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Edited version of your private ruling

Authorisation Number: 1012106065261

Ruling

Subject: Demerger Relief

Question 1

Summary

Question 1

Will the proposed arrangement satisfy the requirements for demerger relief under Division 125 of the Income Tax Assessment Act 1997 (ITAA 1997) so that any capital gain or loss that Company A makes on disposal of its shares in Subco X and Subco Y will be disregarded pursuant to section 125-155 of the ITAA 1997?

Answer

Yes

Detailed reasoning

1. The question can be rephrased as will any capital gain or capital loss from the disposal of the shares, in Subco X and Subco Y by Company A to the shareholders of Company A (that is Mr and Mrs B), be disregarded pursuant to section 125-155. The question is concerned with whether the arrangement will be eligible for demerger relief.

2. In simple terms demerger relief is made available where a corporate group's business is restructured and results in the head entity's shareholders owning a corporation which was previously owned within the group. The effect of the tax relief is to disregard the tax consequences that would otherwise arise from the business restructure.

3. The legislative provisions to allow for demerger relief is in Division 125 of the Income Tax Assessment Act 1997. The relevant policy is set out in section 125-5 of the ITAA 1997 which states that the object of Division 125, which is primarily concerned with providing CGT relief, 'is to facilitate the demerging of entities by ensuring that capital gains tax considerations are not an impediment to restructuring a business'.

4. Section 125-155 of the ITAA 1997 automatically disregards any capital gains or capital losses made by 'demerging entities' when certain CGT events happen to their ownership interests in the entity being demerged (which is called the 'demerged entity').

5. The relevant CGT event in this case would be CGT event A1 (section 104-10) for the transfer of the shares in Subco X and Subco Y from Company A to Mr and Mrs B. The transfer of the shares is a disposal for the purposes of section 104-10(1).

6. For section 125-155 to apply, Company A will have to qualify as a 'demerging entity' and the subsidiaries Subco X and Subco Y will have to qualify as the 'demerger subsidiaries' Further the transfer will have to qualify as a 'demerger'.

7. The precondition for section 125-155 to apply is that the companies Company A and Subco X and Subco Y have to be part of a 'demerger group'.

8. To be a 'demerger group' the companies must be comprised of a 'head entity' of the group and one of more 'demerger subsidiaries'. (see section 125-65(1))

9. Company A would be the 'head entity' of the 'demerger group' as Company A is a company and no other member of the group owns an 'ownership interests' in the Company A (see section 125-65(3).

10. Subco X and Subco Y are the 'demerger subsidiaries' as Company A has a right to receive more than 20% of the distribution of capital and income of those companies and has the right to exercise more than 20% of the voting power of those companies. (See section 125-65(6)).

The tests for whether a 'demerger' happened

11. Pursuant to section 125-70 a 'demerger' happens if

Application of the demerger test to your circumstances

12. There will be a 'demerger' under the proposed arrangement because: 

i. there will be a restructure of the demerger group, as the shares in Subco X and Subco Y are being transferred from Company A to Mr and Mrs B,

i. Company A will dispose of X% (which is greater than 80%) of the shares it holds in Subco X and Subco Y and the transfer is of all of the issued shares in Subco X and Subco Y,

ii. CGT event A1 will happen as the shares in Subco X and Subco Y will be disposed of by the head entity and the shareholders in the head entity will receive shares in the new companies and will receive nothing else,

iii. the acquisition of the shares in Subco X and Subco Y by Mr and Mrs B will only happen because the Shareholders owned shares in Company A,

iv. the new interests acquired are the shares in Subco X and Subco Y and are ordinary shares in a company, they already had shares in Company A,

v. none of the interests are interests in a superannuation fund,

vi. the Shareholders in Company A, Mr and Mrs B, will acquire shares in Subco X and Subco Y in exactly the same proportions as they own and hold shares in Company A and they will retain the same proportionate number of shares in Company A and the same proportionate market value in shares after the demerger.

13. Company A as the demerging entity has disposed of at least 80% (the disposal was actually X%) of their ownership interest (the shares) in another member of the group (Subco X and Subco Y) to the owners (Mr and Mrs B) of the original interests in the in the head entity (Company A ) of the of the demerger group.

14. Any capital gain or capital loss Company A made from CGT event A1 happening to its ownership interests in Subco X and Subco Y under the demerger is disregarded pursuant to section 125-155 of the ITAA 1997.

Do the consolidation rules prevent the demerger relief applying

15. The arrangement indicated that Company A and Subco X and Subco Y would be treated as a consolidated group. The issue arises does this prevent the application of the demerger relief for the arrangement.

16. When a demerged entity is a member of a consolidated group, consideration needs to be given to the interaction of the demerger provisions with the single entity rule in section 701-1 of the ITAA 1997. Under the single entity rule, the subsidiary members of a consolidated group are treated as parts of the head company (and not separate entities) for the group's income tax purposes.

17. However, the single entity rule does not apply to defeat a clearly intended outcome under provisions outside the consolidation rules (such as Parts 3-1 and 3-3 of the ITAA 1997). In such cases, intra-group interests, or legal entities that are part of the head company for consolidation purposes, require a level of recognition in applying provisions that have regard to such interests and entities (for example, in determining eligibility for a concession). Paragraphs 8(c) and 26 to 28 of Taxation Ruling TR 2004/11 explain the Commissioner's view that reading the Act as a whole achieves this outcome (and without the need to rely on section 701-85 of the ITAA 1997).

18. The single entity rule does not prevent recognition of the demerged entity, and the group's membership interests in the demerged entity, just before the relevant CGT event happens. The head company can meet the requirements of a demerging entity in subsection 125-70(7) of the ITAA 1997. That is, the demerger group consists of the head company and the demerged subsidiary, even if there are other interposed subsidiary members. This is consistent with CGT events in relation to the demerger happening to the head company under the single entity rule.

Conclusion

19. Since the conditions of subsection 125-155 of the ITAA 1997 are satisfied any capital gain or loss made by Company A in relation to disposal of the shares in Subco X and Subco Y as part of the demerger is disregarded.

Question 2

Will the 'demerger dividend' to be paid as part of the proposed arrangement satisfy the requirements of Subsections 44(3) and 44(4) Income Tax Assessment Act 1936 ITAA 1936 so that it is non-assessable non-exempt income in the hands of the shareholders?

Answer

Yes

Detailed reasoning

20. Under the demerger dividend provisions, a 'demerger dividend' is deemed not to be paid out of profits (see subsection 44(3)) and is not assessable income (see subsection 44(4)). Provided section 44(5) does not apply.

21. So the issue arises are the transfers of the shares in the Subco X and Subco Y able to be treated as 'demerger dividends'.

Are the transfers of the shares a dividend pursuant to section 44(1)?

22. The transfer of the shares in Subco X and Subco Y from Company A to Mr and Mrs B is a transfer of property.

23. No consideration was mentioned as being paid or payable for the transfer of these shares from Company A to Mr and Mrs B.

24. The proposed action is for Company A to pay an 'in specie' dividend to its shareholders.

25. The transfer of the shares in Subco X and Subco Y from the Company A to Mr and Mrs B(who are shareholders of Company A) could be classed as a dividend within the meaning of s 6 of the Income Tax Assessment Act 1936 (``the Act'').

26. The definition of a dividend is contained in subsection 6(1) of the ITAA 1936. That definition includes as a dividend:

dividend includes:

(a) any distribution made by a company to any of its shareholders, whether in money or other property; and

27. The transfer of the shares in specie would come within the requirements of paragraph (a) and prima facie the transfer of the shares would come within the definition of a dividend.

28. In support of this conclusion is the Federal Court case of Condell v FCT 2007 ATC 4404 l where it was commented that the distribution of shares in specie was a dividend for the purposes of s 44(1).

29. But it is noted that unless the payment is made out of "profits'' there is no basis to treat the transfer as assessable under section 44: see FC of T v Blakely (1951) 9 ATD 239 at 242; (1951) 82 CLR 388 at 397 per Latham CJ. In FC of T v Slater Holdings Ltd (No 2) 84 ATC 4883 at 4889; (1984) 156 CLR 447 at 460.

30. In the Condell case in the Full Federal Court (Condell v FCT 2007 ATC 4404) the dividends were held to be paid out of profits as the head company Hewlett Packard accounted for the payment of the shares by debiting the 'retained earnings' account in their books.

31. The company has advised that it intends to account for the transfer of the shares by debiting the retained earnings account and therefore the 'dividend' is to be treated as though it was paid out of profits.

32. The transfer of the rental properties from Company A to the new companies is proposed to be undertaken at market value and the company has advised that the issued capital of the new companies will be equal to the market value of the properties. The proposed journal entries in the accounts of Company A will be as follows:-

33. The transfers of the shares from Company A to the shareholders will be accounted for via an in specie dividend to its shareholders This will be in the form of the shares Company A holds in Subco X and Subco Y.

34. The applicant has advised that shares will be accounted as a distribution from reserves and retained earnings. The proposed accounting entries will be as follows:

35. As the transfer of shares is accounted for by debiting the retained earnings (namely profits) than the transfer of the shares would be a dividend for the purposes of section 44(1).

Are the transfers of shares a "demerger dividend"?

36. As mentioned above the transfer of the shares would be a dividend pursuant to section 44(1) provided the exclusion provisions in subsections 44(3) and 44(4) do not apply.

37. The effect of subsections 44(3) and 44(4) is to treat a 'demerger dividend' as not assessable under subsection 44(1).

44(3)  [Application to demerger dividend]

This section applies to the demerger dividend as if it had not been paid out of profits.

44(4)  [Assessable/exempt income]  

A demerger dividend is not assessable income or exempt income.

38. Therefore if the dividend is a demerger dividend than 44(3) will apply and the dividend will not be assessable pursuant to section 44(1).

Is the dividend a 'demerger dividend' ?

39. The term 'demerger dividend' is defined in subsection 6(1) of the ITAA 1936 as follows :-

40. The term 'demerger allocation' is defined in subsection 6(1) of the ITAA 1936 as follows to mean:

Is the transfer a 'demerger allocation'

41. The relevant 'demerger allocation' for the proposed arrangement is as per paragraph (b) of the above definition as the ownership interests (namely the shares in Subco X and Subco Y) were disposed of by a member (namely Company A) of a demerger group under a demerger to the owners (namely Mr and Mrs B) of ownership interests in the head entity (namely Company A).

42. The total market value of the demerger allocation is the market value of the interests in the demerged entity namely Subco X and Subco Y.

43. The demerger dividend is the amount that would be assessable under section 44(1) apart from sections 44(3) and (4).

44. The market value of the shares will be the value of the relevant underlying assets less any relevant liabilities of the relevant companies. The underlying assets are the V property valued at $X and the Z property valued at $Y.

45. As the shares were transferred with a large market value the shares comprise a 'demerger allocation' and therefore would be assessable under section 44(1) but for the operation subsection 44(3) and therefore the transfers of the shares are prima facie a demerger dividend. Provided section 44(2) and 44(5) does not apply.

Are subsection 44(2) elections made?

46. Subsection 44(2) allows a company to elect for subsections 44(3) and 44(4) not to apply. The agent has advised that the directors of Company A do not intend to make an election under section 44(2).

Are the 'assets used in the business' test in subsection 44(5) satisfied?

47. Subsection 44(5) of the ITAA 1936 requires that just after the demerger, 50% of the market value of all CGT assets owned by the new companies have to be used, directly or indirectly, in one or more businesses carried on by the new companies (Subco X and Subco Y).

48. The CGT assets owned by Subco X and Subco Y will be investment properties. To satisfy this test, those assets must be used either directly or indirectly in the carrying on of a business by the new companies.

49. The issue that arises is whether the deriving of income from rental properties is sufficient to be regarded as carrying on a business or is it merely deriving income from property.

50. The carrying on of a 'business', usually calls for some activity on the part of whoever carries it on, although depending on the nature of the business, the activity may be intermittent with long intervals of quiescence in between.

51. For determining whether the renting out of property by a company is considered to be a business reference is made to the touchstone case that Australian courts refer to which is the Privy Council decision of American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue (Malaysia) (1979) A.C. 676 at p. 683, [1978] 3 All ER 1185.

52. In the American Leaf Blending case the comment of Lord Diplock at p 684 was as follows

"In the case of a private individual it may well be that the mere receipt of rents from property that he owns raises no presumption that he is carrying on a business. In contrast, in their Lordships' view, in the case of a company incorporated for the purpose of making profits for its shareholders any gainful use to which it puts any of its assets prima facie amounts to the carrying on of a business. Where the gainful use to which a company's property is put is letting it out for rent, their Lordships do not find it easy to envisage circumstances that are likely to arise in practice which would displace the prima facie inference that in doing so it was carrying on a business."

53. The Privy Council, made enquiries to establish the necessary evidence of activity by the company. The relevant information included the company's negotiation of successive lettings of premises and in the preparation of an additional part of the premises suitable for letting. Accordingly, the Privy Council concluded that the evidence served to support the prima facie inference that the company was carrying on the business of letting out its premises for rent. It was accepted that a company may be carrying on a business in a small scale.

54. The American Leaf Blending case has been followed in several Australian court cases1. In another case that did not rely on the American Leaf Blending case a similar decision was made. In Lilydale Pastoral Co. Pty. Ltd. v. FCT 87 ATC 4235; 18 ATR 508, Pincus J, held, in the context of the withholding tax provisions, that the purchase of property to rent out, whether or not after renovating it, and the proprietorship of that property, constitute an undertaking of a business or commercial kind.

55. Having regard to the facts provided by the applicant and of the case law as set out in the American Leaf Blending case, it is considered that the companies Subco X and Subco Y would be carrying on a business. As a consequence, it is accepted that at least 50% (by market value) of the CGT assets owned by Subco X and Subco Y are used to carry on a business, specifically being the business of a landlord and property investor.

Conclusion

56. As a consequence, the dividends under each of the demerger transaction are demerger dividends to which subsections 44(3) and 44(4) of the ITAA 1936 will apply so that it is non-assessable non-exempt income in the hands of the shareholders.

Question 3.

Will the Commissioner make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the whole or any part of the demerger benefit provided to the shareholders of Comapny A?

Question 4.

Will the Commissioner make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole or any part & the capital benefit provided to the shareholders of Company A?

Answers -

No and No

Detailed reasoning

57. These 2 questions are basically connected as the same legislative tests are applied and therefore those issues will be considered together.

58. In summary the answer to the above questions are No and No as Section 45B of the ITAA 1936 will not apply and the Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936.

The Purpose of Section 45B

59. Subsection 45B(1) of the ITAA 1936 represents an integrity measure and is designed to ensure that relevant amounts are treated as assessable dividends for tax purposes if the capital and profit components of a demerger allocation do not reflect the circumstances of the demerger, or certain payments, allocations or distributions are made in substitution for dividends.

60. In the context of a demerger, section 45B serves two objects.

61. The first object of section 45B is concerned with ensuring that the dividend exemption provided for in subsections 44(3) and (4) of the ITAA 1936 is only available in genuine demergers and that the components of a demerger allocation provided to head entity shareholders under a demerger as between capital and profit reflect the circumstances of the demerger.

62. The second object is concerned is concerned with whether or not the demerger benefit or the capital benefit provided pursuant to a demerger is considered to be in substitution for a dividend.

Legislative framework

63. Subsection 45B(2) of the ITAA 1936 sets out the three conditions under which section 45B would apply. It states:

64. If the three conditions are satisfied, the Commissioner 'may' make, in writing, a determination under subsection 45B(3) of the ITAA 1936 that:

65. Paragraph 45B(3)(a) empowers the Commissioner to make a determination that section 45BA applies in whole or in part to a demerger benefit. If the Commissioner determines that section 45BA of the ITAA 1936 applies, the amount of the demerger benefit, or the part of the benefit, is taken not to be a demerger dividend for the purposes of the income tax law.

66. Paragraph 45B(3)(b) empowers the Commissioner to make a determination that section 45C applies in whole or in part to a capital benefit. If the Commissioner determines that section 45C of the ITAA 1936 applies, the amount of the benefit, or the part of the benefit, is taken for the purposes of the income tax law to be an unfranked dividend paid by the company out of its profits to the relevant taxpayer at the same time as the capital benefit is provided.

67. Each of these conditions in section 45B(2) are considered below.

Was there a scheme?

68. A scheme for the purposes of section 45B of the ITAA 1936 is defined in terms of section 177A(1) of the ITAA 1936 by section 160APA of Part IIIAA of the ITAA 1936. A scheme is defined in section 177A(1) of the ITAA 1936 to include;

69. The definition is very widely drawn, and it would be expected that a demerger or part of a demerger would constitute a scheme or part of a scheme (Practice Statement PS LA 2005/21, Application of section 45B of the Income Tax Assessment Act 1936 to Demergers at paragraphs 27-28).

70. The application advised that the company wanted to transfer the shares in the subsidiary companies to the shareholders as part of a demerger.

71. Under the proposed arrangement, the shares in Subco X and Subco Y, which own the rental properties, would be transferred from the head company (Company A), to the shareholders (namely Mr and Mrs B) of the head company, hence enabling the shareholders of Company A to hold shares in Subco X and Subco Y directly.

72. Clearly the demerger arrangement would come within the definition of a scheme for the purposes of section 45B.

Provided With Demerger Benefits

73. The concept of being 'provided with a demerger benefit' is explained in subsection 45B(4) of the ITAA 1936. Subsection 45B(4) provides:

74. On its terms, subsection 45B(4)(a) applies to the proposed arrangement as there will be a transfer of shares in Subco X and Subco Y from the Company A to the shareholders of Company A.

75. Further, paragraph 30 of the Practice Statement 2005/21 states:

    30. Under a demerger, it is expected that a person will always be provided with a demerger benefit. The definition of a demerger under section 125-70 of the ITAA 1997 requires there to be a disposal of ownership interests or an issue of ownership interests to the owners of the head entity. This means the owners of the head entity will invariably be provided with a demerger benefit

76. In the present case, the arrangement has proposed a scheme in which the shareholders of Company A will be transferred ownership of the shares in the companies Subco X and Subco Y. Therefore the transfer will be a demerger benefit in accordance with paragraph 45B(4)(a).

77. For completeness, it is noted that paragraph 45B(4)(b) will not apply as there would be a decrease in the value of the shares in Company A that were held by Mr and Mrs B as the transfer of the shares in Subco X and Subco Y would tend to reduce the value of the shares in Company A.

78. Thus, according to paragraph 30 of the PS 2005/21, the taxpayers would be provided with a 'demerger benefit' for the purposes of subsection 45B(4).

Provided with a Capital Benefit

79. The concept of being provided with a 'capital benefit' is explained in subsection 45B(5) of the ITAA 1936. It refers to the provision of ownership interests in a company (45B(5)(a)) and the distribution of share capital (45B(5)(b)).

80. In the present case, the arrangement has proposed a scheme in which the shareholders will be transferred ownership of the shares in the companies Subco X and Subco Y. The transfer will be a provision of an ownership interest in accordance with paragraph 45B(5)(a)and therefore it will be a capital benefit.

81. For completeness, it is noted that paragraph 45B(5)(b) will not apply as there was no distribution of share capital of Company A and paragraph 45B(5)(c) will not apply as there would be a decrease in the value of the shares in Company A that were held by Mr and Mrs B as the transfer of the shares in Subco X and Subco Y would tend to reduce the value of the shares in Company A.

Demerger benefit v Capital benefit

82. From the above points it will be noted the transfer of shares would give rise to both a demerger benefit and a capital benefit and as such there is a clear overlap in subsections 45B(4) and (5).

83. To prevent the overlap of section 45B(4) and subsection 45B(5), the legislation provides in subsection 45B(6) of the ITAA 1936 that the capital benefit is reduced to the extent that the provision of interests involves a person receiving a 'demerger dividend'.

84. The term 'demerger dividend' is defined in subsection 6(1) of the ITAA 1936 as

85. The 'demerger allocation' is defined in subsection 6(1) of the ITAA as

86. The total market value of the demerger allocation from Company A is the market value of the interests in the demerged entity namely Subco X and Subco Y. The market value of the shares will be the value of the relevant underlying assets less any relevant liabilities of the relevant companies.

87. The underlying assets are the V property valued at $X which will be transferred to Subco X and the Z property valued at $Y, which will be transferred to Subco Y.

88. The application for the ruling was silent as to whether the companies incurred a liability when the properties were transferred from Company A to the companies.

89. As the shares were transferred with a large market value the shares comprise a 'demerger allocation' and as discussed above as the transfer is a payment in specie the transfer would therefore be assessable under section 44(1) but for the operation subsection 44(3) and therefore the transfers of the shares are prima facie a demerger dividend.

90. As the transfer represents a 'demerger allocation' then the capital benefit is reduced to virtually nil and the transfer represents a 'demerger benefit'.

91. As the benefit received is a 'demerger dividend' then the shareholders are 'not provided with a capital benefit'.

The 'benefit received'

92. In the present case the transfer of the shares in Subco X and Subco Y will constitute a 'demerger' benefit for the purposes of section 45B.

Obtaining a tax benefit

93. The third condition is that the scheme enabled a relevant taxpayer to obtain a tax benefit. The meaning of obtaining a tax benefit is defined in subsection 45(9). In this case the Relevant Taxpayers are Mr and Mrs B.

94. As discussed above the demerger dividend, pursuant to subsections 44(3) and (4) of the ITAA 1936, will operate to treat the 'demerger dividend' as non assessable income and non exempt income.

95. The dividend relief provided for under the demergers provisions (in particularly subsection 44(4) ensures that the owners of the head entity (namely Mr and Mrs B) are not subject to tax on the demerger benefit at the time of the demerger.

96. Thus, Mr and Mrs B are subject to less tax than if the demerger dividend (ie the transfer of the shares) had been an assessable dividend.

97. In other words, the tax payable on the demerger benefit will be less than it would be if it had been an assessable dividend.

98. Therefore, the taxpayers would obtain a tax benefit pursuant to subsection 45B(9).

Is the tax benefit a more than incidental purpose?

99. According to paragraph 45B(2)(c), section 45B only applies if, having regard to the relevant circumstances of the scheme, it would be concluded the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit.

100. The test in paragraph 45B(2)(c) of the ITAA 1936 provides that the section will apply if, objectively, the particular scheme demonstrates a more than incidental purpose of enabling the shareholders (or any one of them) to obtain the tax benefit described above.

101. Thus, it is necessary to consider the relevant circumstances of the scheme to determining if the provision of the tax benefit to the relevant taxpayer represents a more than incidental purpose of the scheme.

102. The existence of this purpose is to be determined by consideration of the relevant circumstances that are listed inclusively in subsection 45B(8) of the ITAA 1936.

103. In other words, the application of section 45B will normally be triggered when the shareholder's obtaining a tax benefit is more than merely the natural incident of the demerger scheme.

104. As indicated above a 'demerger' is simply a mechanism for transferring 'ownership interests', or the value thereof, from the head entity of a corporate group to its shareholders whereupon they are received as a tax free gain in the form of a 'demerger dividend' or a 'capital benefit'.

105. Therefore, unless the demerger occurs in the context of a scheme, the essential purpose of which is to enhance business performance, the demerger is simply a group restructure whereby capital and profit of the head entity is transformed into its shareholder's asset in a tax effective way. In which case, it would have to be concluded that enabling the shareholder to obtain a tax benefit would be a substantial purpose of the persons involved in the scheme.

106. In other words, section 45B of the ITAA 1936 would normally apply where the scheme or demerger merely effects a group restructure without the essential object of enhancing the efficiency of businesses run by the group, which is the stated policy objective of demerger tax relief.

Purpose

107. As indicated above a demerger is simply a mechanism for transferring 'ownership interests', or the value thereof, from the head entity of a corporate group to its shareholders whereupon they are received as a tax free gain in the form of a 'demerger dividend' or a 'capital benefit'. Therefore, unless the demerger occurs in the context of a scheme, the essential purpose of which is to enhance business performance, the demerger is simply a group restructure whereby capital and profit of the head entity is transformed into its shareholder's asset in a tax effective way. In which case, it would have to be concluded that enabling the shareholder to obtain a tax benefit would be a substantial purpose of the persons involved in the scheme.

108. In other words, section 45B of the ITAA 1936 would normally apply where the scheme of demerger merely effects a group restructure without the essential object of enhancing the efficiency of businesses run by the group, which, after all, is the stated policy object of demerger tax relief.

109. In her Press Release 40/2002 of 6 May 2002 in regard to demerger tax relief Senator Helen Coonan, the Minister for Revenue stated:

110. Senator Coonan also discussed section 45B of the ITAA 1936 and 'genuine demergers' in the following terms:

What is an incidental purpose?

111. The meaning of the words 'incidental purpose' were mentioned in the Explanatory Memorandum to Taxation Laws Amendment (Company Law Review) Bill 1998 stated, at paragraph 1.32:

112. This does not necessarily mean that an incidental purpose is relatively unimportant to the design of the scheme. The High Court, in its unanimous decision in Mills v Commissioner of Taxation [2012] HCA 51; 2012 ATC 20-360 at paragraph 66, stated in relation to the almost identically worded condition in paragraph 177EA(3)(e) of the ITAA 1936:

113. In Electricity Supply Industry Superannuation (Qld) Ltd v FCT (2002) 51 ATR 163, the Federal Court considered the application of section 177EA to an arrangement that displayed blatant streaming objectives and characteristics. The essential facts of the case are basic and involved the introduction of ESI Super, by subscription, as a member of the Queensland Investment Corporation Investment Trust (the QT). The purpose of the trust was to maximise the after tax returns to its members on funds subscribed. The deed provided for franked dividend income earned by the QT to be placed in a special account called the Franked Dividend Income Account (the FDI Account ). It was held that the tax benefit to the members was not an incidental purpose. Cooper J commented in paragraph 75 as follows

The relevant circumstances

114. The relevant circumstances of a scheme identified in 45B(8) are stated to include the following:

(a) the extent to which the demerger benefit is attributable to profits (realised and unrealised) of the company

115. The contributed share capital of Company A is only $X. Thus, based on the definition provided in paragraph 13 of TR 2003/8, any amount transferred to create the share capital of Subco X and Subco Y would be from Company A's realised and unrealised profits at the time of the demerger.

116. Thus, any demerger allocation and 'demerger benefit' would be made up of a 'demerger dividend' Based on the definition provided in paragraph 50 of PS LA 2005/21, the increased value of the investment properties as held by Company A would constitute unrealised profit at the time of the demerger.

117. Thus, the distribution to the original shareholders from the demerger of Subco and Subco Y will be in the form of profit (which would otherwise be assessable if distributed as a dividend by Company A) rather than capital. Equally, therefore, the attribution of the benefit to the profit rather than capital accounts of Company A is consistent with the arrangement entered into for the transfer of the investment property assets.

118. However, given the extent to which the demerger allocation represents a benefit drawn from profit rather than simply from a return of share capital, this also suggests that the receipt of a tax free benefit could be more than an incidental purpose of the scheme.

(b) the pattern of distributions of dividends

119. Paragraph 59 of PS LA 2005/21 states, in part, that:

120. In the agent's letter, the rulees' agent stated that: 'The retained earnings of the company have been paid out on an ad hoc basis over the years.'

121. According to ATO records, Company A has paid franked dividends since the year ended 30 June 200X:

122. Thus, while the franking account does indicate that Company A has a significant and increasing amount of retained earnings, it is also evident the company has not retained all of its profits over this period. Further, while Company A have paid only minimal dividends in the 200Y to 20XX income years, there is no specific evidence that Company A were retaining profits during this period specifically with a view to taking advantage of a tax effective mode of distribution.

123. Based on the previous history of dividend payments, this factor cannot conclusively be used to argue that the arrangement had more than an incidental tax purpose.

(c) whether the relevant taxpayer has capital losses that, apart from the scheme, would be unutilised.

124. This factor considers whether the shareholders in the head entity are in a position to offset any capital gain from the subsequent disposal of the head entity interests or new ownership interest that Mr B had carried forward losses of less than $1,000 in the 20XX income year, and that Mrs B reported no current year or carried forward losses in the 20XX income year. Based on this information, it is considered that paragraph (c) would not be relevant.

(d) whether some or all of the ownership interests in the company were acquired before 20 September 1985.

125. The Company A shares were acquired by the current shareholders prior to 19 September 1985. Thus, where demerger roll over relief is available, pursuant to subsection 125-80(5), the shares in Subco X and Subco Y can also be taken to have been acquired before 20 September 1985.

126. The decision to demerge may then have been influenced, in part, by a belief of the shareholders or their agent that the shares in Subco X and Subco Y retain a pre-CGT status upon transfer to the original shareholders in Company A. However, the ruling application and the agent's letter does not make specific reference to the expected CGT status of the shares in Subco X and Subco Y in the hands of the original shareholders. Thus, it cannot be confirmed that this factor would have influenced the demerger decision.

(e) whether the relevant taxpayer is a non-resident.

127. There is no suggestion in the ruling application or ATO records that the shareholders in Company A are non-residents. Thus, this factor would have no bearing on the application of section 45B.

(f) whether the cost base is not substantially less than the value of the applicable demerger benefit

128. In this case, no part of the demerger benefit is a capital component or capital benefit such as a return of capital. Further, as the shares in Company A appear to have been acquired pre-CGT, any return of capital would not have resulted in a capital gain to the shareholders. Thus, it is considered that this particular factor does not indicate an intention by the shareholders to gain a tax benefit.

(g) has been repealed effective 14 September 2006,

(h) if the scheme involves the distribution of share capital,

129. There is no suggestion that the scheme proposed by Company A involves the distribution of share capital or share premium, rather than being a distribution from profit. Therefore, it is considered that this factor is not expressly relevant to the current rulees, and as such would not support a finding that the scheme was entered into for more than an incidental purpose of gaining a tax benefit.

(i) if the scheme involves the provision of ownership interests and the later disposal of those interests,

130. There is no indication in the ruling application that the demerger is intended to result in the 'prearranged disposal' of the original shareholders shares in the head entity Company A. Based on the statements of the rulees' agent, the shareholders are simply seeking an injection of additional capital, ownership and expertise into Company A as part of their retirement strategy. As outlined above, the scheme proposed in the ruling application will result in the existing shareholders in Company A being provided with an ownership interest in the form of shares in Subco X and Subco Y, with the sole underlying assets of each new company being one of the investment properties.

131. Given the conditional nature of the assurance provided in the agent's letter, it may be questioned how long the underlying properties will actually remain in Subco X or Subco Y following the demerger, or, alternatively, whether the shareholders will dispose of the Subco X or Subco Y shares soon after their acquisition in order to indirectly effect the disposal of the property asset.

132. Equally, however, in the absence of any evidence of a contract for the immediate disposal of the shares in Subco X or Subco Y, or their underlying assets, it cannot irrefutably be determined that the rulees' 'future intention' to develop and/or sell the properties constitutes a scheme for the 'prearranged disposal' of the properties at the time the scheme is entered into. Further, even if the disposal of the properties were to occur shortly after the demerger, there may be sound business purposes for realising the property assets in the manner described above - such as, for example, a sudden improvement in the property market.

133. Thus, this factor cannot conclusively be applied to suggest a tax purpose that is more than incidental to any business purpose.

(j) whether the profits /assets of the demerging entity and demerged entity are attributable to transactions between the entity and an associate (within the

134. In this regard any transactions between group members have taken place in the ordinary course of the respective entity's commercial activities and on commercial terms. In the absence of any evidence to suggest that the assets of Company A were in any way attributable to transactions entered into with associated entities with a view to altering the concentration of such profits and/or assets within the corporate group prior to the proposed demerger, it is concluded that the transfer of assets fairly reflects that which would be achieved by a business restructure.

(k) any of the matters referred to in subsection 177D(2).

135. This factor takes into account the 'dominant purpose' test contained in Part IVA. However, as stated in paragraph 83 of PS LA 2005/21, '…in the context of section 45B they facilitate the 'more than incidental purpose test' and do not introduce a different purpose test.'

136. The 'matters' referred to in subsection 177D(2) are:

a) the manner in which the scheme was entered into or carried out;

137. In part, paragraph 86 of PS LA 2005/21 suggests that:

138. For example, previous Class Rulings have concluded that section 45B would not apply where there commercial objective was to achieve a separation of two distinct businesses:

139. A further Class Ruling concluded that section 45B did not apply to a separation of two distinct businesses based on commercial objectives was to achieve a separation of two distinct businesses based on different business strategies:

140. In the current case it would appear that the scheme proposed in the ruling application was designed to take advantage of the CGT roll over relief and the income tax exemption under the demerger provisions. For example, the retention of the investment properties within Company A would not prevent their development and/or sale as intended under the arrangement identified in the ruling application.

141. However, based on the reasons provided in the ruling application and the tax agent's letter, it is accepted that there would also be valid business reasons which could justify demerging the properties from the head entity, and that the separation of the insurance business and the investment properties would allow for the pursuit of '…different business strategies and their discrete commercial objectives.'

142. For example, it is not unreasonable to conclude that the transfer of the properties from the core insurance business would reduce '…the entry price for prospective entrants to the business…', which would in turn '…encourage business expansion and stimulate the business through the introduction of fresh business ideas and knowledge.'

143. It is also arguable, as the ruling contends, that the separation of the investment properties from the core insurance business will '…lock in key employees by offering equity participation…', and '…attract new equity participants into the business operations of the company thereby allowing a transition to retirement for the existing owners.'

144. Given these stated business objectives, it is reasonable to accept that Company A would arrange either for:

· the disposal of the properties directly by Company A; or

· the transfer of the properties into another entity or entities.

145. In relation to these two alternatives, given:

· the shareholders desire to move into a succession planning/retirement phase; and

· the stated intention to develop the investment properties prior to disposal

there are arguably sound business reasons for the transfer of the properties to other entities rather than their immediate disposal by Company A , so that:

· new investors could more quickly 'buy into' the core Company A business at the lower entry price (including avoiding the potential cost of developing the properties); and

· the existing shareholders can delay realising the value of their properties until they can maximise their return in a potentially 'improved' market.

(b) the form and substance of the scheme;

146. Given the closely held nature Company A, the divestment of assets of Company A to Subco X and Subco Y, and the subsequent transfer of the shares in these companies to the two shareholders in Company A, will have no impact on the ownership interests of the individual shareholders. The shareholders will be left with the same ownership interest over the assets of the separate companies which they had in Company A.

147. While the divestment of the properties from Company A will reduce its net assets, this is the stated purpose of the arrangement, as it will allow a lower entry price for new investors. Further, as there are currently no other parties with an interest in Company A, this divestment will not affect any other ownership interests.

(c) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

148. In this regard, it is noted that the scheme is stated to have been proposed as a consequence of the age of the shareholders, with the isolation of the insurance business in Company A through the divestment of the investment properties being intended to encourage new investment in the company with a view to succession planning, including the eventual retirement of the shareholders.

149. There is no suggestion that the scheme has been undertaken in order to take advantage of any recent change in taxation law. The demerger CGT roll-over and demerger dividend relief being sought by the rulees has applied for any demerger which occurred after 1 July 2002.

(d) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

150. In this current case, it is clear that the creation of a consolidated group was intended to take advantage of the CGT roll over concessions. It is also clear that, if section 45B were not to apply, the shareholders will receive a tax benefit through an exemption from tax on a distribution which would otherwise be assessable as a dividend.

151. However, it can also be argued that the very purpose of the CGT roll over and dividend demerger provisions was to provide taxpayer's with just such a tax benefit at the time of a restructure. Thus, it may be difficult to justify applying the punitive section 45B to a tax benefit simply on the grounds of the tax benefit derived where the taxpayer can identify a business purpose for the scheme.

(e) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

152. It is clear that the investment property assets may be 'liquidated' or used by the individual shareholders as security once they hold the shares in Subco X and Subco Y. However, given that the taxpayer's are the sole shareholders and directors of Company A, they already have control over the future treatment of the investment property assets.

153. Equally, purely in terms of the return on the property assets, the original shareholders will be in no better position as shareholders of Subco X and Subco Y than if the properties were rented and/ or developed and sold by Company A.

(f) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

154. We have no evidence that the creditors of Company A, or any other third party, would be affected by the scheme entered into.

(g) any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out;

155. Given the closely held nature of the shares in Company A, and the simple nature of the assets which are the subject of the demerger, it is difficult to identify any major consequences which will arise from the scheme other than the business and tax consequences already considered above.

(h) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f).

156. As both Company A, Subco X and Subco Y are or are intended to be closely held, the head entities owners and the members of the demerger group will be the same two people. There will be no change in the interests in and benefits available to any of the individual members of the head or demerger companies as a consequence of the demerger proposal.

157. For the shareholders (Mr and Mrs B) the tax payable on the demerger benefit is less than it would be if they had been an assessable dividend or a dividend respectively. This arises because the CGT and dividend concessions ensure that the demerger is largely free of tax for shareholders. As such, the provision of those benefits will constitute the Company A shareholders obtaining a tax benefit (subsection 45B(9) of the ITAA 1936).

158. An important consideration is that the before the demerger the rental properties were indirectly held by Mr and Mrs B through an interposed company namely Company A. After the demerger the rental properties were held by interposed entities namely Subco X and Subco Y. the reason provided for this restructure was that

"The current structure of the business causes a significant impediment to succession planning. It is necessary to remove the properties from the company in order to attract new equity participants into the business operations of the company thereby allowing a transition to retirement for the existing owners.

The Directors plan is to restructure the company in order to separate the properties from the core business assets of their broking services

159. Thus it is clearly arguable that after the demerger the shareholders still own the same economic assets through an interposed entity, albeit a different company, that they owned before the demerger. The new structure will arguably allow for greater flexibility in making economic decisions and will allow for new business investors to invest in the broking business.

160. In this case, while the conditions of paragraphs 45B(2)(a) and 45B(2)(b) of the ITAA 1936 are arguably met, the requisite purpose of enabling the Company A shareholders to obtain a tax benefit (by way of a demerger benefit or a capital benefit) is not present. In other words, having regard to the relevant circumstances of the scheme set out in subsection 45B(8) of the ITAA 1936, it would not be concluded that any of the parties to the demerger entered into or carried out the scheme to obtain a tax benefit in the form of a demerger benefit or a capital benefit.

161. Those circumstances, particularly those enumerated in paragraph 177D(b) of the ITAA 1936 and incorporated by operation of paragraph 45B(8)(k) of the ITAA 1936, are concerned with the commercial or business effects of the demerger. Under the proposed scheme, it is apparent that a substantial purpose of the demerger is to achieve the separation of two distinct businesses for commercial purposes. Following their separation, each will operate independently separately and allow for independent business directions in the future. This is consistent with the underlying policy object of the demerger provision in the legislation.

162. Therefore, the Commissioner will not make a determination under either paragraph 45B(3)(a) or (b) of the ITAA 1936 that sections 45BA or 45C of the ITAA 1936 applies to the scheme.

Conclusion

163. Having regard to the relevant circumstances of this scheme, it can be concluded that, objectively, the attainment of a tax benefit by Subco X and Subco Y shareholders should be considered to be no more than an incidental aspect of the overall arrangement to restructure the corporate group to facilitate the possible sale of the business. In light of the context surrounding the companies, and the relevant commercial objectives evidently driving the decision to demerge the subsidiary companies it cannot be concluded that any party entered into the scheme for the more than incidental purpose of enabling any taxpayer to obtain a tax benefit.

164. As a consequence, it is considered that the provision of ownership interests Subco X and Subco Y to the shareholders in Company A amount to no more than a necessary element of this business restructure.

165. In such circumstances, the scheme in question is considered to be one which is absent the element of purpose required to enliven the operative provision of section 45B of the ITAA 1936 (subsection 45B(3) of the ITAA 1936).

166. Accordingly, the Commissioner would not 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 under the scheme.

167. Similarly, the Commissioner would not make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the capital benefit provided to the rulee under the scheme.

1 Brookton Co-operative Society Limited v F CT 81 ATC 4346 see Aickin J at page 4363

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