Edited version of your written advice

Authorisation Number: 1012891551094

Date of advice: 14 October 2015

Ruling

Subject: Demerger

Question 1

Can Company X choose to obtain roll-over relief under Subdivision 125-B of the Income Tax Assessment Act 1997 (ITAA 1997) upon the demerger of Company Y by Company Z?

Answer

Yes

Question 2

Can Company Z 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 Z?

Answer

Yes

Question 3

Will the Commissioner confirm that all or any part of the distribution of Company Y shares to Company Z 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 that Act will apply to the whole, or any part, of any benefit provided to the shareholders of Company Z under the proposed arrangement?

Answer

No

Question 5

Will the Commissioner confirm that Division 7A of Part III of the ITAA 1936 will not apply to any distributions made to the shareholders of Company Z under the proposed arrangement?

Answer

Yes

This ruling applies for the following period

Income year ended 30 June 2016

The scheme commences on

1 July 2015

Relevant facts and circumstances

Company Z is the head company of a tax consolidated group comprising a number of wholly owned subsidiaries.

Company Z provides a range of business and commercial services to clients. Company Y operates a business. Company Y only has ordinary shares on issue and is wholly owned by Company Z.

For a variety of commercial reasons it is considered that the demerger of Company Y from Company Z is a desirable strategy to enable both businesses to grow without the hindrance of the other.

There is no intention to sell interests in Company Z or Company Y to third parties other than to facilitate a merger with a smaller business in their industry.

Ownership interest

Company Z has a number of classes of shares on issue, however they are all ordinary shares.

Company Z has a policy of distributing all available profits subject to cash flow restrictions.

No Company Z shareholders acquired their interests before 20 September 1985.

Demerger

The demerger will proceed as follows:

(a) Company Z will make a return of capital and declare a dividend which will be settled by the cancellation of all shares held by Company Z and the issue of new Company Y shares.

(b) The above distributions will be satisfied via the issue of new shares in Company Z to the shareholders of Company Z.

Reasons for the demerger

The reasons for the demerger are as follows:

(a) Company Z and Company Y are fundamentally different businesses operating in distinctly different industries.

(b) The business models of Company Z and Company Y are fundamentally different.

(c) From a commercial perspective both businesses are constrained by the current ownership structure.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 6.

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 109RA.

Income Tax Assessment Act 1936 Section 109L.

Income Tax Assessment Act 1936 Section 177D.

Income Tax Assessment Act 1936 Division 7A.

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

Summary

Company X can choose to obtain roll-over relief under Subdivision 125-B of the Income Tax Assessment Act 1997 (ITAA 1997) upon the demerger of Company Y by Company Z.

Detailed reasoning

1. 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

2. 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 Z as the head entity and includes Company Y as a demerger subsidiary.

3. Company Z will be the head entity because:

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

4. Company Y will be a demerger subsidiary of Company Z because Company Z 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

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

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

• under the restructuring, CGT event G1 will happen to the Company Z shares when the return of capital and dividend distribution is made under the demerger, and Company Z shareholders will acquire new shares in Company Y and nothing else (subparagraph 125-70(1)(c)(i) of the ITAA 1997);

• CGT event C2 will happen upon the disposal of shares in Company Y. Company Y shares will be acquired by Company Z shareholders on the basis of their ownership of shares in Company Z (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 Z nor Company Y are superannuation funds (paragraph 125-70(1)(g) of the ITAA 1997);

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

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

Company Y is the demerged entity 

6. 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.

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

Company Z is the demerging entity

8. 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.

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

Can the Company Z shareholders choose demerger rollover?

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

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

Question 2

Summary

Company Z can disregard under section 125-155 of the ITAA 1997 any capital gain or capital loss arising from CGT event C2 happening to its ownership interests in Company Y upon the demerger of Company Y by Company Z.

Detailed reasoning

12. 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 C2) happening to its ownership interests in a demerged entity under a demerger.

13. In the present case:

• Company Z is the demerging entity,

• CGT event C2 will happen when Company Z disposes of its shares in Company Y and transfers them to the Company Z shareholders (per section 104-10 of the ITAA 1997), and

• this disposal happens under a demerger.

14. Therefore, any capital gain or loss under CGT event C2 made by Company Z on the disposal of its Company Y shares under the demerger will be disregarded (section 125-155 of the ITAA 1997).

Question 3

Summary

The Commissioner can confirm that all of the distribution of Company Y shares to Company Z 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).

Detailed reasoning

Is a dividend paid under the demerger?

15. 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

16. 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).

17. As the capital reduction amount of $50,000 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 Z it will not be a dividend, as defined in subsection 6(1) of the ITAA 1936.

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

Dividend

19. 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 Z 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 Z.

20. 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).

21. 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.

22. In the present circumstances, the dividend paid to the Company Z 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 of that Act will apply to the whole, or any part, of any benefit provided to the shareholders of Company Z under the proposed arrangement.

Detailed reasoning

23. 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.

24. 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).

25. 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.

26. 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).

27. 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

28. 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.

29. In the present circumstances, the following features are considered to constitute the relevant scheme for the purposes of section 45B of the ITAA 1936:

• the transfer of shares in Company Y to the Company Z shareholders under the demerger.

Demerger benefit and capital benefit

30. 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 shareholders of Company Z constitutes a demerger benefit.

31. 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 Z shareholders.

Tax benefit

32. 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.

33. As a result of the demerger, the Company Z 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 Z shareholders on the demerger would be higher if the demerger benefit was an assessable dividend. Accordingly, Company Z shareholders will obtain a tax benefit for the purposes of section 45B.

More than incidental purpose

34. Given that the proposed demerger is a scheme that provides a tax benefit to the Company Z 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.

35. 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.

36. 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).

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

38. 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 benefits provided under this scheme, it is considered that they appropriately reflect a return of share capital to the Company Z shareholders.

39. In the present circumstances, the allocation will be made between capital and profits on the basis of returning the share capital invested by Company Z in Company Y to shareholders with the excess being a dividend from the unrealised profit (increase in value of the Company Y business). For the purposes of this Ruling request it is accepted that this reasonably reflects the circumstances of the demerger.

40. 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 Z has a policy of distributing all available profits subject to cash flow restrictions. The difference in profits distributed compared to total profit is mostly attributable to a build-up in work in progress and uncollected debtors. There is nothing to suggest that the present distribution is in substitution for a dividend.

41. 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 stated that the proposed scheme of the demerger does not involve the later disposal of ownership interests.

45B(8)(k) Part IVA matters

42. 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.

43. 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.

44. 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.

45. If, on the one hand, reference to the matters in subsection 177D(2) 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.

46. 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(2)(a) Manner

47. 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.

48. Given the commercial reasons for the demerger outlined in the application, it is considered that the essential object of the proposed demerger is to produce changes and improvements to the business structures of Company Y and V. Therefore, the tax benefit that Company Z 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.

177D(2)(b) Form and substance

49. Subparagraph 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.

50. The applicant has argued that the commercial benefits of the scheme post demerger are significant as Company Z and Company Y are fundamentally different businesses operating in distinctly different industries. For example, the businesses operate under separate regulatory frameworks and have separate management structures and business models. 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.

45B(8)(k) conclusion

51. Taking into account the matters referred to in paragraphs 177D(2)(a) to (h) of the ITAA 1936, it is considered that the tax free aspect of the transfer of ownership interests in Company Y to the Company Z shareholders is an incidental object of the demerger.

Conclusion - Section 45B(8)

52. 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.

Question 5

Summary

The Commissioner can confirm that Division 7A of Part III of the ITAA 1936 will not apply to any distributions made to the shareholders of Company Z under the proposed arrangement.

Detailed reasoning

53. Division 7A of the ITAA 1936 deals with the circumstances under which certain private company payments will be treated as dividends. Where an amount paid is deemed to be a dividend, the amount becomes assessable to the shareholder or the shareholder's associate.

54. Section 109RA of the ITAA 1936 specifically carves out the application of Division 7A to demerger dividends where section 45B does not apply. In this case, the dividend paid to the Company Z shareholders under the demerger would satisfy the conditions necessary to be a demerger dividend (refer answer to Question 3). Also, section 45B would not apply to the demerger dividend (refer answer to Question 4). Therefore, the demerger dividend is excluded from the application of Division 7A.

55. Subsection 109L(2) of the ITAA 1936 also provides that a private company is not taken under Division 7A of the ITAA 1936 to pay a dividend because of a payment the private company makes to an entity, to the extent that a provision of the ITAA 1936 has the effect that the payment would not be included in the entity's assessable income even though it would otherwise be included.

56. Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined in subsection 6(1) of the ITAA 1936, paid to the shareholders out of profits derived by the company from any source (if the shareholder is a resident of Australia) and from an Australian source (if the shareholder is a non-resident of Australia).

57. The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders. However, paragraph (d) specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the company.

58. As the proposed return of capital is excluded from being assessable as a dividend due to the operation of subsection 6(1) of the ITAA 1936, it is also not assessable under Division 7A of the ITAA 1936 due to the operation of subsection 109L(2) of the ITAA 1936.