conditions are met:

A CGT event occurs during the creation of the right over the asset.
The capital proceeds resulting from this event are lower than the market value of the right at the time of creation.
The gap between the capital proceeds and the market value, known as the “shortfall on creating the right,” exceeds $50,000.

However, to prevent any potential misuse of this $50,000 threshold by creating multiple rights strategically, there’s an anti-avoidance provision. This provision is designed to nullify the availability of the threshold if it’s reasonably determined that multiple rights were created with the intention of exploiting this exemption.

Additional exclusions from division 723

The division also does not apply in the following circumstances:

Conservation Covenant: When the right created is a conservation covenant over land.
Creation Upon Death: If the right is created upon the owner’s death under a will, codicil, or a court order varying or modifying a will or codicil.
Intestacy or Court Order: When the right is created as a result of a total or partial intestacy or a court order varying or modifying the law of intestacy (s 723-20(2)).

Consequences of division 723 application

When Division 723 is applied, its consequences are significant and tied to specific scenarios:

Realization Event Requirement: Division 723 only takes effect when a “realization event” occurs. This means that it operates when an asset is sold or disposed of, and if not for this division, a loss would have been recognized for tax purposes.

Loss Denial: The primary objective of the division is to deny the loss realized by an entity to the extent that it can be attributed to the value shifted out of the underlying asset through the creation of the right. It essentially reduces the amount of any loss incurred upon the realization of the underlying asset.

Adjustment Calculation: To determine the reduction in loss, the division compares two figures: the “shortfall on creating the right” (the difference between the market value and capital proceeds when the right was created) and the “deficit on realization.” The reduction amount is the lesser of these two figures.

Impact of Right Realization: If the owner of the right realizes a gain when selling the right before, during, or within four years after the realization event for the underlying asset, the reduction amount is further reduced by the amount of that gain.

This condition applies to situations where the owner of the right is or was an associate of the owner of the underlying asset.

When only a portion of the underlying asset is realized, the reduction in loss is calculated proportionally.

Replacement Asset Roll-Over: When an underlying asset has been transferred to an associate under a replacement asset roll-over, the tax consequences that would have occurred to the original underlying asset under Division 723 are applied to the replacement asset. This involves decreasing the replacement asset’s reduced cost base (RCB).

Indirect Value Shifting Rules

Indirect value shifting occurs when entities engage in transactions that are not conducted at arm’s length and do not involve market value exchanges. In these situations, the economic value associated with the transaction undergoes a shift, impacting the values of interests held within these entities.

The term “indirect” is used because this value shift affects the values of these interests indirectly, creating a disconnect between their market value and their values for tax purposes.

Purpose of indirect value shifting rules

The primary purpose of indirect value shifting rules is to rectify this distortion in the relationship between market value and tax value.

These rules are designed to ensure that tax calculations align with the true economic impact of these transactions, preventing any unfair tax advantages or disadvantages that may arise from non-market value dealings.

Impact on equity and loan interests

Indirect value shifting rules have a notable impact on equity and loan interests within entities. Specifically, these rules come into play when there’s an indirect value shift, and the entities involved are either commonly controlled or commonly owned. In this context:

A “losing entity” is a company or trust that experiences a decrease in its value due to the value shift.
A “gaining entity” is one that sees an increase in its value because of the shift.

These rules aim to nullify the effects of value shifts by making adjustments to either:

The valuation of the interests for tax purposes immediately prior to the value shift.
Losses or gains that arise when these interests are realized or disposed of.

In doing so, they ensure that tax calculations accurately reflect the economic reality of the transactions and prevent any tax-related distortions caused by these shifts in value. These rules play a crucial role in maintaining the integrity and fairness of the tax system by aligning tax treatment with the underlying economic substance of the transactions.

Exceptions to the application of non-arm's length dealings rules

Non-arm’s length dealings rules do not apply in certain circumstances, including:

These rules do not come into effect when the value of the shift resulting from the non-arm’s length dealings is $50,000 or less.
The rules also do not apply when the value shift originates from a superannuation entity or an entity that does not fall under the categories of a company or trust.
Unless the value shift involves the value of a loan, it is exempt when it occurs within a chain of entities that are wholly owned.
The rules do not apply if the value shift primarily relates to loans or services that are provided at either their direct cost or a price that is commercially realistic.
When the value shift pertains to an asset, it is exempt if the transfer occurs at a value equal to or below the asset’s cost base or cost, whichever is greater, and does not exceed the asset’s market value (in most cases).

Exception for interest holders

Interest holders in the two entities involved in non-arm’s length dealings are also exempt from the impacts of the GVSR if:

They qualify as a small business entity.
They, along with related entities, have net assets totaling $6 million or less, satisfying the capital gains tax maximum net asset threshold test.

Consolidated Groups

The concept of consolidated groups, under the consolidation of entities regime, is governed by the single entity rule. This rule has significant implications for how the GVSR, which deals with value shifting, applies within these groups.

Equity and loan interests within consolidated groups

Within consolidated groups and multiple entry consolidated (MEC) groups during the consolidation process, the GVSR does not affect equity and loan interests held by one group member in another.

This means that value shifts between group members, in terms of these interests, do not trigger the GVSR’s consequences. The single entity rule essentially shields these transactions from the GVSR’s impact.

Treatment of subsidiary members

Under the single entity rule, subsidiary members of a consolidated group or MEC group are treated differently for certain income tax purposes. They are considered integral parts of the head company, rather than separate entities. This treatment simplifies tax considerations within the group.

Leaving tax cost reconstruction rules

To address value shifts between group members, the leaving tax cost reconstruction rules are applicable. These rules are designed to manage the tax implications associated with interests held by group members in one another, ensuring that the tax treatment accurately reflects the economic reality of the group’s internal transactions.

GVSR application to non-group members and non-group member interests

The GVSR may still apply to interests held by non-group members in a consolidated or MEC group, as well as interests held by consolidated or MEC group members in non-group members.

In these cases, the GVSR’s provisions can come into effect to address value shifts, as the single entity rule primarily focuses on protecting interests within the consolidated group itself.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.