Sally, Mandy and Anne each own a third of the total shares in Chowder Pty Ltd (Chowder) which operates the 'Chowgood' restaurant. Chowder also owns 100% of the issued capital in Vegan Pty Ltd (Vegan). Vegan operates the 'Vege Delight' Restaurant. Both the share capital of Chowder and Vegan can be precisely identified as $80,000 and $30,000 respectively. All shares in Chowder and Vegan were acquired after 20 September 1985.
Both Chowder and Vegan operate successful restaurants. The estimated market value of Chowder is $1.5 million (this includes its indirect interest in Vegan) and the estimated market value of Vegan is $500,000.
In previous income years both Chowder and Vegan paid regular large dividends to their shareholders. In 2004, Chowder paid $300,000 in dividends and in 2005 paid $350,000.
In the 2006 income year Chowder did not distribute its net profit. Instead, although Chowder had an operating profit of $250,000 and received a dividend of $200,000 from Vegan, it only declared dividends of $40,000.
In August 2007, Sally, Mandy and Anne decide to demerge Vegan from Chowder. However, the demerger benefit of Vegan shares to Sally, Mandy and Anne does not reflect a correct attribution between capital and profits.
It was agreed that the following would transpire once the demerger was completed:
- Sally will sell some of her shares in Chowder to Phillip, who is the restaurant manager of 'Chowgood';
- Sally would sell the remainder of her shares in Chowder to Mandy and Anne; and
- Sally would retain her shares in Vegan.
Applicants stated reasons for demerger
The following reasons were provided by Sally, Mandy and Anne for the demerger:
- Allow the owners of Chowder to separate their equity interests in both Chowder and Vegan and to be able, as a result, to deal with these interests separately. This is not possible under the current structure where Vegan is a wholly-owned subsidiary;
- Although Sally would like to dispose of her interests in Chowder, she wishes to retain her shareholding in Vegan. This is not possible under the current structure;
- A demerger would allow persons wishing to acquire an equity stake in one restaurant but not the other, to acquire shares in either Chowder or Vegan. This is not possible under the current structure;
- A demerger would facilitate Phillip, the manager of the 'Chowgood' restaurant to acquire shares in Chowder;
- The above factors would facilitate a more efficient running of the businesses, by having separate equity ownership for both companies.
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:
- There was a clear interruption of the pattern of profit distribution by Chowder in the 2006 income year. There was no apparent business purpose for the concentration of these profits in Chowder prior to the demerger and this interruption was also inconsistent with past dividend practice (paragraphs 57 and 84 to 95 of PS LA 2005/21);
- The clear interruption of the pattern of profit distribution in Chowder prior to the demerger clearly benefits Sally, as it effectively converts what would otherwise be dividend income into a tax beneficial capital amount. This is significant as Sally would be entitled to the CGT discount on any subsequent sale of the Chowder shares, as she has held these shares for more than 12 months. This would provide Sally with a significant tax benefit (paragraphs 84 to 95 and 107 to 108 of PS LA 2005/21);
- The demerger allocation of Vegan shares to Sally, Mandy and Anne, did not reflect a correct attribution of capital and profits (paragraphs 49 to 56 of PS LA 2005/21).
- The prearranged disposal of Chowder subsequent to the demerger, suggests that it was undertaken to transfer corporate assets to shareholders rather than restructure the businesses of the respective companies (paragraphs 73 to 78 of PS LA 2005/21). It is also clear on the facts provided that the demerger was conducted for a more than incidental purpose to facilitate the tax effective disposal of Sally's shares in Chowder;
- Post demerger there were no alterations to the business operations of either Chowder or Vegan, other than the sale of shares to the manager of the 'Chowgood' restaurant;
- While Sally wishing to retain her interests in a demerged Vegan is a relevant 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 the substantial purpose in this case is to obtain a tax benefit for Sally and the other shareholders of Chowder;
- While it is acknowledged that the manager of the 'Chowgood' restaurant taking an equity stake in 'Chowgood' may promote some business efficiencies, this factor does not result in the purpose of obtaining a tax benefit being reduced to an insignificant purpose (paragraphs 43 to 45 of PS LA 2005/21).
Based on the above facts, it is clear that a significant purpose of the proposed demerger and subsequent sale was to obtain a tax benefit. The tax benefits were to provide Chowder's shareholders with a tax free demerger dividend and entitle Sally to reduce her assessable income by applying the discount capital gain to the sale of her shares. The demerger also resulted in profits in Vegan being distributed as preferentially taxed capital to Sally, Mandy and Anne. The facts also do not disclose the intention to substantially improve business efficiency.
Accordingly, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA would apply to treat the demerger dividend as assessable income to the shareholders of Chowder.