Edited version of your written advice

Authorisation Number: 1013099410180

Date of advice: 30 September 2016

Ruling

Subject: Proposed demerger of Company X

Question 1

Will section 125-155 of the ITAA 1997 apply to the Taxpayer as a result of the demerger of Company X?

Answer

Yes

Question 2

Will the Commissioner confirm that he will not make a determination under section 45B(3) or 45C(3) of the ITAA 1936 in respect of the in specie distribution occurring as part of the demerger?

Answer

Yes

This ruling applies for the following periods:

01 July 20XX to 30 June 20YY

The scheme commences on:

The year ended 30 June 20YY

Relevant facts and circumstances

The group structure

General structure

The AAA group is a group of entities consisting of two separate businesses:

● the Australian business (AAA Australia), being:

● The Taxpayer; and

● a subsidiary of the Taxpayer; and

● the European business (AAA Europe), being:

● Company X, a subsidiary of the Taxpayer; and

● Several other subsidiaries of the Taxpayer held through Company X;

None of the entities is a corporation sole nor a complying superannuation entity.

The businesses - AAA Europe and AAA Australia

AAA Australia and AAA Europe both carry on the same business type.

However, they operate in different markets. The opportunity and risk profiles of the two businesses differ.

AAA Europe is seen as a growth business with significant long term growth potential.

The Taxpayer

The Taxpayer was created to hold the entities in both AAA Europe and AAA Australia.

Over X% of the total of the Taxpayer's shares on issue are held by Australian resident shareholders, with the remaining less than Y% being held by non-residents. The entities that own shares in the Taxpayer are collectively referred to below as Shareholders.

The Taxpayer has never paid a dividend.

Possible mergers

The AAA group has been approached by a competitor with a non-binding conditional offer to merge the operations of AAA Australia and the competitor by way of share acquisition.

No binding agreement or term sheet has been entered into, other than an Exclusivity Deed Poll.

There are currently no proposals, offers or plans being discussed or considered in connection with the interests in AAA Europe once it has been separated from the Taxpayer by way of the demerger as outlined below. There is also currently no intention on the part of the Taxpayer, Company X or the Shareholders to in any way deal with their interests in AAA Europe following the demerger should it proceed.

The demerger

Under the demerger:

● The Taxpayer will make an in specie distribution of Z% of its shares in Company X to the Shareholders.

● The number and class of shares which will be transferred to each Shareholder under the demerger will correspond to the proportion and class of share each Shareholder currently holds in the Taxpayer.

● In accounting for the demerger, the Taxpayer will register the distribution in its books of account by:

1. Debiting the share capital account;

2. Debiting the balance of the demerger allocation to a Demerger Reserve; and

3. Crediting the investment in Company X (representing the entirety of the book value of Company X).

The Shareholders' agreement and constitution

There are significant issues with, and restrictions in, the Shareholders' Agreement that make growing the AAA business difficult.

The constitution of the Taxpayer (Constitution) provides that its directors may declare that a dividend is payable and that they may fix the amount, the time for payment, and the method of payment (which may include the transfer of assets) of the dividend.

The in specie dividend will be declared by the board of the Taxpayer pursuant to the Constitution prior to the distribution of the dividend.

Reasons provided for demerger

The reasons provided for the demerger are articulated in the Private Ruling application for the Taxpayer (Application) and are as follows:

(a) there are differences between AAA Europe and AAA Australia in terms of market positioning and growth potential;

(b) capital raising will be significantly easier through a demerged Company X;

(c) business efficiencies, including:

(i) management efficiencies and synergies;

(ii) improved governance efficiencies;

(iii) employee incentives and access to talent;

(iv) reporting;

(v) independence and growth opportunities; and

(vi) cost inflation;

(d) flexibility for future transactions, including merger opportunities;

(c) the proposal for demerging at this point in time is to allow for further European expansion;

(d) there are current issues regarding the Shareholders' Agreement that make growing the AAA business difficult.

Other facts

There has been no transfer of any amount to the Taxpayer's share capital account that resulted in it becoming tainted under section 197-50 of the ITAA 1997.

Assumptions

Immediately after the in-specie distribution, the market value of the assets of the Taxpayer will exceed the total amount (as shown in its books of account) of its liabilities and share capital.

Relevant legislative provisions

Income Tax Assessment Act 1936 (ITAA 1936)

Subsection 6(1)

Section 44

Section 45B

Section 45C

Section 177D

Income Tax Assessment Act 1997 (ITAA 1997)

Section 104-25

Section 104-135

Section 125-55

Section 125-70

Section 125-75

Section 125-155

Reasons for decision

Question 1

Summary

Section 125-155 of the ITAA 1997 will apply to the Taxpayer as a result of the demerger of Company X.

Detailed reasoning

Section 125-155 of the ITAA 1997 provides as follows:

Any capital gain or capital loss a demerging entity makes from CGT event A1, CGT event C2, CGT event C3 or CGT event K6 happening to its ownership interests in a demerged entity under a demerger is disregarded.

The various elements of this provision will be satisfied in this case, as discussed in further detail below.

CGT event A1 happens to the Taxpayer

CGT event A1 will happen to the Taxpayer when it makes an in specie distribution to its Shareholders of its shares in Company X, for the following reasons:

● Subsection 104-10(1) provides that CGT event A1 happens if you dispose of a CGT asset.

● The shares held in Company X are a 'CGT asset' given that they are a 'kind of property' (paragraph 108-5(1)(a)).

● There will be a 'disposal' given that there is change of ownership from the Taxpayer to the Shareholders by the in specie distribution of shares whereby both legal and beneficial ownership of the shares are transferred to the Shareholders.

In this case the capital gain or loss under CGT event A1:

● is made by the Taxpayer as a 'demerging entity' (as defined under subsection 125-70(7)); and

● is made by the Taxpayer from the event happening to its ownership interests in Company X as the 'demerged entity' (as defined in subsection 125-70(6).

None of CGT events C2, C3 and K6 will happen to the Taxpayer in relation to the distribution.

There is a demerger

The conditions for a 'demerger' specified in section 125-70 will be met for the following reasons:

● There is a restructuring of the demerger group under which a member of the group (the Taxpayer) will dispose of Z% of its ownership interests in another member of the demerger group ( Company X) to owners of the original interests in the head entity of the group (the Shareholders): paragraph 125-70(1)(a) and subparagraph 125-70(1)(b)(i).

● Under the restructuring, a CGT event will happen to the Shareholders' interest in the taxpayer, and the Shareholders will acquire a new interest (and nothing else) in Company X: subparagraph 125-70(1)(c)(i). The relevant CGT event in this case would be CGT event G1, which concerns capital payments for shares.

CGT event G1 applies in this case for the following reasons:

● Paragraph 104-135(1)(a) is satisfied.

The Taxpayer will make a payment to the Shareholders in respect of the shares they own: paragraph 104-135(1)(a). This payment is comprised of the in specie distribution of Z% of the Taxpayer's shares in Company X. Under section 104-135, the payment can include giving property.

CGT event A1 does not apply in the manner contemplated under paragraph 104-135(1)(a) since there is no disposal of any share owned by the Shareholders in the Taxpayer.

CGT event C2 does not apply in the manner contemplated under paragraph 104-135(1)(a) since the proposal does not involve an end to the Shareholders' ownership of its shares in the Taxpayer under any of the circumstances prescribed under subsection 104-25(1).

● Paragraph 104-135(1)(b) is satisfied.

There is at least some part of the payment that is not a dividend. 'Dividend' in this regard is defined in subsection 6(1) of the ITAA 1936 to include distributions made by a company to any of its shareholders, but excludes 'property distributed by a company to shareholders…. where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company'. It is proposed that the value of the Company X shares distributed will be partly debited against the Taxpayer's share capital account.

The portion of the distribution debited against the share capital account is not a 'dividend' and consequently paragraph 104-135(1)(b) will be satisfied.

It is also noted that there is no evidence on the facts provided in this case to suggest the existence of an arrangement under subsection 6(4) which provides an exception to the abovementioned rule.

● Paragraph 104-135(1)(c) is satisfied.

The payment will not be included in the Shareholders' assessable income. Part of the payment that is debited to the share capital account is a return of capital; the remaining part will be a 'demerger dividend' which is not assessable income or exempt income: subsection 44(4) of the ITAA 1936.

● The acquisition of new interests by the Shareholders under the proposal will happen only because they own shares in the Taxpayer. The in specie distribution of the Taxpayer's shares in Company X is made only to the Shareholders. Consequently paragraph 125-70(1)(d) will be satisfied.

● The new interests acquired will be the 'ownership interests in a company' (paragraph 125-70(1)(e)(i)), being shares in Company X.

● Neither the original interests (being the Shareholders' shares in the Taxpayer) nor the new interests (the shares they will acquire in Company X) 'are in a trust that is a non-complying superannuation fund': paragraph 125-70(1)(g).

● The requirements of subsection 125-70(2) will be met, thereby satisfying the requirement in paragraph 125-70(1)(h). This is because:

● each Shareholder will acquire the same proportion of shares in Company X as it had in the Taxpayer just before the proposed demerger; and

● just after the demerger, each Shareholder will have the same proportionate total market value of shareholding in the Taxpayer and Company X as it had in the Taxpayer just before the demerger.

The number and class of shares which will be transferred to each Shareholder under the demerger will correspond to the proportion and class of share each Shareholder currently holds in the Taxpayer. Under the proposed restructure, the proportionate market value of the Taxpayer's and other Shareholders' shares in both the Taxpayer and Company X just after the demerger will be the same as that of their original interests in the Taxpayer just before the demerger.

The conditions in section 125-155 will be satisfied upon the demerger and therefore the provision will apply to the Taxpayer.

Question 2

Summary

The Commissioner confirms that he will not make a determination under section 45B(3) or 45C(3) of the ITAA 1936 in respect of the in specie distribution occurring as part of the demerger.

Detailed reasoning

Subsection 45B(3) allows the Commissioner to make a determination in relation to a demerger benefit and a capital benefit. However for this provision to apply, the relevant scheme must fall within the scope of section 45B.

Subsection 45C(3) allows the Commissioner to make further determinations in respect of a capital benefit. The application of this provision is however also conditional upon a determination being made under section 45B. Consequently the relevant scheme to which it is concerned must also fall within the scope of section 45B.

Subsection 45B(2) outlines various conditions for the application of section 45B. It provides as follows:

This section applies if:

(a) there is a scheme under which a person is provided with a demerger benefit or a capital benefit by a company; and

(b) under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with the demerger benefit or the capital benefit, obtains a tax benefit; 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 (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit.

The application of the conditions in each of the above paragraphs is considered below.

Paragraph 45B(2)(a)

'Scheme' is defined in section 995-1 of the Income Tax Assessment Act 1997 as 'any arrangement' or 'any scheme, plan, proposal, action, course of action, or course of conduct, whether unilateral or otherwise'. Being a proposed plan or course of action contemplated by the AAA group,the demerger will be considered a 'scheme' under the terms of the prescribed definition.

The relevant scheme in this case to which section 45B applies is the business restructure that comprises principally of the demerger, but also includes the possibility of a subsequent merger with, or acquisition of, other entities.

The distribution of the Company X shares to the Shareholders will be considered a 'demerger benefit' and a 'capital benefit' for the following reasons:

● A person is 'provided with a demerger benefit' if 'a company provides the person with ownership interests in that or another company': paragraph 45B(4)(a).

Under the terms of the demerger, the Taxpayer will provide the Shareholders with shares in Company X, and will thereby be considered to be provided with a demerger benefit as defined in paragraph 45B(4)(a).

● A person is also 'provided with a capital benefit' if a company provides 'ownership interests in a company to a person': paragraph 45B(5)(a).

Subsection 45B(6) provides that 'a person is not provided with a capital benefit to the extent that the provision of interests, the distribution or the thing done referred to in subsection (5) involves the person receiving a demerger dividend'.

'Demerger dividend' is defined as 'part of a demerger allocation that is assessable as a dividend under subsection 44(1) or that would be so assessable apart from subsections 44(3) and (4)'. Section 44 applies in respect of 'dividends' paid to the shareholder, which in turn is defined in subsection 6(1) to exclude property distributed by a company to shareholders where the amount of the value of the property is debited against an amount standing to the credit of the share capital account of the company.

Not all of the Company X share distribution will be debited against an amount standing to the credit of the Taxpayer's share capital account. The portion of the distribution that is not debited to the Share capital account is a 'demerger dividend”. . This amount cannot be regarded as a 'capital benefit' pursuant to subsection 45B(6).

However, the remaining amount - being the amount of the distribution debited against the Share capital account - will be a 'capital benefit' under the terms of paragraph 45B(5)(a), being ownership interests in Company X that are not demerger dividends.

Paragraph 45B(2)(b)

The meaning of 'obtains a tax benefit' is prescribed in subsection 45B(9) as follows:

A relevant taxpayer obtains a tax benefit if an amount of tax payable, or any other amount payable under this Act, by the relevant taxpayer would, apart from this section, be less than the amount that would have been payable, or would be payable at a later time than it would have been payable, if the demerger benefit had been an assessable dividend or the capital benefit had been an assessable dividend.

As addressed in a separate private binding ruling issued to one of the Shareholders, the Shareholders will be entitled to choose the demerger rollover relief pursuant to section 125-55 of the ITAA 1997 as a result of the demerger of Company X.

This means that, when the rollover choice is exercised under subsection 125-55(1), the Shareholders will obtain a 'tax benefit' since no CGT event will be triggered at the time of the distribution - specifically any capital gains and the cost base adjustments in CGT event G1 under section 104-135 will be ignored on the exercise of the rollover choice; this is compared to the situation in which the distribution is treated as an assessable dividend and brought into account in the year of the distribution.

Paragraph 45B(2)(c)

The relevant circumstances which must be considered in the assessment of whether there exists a more-than-incidental purpose of enabling a taxpayer to obtain a tax benefit are outlined in subsection 45B(8).

They are considered in turn below.

Paragraph 45B(8)(a)

This paragraph prescribes the following 'relevant circumstance':

'the extent to which the demerger benefit or capital benefit is attributable to capital or the extent to which the demerger benefit or capital benefit is attributable to profits (realised and unrealised) of the company or of an associate (within the meaning in section 318) of the company;..'

On the facts of this case:

● The in-specie distribution of Company X shares is a distribution of a capital asset of the Taxpayer which will result in a debit to the Taxpayer's share capital account and to a demerger reserve.

● In this regard, paragraph 15 in TR 2003/8 expresses the following view:

In deciding whether, as a question of fact, a distribution has been made out of profits derived by the company in cases where the distribution is not formally acknowledged as such, a substantive approach should be adopted. There does not need to be a formal debiting of an account of profit of the company. So long as the market value of the company assets exceeds the total amount (as shown in its books of account) of its liabilities and share capital what remains is profits. If the distribution is not debited to share capital the distribution is one of profits.

The above is not determinative of this issue but is taken into consideration as part of the assessment of the scheme as a whole.

Paragraph 45B(8)(b)

This paragraph provides:

'the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or by an associate (within the meaning in section 318) of the company;'

In this regard it is noted that the Taxpayer has never paid dividends to its shareholders.

Paragraphs 45B(8)(c) to (f)

These paragraphs require an examination of the tax characteristics of the particular shareholder in question in determining the relevant circumstances of the scheme.

In this case the precise tax profiles of all the Shareholders are not known. However the following general characteristics of the Shareholders, and the provisions to which they relate, have been noted as follows:

● the Shareholders acquired their interests in the Taxpayer after 20 September 1985: paragraph 45B(8)(d); and

● it is stated as a fact that over X% of the Taxpayer's shares on issue are held by Australian resident shareholders, with the remaining less than Y% being held by non-residents: paragraph 45B(8)(e).

Paragraph 45B(8)(h)

This paragraph requires that regard be had to whether the interest held by the owners of the head entity after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of the share capital.

In this case the ATO view as set out in paragraph 70 of PS LA 2005/21 is that the Shareholders' ownership interests in the Taxpayer will not be altered as a result of the distribution:

In the context of demerger, this circumstance would be limited to demergers where the transfer of ownership interests involves 'distributions' (that is, returns) of share capital or share premium. Ordinarily however, a demerger should not disturb the head entity shareholder's existing ownership interest in the way described, owing to the requirements of the proportion test in subsection 125-70(2) of the ITAA 1997. As a consequence, it is unlikely that this circumstance will have significant relevance for demergers.

Paragraph 45B(8)(i)

Under this provision, if the scheme involves the provision and subsequent disposal of ownership interests, the period for which the ownership interests are held and the time at which the arrangement for the disposal of those shares is entered into are taken into account as relevant considerations.

In this case there is no proposal to dispose of Company X after the demerger. It has also been stated in the facts of this case that there is also currently no intention on the part of the Taxpayer, Company X or the Shareholders to in any way deal with their interests in Company X following the demerger should it proceed.

Paragraph 45B(8)(j)

This provision requires consideration of any profits or assets of the demerging entity that might be attributable to, or acquired under transactions with, associated entities. In PS LA 2005/21, it is stated at paragraph 82 that:

'..this relevant circumstance exposes whether the demerger relief is being used as a device for distributing corporate earnings to owners of the head entity. If it is established that part of the profits or assets of the demerging entity are referable to those of an associate and are not explainable by the demerging entity's need to be a viable, stand-alone entity, this is suggestive of a purpose of enabling a taxpayer to obtain a tax benefit by way of non-assessable dividend…'

There is no evidence on the facts provided that suggests that the profits or assets of the Taxpayer and Company X may be attributable to transactions involving an associate rather than by Company X itself as a viable, stand-alone entity. The AAA Europe business originally operated as a stand-alone business.

There are now commercial reasons for the demerger to allow Company X to operate independently; and Company X is currently in a position to operate as a stand-alone entity.

It is also noted that there is likely to be a service and IP licensing agreement between Company X and the Taxpayer, but that these will be arm's length agreements.

Paragraph 45B(8)(k)

This paragraph requires that regard be had to 'any of the matters referred to in subsection 177D(2)', which are matters prescribed for the purposes of determining the 'dominant purpose' test in Part IVA. In the context of section 45B, however, they are to be applied in determining the 'more than incidental' test specific to the provision.

The factors prescribed in subsection 177D(2) focus on indicia that may reveal the true objectives of the relevant scheme. It is recognised that many of the considerations taken into account under this provision may overlap with those already mentioned above.

The circumstances which the Commissioner considers relevant to the assessment of the scheme in this case, and the corresponding paragraphs in subsection 177D(2) to which they relate, are as follows:

● The manner in which the scheme is carried out (paragraph 177D(2)(a)) is the business restructure which consists primarily of the demerger.

An inquiry into the manner of the scheme is an objective inquiry into the reasons a taxpayer had for entering into it (see paragraph 86 in PS LA 2005/21).

In this regard, the demerger would achieve various commercial advantages:

● it would place Company X and the AAA Europe business in a better position in terms of market positioning and growth potential;

● it would enable capital to be raised for Company X more easily;

● it would result in business efficiencies, including the following:

● management efficiencies and synergies;

● improved governance efficiencies;

● employee incentives and access to talent;

● reporting;

● independence and growth opportunities; and

● cost inflation; and

● it would allow flexibility for future transactions, including the acquisition and merger opportunities for the Taxpayer as mentioned above.

These considerations have a significant bearing on the determination of the purpose for which the demerger is proposed.

● The substance of the scheme (paragraph 177D(2)(b)) can be discerned from its effects:paragraph 88 in PS LA 2005/21. In this respect, this consideration overlaps to some extent with that in paragraph 177D(2)(d), under which regard must be had to the result in relation to the operation of the tax acts that, but for this Part (or section 45B, in this context), would be achieved by the scheme.

The effects of the scheme on the parties to the demerger are primarily the (anticipated) commercial positions of Company X and the Taxpayer following the demerger, as well as the capital benefit or demerger benefit afforded to the Taxpayer and its shareholders.

The question as to whether the capital and demerger benefits are sufficiently outweighed by the commercial objectives of the proposal such that they may be regarded as merely an incidental purpose of the scheme is determined by taking into account the previous and following other considerations.

● The time at which the scheme was entered into is also a relevant consideration under paragraph 177D(2)(c). In respect of the timing of the scheme it is stated in the facts above that

it is based largely or primarily on commercial considerations.

● Paragraphs 177D(2)(e) to (h) require a consideration of the change in the financial position of, or other consequences to, the Shareholders or any person who has a connection with the Shareholders, as a result of the scheme. They also require a consideration of the nature of the relationship between the Shareholders and such a person.

In the present case, the demerger results in the acquisition by the Shareholders of shares in Company X; that is, an asset owned previously by the Taxpayer is now directly owned by the Shareholders, which as stated in PS LA 2005/21 'delivers to the head entity's shareholders an asset which they can liquidate, exchange or use as financial security', being a commercial benefit separate to the tax advantage derived from the scheme.

Upon taking into account the abovementioned circumstances, it is the Commissioner's view that the scheme was not carried out for a more than incidental purpose of enabling a taxpayer to obtain a tax benefit under paragraph 45B(2)(c).

The matters which the Commissioner has considered persuasive in reaching this conclusion are as follows:

● The scheme is driven largely by the various commercial objectives articulated in the Application and mentioned above.

● In particular, the various reasons provided for the demerger and for the timing of the demerger are accepted as business objectives that form the essential purpose of the scheme.

● It is also accepted that even if the scheme were to involve the distinct objective of facilitating a future takeover or merger of the Taxpayer with one or more other entities, this is also contemplated on purely commercial grounds and for commercial reasons.

● The tax benefit obtained by a taxpayer is, on the basis of the submissions provided, merely incidental to the primary purposes of the demerger.

For these reasons, the Commissioner will not make a determination under subsection 45B(3) or 45C(3) in respect of this scheme.