House of Representatives

Taxation Laws Amendment (Demutualisation of Non-insurance Mutual Entities) Bill 1999

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

General outline and financial impact

AMENDMENT OF THE INCOME TAX ASSESSMENT ACT 1936

Demutualisation of mutual entities other than insurance companies

Amends the income tax law to introduce a generic framework for the taxation of certain transactions associated with demutualisations of mutual non-insurance organisations. The main features of the generic framework are:

a disposal by a member of a membership interest in a mutual non-insurance organisation will not be subject to the capital gains tax (CGT) provisions when the disposal occurs in the course of a demutualisation arrangement;
an amount will not be included in a members assessable income on the issue of the demutualisation shares;
the amount paid for the acquisition of shares in the demutualised entity allotted to a former member will be determined according to when the original membership interest was acquired:

-
for a pre-CGT member, the amount paid will be determined by reference to the members share of the market value of the demutualising entity determined immediately before demutualisation (reduced by the members share of any franking surplus);
-
for a post-CGT member, the amount paid will be determined by reference to the costs incurred by the member in acquiring and maintaining their rights of membership (for example, joining fees) to the extent that such costs are not deductible;

the provisions will only be available where there is substantial continuity of beneficial interest between the members of the mutual and those who receive shares in the demutualised entity; and
franking account surpluses of the demutualising entity will be retained.

Date of effect: The amendments will apply to demutualisations completed on or after 12 May 1998.

Proposal announced: 1998-99 Budget announcement.

Financial impact: Because of the nature of the measure, it is not possible to provide a reliable estimate of the cost to revenue.

Cost of compliance impact: There would be compliance costs incurred in the demutualisation process under both the existing system of taxation and the proposed provisions dealing with demutualisations.

Under the proposed provisions, there will be some costs incurred in ascertaining the market value of the entity. This is required so as to determine the amount paid for the shares of pre-CGT members. Additional costs will be incurred as the demutualising entity will need to notify members of this amount. There will also be costs in ensuring that substantial continuity of beneficial interest is maintained.

Post-CGT members will need to determine costs of acquiring and maintaining membership interests. In addition, all parties involved in the demutualisation process will incur compliance costs in becoming familiar with the new provisions.

Overall, these costs are not expected to be significant.

Summary of the Regulation Impact Statement

Impact: Medium

Main points: In common with the impact of other newly introduced taxation provisions, some compliance costs are likely for parties involved in the demutualisation process in becoming familiar with the new framework. Overall, compliance costs are not expected to be significant.

Policy objective: The policy objective is to seek to remove impediments to demutualisations of mutual entities other than insurance companies. This will be achieved by the introduction of a broad generic framework which determines the CGT consequences of transactions associated with the demutualisation of these mutual entities.

Chapter 1

Demutualisation of mutual entities other than insurance companies

Overview

1.1 Schedule 1 to the Bill proposes to insert new Division 326 of Schedule 2H into the Income Tax Assessment Act 1936 (the ITAA 1936). New Division 326 provides a framework for the taxation consequences of certain transactions associated with demutualisations of mutual non-insurance organisations.

1.2 New Division 326 addresses the taxation consequences of the disposal by members of their interests in the demutualising organisation and contains rules for determining the cost of acquisition of demutualisation shares issued to members in exchange for the disposal of their interests in the mutual organisation. Different rules are provided according to whether a former member was a pre-capital gains tax (CGT) or post-CGT member.

1.3 New Division 326 will only apply where there is broad continuity of ownership of the accumulated mutual surplus of the demutualising entity between members of the mutual organisation and those who receive shares in the demutualised organisation. The provisions contain some flexibility to allow a small proportion of demutualisation shares to be issued to non-members.

1.4 New Division 326 contains three methods of demutualisation, one of which must be used for the provisions to apply. The methods allow for a holding company to be interposed between the former non-insurance mutual organisation and its members. Also, a trust can be used to facilitate the distribution of shares, or cash from the sale of shares, to members.

Summary of amendments

Purpose of the amendments

1.5 The purpose of the amendments is to provide a generic framework which specifies the taxation consequences of certain transactions likely to occur in the course of an arrangement for the demutualisation of a non-insurance mutual organisation. [Item 1, new Division 326]

1.6 The basic requirements for a demutualisation are that the members of a non-insurance mutual organisation agree to surrender their rights in the company (for example, the right to vote at meetings and/or the right to participate in the surplus of the company on winding up) in exchange for shares in the demutualised entity.

1.7 Broadly, the proposed measures will:

ensure that the CGT provisions will not apply to any disposal constituted by the surrender of a membership interest in a non-insurance mutual organisation [new section 326-65] and that on the issue of demutualisation shares, no amount is included in a members assessable income [new section 326-245] ;
provide that the generic framework will only be available where there is broad continuity of beneficial ownership between members of the non-insurance mutual organisation and persons to whom shares are issued in the demutualised entity [new section 326-60] ;
prescribe the date and cost of acquisition of shares (including bonus shares) acquired by members in a demutualising entity (including its holding company) as part of the demutualisation process [new subdivisions 326-D and 326-E] ;

-
special rules are included which prescribe the date and cost of acquisition of shares where membership rights in the demutualising entity have been obtained by disposing of membership rights in another mutual entity;

prescribe that where a member assigns an interest in a distributing trust or a right to receive shares,the date and cost of acquisition will be determined as if the member had disposed of shares in the demutualised entity [new sections 326-185, 326-195 and 326-200] ;
provide that where special shares representing the voting rights of members are held by a trustee of a distributing trust on behalf of members and the special shares are later converted to ordinary shares, no disposal will be taken to have occurred for CGT purposes [new section 326-215] ; and
ensure that appropriate tax consequences will result where a shareholder is paid an amount out of the accumulated surplus of the former non-insurance mutual after demutualisation [new section 326-225] .

Date of effect

1.8 The amendments, which were foreshadowed by the Treasurer in the 1997-98 Budget and announced in the 1998-99 Budget, apply to demutualisations that are completed on or after 12 May 1998.

Background to the legislation

1.9 In the past three years, a number of large life insurance companies have demutualised. The taxation treatment for the demutualisations of these organisations is prescribed in Division 9AA of Part III of the ITAA 1936.

1.10 There are no similar rules applying to non-insurance mutual organisations. There are difficulties in the existing tax law as it applies to demutualisations of non-insurance organisations, including the possibility of anomalies such as taxpayers being subject to double taxation.

1.11 For example, post-CGT members could incur a CGT liability on the disposal of their membership interests in a non-insurance mutual organisation. The liability would be based on the difference between the consideration received on the disposal of the interest (that is, the market value of the demutualisation shares received) and the relevant cost base. This transaction may not result in any cash flow from which the tax liability can be met.

1.12 A further tax liability may arise to the post-CGT members on the disposal of the demutualisation shares. This would be based on the difference between the market value of the shares at the time of disposal and the relevant cost base (which would include the market value of the surrendered membership rights).

1.13 The Government announced in the 1997-98 Budget the development of a generic framework, in consultation with the public, dealing with the taxation consequences of transactions associated with demutualisations of non-insurance mutual organisations.

1.14 An Issues Paper on the proposed generic framework was issued on 28 May 1997. Following a period of consultation, the Government announced in the 1998-99 Budget its intention to introduce a new generic framework for demutualisations of mutual non-insurance organisations. An Exposure Draft of the proposed framework was subsequently released on 4 February 1999. Comments on the Exposure Draft have been incorporated into this Bill.

Explanation of the amendments

1.15 The explanation is divided into two parts.

Part A sets out the requirements that must be met before the provisions of new Division 326 will be available to members of the non-insurance mutual organisation.

Part B explains the modified CGT consequences of certain transactions that may occur in the course of a demutualisation.

Part A - requirements relating to the demutualisation

1.16 The provisions of new Division 326 can apply to the demutualisation of a non-insurance mutual entity if:

where the demutualisation resolution day is on or after 4 February 1999, the members of the entity have passed a resolution, in accordance with the entitys Constitution, that new Division 326 is to apply to the demutualisation;
the entity was a resident immediately before the demutualisation resolution day ;
the mutual has demutualised in accordance with one of the methods prescribed in new Division 326 ;
the continuity of beneficial interest test is satisfied in relation to the demutualisation; and
the demutualisation is completed on or after 12 May 1998. [New subsection 326-5(1)]

1.17 Where the above requirements are met, the proposed amendments provide modifications to the ITAA 1936 and the Income Tax Assessment Act 1997 (the ITAA 1997). [New subsection 326-5(3)]

1.18 The requirement for the members of the demutualising entity to pass a resolution for new Division 326 to apply ensures that all members will be required to determine their taxation consequences arising from the demutualisation under the proposed rules. Roll-over relief under section 160ZZPH of the ITAA 1936 or section 124-520 of the ITAA 1997, for example, will not be available where such a resolution has been passed. [Part 2, Item 5, Schedule 2, Item 3]

1.19 As new Division 326 was only released as an Exposure Draft on 4 February 1999, the requirement to pass such a resolution only applies from that date. This recognises that some entities which have already demutualised would not be able to comply with this requirement.

1.20 For the purposes of subsection 326-5(1), a demutualisation is taken to have been completed on the day when all the shares in the demutualising entity, or the holding company of the demutualising entity, are issued. [New subsection 326-5(2)]

What is a mutual entity?

1.21 For the purposes of new Division 326 , a mutual entity is an entity which, immediatley before the demutualisation resolution day, is a body corporate that:

is not an insurance company or a mutual affiliate company, as defined in Division 9AA of Part III of the ITAA 1936;
is not carried on for the object of securing a profit or pecuniary gain for its members;
does not have capital divided into shares held by its members; and
does not hold property in which members have a disposable interest except in the event of winding up.

[New subsection 326-10(1)]

1.22 A company that would satisfy these criteria would generally be a company limited by guarantee under the Corporations Law or an association incorporated under State or Territory legislation.

1.23 The requirement that an entity does not hold property in which members have a disposable interest except in the event of winding up would not preclude an entity from being a mutual entity if the entity cannot make distributions to its members on a winding up.

1.24 The definition of mutual entity ensures that there is no overlap between the operation of new Division 326 and the existing law dealing with demutualisations of insurance companies (as prescribed in Division 9AA of Part III of the ITAA 1936).

1.25 A mutual entity which

has passed a demutualisation resolution is called a demutualising entity . [New subsection 326-10(2)] A mutual entity which ceases to be a mutual entity other than by ceasing to be a body corporate is called a demutualised entity . [New subsection326-10(3)]

How is the demutualisation to be effected?

1.26 New Division 326 sets out three methods of demutualisation, one of which must be used to attract the provisions of Division 326. [New section 326-40]

1.27 In describing the demutualisation methods, certain expressions are used. The following tables set out the expressions and their meanings.

Table 1 - Expressions relating to listed public companies
Listed (in relation to a share) A share is listed if it is listed for quotation in the official list of Australian Stock Exchange (ASX) Limited. [New subsection 326-15(1)]
Listed public company This expression has the same meaning as in the ITAA 1997. [New subsection 326-15(2)] Broadly, a listed public company is a company whose shares are listed on an approved stock exchange where more than 20 persons between them control 75% or more of the voting power and receive 75% or more of the dividends and distributions of capital of the company.
Listing resolution A resolution passed by the members of a mutual entity requiring the entity, or a holding company of the entity, to become a listed public company. [New subsection 326-15(3)]
Demutualisation listing day The day on which the demutualisation shares are first listed. [New subsection 326-15(4)]
Table 2 - Expressions relating to the timing of the demutualisation
Demutualisation resolution A resolution passed by the members of a mutual entity to proceed with the demutualisation of the entity. [New subsection 326-20(1)]
Demutualisation resolution day The day on which the demutualisation resolution is passed by members of the mutual entity. [New subsection 326-20(2)]
Limitation period The period ending 2 years after the demutualisation resolution day. It is the period in which the demutualisation must be completed unless the Commissioner allows an extension. [New subsection 326-20(3)]
Table 3 Expressions relating to membership
Existing member A person who is:

a member of the mutual entity at the earlier of the demutualisation resolution day and the share allocation cut-off day; or
a person who became entitled to an allocation of demutualisation shares because of the death of a member. [New subsection 326-30(1)]

New member A person who is a member of the mutual entity other than an existing member. [New subsection 326-30(3)]
Member An existing member or a new member . [New subsection 326-30(4)]
Share allocation cut-off day The day after which any person who becomes a member has no entitlement to demutualisation shares. [New subsection 326-30(2)]
Pre-CGT member A person:

whose membership rights in the entity are a pre-CGT asset within the meaning of the ITAA 1997; or
who acquired membership rights in the mutual entity by disposing of rights in another mutual entity and who acquired those other rights before 20September 1985. [New subsection 326-35(1)]

Post-CGT member Any member who is not a pre-CGT member. [New subsection 326-35(2)]
Table 4 Expressions relating to shares
Demutualisation shares Ordinary shares issued to members by the demutualising entity or its holding company as part of the demutualisation process; or
Special shares or ordinary shares (including those which replace special shares) issued to a distributing trust by the demutualising entity as part of the demutualisation process. [New section 326-25]

1.28 The definition of demutualisation resolution , described above, is a resolution passed by the members of a mutual entity to proceed with the demutualisation of the entity. It is considered that proceed has a wide meaning, thus encompassing resolutions which have the effect of pursuing a demutualisation. For example, if the enactment of legislation is necessary to facilitate the demutualisation of an entity, a resolution passed by the members of the entity requring the entity to seek to obtain the enactment of such legislation would satisfy the definition of a demutualsiation resolution .

1.29 As outlined above, a pre-CGT member will include a member whose membership rights were a pre-CGT asset for the purposes of the ITAA 1997. This provision will ensure that where Division 149 of the ITAA 1997 has applied to an entitys membership rights in a mutual entity, then that entity will be a post-CGT member for the purposes of new Division 326 . Similarly, if an entity has transferred pre-CGT membership rights in a mutual entity to another entity, and a CGT roll-over provision has applied so that the pre-CGT status of the membership rights is maintained, the new owner of the membership rights will be a pre-CGT member for the purposes of new Division 326 .

1.30 A pre-CGT member also includes a member who acquired membership rights in the demutualising entity by disposing of rights in another mutual entity where the member acquired those other rights before 20 September 1985.

1.31 This applies to taxpayers who are members of a mutual entity which was formed, for example, by the merger of several mutual entities. Even if the merger occurred on or after 20 September 1985, a member will still be a pre-CGT member if membership rights in one of the pre-merger mutual entities was acquired before 20 September 1985.

Example

1.32 Bob has been a member of mutual entity A since 15 July 1985. On 21 April 1990, mutual entity A merges with mutual entities B and C to form mutual entity D. On 10 June 1998, the members of mutual entity D resolve to demutualise and to use the provisions of new Division 326 .

1.33 For the purposes of new Division 326 , Bob will be classified as a pre-CGT member because he acquired his rights in former mutual entityA before 20 September 1985.

Methods of demutualisation

1.34 There are three acceptable methods of demutualisation. Requirements which must be met under each of the demutualisation methods are:

all membership rights in the mutual entity must be extinguished;
the entity must become a company with a share capital; and
if the members of the entity passed a listing resolution, ordinary shares are listed within the limitation period.

1.35 Specific requirements for each demutualisation method are outlined below.

Method 1 - issue of demutualisation shares directly to members

1.36 Under this method, ordinary shares of one class in the demutualising entity are issued within the limitation period to existing members in exchange for their membership rights. Shares of the same class may also be issued to new members. [New subsection 326-45(1)]

1.37 New subsection 326-45(2) illustrates this demutualisation method.

Method 2 holding company interposed between mutual entity and members

1.38 Under this method, shares of one class in the demutualising entity are issued within the limitation period to a holding company. Shares of one class in the holding company are then issued within the limitation period to members in exchange for their membership rights. Shares of the same class can also be issued to new members. [New subsection 326-50(1)]

1.39 New subsection 326-50(2) illustrates this demutualisation method.

Method 3 - distributing trust interposed between mutual entity and members

1.40 Under this method, the demutualising entity issues special shares (which carry only voting rights in respect of the demutualising entity) within the limitation period to the trustee of a distributing trust to hold for the benefit of existing and new members. This issue takes place before the issue of ordinary shares. After the issue of the ordinary shares, the rights attaching to the special shares must become the same as those attaching to the ordinary shares. The special shares must then be treated as ordinary shares.

1.41 Ordinary shares of one class must also be issued within the limitation period to the trustee to hold for the benefit of existing or new members. The trustee must either distribute the shares in specie to members or sell the shares and distribute the proceeds to members. Each member must make a choice in this regard. [New subsection 326-55(1)]

1.42 For the purposes of this demutualisation method, the trust must be established solely for the purposes of performing these functions. [New subsection 326-55(2)]

1.43 New subsection 326-55(3) illustrates this demutualisation method.

Continuity of beneficial interest test

1.44 New Division 326 will apply to a demutualisation only if the continuity of beneficial interest test is satisfied. [New subsection326-60(1)]

1.45 The continuity of beneficial interest test is satisfied if:

each existing member of the mutual entity is given an opportunity to:

-
take up shares in the demutualised entity or in a holding company of the demutualised entity; or
-
have shares in the demutualised entity issued to a trustee of a distributing trust on behalf of the member;

at least 90% of the ordinary shares issued in the demutualised entity or holding company in connection with the demutualisation are issued to existing members or to a distributing trust on behalf of existing members; and
the accumulated surplus of the mutual entity is distributed to existing members in the form of shares or cash from the sale of shares in a manner broadly consistent with any one or more of the following:

-
the level of contributions made by members to the mutual surplus;
-
the value of existing membership rights (for example, voting rights); or
-
the respective rights of members to participate in the mutual surplus (and any other membership rights) on winding up.

[New subsection 326-60(2)]

1.46 The accumulated surplus of a mutual entity is the net assets of the entity on the demutualisation resolution day. [New subsection 326-60(3)]

1.47 Where the allocation method of the accumulated surplus of a mutual entity is approved by a Court or by a majority of each class of members of the entity, it would be expected that the final condition of the continuity of beneficial interest test would be satisfied.

1.48 The continuity of beneficial interest test will allow a maximum of 10% of the ordinary shares to be issued to new members. This will mean that the demutualising entity can issue a limited number of ordinary shares to employees of the mutual entity or charities.

Example

1.49 The members of a sporting club which is a company limited by guarantee passes a resolution to demutualise. Under the constituent documents of the sporting club, there are several classes of membership rights. Class A members pay a joining fee of $20 and have access to all the facilities of the club. Class B members pay a joining fee of $10 and have access only to the bar and restaurant facilities. The winding up clause in the club constituent documents provides that, on winding up, any surplus assets are to be transferred to an association with similar objects as the sporting club.

1.50 On demutualisation, Class A members are issued with 200 shares each and Class B members are issued with 100 shares each. This allocation of shares is in proportions broadly consistent with members' mutual participation because shares have been allocated according to the level of contributions made by members.

Shares not received by a member

1.51 The continuity of beneficial interest test will only be satisfied if at least 90% of the ordinary shares are issued to, or on behalf of, existing members. It is possible that an entity could fail the test if more than 10% of the shares have not been received by members because their whereabouts is not known.

1.52 However, for the purpose of the continuity of beneficial interest test, shares will be taken to have been issued to a member if a member is able to claim the shares either from the demutualised entity or from the administrative authority in a particular State or Territory which has the responsibility for unclaimed moneys. This will be sufficient to allow the continuity of beneficial interest test to be satisfied.

Part B - Taxation consequences of demutualisation

1.53 New Division 326 sets out the taxation consequences that result from certain transactions that occur as part of the demutualisation process. These consequences are described below.

Extinguishment of membership rights

1.54 As part of the demutualisation process, the membership rights of each member in the mutual entity are extinguished. This represents a disposal of those membership rights for CGT purposes. In relation to members who acquired membership rights before 20 September 1985, a CGT liability would not arise in respect of the disposal. However, in relation to members who acquired membership rights on or after that date, a CGT liability could arise on the disposal.

1.55 New subsection 326-65(2) provides that a capital gain or loss which arises in respect of the extinguishment of the membership rights of a member is to be disregarded.

Disposal of demutualisation shares by member of a mutual entity

1.56 A member allotted shares as part of the demutualisation process may subsequently dispose of those shares. Therefore, the proposed provisions specify the amount that members will be taken to have paid for the acquisition of the shares. This will determine the CGT consequences for the member when the shares are disposed of.

1.57 The provisions will also set out the date of acquisition of the shares. This is necessary for the purposes of the indexation provisions contained in the existing law.

1.58 There are different rules which apply to determine the cost of acquiring the shares for pre-CGT and post-CGT members.

1.59 The Division also provides that a demutualising entity can convert to a listed public company or an unlisted company limited by shares. The rules for determining the cost of acquiring shares for each type of company are contained in new Subdivisions 326-D and 326-E and are separately described below.

Mutual organisation which converts to a listed public company

1.60 New Subdivision 326-D applies where a member disposes of a demutualisation share (or an interest in such a share) in a former mutual entity (or a holding company of the entity) which has converted to a listed public company. The Subdivision also applies to the disposal of a bonus share (called a non-demutualisation bonus share ), or an interest in such a share,where the original share in respect of the bonus share is a demutualisation share (called a demutualisation original share ). [New section 326-70]

1.61 The reference to an interest in a share ensures that the provisions will apply appropriately where, for example, the demutualisation shares are jointly owned because the membership in the mutual was jointly held. The interest is the percentage interest that a taxpayer owns in each share.

1.62 If a pre-CGT member disposes of a share before demutualisation listing day, and the demutualising entity was not formed by the merger of other mutual entities, then the member is unable to incur a capital loss on that disposal. [New section 326-75]

1.63 The basis for working out the cost of acquisition is different for demutualisation shares and demutualisation original shares.

Demutualisation shares other than demutualisation original shares

1.64 The following diagram summarises the cost of acquisition of demutualisation shares other than demutualisation original shares for pre-CGT and post-CGT members.

MUTUAL WHICH BECOMES A LISTED PUBLIC COMPANY

1.65 The basis for working out the cost of acquisition for demutualisation shares is different for disposals prior to and after demutualisation listing day.

Pre-CGT members - disposals prior to demutualisation listing day

1.66 For pre-CGT members who dispose of a demutualisation share, or an interest in such a share, before demutualisation listing day, the cost of acquiring the share is determined by reference to the adjusted market value of the mutual entity as at demutualisation resolution day. The adjusted market value is apportioned across all shares issued in the demutualised entity (to pre-CGT and post-CGT members). [New section326-80]

1.67 The adjusted market value is the market value of the demutualising entity on demutualisation resolution day (as determined by a qualified valuer) reduced by the value of any franking surplus on that day. [New subsection 326-120(1)] The value of the franking surplus in relation to each share is the value of the accumulated franking credits of the demutualising entity divided by total number of shares. The value of any franking surplus is removed because this value will flow through to shareholders at some point in the future by way of franked dividends. If the value of the franking surplus was not removed, then the market valuation of the entity would be increased, providing a double benefit for pre-CGT members.

1.68 Where an interest in a share is disposed of instead of a share itself, the cost of the interest is determined by multiplying the cost of a share (as determined by the provisions) by the percentage interest in each share that is disposed of.

Example 1.69 The members of mutual entity A have resolved that the entity should demutualise and use the provisions of new Division 326 . The market value of the entity on demutualisation resolution day is $1 million. The value of the franking surplus is $10,000. The entity issues 100,000 shares to its members (both pre-CGT and post-CGT members).1.70 If a pre-CGT member disposes of a share before demutualisation listing day, the cost of acquiring the share will be calculated as follows:

Adjusted market value = $1 million - $10,000 = $990,000 Cost of a share = $990,000 / 100,000 = $9.90

1.71 If John and Tony were joint owners of shares in the demutualised entity, the cost of their interest in each share would be $9.90x50% = $4.95.

Pre-CGT members - disposals on or after demutualisation listing day

1.72 For disposals on or after demutualisation listing day,the cost of acquiring shares for pre-CGT members will be the lesser of:

the adjusted market value apportioned across all shares in the demutualised entity; and
the adjusted first day trading price of a demutualisation share.

[New section 326-85]

1.73 The adjusted first day trading price is the price at which the shares were last traded on the Australian Stock Exchange on the demutualisation listing day, reduced by the accumulated value of any franking surplus (see paragraph 1.67) which exists on the demutualisation listing day. [New section 326-130]

1.74 A lesser of rule is necessary in this situation to ensure that a capital loss cannot be created on the demutualisation of the entity. Thus, the cost base of each share will be the lesser of the two amounts. As mentioned above, where a share is disposed of before demutualisation listing day, a capital loss will not be able to be incurred.

Example 1.75 In the previous example, the cost of shares based on adjusted market value was $9.90. The adjusted first day trading price of a share in demutualised entity A is $8.50. If a pre-CGT member disposes of a share on or after demutualisation listing day, the cost of each share will be the lesser of $9.90 and $8.50. That is, the cost of a share will be $8.50.

Pre-CGT members merger

1.76 A modified rule applies to determine the cost of acquiring a share where a member has obtained membership rights in a mutual entity by disposing of pre-CGT membership rights in another mutual entity.

1.77 In this case, where a pre-CGT member disposes of a demutualisation share, or an interest in such a share, the cost of acquiring the share is determined by reference to the sum of:

the undeducted membership costs of the member; and
the members share of the adjusted market value of the other mutual entity at the time of the merger.

1.78 Where a person was a member of more than one mutual entity prior to a merger, the cost of acquiring a share in the demutualising entity will take into account the members share of the adjusted market value of all of the mutual entities that the person was a member of and which were involved in the merger.

1.79 The cost of acquiring the share will also include any amount that the member actually paid for the acquisition of the share. [New section 326-90]

1.80 The adjusted market value in this case is the market value of the other entity when the membership rights in the entity were disposed of (as determined by a qualified valuer) reduced by the accumulated value of any franking surplus (see paragraph 1.67) on that day. [New subsection 326-120(2)]

1.81 Undeducted membership costs are the undeducted amounts of the costs that were incurred by the member in maintaining membership in the demutualising entity, less any distributions made to the member that were not included in the members assessable income. [New paragraph326-125(2)(a)] It would be expected that costs incurred in maintaining membership would include those costs which, if the member did not incur them, would result in the membership rights ceasing.

Example 1.82 Alison has basic membership of AA Road Service, a mutual road service organisation. Alison paid a joining fee of $30 in 1994 and as a member is entitled to emergency road service in the event her car breaks down. Alison has paid an annual renewal fee of $50 each year since 1994. Including the 1999 membership year, Alisons undeducted membership costs are $330 (indexed).1.83 Alison can choose to upgrade her level of services to membership plus for $120 per year. This entitles her to additional service calls each year free of charge. If Alison takes up membership plus, her undeducted membership costs would be limited to $330 (indexed), being the amount paid that, if Alison did not pay, would result in her membership rights ceasing.1.84 Where membership of a mutual entity was held jointly, then undeducted membership costs will include the costs incurred by all of the members. [New subsection 326-125(3)] This is necessary to ensure that the formulae for calculating the cost of acquisition of a share applies appropriately. Specifically, the reference in the formulae to an interest disposed of will ensure that apportionment of the cost base between joint owners will be achieved by the formulae.1.85 The undeducted amount of a cost is the amount of the cost which has not been allowed, or is not allowable, as a deduction. [New subsection 326-125(4)] . The reference to a cost being allowed or allowable as a deduction would not include a situation where a cost has been indirectly allowed as a deduction.

Example 1.86 Bob uses his car mainly for business purposes. Bob is a member of AA Road Service, which entitles him to roadside assistance in the event of his car breaking down. Bob has claimed costs relating to the business use of his car under the cents per kilometre method. Bobs undeducted membership costs are not reduced in these circumstances as the membership fees have not been directly deducted.1.87 If the indexation factor related to the adjusted market value and undeducted membership costs exceeds one, then those amounts can be indexed according to that indexation factor. [New subsections326-120(3), 326-125(5) and new section 326-230] :

The indexation factor relating to the adjusted market value is calculated by dividing the index number for the quarter in which the demutualisation resolution day occurred by the index number for the quarter in which the membership rights in the original mutual entity were disposed of. [New subsection 326 - 235(1)]
The indexation factor relating to the undeducted membership costs is calculated by dividing the index number for the quarter in which the demutualisation resolution day occurred by the index number for the quarter in the costs was incurred. [New subsection326-235(2)]

1.88 The indexation factor is to be worked out to 3 decimal places, rounding up if the fourth decimal place is 5 or more. [New subsection 326-235(3)] The index number for a quarter is the All Groups Consumer Price Index number (being the weighted average of the eight capital cities) first published by the Australian Statistician for the quarter. [New section326-240]

Example 1.89 Mutual entities D and E merge on 25 June 1988 to form mutual entity F. At that time, the adjusted market value of mutual entity D was $500,000 and it had 1,000 members. Mutual entity F demutualises on 10August 1998.1.90 Jane, who was originally a pre-CGT member of mutual entity D, has undeducted membership costs of $2,000. Jane receives 5,000 shares on the demutualisation of mutual entity F. Jane then disposes of her shares. The cost of acquisition of each of those shares for CGT purposes (ignoring indexation) will be:

[$2,000 + $500,000/1,000] / 5,000 = $0.50 per share

Post-CGT members

1.91 For post-CGT members who dispose of a demutualisation share, or an interest in such a share, the cost of acquiring the share is determined by reference to the undeducted membership costs of the member. The undeducted membership costs are apportioned across all shares issued to the member. The cost of acquiring the shares will also include any amount actually paid for the acquisition of the shares. [New section 326-95]

1.92 Undeducted membership costs are the sum of the undeducted amounts of the costs that were incurred by the member in acquiring and maintaining membership in the demutualising entity less any distributions made to the member that were not included in the members assessable income. [New subsection 326-125(1)]

Example 1.93 Jill is a post-CGT member of mutual entity G. The members of the entity resolve that the entity should demutualise. Jill has undeducted membership costs of $1,000. Jill receives 500 shares in the demutualised entity.1.94 The cost of acquisition of each of the shares that Jill receives will be:

$1,000/500 = $2.00

Post-CGT members merger

1.95 A modified rule applies to determine the cost of acquiring a share where a member has obtained membership rights in a mutual entity by disposing of post-CGT membership rights in another mutual entity.

1.96 Where a post-CGT member disposes of a demutualisation share, or an interest in such a share, the cost of acquiring the share is determined as outlined in paragraph 1.91.

1.97 However, in this case, undeducted membership costs is the sum of the undeducted amounts of the costs that were incurred by the member in:

acquiring and maintaining membership in the other entity; and
maintaining membership in the demutualising entity;

less any distributions made to the member by either entity that were not included in the members assessable income. [New paragraph 326-125(2)(b)]

Demutualisation original shares

1.98 The following diagram summarises the cost of acquisition of demutualisation original shares or non-demutualisation bonus shares for pre-CGT and post-CGT members.

MUTUAL WHICH BECOMES A LISTED PUBLIC COMPANY

1.99 Division 8 of Part IIIA of the ITAA 1936, and Subdivision 130-A of Part 3-3 of the ITAA 1997, provide that where bonus shares are issued to a taxpayer by a company and no part of the paid up value of the bonus shares is a dividend, the cost base of the original shares to which the bonus shares relate is to be apportioned between the bonus shares and the original shares.

1.100 Where bonus shares (referred to as non-demutualisation bonus shares )are issued to members it is necessary to ensure that the cost of acquiring the demutualisation shares to which the bonus shares relate (referred to as demutualisation original shares ) will be apportioned between the demutualisation original shares and the non-demutualisation bonus shares in accordance with Division 8 of Part IIIA of the ITAA 1936 or Subdivision 130-A of Part 3-3 of the ITAA 1997.

1.101 To achieve this, where bonus shares have been paid on demutualisation shares, and a share is then disposed of, the proposed provisions allocate a total amount paid for the demutualisation shares. The ITAA 1936 or the ITAA 1997 allocate this total amount over the original shares and the bonus shares.

Pre-CGT members - disposals prior to demutualisation listing day

1.102 Where a pre-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, before the demutualisation listing day, the cost of acquiring the share is determined by applying Division 8 or Subdivision 130-A to the members share (based on the number of shares issued to the member) of the adjusted market value of the mutual entity at demutualisation resolution day. [New section 326-100]

Example 1.103 Andrew is a pre-CGT member of a mutual entity which demutualises. The adjusted market value of the entity on demutualisation resolution day is $100,000. The entity issues 100,000 shares and Andrew receives 5,000 of those shares. The entity subsequently makes a bonus issue on the original demutualisation shares.1.104 When Andrew disposes of either a bonus share or an original share, the cost base of the share will be determined by applying the bonus share provisions of the ITAA 1936 or ITAA 1997 to the following amount:

5,000/100,000 x $100,000 = $5,000

1.105 That is, $5,000 will be spread over the number of bonus and original shares to determine the cost of each share.

Pre-CGT members disposals on or after demutualisation listing day

1.106 Where a pre-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, and the disposal occurred on or after demutualisation listing day, the cost of acquiring the share is determined by applying Division 8 or Subdivision 130-A to the lesser of:

the members share (based on the number of shares issued to the member) of the adjusted market value of the mutual entity at demutualisation resolution day; and
the adjusted first day trading price of the demutualisation share multiplied by the number of shares that the member received on demutualisation.

[New section 326-105]

Example 1.107 In the previous example, the adjusted market value of the bonus shares was $5,000. If the adjusted first day trading price of a demutualisation share was $0.90, then the amount spread over the original and bonus shares will be the lesser of $5,000 and the following amount:

$0.90 x 5000 = $4,500

1.108 That is, $4,500 will be spread over the number of bonus and original shares to determine the cost of each share.

Pre-CGT members - merger

1.109 Where a pre-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, and the member acquired the membership rights by disposing of membership rights in another mutual entity, then the cost of acquiring the share is determined by applying Division 8 or Subdivision 130-A to the sum of:

the undeducted membership costs of the member; and
the members share of the adjusted market value of the other mutual entity when the other entity merged with the demutualising entity.

1.110 The cost will also take into account any amount actually paid for the acquisition of the share. [New section 326-110]

Post-CGT member (including merger)

1.111 Where a post-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, the cost of acquiring the share is determined by applying Division8 or Subdivision 130-A to the sum of the undeducted membership costs of the member and any amount actually paid for the acquisition of the share less any distributions made to the member that were not included in the members assessable income. [New section326-115]

Tax mutual which converts to an unlisted company

1.112 New Subdivision 326-E applies where a member disposes of a demutualisation share, or an interest in such a share, in a former mutual entity (or a holding company of the entity) which has converted to an unlisted company limited by shares. It also provides for the disposal of a bonus share as mentioned in Division 8 or Subdivision 130-A ( non-demutualisation bonus shares ), or an interest in such a share,where the original shares in respect of the bonus shares are demutualisation shares ( demutualisation original shares ). [New section 326-135]

Demutualisation shares other than demutualisation original shares

1.113 The following diagram summarises the cost of acquisition of demutualisation shares other than demutualisation original shares for pre-CGT and post-CGT members.

MUTUAL WHICH BECOMES A COMPANY OTHER THAN A LISTED PUBLIC COMPANY

Pre-CGT members

1.114 For pre-CGT members who dispose of a demutualisation share, or an interest in such a share, the cost of acquiring the share is determined by reference to the adjusted market value of the mutual entity as at demutualisation resolution day. The adjusted market value is apportioned across all shares issued in the demutualised entity. [New section 326-140]

1.115 The adjusted market value is the lesser of the issue day adjusted market value and the resolution day adjusted market value [new subsection 326-170(2)] :

the issue day adjusted market value is the market value (as determined by a qualified valuer) of the demutualised entity on the day the demutualisation shares were issued less the value of any class C franking surplus (see paragraph 1.67) which the entity had on that day; [New subsection 326-170(4)]
the resolution day adjusted market value is the market value (as determined by a qualified valuer) of the demutualised entity on the demutualisation resolution day less the accumulated value of any class C franking surplus (see paragraph 1.67) which the entity had on that day. [New subsection 326-170(5)]

1.116 As discussed previously, this lesser of rule will ensure that a capital loss cannot be created on the demutualisation of the entity.

Example 1.117 The members of mutual entity H resolve that the entity should demutualise. The adjusted market value of the entity is $1.5 million on demutualisation resolution day and $1.8 million on the day the shares in the entity were issued.1.118 For pre-CGT members of the entity, the cost of each share will be determined by reference to the adjusted market value of $1.5 million.

Pre-CGT members merger

1.119 A modified rule applies to determine the cost of acquiring a share where a member has obtained membership rights in a mutual entity by disposing of pre-CGT membership rights in another mutual entity.

1.120 In this case, where a pre-CGT member disposes of a demutualisation share, or an interest in such a share, the cost of acquiring the share is determined by reference to the sum of:

the undeducted membership costs of the member; and
the members share of the adjusted market value of the other mutual entity when the other entity merged with the demutualising entity.

1.121 The cost of acquiring the share will also include any amount that the member actually paid for the acquisition of the share. [New section 326-145]

1.122 The adjusted market value in this case is the disposal day adjusted market value . [New subsection 326-170(3)] This is the market value of the other entity when the membership rights in the entity were disposed of (as determined by a qualified valuer) reduced by the value of any franking surplus (see paragraph 1.67) on that day. [New subsection 326-170(6)] This amount can also be indexed. [New subsection 326-170(7)]

1.123 Undeducted membership costs are the undeducted amounts of the costs that were incurred by the member in maintaining membership in the demutualising entity, less any distributions made to the member that were not included in the members assessable income. [New paragraph 326-175(2)(a)]

1.124 Where membership of a mutual entity was held jointly, then undeducted membership costs will include the costs incurred by all of the members. [New subsection 326-175(3)]

1.125 The undeducted amount of a cost is the amount of the cost which has not been allowed, or is not allowable, as a deduction. [New subsection 326-175(4)]

1.126 If the indexation factor related to the adjusted market value and undeducted membership costs exceeds one, then those amounts can be indexed according to that indexation factor. [New subsection326-175(5) and new section 326-230]

Post-CGT members (including merger)

1.127 For post-CGT members who dispose of a demutualisation share, or an interest in such a share, the cost of acquiring the share is determined by reference to the undeducted membership costs of the member. The undeducted membership costs are apportioned across all shares issued to the member. The cost of acquiring the shares will also include any amount actually paid for the acquisition of the shares. [New section 326-150]

1.128 Undeducted membership costs are the sum of the undeducted amounts of the costs that were incurred by the member in acquiring and maintaining membership in the demutualising entity less any distributions made to the member that were not included in the members assessable income. [New subsection 326-175(1)]

1.129 However, in the case of a merger, undeducted membership costs is the sum of the undeducted amounts of the costs that were incurred by the member in:

acquiring and maintaining membership in the other entity; and
maintaining membership in the demutualising entity;

less any distributions made to the member by either entity that were not included in the members assessable income. [New paragraph 326-175(2)(b)]

Demutualisation original shares

1.130 The following chart summarises the cost of acquisition of demutualisation original shares or non-demutualisation bonus shares for pre-CGT and post-CGT members.

MUTUAL BECOMES A COMPANY OTHER THAN A LISTED PUBLIC COMPANY

Pre-CGT members

1.131 Where a pre-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, the cost of acquiring the share is determined by applying Division8 or Subdivision 130-A to the members share (based on the number of shares issued to the member) of the adjusted market value of the mutual entity at demutualisation resolution day. [New section 326-155]

Pre-CGT members - merger

1.132 Where a pre-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, and the member acquired the membership rights by disposing of membership rights in another mutual entity, then the cost of acquiring the share is determined by applying Division 8 or Subdivision 130-A to the sum of:

the undeducted membership costs of the member; and
the members share of the adjusted market value of the other mutual entity when the other entity merged with the demutualising entity.

1.133 The cost will also take into account any amount actually paid for the acquisition of the share. [New section 326-160]

Post-CGT members (including merger)

1.134 Where a post-CGT member disposes of a demutualisation original share or a non-demutualisation bonus share, or an interest in such a share, the cost of acquiring the share is determined by applying Division8 or Subdivision 130-A to the sum of:

the undeducted membership costs of the member; and
any amount actually paid for the acquisition of the share.

[New section 326-165]

Date of acquisition

1.135 Demutualisation shares and demutualisation original shares will be taken to have been acquired on the demutualisation resolution day . The amount that new Division 326 prescribes as being the amount paid for the shares will also be taken to have been paid on that day.

1.136 Where the amount taken to have been paid for the shares includes an amount of actual consideration, this amount will be taken to have been paid when it was actually paid.

Capital gains or losses incurred on disposal of interests

1.137 A special rule applies where a post-CGT member of a mutual entity that demutualises acquired rights in the entity by the disposal of membership rights in another mutual entity and the member made a capital gain or loss on that disposal. [New section 326-180]

1.138 Where this has occurred, the cost of acquisition of each share, or interest in a share, in the demutualised entity (or holding company) will be proportionately increased by the capital gain or reduced by the capital loss, as the case may be. [New subsection 326-180(3)]

1.139 Where the member disposes of a demutualisation original share or non-demutualisation bonus share, the amount paid for the acquisition of all of the demutualisation original shares is increased by the amount of the capital gain or reduced by the capital loss, as the case may be. [New subsection 326-180(2)]

1.140 These rules ensure that a member will not be disadvantaged (or in the case of a capital loss, be able to benefit) from having included a capital gain in their assessable income (or in the case of a capital loss, a reduction in their assessable capital gains) as a result of the disposal of their membership interests.

Example 1.141 Ted acquired membership rights in mutual entity A in 1989 for $100. In 1990, mutual entity A is subject to a takeover by mutual entity B. In return for disposing of membership rights, members of mutual entity A are offered membership rights in mutual entity B. These membership rights have been given a market value of $200. Ted calculates his capital gain on the disposal of his membership rights in mutual entity A, ignoring indexation, as $100. Mutual entity B demutualises in 1999.1.142 The cost of acquisition of the shares that Ted receives in mutual entity B will be proportionately increased by $100.

Disposal of rights in demutualising entity or holding company

1.143 At the time of the extinguishment of a members interest in the demutualising entity, the member acquires an enforceable right to receive shares in the demutualised entity or holding company. It is possible that in some circumstances a member may assign some or all of this right to a third person prior to the issue of shares in the demutualised entity.

1.144 Where this occurs, new sections 326-185 and 326-195 prescribe the amount that the member is taken to have paid for the acquisition of the right for the purpose of working out whether the member made a capital gain or loss from the disposal. The amount paid is determined by multiplying the number of shares that the right entitled the member to by the cost of each share. The cost of a share is determined as if the disposal was a disposal of a share.

1.145 If the member is a pre-CGT member who did not obtain membership rights through a merger, a capital loss cannot be incurred by the disposal of a right. The member is taken to have paid the deemed amount, and to have acquired the right, on the demutualisation resolution day.

1.146 Where the right is disposed of by the issue of demutualisation shares to the member, the CGT provisions will not apply to this disposal. [New section 326-190]

Example 1.147 Neil is a member of mutual entity J which has commenced demutualisation. The entity has informed Neil that he will be entitled to receive 1,000 shares in the demutualised entity. Prior to the issue of the shares, Neil assigns his rights to the shares to an arms length party for $5,000.1.148 Neil has determined that if he had disposed of a share, his cost of acquisition of each share would be $4.00. Neil is taken to have paid the following amount for the acquisition of the right disposed of:

$4.00 x 1,000 = $4,000

1.149 Therefore, Neil has made a capital gain from the disposal of the right equal to the following:

$5,000 - $4,000 = $1,000

Disposal of interest in trust

1.150 Where the distributing trust method of demutualisation applies, a members interest in the demutualising entity is extinguished in exchange for an interest in a distributing trust. Again, it is possible that in some circumstances a member may assign some or all of this interest to a third person prior to the distribution of the shares (or the proceeds from the sale of the shares) in the demutualised entity to the member.

1.151 Where this occurs, new section 326-200 prescribes the amount that the member is taken to have paid for the acquisition of the interest for the purpose of working out whether the member made a capital gain or loss from the disposal. The amount paid is determined by multiplying the number of shares that the interest entitled the member to by the cost of each share. The cost of a share is determined as if the disposal was a disposal of a share.

1.152 If the member is a pre-CGT member who did not obtain membership rights through a merger, a capital loss cannot be incurred by the disposal of the interest. The member is taken to have paid the deemed amount, and to have acquired the interest, on the demutualisation resolution day.

Trustee of distributing trust distributes an ordinary share to a member

1.153 New section 326-205 provides that Part IIIA of the ITAA 1936 or Part 3-1 or 3-3 of the ITAA 1997 will not apply to any disposal or CGT event arising where the trustee of a distributing trust transfers a demutualisation share to a member of the demutualising entity.

1.154 This provision will ensure that a member will not be taken to have disposed of an interest in the trust merely because of the receipt of the shares which satisfies that interest.

Trustee of distributing trust sells shares (including bonus shares) on behalf of members

1.155 If under the distributing trust method of demutualisation, the trustee of the trust disposes of an ordinary or bonus share on behalf of the member (who has elected to receive cash instead of the share), new section 326-210 provides that the disposal of the share is treated as if the member had disposed of the share.

1.156 The rules dealing with the determination of the cost of acquisition of a demutualisation share will then apply to determine the CGT consequences from the disposal of the shares.

Special shares issued to a distributing trust converted to shares of the same class

1.157 Under the distributing trust method of demutualisation, special shares are issued to the trustee of a distributing trust to hold for the benefit of members pending the issue of ordinary shares. When the ordinary shares are issued, the rights attaching to the special shares must become the same as those attaching to the ordinary shares. [New section 326-55]

1.158 New section 326-215 provides that Part IIIA of the ITAA 1936 or Part 3-1 or 3-3 of the ITAA 1997will not apply in respect of the change in rights. This would ensure that Division 19B of Part IIIA of the ITAA 1936 or Division 140 of Part 3-3 of the ITAA 1997, for example, would not apply to the change in rights.

Roll-over provision

1.159 New section 326-220 applies where a roll-over provision applies to certain disposals of a demutualisation share, or an interest in such a share. Specifically, the rules apply where under any method of demutualisation:

a demutualisation share or interest in such a share is disposed of before demutualisation listing day;
a roll-over provision applies to the disposal;
the person who disposed of the share or interest would have made a capital loss from the disposal, but for new section 326-75 and this provision; and
the person who acquires the share or interest (the transferee ) subsequently disposes of the share or interest.

1.160 If the transferee disposes of the share or interest before the demutualisation listing day, any capital loss incurred is to be disregarded. [New subsection 326-220(2)] If the disposal takes place on or after the demutualisation listing day, then Subdivision D applies to the original disposal subject to the roll-over as if it occurred on or after the demutualisation listing day. [New subsection 326-220(3)]

1.161 A roll-over provision is:

section 160X or any provision of Division 17 of the ITAA 1936; or
any provision of Divisions 122, 126 and 128 of Part 3-3 of the ITAA 1997.

[New subsection 326-220(4)]

1.162 This ensures that the rule outlined in paragraph 1.74 dealing with pre-CGT members and the treatment of capital losses cannot be avoided by the use of roll-over provisions.

Non-assessable amounts distributed to shareholders

1.163 Where a demutualised entity makes a payment to a shareholder and the payment constitutes a non-assessable dividend, new section326-225 provides that the payment is taken not to be a dividend for the purposes of section 160ZL of the ITAA 1936 or section 104-135 of the ITAA 1997.

1.164 This provision will ensure that the payment will reduce the shareholders cost base in respect of the shares in the demutualised entity.

Issue of shares to members

1.165 New section 326-245 provides that no amount will be included in a taxpayers assessable income as a result of the issue of demutualisation shares to the taxpayer. A taxpayer includes the trustee of a distributing trust.

1.166 In the absence of this provision, the value of the demutualisation shares could be assessable, for example, as a dividend under subsection 44(1) of the ITAA 1936.

Consequential amendments

1.167 Item 2 of Part 2 proposes consequential amendments to Division 7B of Part IIIA of the ITAA 1936. That Division deals with the tainting of share capital accounts of a company. Tainting can occur where an amount is transferred into a share capital account from another account (such as a retained profits account). Broadly, the consequence of this is that distributions from the account will be treated as unfrankable and unrebateable dividends.

1.168 Section 160ARDM of Division 7B contains the rules for determining when a share capital account becomes tainted. New subsection 160ARDM(3) will provide that the tainting rules will not apply where an amount or amounts are transferred to a share capital account in connection with the demutualisation of a mutual entity to which new Division 326 applies, and the amount of the sum of the amounts transferred does not exceed the total of the capital amounts:

in respect of which deductions are not allowable to the members; and
that were not payments for goods and services provided by the entity.

1.169 The capital amounts must have been contributed to the entity by members of the entity before it demutualised. If the amount transferred exceeds this amount, the tainting rules will only apply to the excess.

1.170 Where the demutualising entity was formed by the merger of two or more mutual entities, the capital amounts must have been contributed to the entity by post-merger members of the entity before it demutualised. In addition, the market values of the merging entities as determined by a qualified valuer at the time of the merger will also be included in the amount eligible to be transferred. [New subsection 160ARDM(4)]

1.171 Section 160ARDQ of Division 7B contains consequences for the franking account of a company when a share capital account becomes tainted. Analogous amendments to those proposed for section 160ARDM are also proposed to section 160ARDQ of the ITAA 1936. [Item 3 of Part2]

1.172 The proposed amendments to subsections 160ARDM(4) and 160ARDQ(4) will apply to demutualisations commenced prior to 11August 1998. [Item 4 of Part 2]

1.173 The rationale for the amendments to sections 160ARDM and 160ARDQ is to allow mutual entities other than insurance companies to create a limited amount of contributed capital on demutualisation without adverse taxation consequences arising under Division 7B. While a mutual entity does not have any contributed capital in a formal sense, there are amounts paid by members which are analogous to ordinary capital contributions made by shareholders in a company limited by shares.

1.174 Item 5 of Part 2 proposes a consequential amendment to section 160ZZPH of the ITAA 1936 to provide that if the members of a demutualising entity have elected to apply new Division 326 to the demutualisation of the entity, then section 160ZZPH cannot have any application. [New subsection 160ZZPH(1A)] A corresponding amendment has been made to section 124-520 of the ITAA 1997. [Schedule 2 Item 3, new subsection 124-520(3)]

1.175 These amendments ensure that new Division 326 and section 160ZZPH of the ITAA 1936 (or section 124-520 of the ITAA 1997) cannot both apply to the demutualisation of a mutual entity.

1.176 Items 1 and 2 of Schedule 2 insert signposts into the ITAA 1997 to provide that new Division 326 modifies the determination of the date of acquisition and cost base of a CGT asset which was connected with the demutualisation of a mutual entity (other than an insurance company).

REGULATION IMPACT STATEMENT

Specification of policy objective

1.177 The policy objective is to provide a generic framework which determines the capital gains tax (CGT) consequences of transactions associated with the demutualisation of mutual organisations other than insurance companies. [F1]

Background

1.178 The income tax law contains specific provisions which determine the taxation consequences where a life or general insurance organisation demutualises. Broadly, the provisions ensure that the member of the organisation is only taxable when the shares which are acquired by the member as part of the demutualisation process are disposed of.

1.179 Other organisations can also potentially demutualise. Examples of these non-insurance mutual organisations may include social and sporting clubs, associations and some friendly societies. [F2] However, the income tax law currently does not contain provisions which specifically deal with the demutualisation of non-insurance mutual organisations.

1.180 The application of the existing tax law to demutualisations of non-insurance mutual organisations can give rise to CGT anomalies. For example, members who dispose of their membership interests in a noninsurance mutual organisation may be taxable under the CGT provisions on the value of property (typically shares) received as consideration for the disposal of the membership interests. [F3] This can occur even where there has not been any cash flow from which the tax liability can be met.

1.181 Further, the cost of the shares issued in the demutualised entity, for the purposes of the CGT provisions, may be negligible. [F4] When a member subsequently disposes of the shares, a CGT liability may arise on part of the value of the shares that has already attracted CGT at demutualisation. Thus, there is potential for double taxation.

1.182 The anomalies that can arise under the existing tax law may act as an impediment to organisations wanting to demutualise. There may be sound commercial reasons for an organisation seeking to demutualise (for example, to maintain competitiveness).

1.183 The Government announced in the 1997-98 Budget that a generic framework for determining the taxation consequences where a non-insurance organisation demutualises would be developed in consultation with the public. As noted below, an Issues Paper was released by the Government on 28 May 1997.

Identification of implementation options

1.184 Extending the provisions dealing with life and general insurance organisations to non-insurance organisations is not a valid option because of the difference in the way the income tax law applies to insurance and non-insurance organisations prior to demutualisation. [F5] Inappropriate concessional treatment would be provided in certain circumstances which would undermine the integrity of the taxation system.

1.185 Thus, the implementation option for achieving the Governments policy involves amending the income tax law to give effect to the following features:

a capital gain or loss will not arise on the extinguishment of a membership interest in the non-insurance organisation. Any CGT liability will thus be deferred until the disposal of the demutualisation shares;
an amount will not be included in a members assessable income on the issue of demutualisation shares;
franking account surpluses of the demutualising entity will be retained; [F6]
the cost of the demutualisation shares for CGT purposes will be determined according to when the membership interests were acquired;

-
for pre-CGT members, the cost will be the members share of the market value of the demutualising entity determined immediately before demutualisation (reduced by their share of any franking account surplus);
-
for post-CGT members, the cost will be the costs incurred by those members in acquiring and maintaining their rights of membership (for example, joining fees) to the extent that such costs are not deductible;

there will be specific provisions establishing the cost of shares where members have acquired membership interests in a demutualising entity by disposing of their membership interests in another tax mutual (for example, on a merger or takeover);
a holding company or a trust will be allowed to be interposed between the members and the demutualising entity to facilitate the demutualisation process; and
the provisions will only be available where there is substantial continuity of beneficial interest between the members of the tax mutual and those who receive shares in the demutualised entity. [F7]

1.186 The features outlined above are generally consistent with the existing provisions dealing with the demutualisation of life and general insurance organisations. There are differences in regards to the determination of the cost of the demutualisation shares for CGT purposes and the treatment of the entitys franking account surplus on demutualisation. [F8]

1.187 The amendments do not allow for the status of pre-CGT members to be retained post-demutualisation. This is because the rights associated with the assets have changed a non-tradeable mutual interest has been converted to a tradeable share and any gains on the demutualisation shares after demutualisation should be subject to tax. This is consistent with the treatment of pre-CGT interests in life and general insurance organisations.

Assessment of impact (costs and benefits) of the measures

Impact group identification

1.188 These measures will impact on demutualising non-insurance mutual organisations and their members. Organisations which the provisions could impact on range from large entities such as the Australian Stock Exchange to small entities such as sporting clubs.

1.189 The impact on members will depend on when their membership interests were acquired. That is, there is different taxation treatment for pre-CGT and post-CGT members. There are also specific rules for members who acquired their membership interests through a merger or takeover of another entity.

1.190 These measures may also impact on the Australian Taxation Office in regards to the cost of administering the provisions. The measures will also impact on the Government to the extent that revenue may change as a result of the measures.

Compliance costs

1.191 There would be compliance costs incurred in the demutualisation process under both the existing system of taxation and the new provisions dealing with demutualisations. For example, under the existing law members would need to ascertain the value of their membership rights and the costs of acquiring and maintaining those membership rights. Professional advice may be required to determine the value of the membership rights.

1.192 Under the new provisions, there will be some compliance costs for a demutualising entity in ascertaining the market value of the entity. [F9] This is required to determine the cost of shares for pre-CGT members. Additional costs will be incurred as the demutualising entity will need to notify members of this cost. The entity will also have to ensure that substantial continuity of beneficial interest is maintained. In general, these costs are not expected to be significant.

1.193 Consistent with the existing law, post-CGT members will still need to determine their costs of acquiring and maintaining their membership interests. All parties involved in the demutualisation process will also incur compliance costs in becoming familiar with the new provisions. In general, these costs are not expected to be significant.

1.194 No quantitative estimate has been made of the above compliance costs, either for a typical individual case or in the aggregate. This is because there is significant uncertainty regarding the number of demutualisations which will occur in the future.

Estimated costs

Administrative costs

1.195 The administrative costs to the ATO are expected to be minimal. It is envisaged that the provisions will not be widely used. In addition, it will be the entity demutualising that will be required to inform members of their cost of shares for CGT purposes, where relevant.

Revenue

1.196Under the existing income tax law, non-insurance mutual organisations are only taxable on their non-mutual income (for example, investment income). The organisations are not taxable on membership fees and the members generally do not derive taxable amounts from the organisation. As a result of demutualisation, the organisation will become fully taxable on all sources of income and the members will potentially be drawn into the income tax net.

1.197 The conventional benchmark for assessing the impact on taxation revenue of the option is the taxation that would result if there was a demutualisation under the current income tax law.

1.198 However, there would be strong grounds for the demutualisation not going ahead because of the potential for double taxation in certain instances, as discussed above. Thus, taxation revenue could be greater than before the implementation of the proposed measures.

1.199 Under the option proposed, a demutualisation would result in a more appropriate taxation treatment. That is, the double taxation would not arise. Thus, the taxation impediment to demutualisation would be removed. The impact on taxation revenue is likely to be positive.

1.200 It is not possible to reliably quantify the change in revenue because of, for example, the significant uncertainty about the number of demutualisations which may take place.

Assessment of Benefits

1.201 An entity may demutualise as a response to an environment of increased competition. The proposed generic framework assists this process through the removal of tax impediments to demutualisation, thus providing greater certainty in the income tax law.

1.202 Using a generic framework approach will reduce the possible need for special legislation for each entity or type of entity that potentially may demutualise. The costs involved in providing entity specific legislation for demutualisation would include possible inconsistency between entity types and the administration costs in implementing the legislation.

1.203 As discussed above, these provisions are broadly consistent with those dealing with the demutualisation of life and general insurance organisations. However, there are several differences.

1.204 The cost of shares for CGT purposes in a general insurance company is taken to be the members share of the net tangible asset value of the entity at demutualisation. This treatment, which is concessional for post-CGT members because it provides a higher cost, was given because these organisations are taxed on their mutual income.

1.205 There is no similar justification for extending this concessional treatment to post-CGT members of a non-insurance organisation. A cost for CGT purposes based on the costs of acquisition and maintenance of the membership interests is consistent with normal CGT rules.

1.206 Another difference between the implementation option and the existing law is that franking surpluses of life and general insurance companies are extinguished on demutualisation. In contrast, non-insurance organisations will be allowed to retain their franking account surpluses. This recognises that the extinguishment of franking surpluses may lead to double taxation, with tax having to be paid both by the organisation and by the shareholder.

1.207 As noted above, the cost of the shares for pre-CGT members is based on the market value of the demutualising entity reduced by the value of their share of any franking account surplus. This is to prevent pre-CGT members gaining a double benefit (that is, if the full market value were allowed, pre-CGT members would have access to dividends which had tax credits attached as well as a higher cost that reflected the ability of the entity to pay such dividends).

Consultation

1.208 An Issues Paper on a Generic Taxation Framework for Demutualisations of Non-Insurance Organisations was issued on 28 May 1997. A number of submissions were received. [F10] The views put forward in these submissions were considered in the course of finalising the legislation. The ATO and the Treasury have consulted with interested parties on the development and implementation of the measures, particularly those that intend to demutualise in the near future.

Conclusion

1.209 The proposed measures will increase the efficiency and effectiveness of the tax system by removing anomalies and providing greater certainty in the tax treatment which applies to members of non-insurance tax mutuals that demutualise. Compliance and administration costs are not expected to be significantly different from those which would occur under the existing law.


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