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Ruling

Subject: Company demerger

Question 1

Will the Commissioner, under paragraph 45B(3)(a) of the Income Tax Assessment Act 1936 (ITAA 1936), make a determination that section 45BA of the ITAA 1936 applies as a result of the demerger?

Answer

No

This ruling applies for the following periods:

1 July 2006 to 30 June 2007

The scheme commences on:

1 July 2006

Relevant facts and circumstances

ACO carried on a business in several locations.

ACO held an interest in BCO which carried on an unrelated business.

ACO owned a minority interest in BCO.

The directors of ACO resolved:

· to distribute the interests that ACO held in BCO to ACO shareholders

· the distribution was a dividend wholly out of retained earnings of ACO

· the dividend was franked to 100%

· the value of the BCO shares was stated.

By letter, ACO advised its shareholders that BCO shares would be transferred to them by a date.

There were several shareholders of ACO.

ACO distributed BCO shares to its shareholders in the same proportion as the shareholders' interests in ACO.

The market value of the BCO shares was calculated. This amount was also the initial cost and accounting carrying value of the BCO shares.

No portion of the distribution amount was debited against share capital account of ACO.

The shareholders of ACO entered into a non-binding letter of intent with XCO for XCO to purchase 100% of their shares in ACO. A condition of the purchase of the ACO shares was that ACO dispose of its BCO shares.

XCO carried on a business in several locations.

XCO acquired all the shares in ACO.

The acquisition was financed by a mixture of shares and cash.

ACO and BCO continued to carry on their respective businesses. Some of the directors of ACO and BCO were replaced.

Dividends were paid by ACO for the financial years ended 30 June 2006 and 2007.

Loans by ACO to associates or subsidiaries, and related party transactions were of minor value compared with ACO's overall operations.

The shareholders of ACO did not have capital losses or carried forward capital losses in the year they received the BCO shares.

The shareholders were residents of Australia for the purposes of subsection 6(1) of the ITAA 1936 at the time they received the BCO shares.

ACO did not make an election under subsection 44(2) of the ITAA 1936.

The applicant states that:

The board of ACO were actively reviewing opportunities to accelerate growth in revenue. The broad opportunities being considered included raising working capital as well as mergers and acquisitions involving similar groups. The board had engaged corporate advisors to assist in finding and developing opportunities and by the end of the 2006 financial year the board were communicating with a number of potential parties.

Fully franked dividends were distributed wholly from the retained earnings of ACO. ACO had sufficient retained earnings and was in a net asset surplus so no portion of the dividend was debited against share capital account.

The dividends (interests in BCO) that have been distributed in specie to the ACO shareholders solely represent the market value of the shares in the demerged entity. Therefore the value of the demerger dividend represents the realised and unrealised profit of BCO.

ACO does not have a regular pattern of distribution of dividends to its shareholders. A dividend was paid during the year ended 30 June 2006. Dividends were paid during the year ended 30 June 2007 to prepare the company balance sheet for subsequent acquisition of ACO by XCO.

The primary purpose of the demerger of BCO from ACO was to facilitate the sale of ACO to XCO. The original shareholders in ACO, each of whom received an in-specie BCO share benefit, remain owners of their BCO shares. Moreover, no arrangement has been made for future disposal of the original owner's interest in BCO.

There are no sales or profits derived from transactions between ACO and BCO or their associates. There is no concentration of assets or profits of the corporate group in BCO beyond that which is explicable by the business structure.

The substance of the demerger of BCO is that it enabled the ACO shareholders to assume proprietorship control of BCO and ensure that they could carry on that business as an independent and viable entity capable of conducting the business in its own right. The spin-off of BCO also satisfied certain preconditions of the XCO offer to purchase and thus facilitate the eventual sale of ACO to XCO.

In relation to the tax benefits, the extent of the demerger benefit derived by the shareholders in the form of the demerger dividend is, in a macro sense, offset by the franking credits available to the shareholders.

ACO was a minority shareholder in BCO. Moreover, ACO and BCO carried on different business in different industries. There was little synergy between the two businesses and limited scope for achieving benefits of horizontal integration. The spin off of BCO from the ACO group overcame these issues.

XCO requested that ACO dispose of its minority interest in BCO as a condition of sale as it did not add value to its core operations. The ACO shareholders were not going to receive any value for BCO and therefore demerged the business from the ACO business. The separation of the two businesses enabled compliance with the conditions of sale of ACO to XCO. BCO continues in existence as a viable independent business today.

Relevant legislative provisions

Subsection 44(1) of the Income Tax Assessment Act 1936

Subsection 44(2) of the Income Tax Assessment Act 1936

Section 45B of the Income Tax Assessment Act 1936

Section 45BA of the Income Tax Assessment Act 1936

Subsection 177A(1) of the Income Tax Assessment Act 1936

Paragraph 177D(b) of the Income Tax Assessment Act 1936

Subsection 125-70(1) of the Income Tax Assessment Act 1997

Reasons for decision

Summary

The Commissioner will not make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies as a result of the demerger.

Section 125-70

A demerger is defined in subsection 125-70(1) of the Income Tax Assessment Act 1997. The divestment by ACO of its interests in BCO to ACO shareholders is a demerger because the shareholders of ACO have:

· acquired as new interests at least 80% of ACO's ownership interests in BCO. (ACO shareholders received 100% of the BCO shares and options) owned by ACO);

· acquired nothing other than their new interests (shares and options) in BCO; and

· held the same proportion of interests pre and post demerger

Section 45B

Section 45B of the ITAA 1936, if applicable, allows the Commissioner to make a determination that all or part of an allocation received by a shareholder as a result of a demerger is to be treated as an unfranked dividend.

Section 45B of the ITAA 1936 applies where:

(a) there is a scheme under which a person is provided with a demerger or capital benefit by a company (paragraph 45B(2)(a));

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

(c) having regard to the relevant circumstances of the scheme, it would be concluded that 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, (other than an incidental purpose) of enabling a taxpayer to obtain a tax benefit (paragraph 45B(2)(c)).

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

A scheme has the meaning as provided in subsection 177A(1) of the ITAA 1936. It includes any agreement, arrangement, undertaking, promise, undertaking, scheme, plan or proposal. The sequence of steps undertaken by ACO to transfer the BCO shares to ACO shareholders is a scheme.

A person is provided with a demerger benefit if a company provides the person with an ownership interest in that or another company (paragraph 45B(4)(a) of the ITAA 1936). A person is provided with a capital benefit if the person is provided with an ownership interest in a company (paragraph 45B(5)(a)). To the extent that the provision of an ownership interest is a demerger dividend, it is not a capital benefit (subsection 45B(6)). A demerger dividend is that part of a demerger allocation (ie. the market value of ownership interests provided) that is assessable as a dividend under subsection 44(1) of the ITAA 1936.

A payment to a shareholder out of profits of a company is a dividend, and is assessable to the shareholder as ordinary income under subsection 44(1) of ITAA 1936. In the present case, the distribution of BCO shares was treated as a dividend wholly out of retained earnings. The distribution of BCO shares is a demerger dividend. Thus it is not a capital benefit. The market value of BCO shares transferred to ACO shareholders is the demerger benefit.

As just noted, the distribution of BCO shares is a dividend and is assessable to ACO shareholder. If demerger relief is granted, the distribution is not assessable and ACO shareholders will obtain a tax benefit.

The relevant circumstances referred to in paragraph 45B(2)(c)) of the ITAA 1936 are outlined in subsection 45B(8).

Relevant circumstances

Appropriate capital and profit allocation

Paragraph 45B(8)(a) concerns the extent to which the demerger benefit or capital benefit is attributable to capital or to profits of the company or of an associate of the company.

BCO shares were worth a minor amount against the enterprise value of ACO when ACO shares were sold. As no amounts can be identified as being contributed by ACO shareholders, apportionment in accordance with relative market values of the two entities is appropriate. On this basis the capital component in the demerger benefit would be insignificant.

Pattern of distributions

Paragraph 45B(8)(b) directs attention to the pattern of distributions of dividends, returns of capital or share premium by the company or by an associate of the company.

ACO had profits and losses in the previous years.

Several dividends had been paid. On 30 June 2007, ACO retained an average balance of cash and cash equivalent assets.

It appears that ACO distributed profits as it had funds surplus to it requirements. It is particularly noticeable that during in 2007 year, efforts were made to distribute profits by way of dividends before ownership of the company changed. It would be expected that the company would retain sufficient fund to enable it to continue the expansion it was undertaking.

There is no evidence that the distribution of BCO shares was an attempt to secure a tax-effective mode of profit distribution by way of dividend substitution.

Shareholders with capital losses

Paragraph 45B(8)(c) is concerned with whether a relevant taxpayer has capital losses that, apart from the scheme, would be carried forward to a later year of income.

No shareholder has a capital loss. This is not a consideration.

Pre-CGT ownership interests

Paragraph 45B(8)(d) directs attention to whether some or all of the ownership interests in the company or in an associate were acquired, or are taken to have been acquired, by the relevant taxpayer before 20 September 1985.

All shares were acquired after 20 September 1985. This is not a consideration.

Residency of owners of the head entity

Paragraph 45B(8)(e) requires consideration of whether the owners of the head entity are non-residents.

All shareholders are residents for Australian income tax purposes.

Cost base of the ownership interests

Paragraph 45B(8)(f) directs attention to whether the cost base of a relevant ownership interest is not substantially less than the value of the applicable demerger benefit or capital benefit.

The shareholders had sizeable cost bases. However there is no capital component in the demerger dividend paid by ACO. This is not a consideration.

Distributions of share capital or share premium affecting interests held

Paragraph 45B(8)(h) directs attention to whether the interests held by taxpayers after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital or share premium.

There was no distribution of share capital or share premium. The percentage interests held by all shareholders remains unchanged. This is not a consideration.

Disposal of ownership interests

Paragraph 45B(8)(i) directs attention to whether the scheme 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.

In this case the demerger was a preparatory step for the disposal of ownership interests, so attention needs to be directed to ownership interests provided and any later disposal of those interests, or increases in the value of any ownership interests and the later disposal of those interests.

The ownership interests disposed of were the ACO shares. The book value of ACO (the value of shareholders equity shown in the balance sheet) was slightly more than assets included in cash or cash equivalents. On the other hand, the ACO shares were valued at considerably more when the company was sold. The company owned depreciable assets and the majority of the value of the company was in the goodwill and other intangible assets. Thus the majority of the proceeds from the sale of the shares was attributable to goodwill and other intangibles.

The BCO shares to which the demerger allocation related were not sold. The BCO shares were transferred at their market value which was more or less their original cost. After the demerger, the original owners of ACO retained their original ACO interests and held new BCO interests. The decrease in value of the ACO shares was equal to the value of the BCO shares. There was no transfer of value from or to the ACO shares because of the transfer of the shares.

Transactions between the entity and an associate

Paragraph 45B(8)(j) directs attention to transaction between a demerging entity and a demerged entity. Transactions between ACO and BCO are of minor value compared with ACO's overall operations. This is not a consideration.

Part IVA matters

Paragraph 45B(8)(k) requires regard be had to any of the matters referred to in subparagraphs 177D(b)(i) to (viii) of the ITAA 1936. Many of the relevant circumstances already discussed above in respect of paragraphs 45B(8)(a) to (j) amplify or elaborate on the paragraph 177D(b) matters and to this extent there may be some overlap.

Paragraph 177(D)(b) matters

Subparagraph 177D(b)(i)

Subparagraph 177D(b)(i) refers to the manner in which a scheme is entered into or carried out. The separation was effected by the declaration of a dividend that was funded from the retained earnings of ACO and was equal in value to the shares/options distributed. No amount was debited to the paid up capital account. At the time of the distribution, the dividend was a fully franked dividend. However, the demerger provisions will now be applied with the effect that any dividend will be a non-assessable demerger dividend.

Subparagraph 177D(b)(ii)

Subparagraph 177D(b)(ii) refers to the form and substance of a scheme. The two companies had to be separated in preparation for the sale of the ACO shares. The dividend was declared, the BCO shares were distributed and the shareholders subsequently sold their ACO shares. The essential nature of the scheme is that it separated the two companies. It was a condition that XCO imposed on ACO as part of the takeover.

Subparagraph 177D(b)(iii)

Subparagraph 177D(b)(iii) directs attention to the time at which the scheme was entered into and the length of the period during which the scheme was carried out. The timing and length of the demerger was dictated by XCO. The various parts were undertaken in a logical succession of steps and were completed within an acceptable time span. There was no law change pending. There is nothing that is contrived or artificial about the timing of the transactions.

Subparagraph 177D(b)(iv)

Subparagraph 177D(b)(iv) requires regard be had to the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme. The interpretation of the words 'this Part' are taken to be a reference to 'this section' (see paragraph 92 of Law Administration Practice Statement PS LA 2005/21). This issue is a matter of identifying the tax results of the scheme if section 45B were not to apply. The benefit to be derived by the shareholders is that the demerger dividend of $738,301 would be tax free but this is as a consequence of the operation of the demerger provisions. No other benefits arise from the postponement or the shifting of capital gains or income tax liabilities.

Subparagraph 177D(b)(v)

Subparagraph 177D(b)(v) requires regard be had to 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. The ACO shareholders are provided with a direct interest in BCO which they had previously owned indirectly. As the applicant notes the demerger did not deliver to the ACO shareholders an asset (BCO shares) which they could exchange or use as financial security. Nor did the demerger deliver to the shareholders a liquid asset that is readily exchangeable for cash.

Subparagraph 177D(b)(vi)

Subparagraph 177D(b)(vi) requires regard be had to 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. This is not a consideration.

Subparagraph 177D(b)(vii)

Subparagraph 177D(b)(vii) requires regard be had to any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out.

ACO was a minority shareholder in BCO. ACO and BCO carried on businesses in different locations and industries. The directors of ACO had been considering an expansion of the company's business through raising additional working capital or by way of merger or acquisition. In the end XCO provided a suitable opportunity to expand. There was little synergy between the ACO and BCO businesses and with a minority shareholding BCO was not a suitable fit with ACO. The dispose of the BCO was a precondition to expansion. ACO and BCO continue in existence as viable independent businesses.

Subparagraph l77D(b)(viii)

Subparagraph 177D(b)(viii) requires regard be had to the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi). This is not a consideration.

Conclusion

The rulees were shareholders. Section 45B of the ITAA 1936, if applicable, allows the Commissioner to make a determination that all or part of an allocation they received as a result of the demerger is to be treated as an unfranked dividend in their hands.

The desire to expand the business had existed for some time. Corporate advisors had been engaged to advise on appropriate strategies.

The demerger achieved a splitting of incompatible businesses and the subsequent joining of two complementary businesses. They were complementary in both the services they provided and the geographical areas in which they operated.

Although there was an arrangement to dispose of ownership interests, it does not lead to an adverse conclusion. There was a business case for the demerger. It could be expected that there would be increased opportunities and efficiencies.

A consideration of the relevant circumstances indicates that the requisite purpose of obtaining a tax benefit is not present.

The Commissioner will not make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies as a result of the demerger of BCO from ACO.