Edited version of your written advice

Authorisation Number: 1013062768566

Date of advice: 29 July 2016

Ruling

Subject: Demerger

Question 1

Will the Commissioner of Taxation (the Commissioner) confirm that the proposed demerger satisfies the requirements for the demerger roll-over relief under Division 125 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the Commissioner confirm that the Company X shareholders are entitled to choose demerger roll-over under section 125-55 of the ITAA 1997?

Answer

Yes

Question 3

Will the Commissioner confirm that all, or any part, of the distribution of Company Y shares to Company X shareholders that is a dividend will constitute a demerger dividend, and therefore be neither assessable income nor exempt income pursuant to subsections 44(3) and 44(4) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 4

Will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that section 45BA or section 45C of the ITAA 1936 applies to the whole, or any part, of the demerger benefit or capital benefit provided to the Company X shareholders under the proposed demerger?

Answer

No

Question 5

Will the Commissioner confirm that Division 7A of the ITAA 1936 will not apply to any distributions made to the Company X shareholders under the proposed demerger?

Answer

Yes

Question 6

Will the Commissioner confirm that any capital gain or capital loss that arises to Company X under CGT event A1 from the disposal of its shares in Company Y under the proposed demerger is disregarded under section 125-155 of the ITAA 1997?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances:

Background

Company X

Company X is an Australian private company.

Company X's combined business operations fall under two broad product and service offerings.

Company has fully paid ordinary shares on issue which are held by Australian resident taxpayers.

All the shareholders of Company X acquired shares after 20 September 1985.

There have been no previous distributions of share capital.

Company X has not had the capacity to pay dividends since its incorporation.

Company Y

Company Y is an Australian private company.

Company Y has fully paid ordinary shares on issue.

There have been no previous distributions of share capital.

Proposed restructure

Company X will incorporate a 100% owned Australian private company (Company Y).

Company X will form a tax consolidated group. The members of the tax consolidated group will be Company X and Company Y.

Company X will transfer one part of its business to Company Y.

In exchange for the transfer of the business, Company Y will issue further shares to Company X equal to the value of the assets transferred.

Company X will demerge all its interest in Company Y to Company X shareholders in proportion to their current shareholding.

Proposed capital raising activities

The board of Company X are currently planning a raise capital by way of issue of new shares to potential investors.

Post demerger, Company Y will also raise money and capital by way of an issue of new shares.

There are no plans for an exit event for either entity post the demerger.

Reasons for the Proposed demerger

As the two business units are operating in very distinct industries and are at different points in their business life cycle a demerger of the two business units will generate additional business efficiencies. A demerger would allow each business unit to focus on their core business, targeting investors and strategic partners that will not be possible if the two business units continue to operate as one company.

The two business units have different commercial environments, risk profiles and growth expectations. The proposed demerger is intended to remove any of the conflicts and inefficiencies that exist as a result of operating these two businesses under the one company.

Other matters

Company X will not make an election under subsection 44(2) of the ITAA 1936.

There is no intention that Company X shareholders will dispose of the shares in Company Y following the demerger taking place.

The share capital account of Company X is not tainted within the meaning of Division 197 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 section 44

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 45BA

Income Tax Assessment Act 1936 section 45C

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 Division 125

Income Tax Assessment Act 1997 subdivision 125-B

Income Tax Assessment Act 1997 section 125-55

Income Tax Assessment Act 1997 section 125-65

Income Tax Assessment Act 1997 section 125-70

Income Tax Assessment Act 1997 section 125-155

Reasons for decision

Question 1 & 2

Summary

Company X shareholders can choose to obtain roll-over relief under Subdivision 125-B of the ITAA 1997 upon the demerger of Company Y by Company X.

Detailed reasoning

In order for the demerger CGT outcomes contained in Division 125 of the ITAA 1997 to apply to a company or trust, a number of defined terms must be satisfied, including:

• demerger group (subsection 125-65(1) of the ITAA 1997);

• demerger (subsection 125-70(1) of the ITAA 1997);

• demerged entity (paragraph 125-70(6)(a) of the ITAA 1997); and

• demerging entity (paragraph 125-70(7)(a) of the ITAA 1997).

Demerger Group

A demerger group comprises one head entity and at least one demerger subsidiary (subsection 125-65(1) of the ITAA 1997). The demerger group in this case comprises Company X as the head entity and includes Company Y as a demerger subsidiary.

Company X will be the head entity because:

• no other member of the demerger group holds ownership interests in Company X (subsection 125-65(3) of the ITAA 1997); and

• there will be no other company or trust capable of being a head entity of a demerger group of which Company X could be a demerger subsidiary (subsection 125-65(4) of the ITAA 1997).

Company Y will be a demerger subsidiary of Company X because Company X owns ownership interests in Company Y that carry more than 20% of the rights to any distribution of income and capital, and the right to exercise more than 20% of the voting power of Company Y (subsection 125-65(6) of the ITAA 1997).

Demerger

Subsection 125-70(1) of the ITAA 1997 describes when a demerger happens. A demerger will happen to the Company X demerger group because:

• there will be a restructuring (paragraph 125-70(1)(a) of the ITAA 1997), and Company X will dispose of at least 80% of its Company Y shares to the owners of Company X (subparagraph 125-70(1)(b)(i) of the ITAA 1997);

• under the restructuring, CGT event G1 will happen to the Company X shares under the demerger, and Company X shareholders will acquire new shares in Company Y and nothing else (subparagraph 125-70(1)(c)(i) of the ITAA 1997);

• CGT event A1 will happen upon the disposal of shares in Company Y. Company Y shares will be acquired by Company X shareholders on the basis of their ownership of shares in Company X (paragraph 125-70(1)(d) and subparagraph 125-70(1)(e)(i) of the ITAA 1997);

• paragraph 125-70(1)(f) of the ITAA 1997 repealed;

• neither Company X nor Company Y are superannuation funds (paragraph 125-70(1)(g) of the ITAA 1997);

• Company X shareholders will acquire Company Y shares in the same proportion as they own Company X shares just before the demerger (paragraph 125-70(2)(a) of the ITAA 1997);

• each of the Company X shareholders will own shares in Company X and Company Y that (just after the demerger) represent the same proportionate total market value as their Company X shares represented (just before the demerger) (paragraph 125-70(2)(b) of the ITAA 1997);

• under the scheme, there will be no buy-back of shares for the purposes of Division 16K of Part III of the ITAA 1936 (subsection 125-70(4) of the ITAA 1997); and

• there will be no rollover available under another provision for any CGT events that happen to the Company X shares under the restructure (subsection 125-70(5) of the ITAA 1997).  

Company Y is the demerged entity 

Relevantly, subsection 125-70(6) of the ITAA 1997 defines a demerged entity to be a former member of a demerger group in which ownership interests are acquired by shareholders of the head entity under a demerger.

In the present circumstances, Company Y is the demerged entity since the Company X shareholders receive shares in Company Y under a demerger.

Company X is the demerging entity

Relevantly, subsection 125-70(7) of the ITAA 1997 defines a demerging entity to be a member of a demerger group who disposes of at least 80% of its total ownership interests in another member of the demerger group to owners of original interests in the head entity under a demerger.

In the present circumstances, Company X is the demerging entity since it disposes of 100% of its shares in Company Y to the Company X shareholders under a demerger.

Can the Company X shareholders choose demerger rollover?

Subsection 125-55(1) of the ITAA 1997 relevantly provides that demerger rollover may be chosen if:

• a shareholder owns a share in a company - the Company X shareholders satisfy this requirement;

• the company is the head entity of a demerger group - this requirement is satisfied;

• a demerger happens to the demerger group - this requirement is satisfied; and

• under the demerger a CGT event happens to the original interest (Company X shares) and a new or replacement interest is acquired in the demerged entity - this requirement will be satisfied as CGT event G1 happens to the Company X shares when the Company X shareholders receive Company Y shares under the demerger.

Therefore Company X shareholders will be eligible to choose rollover under subsection 125-55(1) of the ITAA 1997.

Capital gains and cost base adjustments for the Company X shareholders

If a Company X shareholder chooses demerger roll-over:

• it will disregard any capital gain made in respect of CGT event G1 that happens to its Company X shares (subsection 125-80(1) of the ITAA 1997);

• the first element of the cost base and reduced cost base of the Company X shares and the corresponding Company Y shares acquired under the demerger, will be the sum of its original cost bases (just before the demerger) of the Company X shares, apportioned over those Company X and Company Y shares on a reasonable basis having regard to the market values (just after the demerger) of the Company X shares and Company Y shares, or a reasonable approximation of those market values (subsections 125-80(2) and (3) of the ITAA 1997).

If a Company X shareholder does not choose demerger roll-over:

• it will not be entitled to disregard any capital gain made in respect of CGT event G1 that happens to its Company X shares under the demerger;

• the cost base and reduced cost base of the Company X shares and Company Y shares will be calculated in the same manner set out in the preceding paragraph.

Question 3

Summary

All or any part of the distribution of Company Y shares to Company X shareholders that is a dividend will constitute a demerger dividend, and therefore be neither assessable income nor exempt income pursuant to subsections 44(3) and 44(4) of the ITAA 1936.

Detailed reasoning

Is a dividend paid under the demerger?

Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income a dividend, as defined in subsection 6(1) of the ITAA 1936, paid to a shareholder out of company profits.

Capital reduction amount

The definition of a dividend in subsection 6(1) of the ITAA 1936 excludes amounts debited against an amount standing to the credit of the share capital account of the company (paragraph (d) of the subsection 6(1) of the ITAA 1936 definition of a dividend).

As the capital reduction amount will be debited against an amount standing to the credit of the share capital account (as that term is defined in subsection 6(1) of the ITAA 1936) of Company X it will not be a dividend, as defined in subsection 6(1).

Therefore, the capital reduction amount will not be assessable income of the shareholders of Company X for the purposes of subsection 44(1) of the ITAA 1936.

Dividend

The definition of a dividend includes any amount distributed or credited by a company to any of its shareholders. Therefore, the distribution of the Company Y shares will, in part, constitute a dividend of the Company X shareholders. The total amount of the dividend will be the market value of the Company Y shares at the time of the demerger excluding the amount debited to the share capital account of Company X.

In general, a dividend satisfied by a distribution of property (such as shares in a subsidiary) will be a dividend paid out of profits derived if, immediately after the distribution of that property, the market value of the assets of the company exceed the total amount (as shown in the company's books of account) of its liabilities and share capital (see paragraph 8 of Taxation Ruling TR 2003/8).

However, a demerger dividend is taken not to have been paid out of profits and is neither an assessable income nor an exempt income amount (subsections 44(3) and (4) of the ITAA 1936) where:

• the dividend is a demerger dividend (as defined in subsection 6(1) of the ITAA 1936);

• the head entity does not elect that subsections 44(3) and (4) of the ITAA 1936 do not apply to the demerger dividend (subsection 44(2) of the ITAA 1936); and

• subsection 44(5) of the ITAA 1936 is satisfied.

In the present circumstances, the dividend paid to the Company X shareholders under the demerger would satisfy the conditions necessary to be a demerger dividend and would therefore be neither assessable income nor exempt income pursuant to subsections 44(3) and 44(4) of the ITAA 1936.

Question 4

Summary

The Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45BA or section 45C will apply to the whole, or any part, of any benefit provided to the Company X shareholders under the proposed arrangement.

Detailed reasoning

Subsection 45B(1) of the ITAA 1936 provides that the purpose of section 45B is to ensure that relevant amounts are treated as 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.

Subsection 45B(2) of the ITAA 1936 sets out the conditions that must be met in order for section 45B to apply. Relevantly, this section applies if:

• there is a scheme under which a person is provided with a demerger benefit or capital benefit by a company (paragraph 45B(2)(a) of the ITAA 1936); and

• under the scheme a taxpayer, who may or may not be the person provided with the demerger benefit or the capital benefit, obtains a tax benefit (paragraph 45B(2)(b) of the ITAA 1936); and

• having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, entered into the scheme or carried out the scheme or any part of the scheme for a purpose, other than an incidental purpose, of enabling a taxpayer to obtain a tax benefit (paragraph 45B(2)(c) of the ITAA 1936).

Where the requirements of subsection 45B(2) of the ITAA 1936 are met, subsection 45B(3) empowers the Commissioner to make a determination under either or both of section 45BA in relation to a demerger benefit and section 45C in relation to a capital benefit.

The effect of a determination made under paragraph 45B(3)(a) of the ITAA 1936 is that part or all of a demerger benefit will be treated as not being a demerger dividend (subsection 45BA(1) of the ITAA 1936).

The effect of a determination made under paragraph 45B(3)(b) of the ITAA 1936 is that part or all of a capital benefit will be an unfranked dividend paid to the relevant taxpayer out of profits (subsections 45C(1) and (2) of the ITAA 1936).

Scheme

A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided in subsection 177A(1) of Part IVA of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan, or proposal. In particular, a scheme is anything that satisfies any of the terms in the statutory definition.

In the present circumstances, the transfer of shares in Company Y to the Company X shareholders under the demerger constitutes the relevant scheme for the purposes of section 45B of the ITAA 1936.

Demerger benefit and capital benefit

The provision of ownership interests to a shareholder under a demerger constitutes the shareholder being provided with a demerger benefit (subsection 45B(4) of the ITAA 1936). Therefore, under the proposed scheme, the market value of the Company Y shares provided to the Company X shareholders constitutes a demerger benefit.

The provision of those Company Y shares also constitutes a capital benefit to the extent it is not a demerger dividend (paragraph 45B(5)(a) and subsection 45B(6) of the ITAA 1936). As such, the market value of the Company Y shares distributed under the demerger less the demerger dividend is a capital benefit provided to the Company X shareholders.

Tax benefit

Subsection 45B(9) of the ITAA 1936 provides, inter alia, that a relevant taxpayer 'obtains a tax benefit' if an amount of tax payable by that taxpayer would, apart from the operation of section 45B, be less than the amount that would have been payable if the 'demerger benefit' had been an assessable dividend or the capital benefit had been a dividend.

As a result of the demerger, the Company X shareholders would, apart from the operation of section 45B of the ITAA 1936, receive a demerger dividend equal to the market value of the shares in Company Y at the time of the demerger less the amount debited to share capital that is neither assessable income nor exempt income. The tax payable by Company X shareholders on the demerger would be higher if the demerger benefit was an assessable dividend. Accordingly, Company X shareholders will obtain a tax benefit for the purposes of section 45B.

More than incidental purpose

Given that the proposed demerger is a scheme that provides a tax benefit to the Company X shareholders, the operation of section 45B of the ITAA 1936 turns on the objective purpose test in paragraph 45B(2)(c). This paragraph provides that the section will apply if enabling the shareholder to obtain the tax benefit is a more than incidental purpose of the scheme.

The requisite purpose is to be determined having regard to the relevant circumstances of the scheme which are listed inclusively in subsection 45B(8) of the ITAA 1936. Each of the circumstances must be considered in order to determine whether or not, individually or collectively, they reveal the existence of the requisite purpose.

Relevant circumstances

The relevant circumstances include the tax and non-tax (i.e. business and other financial) implications of the scheme, the latter covered largely by the matters in subsection 177D(2) of the ITAA 1936, which are included in subsection 45B(8) by virtue of paragraph (k).

In this case, the nature of the scheme indicates that the more pertinent circumstances are those covered by paragraphs (a), (b), (i), (j) and (k) of subsection 45B(8) of the ITAA 1936.

Paragraph 45B(8)(a) of the ITAA 1936 refers to the extent to which the capital benefit is attributable to capital or profits (realised and unrealised) of the company or an associate (within the meaning of section 318 of the ITAA 1936) of the company. In the circumstances of the capital benefit provided under this scheme, it is considered that they appropriately reflect a return of share capital to the Company X shareholders.

In the present case, the proposed demerger will result in a return of capital and a demerger dividend sourced from realised and unrealised profits which are considered to be an appropriate allocation of share capital and profits in accordance with PSLA 2005/21. Therefore, this factor does not incline for, or against, a conclusion as to the requisite purpose.

Paragraph 45B(8)(b) of the ITAA 1936 refers to the pattern of distributions made by a company or an associate of the company. In this case, Company X has not had the capacity to pay dividends since its incorporation and it should not be concluded that the present distribution is in substitution for a dividend. Therefore, this factor does not incline for, or against, a conclusion as to the requisite purpose.

Paragraph 45B(8)(i) of the ITAA 1936 directs attention to those cases where the scheme of demerger involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests. The demerger arrangement does not involve the later disposal of ownership interests and there is no intention that Company X shareholders will dispose of the shares in Company Y following the demerger. Therefore, this factor does not incline for, or against, a conclusion as to the requisite purpose.

Paragraph 45B(8)(j) of the ITAA 1936 applies to circumstances where the profits and assets of the demerging entity are attributable to or acquired under transactions with associated entities. This relevant circumstance aims to expose instances where demerger relief is being used as a vehicle for distributing corporate earnings by way of non-assessable dividend. In this case, there are no profits derived by Company X or assets held by Company X that are attributable to transactions with Company Y or other related parties. Therefore, this factor does not incline for, or against, a conclusion as to the requisite purpose.

45B(8)(k) Part IVA matters

This circumstance requires regard to be had to any of the matters referred to in paragraphs 177D(2)(a) to (h) of the ITAA 1936.

The incorporation of the Part IVA factors into section 45B of the ITAA 1936 does not introduce a different (dominant) purpose test into section 45B. The matters are applied in the context of the 'more than incidental purpose test' in section 45B.

The eight matters in subsection 177D(2) of the ITAA 1936 constitute the essential facts and circumstances of a scheme, including the outcomes for the parties to the scheme, by reference to which the tax and non-tax objects of the scheme can be identified and contrasted from an objective point of view.

If, on the one hand, reference to the matters in subsection 177D(2) of the ITAA 1936 reveal that the essential object of a demerger is to produce changes and improvements to the business structures of the corporate group, the tax free aspect of the transfer of ownership interests to the head entity's owners is more likely to be an incidental object of the demerger.

If on the other hand reference to those matters reveals that the transfer of ownership interests from the corporate group to the head entity's shareholders is an essential object of the scheme, the tax-free aspect of the transfer would ordinarily be a substantial object of the demerger.

Paragraph 177D(2)(a) of the ITAA 1936 requires an inquiry into the manner in which the scheme was entered into or carried out.

Given the commercial reasons for the demerger, it is considered that the essential object of the proposed demerger is to achieve the separation of each business in order for both Company X and Company Y to become viable, stand-alone entities. Therefore, the tax benefit that Company X shareholders would receive is an incidental object of the demerger. As a result, it is considered that the 'manner' of the scheme does not point toward there being a more than incidental purpose of obtaining the tax benefit.

Paragraph 177D(2)(b) of the ITAA 1936 refers to the form and substance of the scheme. The form of a scheme is the way it presents and the substance of a scheme is a reference to its essential nature which normally would be determined from the effects of the scheme on the commercial and economic circumstances of the parties involved in the scheme.

Based on a review of the benefits outlined in the ruling application that both businesses expect to achieve, it is considered that this factor does not point toward there being a more than incidental purpose of obtaining the tax benefit.

It is considered that none of the matters in paragraphs 177D(2)(c) to (h) incline towards a requisite purpose.

Conclusion

Having regard to the relevant circumstances of the proposed scheme, as set out in subsection 45B(8) of the ITAA 1936, it is considered that the proposed demerger is not being undertaken for the more than incidental purpose of obtaining a tax benefit.

Accordingly, the Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45BA or section 45C will apply to the whole, or any part, of any benefit provided to the Company X shareholders under the proposed arrangement.

Question 5

Summary

Division 7A of the ITAA 1936 will not apply to the distributions that will be made under the proposed demerger.

Detailed reasoning

Division 7A of the ITAA 1936 applies to treat certain distributions to entities connected with a private company as an assessable dividend. In particular section 109C of the ITAA 1936 treats certain payments made by a private company as a dividend where:

the private company pays an amount to the entity during the year and either:

(a) the payment is made when the entity is a shareholder in the private company or an associate of such a shareholder; or

(b) a reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been such a shareholder or associate at some time.

Further, paragraph 109C(3)(c) of the ITAA 1936 specifically includes a transfer of property as a payment within the meaning of the section. Prima facie, the transfer of Company Y shares to Company X shareholders may satisfy this requirement. However, the outline to Division 7A of the ITAA 1936 notes that '... this Division does not apply to demerger dividends. (see Subdivision DA).'

The operative provision is contained in section 109RA of the ITAA 1936 which provides that the Division does not apply to a demerger dividend to which section 45B of the ITAA 1936 does not apply.

In the present circumstances the Commissioner is of the view that section 45B of the ITAA 1936 does not apply to the arrangement, therefore Division 7A of the ITAA 1936 has no application.

Question 6

Summary

Company X can disregard under section 125-155 of the ITAA 1997 any capital gain or capital loss arising from CGT event A1 happening to its ownership interests in Company Y upon the demerger of Company Y by Company X.

Detailed reasoning

Section 125-155 of the ITAA 1997 provides that a demerging entity may ignore capital gains or capital losses arising from certain CGT events (including CGT event A1) happening to its ownership interests in a demerged entity under a demerger.

In the present case:

• Company X is the demerging entity,

• CGT event A1 will happen when Company X disposes of its shares in Company Y and transfers them to the Company X shareholders (per section 104-10 of the ITAA 1997), and

• this disposal happens under a demerger.

Therefore, any capital gain or loss under CGT event A1 made by Company X on the disposal of its Company Y shares under the demerger will be disregarded (section 125-155 of the ITAA 1997).

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