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Ruling

Subject: Proposed demerger of Company Z by Company Y

Question 1

Will the Commissioner of Taxation (the Commissioner) confirm that as a shareholder of Company Y, Shareholder C will be entitled to choose demerger rollover relief pursuant to section 125-55 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the Commissioner confirm that, should Shareholder C choose demerger rollover relief, they will be taken to have acquired the shares in Company Z they receive under the restructure on the same date as they acquired their corresponding shares in Company Y?

Answer

Yes

Question 3

Will the Commissioner confirm that all or any part of the in specie distribution of Company Z shares to Shareholder C that is a dividend will constitute a demerger dividend, and therefore be neither assessable income nor exempt income for the purposes of subsections 44(3) and 44(4) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No, due to the operation of section 45B of the ITAA 1936, the Company Z shares Shareholder C would receive under the proposed scheme will not constitute a demerger dividend that is neither assessable income nor exempt income.

Question 4

Will the Commissioner confirm that section 45B of the ITAA 1936 would not apply to treat any part of the demerger allocation as assessable?

Answer

If the scheme were to go ahead as proposed, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the whole, or part, of the 'demerger benefit' provided under the proposed scheme.

Question 5

Will Part IVA of the ITAA 1936 apply to the proposed demerger?

Answer

No, however, Part IVA of the ITAA 1936 could still apply to a different scheme, for example, a wider arrangement that involves the sale of the Company Z shares by Shareholder C subsequent to the proposed demerger.

Question 6

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

Answer

Yes

Facts

Overview:

The scheme that is the subject of this ruling involves the proposed demerger of Company Z by Company Y.

Company Y

Company Y is the head company of a consolidated group for tax purposes.

Company Y has ordinary and other classes of shares on issue.

Shareholder C is a Company Y shareholder.

Shareholder C owns ordinary and other classes of shares in Company Y that were acquired before 20 September 1985.

Company Z

Company Z is a wholly-owned subsidiary of Company Y.

At the time of the proposed demerger, Company Z will have ordinary and other classes of shares on issue.

All of the shares currently on issue in Company Z are post-CGT.

Proposed demerger of Company Z from Company Y

Company Y proposes to undertake a restructure under which 100% of its shareholding in Company Z will be distributed to the holders of ordinary and other classes of shares in Company Y (Company Y shareholders). Under the proposal, the owners of ordinary and other classes of shares in Company Y will receive ordinary and other classes of shares in Company Z (and nothing else) in the same proportion to their existing shareholding of ordinary and other classes of shares in Company Y.

Accounting for the distribution

In accounting for the proposed demerger, Company Y will register in its books of account the current market value of Company Z by debiting an amount to share capital and the remainder to an asset revaluation reserve.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 6(1).

Income Tax Assessment Act 1936 Section 44.

Income Tax Assessment Act 1936 Section 45B.

Income Tax Assessment Act 1936 Section 45C.

Income Tax Assessment Act 1936 Division 7A.

Income Tax Assessment Act 1936 Section 109L.

Income Tax Assessment Act 1936 Section 109C.

Income Tax Assessment Act 1936 Section 177D.

Income Tax Assessment Act 1936 Section 177F.

Income Tax Assessment Act 1997 Division 125.

Income Tax Assessment Act 1997 Section 125-60.

Income Tax Assessment Act 1997 Section 125-65.

Income Tax Assessment Act 1997 Section 125-70.

Income Tax Assessment Act 1997 Subsection 104-135.

Income Tax Assessment Act 1997 Section 125-80.

Reasons for decision

Question 1

Summary

As a shareholder of Company Y, Shareholder C will be entitled to choose demerger rollover relief pursuant to section 125-55 of the ITAA 1997.

Detailed reasoning

In order for the demerger CGT outcomes contained in Division 125 of the ITAA 1997 to apply to shareholders and members of a company group, 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 Y as the head entity and includes Company Z as a demerger subsidiary.

Company Y will be the head entity because:

no other member of the Company Y group holds ownership interests in Company Y (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 Y could be a demerger subsidiary (subsection 125-65(4) of the ITAA 1997).

Company Z will be a demerger subsidiary of Company Y because Company Y owns ownership interests in Company Z 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 Z (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 Y demerger group because:

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

under the restructuring, CGT event A1 will happen to Company Y and Company Y shareholders will acquire new shares in Company Z and nothing else (subparagraph 125-70(1)(c)(i) of the ITAA 1997);

CGT event G1 will happen to the Company Y shareholders upon the return of capital. Company Z shares will be acquired by Company Y shareholders on the basis of their ownership of shares in Company Y (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 Y nor Company Z are superannuation funds (paragraph125-70(1)(g) of the ITAA 1997);

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

each of the Company Y shareholders will own shares in Company Y and Company Z that (just after the demerger) represent the same proportionate total market value as their Company Y 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 Y shares under the restructure (subsection 125-70(5) of the ITAA 1997).  

Company Z 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 Z is the demerged entity since the Company Y shareholders receive shares in Company Z under a demerger.

Company Y 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 Y is the demerging entity since it disposes of 100% of its shares in Company Z to the Company Y shareholders under a demerger.

Can the Company Y 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 Y 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 Y 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 Y shares when the Company Y shareholders receive Company Z shares under the demerger.

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

Capital gains and cost base adjustments for Shareholder C

Shareholder C is entitled to disregard any capital gain made as a result of CGT Event G1 happening to their Company Y shares as they were acquired before 20 September 1985 (subsection 104-135(5) of the ITAA 1997). This will be the case irrespective of whether they choose demerger rollover.

If Shareholder C chooses demerger rollover:

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

If Shareholder C does not choose demerger rollover:

the first element of the cost base and reduced cost base of those Company Z shares is calculated in accordance with the rules in Division 110 and 112 of the ITAA 1997 to be equal to their market value at the time of the demerger.

Question 2

Summary

If Shareholder C chooses demerger rollover they will be taken to have acquired their Company Z shares they receive under the proposed demerger arrangement on the same date as they acquired their corresponding shares in Company Y.

Detailed reasoning

Section 125-80 of the ITAA 1997 explains the consequences of choosing rollover. In particular, subsection 125-80(5) provides that if you acquired all of your original interests before 20 September 1985, you are taken to have acquired all of your new interests before that day.

As Shareholder C acquired their interests in Company Y before 20 September 1985, if they choose rollover, they will be taken to have acquired the Company Z shares they receive under the proposed demerger on the same date they acquired their corresponding Company Y shares.

Question 3

Summary

The Company Z shares Shareholder C would receive under the proposed scheme will not be a demerger dividend that is neither assessable income nor exempt income pursuant to subsections 44(3) and 44(4) of the ITAA 1936.

Detailed reasoning

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).

In the present circumstances, the capital reduction amount will be debited against an amount standing to the credit of Company Y's share capital account (as that term is defined in section 6D of the ITAA 1936), therefore it will not be a dividend as defined in section 6(1) of the ITAA 1936.

Consequently the capital reduction amount will not be assessable income of the shareholders of Company Y 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 in specie distribution of the Company Z shares will, in part, constitute a dividend of the Company Y shareholders. The total amount of the dividend will be the market value of the Company Z shares at the time of the demerger excluding the amount debited to the share capital account of Company Y.

In general, a dividend satisfied by an in specie 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 Shareholder C under the demerger satisfies the conditions necessary to be a demerger dividend.

Amount not taken to be a demerger dividend

The concept of a demerger dividend however is also subject to the dividend integrity measure in sections 45B to 45D of the ITAA 1936. In particular, section 45BA explains that where a determination is made under paragraph 45B(3)(a), the whole, or part, of the demerger benefit is taken not to be a demerger dividend.

In the circumstances described in the ruling application, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA applies in relation to the whole, or part, of the demerger benefit. As a result, no part of the dividend to be paid to Shareholder C under the demerger would be taken to be a demerger dividend. Shareholder C would therefore be required to include the value of this dividend in their assessable income under subsection 44(1) of the ITAA 1936.

Question 4

Summary

If the scheme were to go ahead as proposed, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA applies to the whole, or part, of the 'demerger benefit' provided under the proposed scheme.

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.

The conditions that must be met in order for section 45B of the ITAA 1936 to apply are set out in subsection 45B(2). Relevantly, that 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).

Each of the key terms referred to in subsection 45B(2) of the ITAA 1936 is considered below.

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. 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, it is considered that the transfer of Company Z shares under a demerger to the Company Y shareholders 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 Z shares provided to the Company Y shareholders constitutes a demerger benefit.

The provision of those Company Z 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 Z shares distributed under the demerger less the demerger dividend is a capital benefit provided to the Company Y 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, Shareholder C would, apart from the operation of section 45B of the ITAA 1936, receive a demerger dividend equal to the market value of the Company Z shares 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 Shareholder C on the demerger would be higher if the demerger benefit was an assessable dividend. Accordingly, Shareholder C 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 Y 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.

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 paragraph 177D(b) of the ITAA 1936, which are included in subsection 45B(8) by virtue of paragraph (k).

45B(8)(a) Appropriate capital and profit allocation

Paragraph 45B(8)(a) of the ITAA 1936 directs attention to the composition of the demerger benefit, as between share capital and profits (realised and unrealised), provided to the head entity's owners. If the composition of the demerger benefit is inconsistent with the substance (that is, the capital and profit it is attributable to) this would tend to a conclusion that the requisite purpose exists.

In the present circumstances, the proposed demerger will result in a return of capital and amounts in excess of this, a demerger dividend sourced from retained earnings.

There is no indication that the components of the demerger benefit, as between paid in capital and profits, have not been properly attributed to each and in that regard, this factor does not incline towards the requisite purpose.

45B(8)(b) Pattern of distributions

Paragraph 45B(8)(b) of the ITAA 1936 directs attention to the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or an associate (within the meaning in section 318 of the ITAA 1936) of the company. The inference here is that an interruption to the normal pattern of profit distribution and its replacement with a distribution under a demerger would suggest dividend substitution.

Relevantly, caution should be exercised when a company has a 'non dividend' policy. When a company accumulates all its profits, a subsequent distribution of profit, if it occurs, is more likely to occur as a single, extraordinary payment. It may in such cases, be tempting to seek to secure a tax-effective mode of distribution.

In the Commissioner's view, the distribution of the dividend that would result from the demerger of Company Z from Company Y is extraordinary when compared with the pattern of dividend distributions made prior to the proposed demerger.

By undertaking a demerger, the Company Y shareholders acquire direct ownership of Company Z and in doing so, secure a tax effective mode of accessing the profits of the company in the form of a demerger dividend that is neither assessable income nor exempt income.

This factor inclines towards the requisite purpose.

45B(8)(c) Capital losses

This circumstance is concerned with whether there is an advantage to the taxpayer in dealing in capital rather than income.

A taxpayer with capital losses may be in a position to offset any capital gain from the subsequent disposal of new ownership interests. Hence a shareholder with sufficient capital losses has the ability to turn the profit distribution into money tax free.

In the present circumstances, the relevant taxpayers do not have any capital losses. Accordingly, this factor does not incline towards the requisite purpose.

45B(8)(d) Pre CGT ownership interests

This circumstance looks at the CGT status of the ownership interest in the head entity, and as a result of the demerger, the CGT status of the ownership interests in the demerged entity. In other words, the decision to deliver ownership interests under a demerger could be influenced by owners of the head entity receiving new pre-CGT interests.

The relevant taxpayers acquired their shares in Company Y prior to 20 September 1985, thus they are considered to be a pre-CGT asset.

Although Company Z was incorporated post-CGT, upon the demerger happening, the Company Z shares will be deemed pre-CGT assets in the hands of the relevant taxpayers by virtue of subsection 125-80(5) of the ITAA 1997. Therefore the relevant taxpayers would receive pre-CGT interests in Company Z, that, but for the demerger, have a post-CGT status when held by Company Y.

Whilst the Applicant has stated that the nature of the assets in Company Z are such that if the Company Z shares were disposed of, it would likely give rise to a CGT Event K6, whether CGT Event K6 arises will be dependant on the relative market values of the assets that were acquired pre 20 September 1985 and post 20 September 1985 at the time of the disposal of the shares. In any event there are still advantages in the shareholders obtaining pre-CGT interests. CGT Event K6 only applies to that proportion of the share interest attributable to post-CGT assets.

Based on the information available, the conversion of the Company Z shares into pre-CGT interests points towards the requisite purpose.

45B(8)(e) Residency

In the present circumstances, all of the relevant shareholders are Australian residents for income tax purposes; therefore this factor does not incline towards the requisite purpose.

45B(8)(f) Cost base of ownership interests

Paragraph 45B(8)(f) of the ITAA 1936 directs attention to whether the cost base (for the purpose of the ITAA 1997) of the relevant ownership interest provided to the head entities owner is not substantially less than the value of the applicable capital component of the demerger benefit or the capital benefit.

The demerger could be influenced by the opportunity to obtain a distribution under a demerger that is subject to the CGT rollover which, but for the concession, would result in a capital gain.

As the relevant taxpayers acquired their shares in Company Y prior to 20 September 1985 this factor is not considered to be relevant to the current situation.

45B(8)(g) repealed

45B(8)(h) Nature of interest after the demerger

This circumstance requires a comparison of the respective interests held by shareholders after the distribution of capital. Ordinarily, this circumstance would not have significant relevance for demergers as, owing to the requirements of the proportion test in subsection 125-70(2) of the ITAA 1997, demerger would not disturb the relevant taxpayers' proportionate interests in the head entity.

In this case the capital interest held by the relevant taxpayer's after the proposed distribution will be the same as the interests would have been if an equivalent dividend had been paid instead of the distribution of share capital.

This factor is not considered to be relevant to the current situation.

45B(8)(i) Provision of ownership interests and later disposal

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; recognising that the proceeds on disposal of such ownership interests provide the equivalent of a cash dividend in a more tax-effective form.

The Applicant has submitted that the proposed scheme of the demerger does not involve the later disposal of either the Company Z or Company Y ownership interests.

On the basis that a disposal is not in contemplation under the scheme, this factor does not incline towards the requisite purpose.

45B(8)(j) Transactions between entity and associates

Paragraph 45B(8)(j) of the ITAA 1936 is stated to apply only to demergers and requires that regard be had to whether the profits and assets of the demerging entity are attributable to or acquired under transactions with associated entities (within the meaning of section 318 of the ITAA 1936). The demerging entity is the entity that provides ownership interests in the demerger entity to the head entity owners (paragraph 81 PS LA 2005/21).

This relevant circumstance elaborates on paragraph 45B(8)(a) of the ITAA 1936, and looks for the concentration of assets or profits of the corporate group in the demerging entity beyond that which would be explicable by a business restructure; the premise being that the demerger is being used to deliver assets or profits tax free to the head entity's owners in the form of an ownership interest. The implication here is that the purpose for the demerger must be more than a mere transfer of property from the corporate group to the head entity's shareholders.

The Applicant advised that some of the profits of Company Y are derived from the business operations of an associate entity (as defined in section 318 of ITAA 1936).

However this circumstances looks at whether there has been a concentration of assets and profit in the demerging entity that can be attributable to that of associates.

In the present circumstances there is no evidence to suggest that there has been a concentration of assets and profit in Company Y in readiness for demerger. Accordingly, this circumstance does not incline towards the requisite purpose.

45B(8)(k) Part IVA matters

This circumstance requires regard to be had to any of the matters referred to in subparagraphs 177D(b)(i) to (viii) 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 paragraph 177D(b) 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 paragraph 177D(b) 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.

177D(b)(i) Manner

As stated in paragraph 87 of PSLA 2005/21, an inquiry into the manner of the scheme is an objective inquiry as to the reasons for entering into it. In the context of the policy intent behind the demerger's measure, 'manner' is examinable from the perspective of the scheme being a business restructure. In considering section 45B of the ITAA 1936, it will be more likely to apply to a demerger where the decision to execute a restructure cannot be explained by reasons other than the tax-free distribution to shareholders.

In the private ruling request the Applicant put forward a number of reasons for undertaking the proposed demerger, each of these are considered in detail below.

Different commercial objectives and imperatives

The Applicant asserts that the businesses housed by Company Y have separate and fundamentally different commercial drivers and objectives. As such, the Applicant submits that the proposed demerger would allow two discrete and two very different businesses to further develop in their own right, having regard solely to their business objectives and with the aim of becoming wholly independent of each other.

The Applicant however has not identified how the proposed demerger would in fact facilitate the development of the businesses in their own right post demerger. Ordinarily when a demerger is said to be undertaken for business efficiency reasons, it is considered that this would be reflected in the structural, financial and personnel changes that would be expected to be made to the entities post demerger, as a means of improving profitability. In the present circumstances there is no evidence to suggest that the proposed demerger will bring about any such changes to either Company Y or Company Z.

Significantly, the reference by the Applicant to the effective separation of two distinct businesses is merely a reference to the legal effect of a demerger, and says nothing about how the business will operate.

Post demerger, the essential nature of the operations of both Company Y and Company Z will remain unchanged. The Applicant has also failed to explain why having the shares in Company Z held directly by the Company Y shareholders will create greater efficiency in conducting the businesses.

Separation of management

The Applicant stated that the proposed demerger would enable the legal ownership to be aligned, with all Company Z shareholders being involved in the management of that business, and with a separate management structure in place for the operations of Company Y.

The Applicant expanded on this in further correspondence in which they asserted that the efficient management of Company Z's business is impeded by the fact that Company Z is a subsidiary of Company Y. The reason for this being that under the present structure it is ultimately the Board of Company Y which must approve the business decisions of Company Z and due to the operations of Company Y, the Company Y Board has less incentive to grow the business of Company Z. Post demerger, the separation of Company Z and Company Y will enable the businesses to be managed in an independent and autonomous manner.

When examining the management structure of Company Y and Company Z pre and post demerger, it is evident that there will be no change in the management of either business that would remove the impediment the Applicant asserts is currently present.

The directors of Company Z are also the directors of Company Y; post demerger, the same directors will continue to be directors of both businesses. Consequently the same directors will approve the business decisions of Company Z post demerger. This is contradictory to the Applicant's assertion that the Company Y Board has less incentive to grow the business of Company Z as the board of directors are and will continue to be, the same for Company Z and Company Y.

There is also no evidence to suggest that a demerger will enable Company Z to be managed in an independent and autonomous manner. The day to day management of Company Z is carried out by members from the management team of Company Y. Post demerger this management structure will not alter, hence the demerger will not bring about a separation of control in the decision making activities of either business that would aid in their development post demerger.

Different risk profiles

The Applicant submits that the business of Company Y and Company Z have fundamentally different risk profiles. Consequently, the Applicant considers that demerging the entities will allow two discrete and very different businesses to further develop in their own right having regard solely to their business objectives and different risk profiles.

Whilst the Applicant has submitted that Company Z and the business of Company Y have different risk profiles, they have not identified how these businesses intend to develop post demerger and what plans they have in place to facilitate this.

Financial benefits

The Applicant stated that the Company Y group is of the view that the current structure may be detrimental in terms of the ability to raise finance going forward as the two businesses have different capital requirements and also distinctly different abilities to raise finance. As such, being owned as they currently are potentially restricts the ability of each business to raise capital on terms that are acceptable and preferred given their different asset bases.

The Applicant also considers that demerging Company Z will allow greater flexibility in financing arrangements for Company Y and post demerger, it is expected that the intercompany arrangements between Company Y and Company Z will cease, and that each entity would be responsible for raising capital separately for their independent purposes.

The desire to raise finance as a means for undertaking the demerger contradicts the Applicant's submission that Company Z and Company Y will be equity funded post demerger. Further, the Applicant has failed to detail what financial requirements may be needed in the future, indicating that obtaining external finance is not a serious consideration in undertaking the demerger.

Asset protection

The Applicant asserts that the separation of Company Y and Company Z by way of a demerger will achieve the objective of creating greater asset protection over the assets of Company Z. As a separately owned entity, Company Z will be in a better position to legally protect ownership of its assets from any claims that may arise as a result of the actions relating to the business activities of Company Y.

However, asset protection is not a matter which will substantially affect the business operations of Company Y or Company Z.

By virtue of the Corporations Act 2001, one of the main benefits of creating a company limited by shares is that the liability of the shareholders will be limited, meaning that, in the case of financial disaster, the shareholders only have to provide funds to the company to the extent of the fully paid-up value of their shares in that company.

Further, it is only in exceptional circumstances that the corporate veil will be pierced, in particular cases involving insolvency and even then, a number of requirements must be satisfied.

It is also noted that a director is similarly liable for the insolvent trading of their company and a director failing to prevent their company from insolvent trading can be ordered to compensate the company. Pre and post demerger the directors of Company Y and Company Z are the same. As a consequence, any asset protection advantage in demerger is marginal, as the same individuals remain potentially liable for the debts of Company Y and Company Z both pre and post demerger.

Flexibility

The Applicant considers that the current structure creates a significant impediment to transacting at the Company Y level as, for example, it restricts a potential sale. As such the proposed demerger would remove this impediment.

The Applicant also submitted that Company Y considers it desirable to have an ownership structure in place that provides it with the maximum flexibility to effect a sale, merger or the like should it choose. The Applicant is of the view that the current structure limits this flexibility.

However, the Applicant also submitted that while this flexibility is sought for potential future transactions, the shareholders in Company Y have no immediate intention of selling their holdings in Company Y or Company Z after the demerger. They are merely focused on establishing an ownership structure that maximizes their flexibility going forward.

Whilst the Company Y shareholders may not have an immediate intention to sell their holdings in Company Y or Company Z, the demerger enables the Company Y shareholders to have interests in two separate businesses and in doing so, achieve pre-CGT status for both Company Y and Company Z.

Allowing the Company Y shareholders to be in a position to deal with their holdings in Company Y and Company Z independently is more directed towards a later disposal than a business restructure.

Conclusion

The lack of evidence to support the business reasons for the restructure points toward the demerger being for a more than incidental purpose of obtaining the tax benefit in the form of the distribution of Company Z shares.

177D(b)(ii) Form and substance

Subparagraph 177D(b)(ii) 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.

The proposed scheme takes the form of a demerger in that it would accord with the steps that satisfy the definition of demerger in section 125-70 of the ITAA 1997. The substance of the scheme, however, does not conform to a business restructure which creates discrete, independent businesses capable of enhancing their purported efficiency.

Post demerger, there is no evidence to suggest that there will be a transformation of Company Y or Company Z into two discrete independent businesses. Objectively, this would indicate that the substance of the proposed scheme is nothing more than the transfer of assets in specie by Company Y to the Company Y shareholders by way of a capital reduction and distribution of profit in the form of a demerger dividend.

The reasons put forward by the Applicant for undertaking a demerger lack substance and fail to identify the commercial benefits that would be expected to flow from a demerger being driven for business efficiency reasons.

Post demerger, Company Z and Company Y will continue to operate under the current management structure.

Based on the facts provided, it is considered that entry into, and the carrying out of the scheme, is not proximate to any significant commercial occasion for Company Y or Company Z. The absence of temporal proximity between the demerger and business alterations is significant as it repudiates the argument put forward by the Applicant that the tax benefit is subordinate to the commercial reasons for undertaking the demerger.

As a consequence of the scheme, the relevant taxpayers will acquire direct ownership in Company Z and will have the ability to deal with these interests separately. More importantly, the substance of the proposed scheme is the receipt by the relevant taxpayers of a tax free distribution of profits by way of a transfer of shares.

This factor points to a more than incidental purpose of enabling the relevant taxpayers to obtain a tax benefit.

177D(b)(iii) Timing

This paragraph references not only time measurement but the timing of the scheme from the point of view of the scheme's coincidence with events or circumstances beyond the scheme itself.

Whilst the Applicant has advised that having an ownership structure in place that will provide maximum flexibility to facilitate a sale, merger or other transaction is desired, they have also provided that a sale or the like is not currently in contemplation.

On the basis a disposal is not in contemplation, the timing of the scheme would incline against the requisite purpose.

177D(b)(iv) Result in relation to the Act but for this Part

But for the application of section 45B of the ITAA 1936, the proposed scheme would result in the relevant taxpayers receiving a demerger dividend free of tax. This is an immediate consequence that prima facie, would point objectively to the requisite purpose of enabling the relevant taxpayers to obtain a tax benefit.

Further, there is also the potential for the tax benefit to be compounded by the fact that the relevant taxpayers will hold the Company Z shares as pre-CGT assets with the advantages that entails. Even if CGT Event K6 is triggered on any later disposal, the relevant taxpayers would be eligible to apply the 50% CGT discount to any gain by virtue of Division 115 of the ITAA 1997.

This factor inclines towards the requisite purpose.

177D(b)(v) Change in financial position of the relevant taxpayers

A demerger provides the head entity's owners with an ownership interest which, prior to the demerger, was owned by the corporate group, and in which, they had only the economic interest of an underlying owner. In financial terms, the demerger delivers to the head entity's shareholders an asset which they can liquidate, exchange or use as financial security.

The essential benefit to the financial position of the relevant taxpayers from the proposed scheme is that they will obtain direct ownership of the Company Z shares, having received them free of tax via a demerger dividend that is neither assessable income nor exempt income.

Given the substantial market value of the Company Z shares in the form of a pre-CGT asset, their acquisition by way of direct ownership free of tax represents a significant advantage to the financial position of the relevant taxpayers.

This factor inclines towards the requisite purpose.

177D(b)(vi) Any change in financial position of any person other than the relevant taxpayers

Relevantly, this matter would cover consideration of the financial changes for the corporate entities involved in the scheme that ordinarily would pertain to, or are consistent with a business restructure. For example, establishing the business independence of the demerged entity would involve the severing of business and financial ties with other members of the Company Y group and revising relations with creditors to disentangle group security arrangements.

Whilst the Applicant has advised that it is expected, post demerger, that the intercompany financing arrangements between Company Y and Company Z will cease, the Applicant has failed to explain how the entities will be funded post demerger, what plans they have in place to raise finance and what finance, if any, the entities will require.

The absence of these changes in the present scheme would point objectively to the tax purpose for the demerger being more than incidental.

177D(b)(vii) Any other consequence for the relevant taxpayers or any other person

Subparagraph 177D(b)(vii) of the ITAA 1936 directs attention to any 'other' consequence of the demerger scheme for the head entity's owners or for any person connected with the head entity's owners.

In the present circumstances it is considered that there are no other consequences for the relevant taxpayers or any other person.

This factor is not considered relevant to the current situation.

177D(b)(viii) Connection between the relevant taxpayers and any person referred to in (vi) above

Subparagraph 177D(b)(viii) of the ITAA 1936 requires consideration of the nature of any connection (whether of a business, family or other nature) between the head entity's owners and any person referred to in subparagraph (vi).

This factor is not considered to be relevant to the current situation.

Determination under paragraph 45B(3)(a) of the ITAA 1997

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 being undertaken for the more than incidental purpose (if not the dominant purpose) of obtaining a tax benefit.

Accordingly, if the scheme were to go ahead as proposed, a determination would be made by the Commissioner under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the 'demerger benefit' provided under the proposed scheme. The effect of such a determination would be that the whole or part of the demerger benefit would be taken to not be a demerger dividend.

The Commissioner would not make a determination under paragraph 45B(3)(b)

The Commissioner would not make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies. The capital reduction amount is not considered to disclose a purpose of making a distribution of share capital in substitution for a dividend. No part of the capital benefit amount could, objectively, be considered to represent a distribution made in substitution for a dividend.

Question 5

Summary

The Commissioner is providing this advice on the basis that Shareholder C is the 'relevant taxpayer' for the purposes of Part IVA of the ITAA 1936. The relevant scheme ruled on for the purpose of Part IVA is the demerger of Company Z from Company Y as outlined in the ruling application (referred to as the 'demerger scheme').

As a determination would be made under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA applies to the whole or part of the demerger benefit obtained by Shareholder C under the 'demerger scheme', a determination would not be made under section 177F of the ITAA 1936 to cancel the tax benefit obtained by Shareholder C under the 'demerger scheme'.

However, Part IVA could still apply to a different scheme, for example, a wider arrangement that involves the sale of the Company Z shares by Shareholder C subsequent to the proposed demerger.

Detailed reasoning

Section 177D of the ITAA 1936 provides that Part IVA applies to any scheme entered into where a taxpayer (referred to as the relevant taxpayer) has obtained, or would but for section 177F obtain, a tax benefit and, after having regard to the matters listed in paragraphs 177D(b)(i) to (viii), it would be concluded that one of the persons who entered into or carried out the scheme did so for the dominant purpose of enabling the taxpayer to obtain a tax benefit from the scheme.

The scheme identified for the purpose of Part IVA of the ITAA 1936 is the 'demerger scheme', being the demerger of Company Z from Company Y. Shareholder C is the 'relevant taxpayer'.

The Commissioner has concluded for the purpose of section 45B(2) of the ITAA 1936 that the 'demerger scheme' is to be undertaken for a purpose, other than an incidental purpose, of enabling a taxpayer (Shareholder C) to obtain a tax benefit. In the context of section 45B, the tax benefit would be the demerger dividend.

Accordingly, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA applies to the whole or part of the demerger benefit obtained by Shareholder C under the 'demerger scheme'.

The corollary of that conclusion which is relevant to the application of Part IVA of the ITAA 1936 is that whilst Part IVA is capable of applying, the Commissioner will not make a determination under Part IVA where he has made a determination that section 45B will apply to the proposed 'demerger scheme'.

However, Part IVA of the ITAA 1936 could apply to an arrangement that includes all or part of the arrangement described in the ruling application. For example, in the event that, subsequent to the proposed demerger, the rulees were to sell their newly-acquired shares in Company Z, Part IVA could apply to a scheme that includes the subsequent sale.

Question 6

Summary

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

Detailed reasoning

Subsection 109L(1) of the ITAA 1936 provides, relevantly, that a private company is not taken under section 109C to pay a dividend because of a payment the private company makes to an entity, to the extent that the payment would be included in the entity's assessable income apart from Division 7A of the ITAA 1997. A payment to an entity for these purposes includes a transfer of property to the entity (paragraph 109C(3)(c) of the ITAA 1936).

Under the proposed arrangement, the Company Y shareholders will receive a demerger benefit in an amount equal to the market value of Company Z shares at the time they are provided (subsection 45B(4) and paragraph 45BA(2)(a) of the ITAA 1936). As the Commissioner would make a determination that section 45BA of the ITAA 1936 applies to the proposed arrangement, no part of this demerger benefit will be a 'demerger dividend' (subsection 45B(1) of the ITAA 1936). It follows that, to the extent that it is paid out of profits, the distribution of shares by Company Y to its shareholders will give rise to assessable dividends under section 44 of the ITAA 1936 and, accordingly, will not attract the operation of Division 7A (section 109L of the ITAA 1936).