• Example 4- Scheme involving pre-arranged disposal of ownership interests

    The facts

    Sam owns 100% of the issued capital in Engin Pty Ltd (Engin) and is its sole director. Engin owns 50% of the issued capital in Subang Pty Ltd (Subang). The other 50% of issued capital in Subang is owned by Amanda.

    Both Engin and Subang operate successful engineering businesses, although both companies operate in different localities and have different segments of the engineering market.

    Sam paid $1,000 for his shares in Engin and Engin paid $2,000 for its 50% stake in Subang. All the shares in both Engin and Subang were acquired after 20 September 1985.

    Although both Engin and Subang have paid dividends to their shareholders in previous years, considerable profits have been retained resulting in increased share value. Engin has a current market value of $1.9 million (with $1.4 million of this value relating to Engin's holdings in Subang).

    Sam acknowledges he was negotiating to dispose of Engin's shares in Subang to a third party (an employee of Subang). These negotiations fell through however due to a failure of Sam and the employee agreeing on the sale price. The negotiations were not conditional upon a demerger.

    Applicant's stated reasons for demerger

    Sam states a demerger would provide the following commercial benefits:

    • Sam is conducting negotiations to sell 50% of his shares in Engin to Lucy, an employee of Engin. The proposed sale is conditional upon a demerger occurring, as there has been an established history of conflict between Lucy and the half owner of Subang, Amanda. For the last 10 years, Lucy and Amanda have litigated in the Courts against the other in various commercial and civil disputes. Accordingly, Lucy does not wish to acquire an indirect interest in Subang, due to the high risk of disputes occurring with Amanda. Any disputes may affect the business performance of both Subang and Engin;
    • Admission of new equity participants into the business of Engin will enhance its performance, as these new equity participants will have a stake in the business;
    • A demerger will allow a separation of risk should either business fail.

    Commissioner's analysis and decision

    In examining the current demerger proposal in relation to the "relevant circumstances" stated in subsection 45B(8), the Commissioner took into account the following factors:

    • The significant profit accumulations in both Engin and Subang. This is of particular importance given that the investment in Subang had a cost of only $2000 and the company now has a market value of $1.4 million (paragraphs 57 to 58 of PS LA 2005/21);
    • A demerger would deliver significant tax concessions to Sam in that due to the large profit accumulations in Subang, a large tax free demerger dividend of $1.4 million would be paid to him (paragraphs 94 to 95 of PS LA 2005/21);
    • The proposed subsequent sale of Sam's 50% stake in Engin is significant as it indicates the tax effective disposal of the Engin shares is a significant factor of the scheme (as this sale would be entitled to the CGT discount). Therefore a significant purpose of the demerger is arguably the tax concessions granted to Sam (paragraphs 73 to 78 of PS LA 2005/21);
    • A demerger would not enhance the effectiveness of asset protection for Engin should Subang's business fail, as Engin is a separate legal entity from Subang.
    • While a demerger would provide some asset protection for Subang should Engin's business fail, this factor alone does not preclude the application of section 45B;
    • While Lucy's conflict with Amanda may be a factor, where there exists more than one purpose for a demerger, the tax purpose must be incidental and subordinate to the other substantial purpose or purposes. It is the Commissioner's view that a substantial purpose in this case is to obtain a tax benefit for Sam (paragraphs 43 to 45 of PS LA 2005/21).
    • It is acknowledged that the introduction of an experienced employee as an equity owner in Engin is a relevant factor and may increase productivity and profit. However where there exists more than one purpose for a demerger, the tax purpose must be incidental and subordinate to the other substantial purpose or purposes. It is the Commissioner's view that the substantial purpose is to obtain a tax benefit (paragraphs 43 to 45 of PS LA 2005/21).

    Based on the above facts, the Commissioner would exercise his discretion to make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the demerger benefit provided to Sam under the scheme.

      Last modified: 03 Feb 2016QC 22770