Edited version of private advice

Authorisation Number: 1052170543061

Date of advice: 12 October 2023

Ruling

Subject: Demerger relief

Question 1

Will the shareholder (the Trustee) of Head Co be able to choose to obtain demerger roll-over under section 122-55 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the shareholder of Head Co be required to make a cost base adjustment for the shares held in Head Co under section 125-80 of the ITAA 1997 as a result of the proposed demerger?

Answer

Yes - to the extent that the Trustee's shares in Head Co are not pre-CGT.

Question 3

Will the Commissioner confirm that all, or any part, of the distribution of Demerger Subsidiary shares to the shareholder of Head Co that is a dividend will constitute a demerger dividend, and therefore be neither assessable income nor exempt income pursuant to subsections 44(3) to 44(5) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 4

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

Answer

No

This ruling applies for the following period:

1 July 2023 to 30 June 2024

The scheme commenced on:

1 July 2023

Relevant facts and circumstances

1.    Head Co was established on 22 January 1980 and the sole shareholder is the corporate trustee for the Trust, Trustee.

2.    Demerger Subsidiary was established on 16 March 1981 and is 100% owned directly by Head Co. Demerger Subsidiary is the only entity within the Group that is owned by another company and not directly by the Trustee.

3.    Head Co has X ordinary shares on issue to the Trustee.

4.    Demerger Subsidiary has X ordinary shares on issue to Head Co.

5.    Head Co is the entity that holds the A Business as its core business asset and the operations of this business are run through Head Co.

6.    The investment in Demerger Subsidiary is held on the books of Head Co at the existing $2 of share capital from when the entity was first established. Typically, Demerger Subsidiary pays an annual dividend to Head Co and the dividend is then paid up to the Trustee.

7.    Demerger Subsidiary is the entity that holds B Business and it is run through Demerger Subsidiary.

8.    Until XX XX XX Head Co had one Z class share owned by Individual. As the Group is to demerge Demerger Subsidiary from Head Co, the Z class share was cancelled. The original intent of the Z class share issue was to meet the historical corporation's law requirement that required companies to have at least two shareholders. The Z class share did not have any voting rights or right to receive any dividends from the company. On return of capital, the Z class shareholder was only to receive the original capital that was invested and had no further right to participate in the division of any surplus assets or profits of Head Co.

9.    Regular dividends have been paid from Head Co to the shareholders and Demerger Subsidiary Head Co.

10.  Retained earnings Head Co Pty Ltd

Year Amount

2021 $XXX

2022 $XXX

11.  Head Co to Trust dividends:

Year Dividends

2018 $XXX

2019 $XXX

2020 $XXX

2021 $XXX

2022 $XXX

12.  Retained earnings Demerger Subsidiary

Year Amount

2021 $XXX

2022 $XXX

13.  Demerger Subsidiary to Head Co dividends

Year Dividends

2018 $XXX

2019 $XXX

2020 $XXX

2021 $XXX

2022 $XXX

14.  The Group seeks to have a corporate structure which is flat in nature and this is reflective of all of the other assets and company structure within the group. The demerger of Demerger Subsidiary from Head Co will have commercial advantages for the group being that it will have a consistent ownership structure. It will also give the group flexibility should it seek to divest any of its companies or assets in the future. It is unknown to the current Directors as to the reason why Demerger Subsidiary was incorporated as a subsidiary of Head Co, as it serves no commercial benefit to the group to have this structure.

15.  The operations of Head Co and Demerger Subsidiary are currently separate and following the demerger will continue to be separate. The management of the individual businesses will not change following the demerger.

16.  As at XX XX XX, business valuations for Head Co and Demerger Subsidiary were obtained from an independent expert accounting report. It is management's opinion that the relative market values of the entities remain as at the date of this ruling being submitted, to be in accordance with those derived from the comprehensive analysis undertaken in the XX XX XX reports. According to the business valuation reports the enterprise and equity value of the entities as at XX XX XX are as follows:

Entity Enterprise Value Total Equity Value

Head Co $XX $XX

Demerger Subsidiary $XX $XX

Total $XX

17.  The total equity value of Head Co includes the separate book value of Demerger Subsidiary; however, the enterprise values of Head Co and Demerger Subsidiary separately assess the future maintainable earnings of each of the businesses at an EBITDA multiple of 12.

18.  Therefore, the relative market value of Demerger Subsidiary to Head Co under each valuation method is as follows:

Method Calculation Relative Market Value %

Enterprise Value $XX / $XX XX%

Equity Value $XX / $XX XX%

Relative market % for demerger purposes XX%

19.  The investment of Demerger Subsidiary is not held on the books of Head Co at market value, but rather the original contributed capital of $2. In order to be able to split the share capital of Head Co respectively using the relative market value method, it is proposed that prior to the demerger taking place Head Co will issue an additional 98 shares to the Trust or a nominal number of shares that will allow for the share capital account to be updated proportionately following the transfer of the Demerger Subsidiary shares to the Trust to affect the demerger.

20.  It is proposed that the value of the Demerger Subsidiary shares will be partly debited against Head Co's share capital account.

21.  The market valuations for Demerger Subsidiary and Head Co will be updated just before the demerger and calculations adjusted accordingly.

22.  There are no further changes proposed to the share capital account prior to the demerger and the intent behind the Z class share cancellation and the above issue of 98 shares in Head Co are undertaken such that the demerger of Demerger Subsidiary from Head Co could be undertaken.

23.  The group structure post the proposed demerger as it will relate to the Head Co and Demerger Subsidiary entities will be that the Trustee will hold all of the shares in both Head and Demerger Subsidiary directly.

24.  Head Co's share capital account is not a 'tainted share capital account' as defined in section 197-50 of the ITAA 1997.

25.  Head Co will not make an election under subsection 44(2) of the ITAA 1936.

26.  There is no arrangement to which subsection 6(4) of the ITAA 1936 applies.

27.  50% or more of the CGT assets owned by Demerger Subsidiary will be used in carrying on its business for the purposes of subsection 44(5) of the ITAA 1936.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 subsection 6(4)

Income Tax Assessment Act 1936 subsection 44(2)

Income Tax Assessment Act 1936 subsection 44(5)

Income Tax Assessment Act 1936 section 44

Income Tax Assessment Act 1936 section 45A

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 45C

Income Tax Assessment Act 1997 subsection 104-10(1)

Income Tax Assessment Act 1997 section 104-135

Income Tax Assessment Act 1997 subsection 104-135(3)

Income Tax Assessment Act 1997 subsection 125-55(1)

Income Tax Assessment Act 1997 subsection 125-55(2)

Income Tax Assessment Act 1997 subsection 125-60(1)

Income Tax Assessment Act 1997 subsection 125-70

Income Tax Assessment Act 1997 subsection125-70(1)

Income Tax Assessment Act 1997 paragraph 125-70(1)(a)

Income Tax Assessment Act 1997 paragraph 125-70(1)(b)

Income Tax Assessment Act 1997 paragraph 125-70(1)(c)

Income Tax Assessment Act 1997 paragraph 125-70(1)(d)

Income Tax Assessment Act 1997 paragraph 125-70(1)(e)

Income Tax Assessment Act 1997 paragraph 125-70(1)(g)

Income Tax Assessment Act 1997 paragraph 125-70(1)(h)

Income Tax Assessment Act 1997 subsection 125-70(2)

Income Tax Assessment Act 1997 paragraph 125-70(2)(a)

Income Tax Assessment Act 1997 paragraph 125-70(2)(b)

Income Tax Assessment Act 1997 subsection 125-70(4)

Income Tax Assessment Act 1997 subsection 125-70(5)

Income Tax Assessment Act 1997 subsection 125-70(6)

Income Tax Assessment Act 1997 subsection 125-70(7)

Income Tax Assessment Act 1997 subsection 125-80(1)

Income Tax Assessment Act 1997 subsection 125-80(2)

Income Tax Assessment Act 1997 subsection 125-80(3)

Income Tax Assessment Act 1997 subsection 125-80(5)

Income Tax Assessment Act 1997 subsection 125-80(6)

Income Tax Assessment Act 1997 subsection 125-85(1)

Income Tax Assessment Act 1997 subsection 125-85(2)

Income Tax Assessment Act 1997 Division 197

Income Tax Assessment Act 1997 section 197-50

Reasons for decision

Questions 1 and 2

Summary

The Trustee will be entitled to choose demerger roll-over under section 125-55 of the ITAA 1997.

As there is a mix of pre and post Head Co shares, a consequence of choosing the roll-over under section 125-55 of the ITAA 1997 is that a proportion of the Demerger Subsidiary shares will be deemed to be pre-CGT in accordance with subsections 125-80(5) and 125-80(6) of the ITAA 1997. The cost base of Demerger Subsidiary shares that are not deemed to be pre-CGT, is a reasonable proportion of the cost base of the Head Co shares that were acquired post CGT.

Detailed reasoning

Demerger - CGT roll-over: shareholders

Division 125 of the ITAA 1997 provides roll-over relief for CGT consequences of a demerger.

Subdivision 125-B of the ITAA 1997 sets out the rules and consequences for shareholders. Section 125-55 of the ITAA 1997 sets out the requirements for shareholders to obtain demerger roll-over:

(a)          you own an ownership interest in the company (your original interest); and

(b)          the company or trust is the head entity of a demerger group; and

(c)           a demerger happens to the demerger group; and

(d)          under the demerger, a CGT event happens to your original interest and you acquire a new or replacement interest (your new interest) in the demerged entity

You own an ownership interest in a company

An 'ownership interest' is defined in subsection 125-60(1) of the ITAA 1997. Specifically, under paragraph 125-60(1)(a) of the ITAA 1997, for an interest in a company, it means a 'share' in the company, or an option, right or similar interest issued by the company that gives the owner an entitlement to acquire a share in the company. The term 'share' is defined in subsection 995-1(1) of the ITAA 1997 and includes a share in the capital of the company and includes stock. The Trust owns the ordinary shares in Head Co.

The only ownership interests in Head Co are the ordinary shares that are owned by the Trust. Each of these ordinary shares in Head Co is an 'original interest' for the purposes of section 125-55 of the ITAA 1997.

The company is the head entity of a demerger group

Subsection 125-65(1) of the ITAA 1997 provides that a demerger group consists of the head entity of the group and at least one demerger subsidiary.

A company or trust is a head entity of a demerger group if no other member of the group owns ownership interests in the company or trust (subsections 125-65(3) and (4) of the ITAA 1997).

Broadly, a company or trust is a demerger subsidiary if another company or trust in the demerger group owns or has the right to acquire ownership interests that carry between them the right to receive 20% of any distribution of income or capital or exercise 20% of the voting power of the company (subsection 125-65(5) of the ITAA 1997).

Head Co is the head entity of a demerger group and Demerger Subsidiary the demerger subsidiary: i.e. the demerger group consists of Head Co and Demerger Subsidiary for the purposes of section 125-55 of the ITAA 1997.

A demerger happens

A demerger happens to a demerger group if there is a restructuring of the demerger group (paragraph 125-70(1)(a) of the ITAA 1997) and under the restructuring:

•                     Members of the demerger group dispose of at least 80% of their total ownership interests in the demerged entity to owners of original interests in the head entity of the group, at least 80% of the total ownership interests of members of the demerger group in the demerged entity end and new interests are issued to owners of original interests in the head entity, the demerged entity issues sufficient new ownership interests in itself such that owners of original interests in the head entity own at least 80% of the total ownership interests in the demerged entity, or some combination of the above three processes happens with the effect that members of the demerger group stop owning at least 80% of the total ownership interest owned by members of the demerger group in another member of the group (paragraph 125-70(1)(b) of the ITAA 1997)

A demerged entity is an entity that is a former member of a demerger group if under the demerger that happens to the group, ownership interests in the entity are acquired by shareholders in the head entity of the group if it is a company or unitholders or holders of interests in the head entity if it is a trust (subsection 125-70(6) of the ITAA 1997).

A demerging entity is an entity that is a member of a demerger group just before the CGT event happens, and under a demerger that happens to the group the entity, alone or together with other members of the demerger group, stops owning at least 80% of their total ownership interests in another member of the demerger group including by disposing of the interest to owners of original interests (subsection 125-70(7) of the ITAA 1997).

•                     Whether or not a CGT event happens to an original interest owned by an entity in the head entity of the group, the entity acquires a new interest and nothing else (paragraph 125-70(1)(c) of the ITAA 1997)

•                     The acquisition by entities of new interests happens only because those entities own or owned original interests (paragraph 125-70(1)(d) of the ITAA 1997)

•                     The new interests acquired are ownership interests in a company, if the head entity is a company; or are ownership interests in a trust, if the head entity is a trust (paragraph 125-70(1)(e) of the ITAA 1997).

•                     Neither the original interests nor the new interests are in a trust that is a non-complying superannuation fund (paragraph 125-70(1)(g) of the ITAA 1997).

•                     Each owner (the 'original owner') of original interest in the head entity of the demerger group must acquire the same proportion, or as nearly as practicable the same proportion, of the new interests in the demerged entity as the original owner owned in the head entity just before the demerger (paragraph 125-70(1)(h) and paragraph 125-70(2)(a) of the ITAA 1997).

•                     Each original owner, just after the demerger, must have the same proportionate total market value of ownership interests in the head entity and demerged entity as they owned in the head entity just before the demerger (paragraph 125-70(2)(b) of the ITAA 1997).

A demerger does not encompass an off-market share buy-back that is subject to Division 16K of Part III of the ITAA 1936 (subsection 125-70(4) of the ITAA 1997) or occur where roll-over will be available under another provision of the ITAA 1936 or ITAA 1997 (subsection 125-70(5) of the ITAA 1997).

The term restructuring in paragraph 125-70(1)(a) has its ordinary business meaning, which is the reorganisation of a group of companies or trusts. All steps occurring under a single plan or reorganisation will usually constitute the restructuring. These may include transactions occurring before and /or after the transactions mentioned in paragraph 125-70(1)(b) of the ITAA 1997, and as such must be taken into account in determining whether the conditions in subsections 125-70(1) and (2) of the ITAA 1997 are satisfied.

TD 2020/6 Income tax: what is a 'restructuring' for the purposes of subsection 125-70(1) of the Income Tax Assessment Act 1997, explains that the Commissioner considers all of the facts and circumstances in determining the scope of the restructure for the purposes of the demerger provisions. TD 2020/6 provides that the commercial understanding and the objectively inferred plan for reorganisation will determine which steps or transactions form part of the restructuring of the demerger group.

The objectively inferred purpose of the proposed restructuring is to transfer the ownership of Demerger Subsidiary from Head Co to the Trust. The steps which are integral to achieving that outcome and are considered to satisfy the first element required under a demerger, that is, that there is a restructuring of the demerger group are:

•                     The market valuation of Head Co and Demerger Subsidiary shares.

•                     Part of the proposed market valuation of Demerger Subsidiary shares will be debited to the share capital of Head Co.

•                     Head Co will make an in-specie distribution of Demerger Subsidiary shares to the Trust in proportion to their current shareholdings in Head Co - having regard to the market value of the Head Co and Demerger Subsidiary shares.

All of the above steps in this instance are considered to occur under a single plan of reorganisation - notwithstanding, each step may be considered legally independent of the other (paragraph 3 of TD 2020/6.)

Conclusion

A demerger will happen to the demerger group of which Head Co is the head entity and Demerger Subsidiary the demerger subsidiary as:

•                     the distribution of Demerger Subsidiary shares to the Trustee will effect a restructuring of the demerger group for the purposes of paragraph 125-70(1)(a) of the ITAA 1997;

•                     under the restructuring, Head Co will dispose of a least 80% (i.e.100%) of its ownership interest (shares) in Demerger Subsidiary to the Trustee, being the owner of original interest (shares) in Head Co for the purposes of paragraph 125-70(1)(b) of the ITAA 1997 (Demerger Subsidiary is the demerged entity as the Trustee will receive Demerger Subsidiary shares under a demerger, and Head Co is the demerging entity as it will dispose of 100% of its shares in Demerger Subsidiary to the Trustee under a demerger.);

•                     under the restructuring, a CGT event G1 will happen to Head Co shares (refer to the discussion below), and the Trustee will receive shares in Demerger Subsidiary, being the new interests, and nothing else for the purposes of paragraph 125-70(1)(c) of the ITAA 1997;

•                     the Trustee will receive shares in Demerger Subsidiary solely on the basis of their shareholding in Head Co for the purposes of paragraph 125-70(1)(d) of the ITAA 1997;

•                     Head Co is a company and the new interests acquired, being Demerger Subsidiary shares, are ownership interests in a company for the purposes of paragraph 125-70(1)(e) of the ITAA 1997;

•                     neither Head Co nor Demerger Subsidiary is a trust that is a non-complying superannuation fund for the purposes of paragraph 125-70(1)(g) of the ITAA 1997;

•                     the Trustee will acquire the same proportion of new interests in the demerged entity (the shares in Demerger Subsidiary distributed to the Trustee) as the proportion of shares they owned in Head Co just before the demerger for the purposes of paragraph 125-70(2)(a) of the ITAA 1997;

•                     just after the demerger, the Trustee will have the same proportionate total market value of shares in Head Co and Demerger Subsidiary as they owned in Head Co just before the demerger for the purposes of paragraph 125-70(2)(b) of the ITAA 1997;

•                     the restructuring will not constitute an off-market share buy-back subject to Division 16K of Part III of the ITAA 1936 for the purposes of subsection 125-70(4) of the ITAA 1997, and

•                     no other roll-over applies in these circumstances for the purposes of subsection 125-70(5) of the ITAA 1997.

A CGT event happens to your original interest and you acquire a new or replacement interest

Under section 104-135 of the ITAA 1997, CGT event G1 happens if:

•                     a company makes a payment to a shareholder in respect of a share they own in the company (other than where CGT event A1 or C2 happens in relation to the share)

•                     some or all of the payment (the 'non-assessable part') is not a dividend or an amount taken to be a dividend under section 47of the ITAA 1936, and

•                     the payment is not included in the taxpayer's assessable income.

For the purposes of CGT event G1 the 'payment' can include giving property and the provision refers to section 103-5.

Section 103-5 provides that:

Giving property as part of a transaction

There are a number of provisions in this Part and Part 3-3 that say that a payment, cost or expenditure can include giving property.

To the extent that such a provision does say that a payment, cost or expenditure can include giving property, use the market value of the property in working out the amount of the payment, cost or expenditure

Broadly, the taxpayer makes a capital gain if the amount of the non-assessable part exceeds the share's cost base: they cannot make a capital loss (subsection 104-135(3) of the ITAA 1997).

In these circumstances:

(a)          Head Co will make a payment to the Trustee in respect of the shares the Trustee owns in Head Co and that payment does not relate to CGT events A1 or C2 happening to the shares as there is no disposal or cancellation of any share owned by the Trustee in Head Co, thereby satisfying paragraph 104-135(1)(a) of the ITAA 1997. This payment comprises the Trustee's portion of the in specie distribution of 100% of Head Co shares in Demerger Subsidiary. Consequently, in this case the transfer of the shares in Demerger Subsidiary by Head Co to the Trustee is a payment for the purposes of CGT event G1.

(b)          There is at least some part of the payment that is not a dividend, thereby satisfying paragraph 104-135(1)(b) of the ITAA 1997. 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 Demerger Subsidiary shares will be partly debited against head Co's share capital account. The portion of the distribution debited against the share capital account is not a dividend.

(c)           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.

(d)          The payment will not be included in the Trust's assessable income, thereby satisfying paragraph 104-135(1)(c) of the ITAA 1997. 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' under subsection 6(1) of the ITAA 1936, being part of the 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)'. A demerger dividend is not assessable income or exempt income: subsection 44(4) of the ITAA 1936.

CGT event G1 will happen in relation to the shares held by the Trustee in Head Co to the extent that Head Co makes a return of capital to the Trustee. However, any capital gain from CGT event G1 happening to pre-CGT shares is disregarded under subsection 104-135(5) of the ITAA 1997.

Consequences

As the conditions in section 125-55 of the ITAA 1997 will be satisfied under the terms of the proposed demerger, the Trustee may choose to obtain a roll-over under that provision.

If the roll-over is chosen, a capital gain or capital loss a taxpayer makes from a CGT event happening under the demerger to an original interest the taxpayer owns is disregarded - including CGT event G1 (subsection 125-80(1) of the ITAA 1997). In this case, the Trustee can also disregard any capital gain as a result of CGT event G1 applying where the shares were acquired before 20 September 1985 (subsection 104-135(5) of the ITAA 1997).

Pre-CGT shares

Pursuant to subsection 125-80(6) of the ITAA 1997, if some of the taxpayer's original interests were acquired before 20 September 1985, the taxpayer is taken to have acquired a reasonable whole number of the new interests before that day, having regard to:

•                     the market values of the original interests and remaining original interests just after the demerger, or an anticipated reasonable approximation of those market values, and

•                     the market values of the new interests just after the demerger, or an anticipated reasonable approximation of those market values.

For example:

Austral Pty Ltd wholly owns Bianco Pty Ltd. A demerger happens where Austral Pty Ltd transfers its shareholding in Bianco Pty Ltd to its shareholders. Just before the demerger,

Rosanna owns 1,000 ordinary shares in Austral Pty Ltd, of which 300 were acquired before 20 September 1985. As part of the demerger, Rosanna acquired 150 Bianco Pty Ltd shares.

The number of Bianco Pty Ltd shares Rosanna received that are taken to be acquired before 20 September 1985 is:

300

1,000 × 150 = 45

Broadly, where the Trustee chooses demerger roll-over relief for their pre-CGT Head Co shares, the Trustee is taken to have acquired the corresponding proportion of Demerger Subsidiary shares under the demerger before 20 September 1985.

Post CGT shares

Section 125-80 of the ITAA 1997 requires a taxpayer to re-calculate the cost base for each post-demerger interest a taxpayer owns.

Post CGT shares

Section 125-80 of the ITAA 1997 requires a taxpayer to re-calculate the cost base for each post-demerger interest a taxpayer owns.

Under subsection 125-80(1) a capital gain or capital loss that happens to an original interest under a demerger is disregarded - including any capital gain arising from CGT event G1.

Under subsection 125-80(2) of the ITAA 1997:

If you choose the roll-over, the first element of the cost base and reduced cost base of:

(a) each new interest that you are not taken to have acquired before 20 September 1985, and

(b) if not all of your original interests ended under the demerger - each of your remaining original interests that you acquired on or after 20 September 1985,

is such proportion of the sum of the cost bases of all your original interests that you acquired on or after 20 September 1985 (worked out just before the demerger) as is reasonable having regard to the matters specified in subsection (3).

To the extent that the Trustee's shares in Head Co are not pre-CGT, the Trustee will be required to make a cost base adjustment for the shares held in Head Co under section 125-80 of the ITAA 1997.

Where the Trustee chooses demerger roll-over relief for their post-CGT Head Co shares, they must recalculate the cost base and reduced cost base of their Head Co and Demerger Subsidiary shares.

The first element of the cost base and reduced cost base of each post-CGT Head Co share and corresponding Demerger Subsidiary share received under the demerger is worked out as follows:

•                     take the sum of the cost bases of the post-CGT Head Co shares (just before the demerger); and

•                     apportion that sum over the post-CGT Head Co shares and corresponding new Demerger Subsidiary shares received under the demerger.

The apportionment of this sum is done on a reasonable basis having regard to the market values (just after the demerger) of the Head Co shares and Demerger Subsidiary shares, or a reasonable approximation of those market values. (Refer to Taxation Determination TD 2006/73 Income tax: demergers: in reallocating the cost bases of ownership interests under a demerger, as required by subsection 125-80(2) of the Income Tax Assessment Act 1997, is there more than one method that produces a reasonable apportionment?).

Question 3

Summary

To the extent that the distribution of Demerger Subsidiary shares to the Trust is a dividend it will constitute a demerger dividend, and therefore be neither assessable income nor exempt income of the Trust pursuant to subsections 44(3) and 44(4) of the ITAA 1936.

Detailed reasoning

Is a dividend paid under the demerger?

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

Capital reduction amount

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

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

Dividend

The definition of a dividend includes any amount distributed or credited by a company to any of its shareholders. Therefore, the distribution by Head Co of Demerger Subsidiary shares will, in part, constitute a dividend of Demerger Subsidiary's shareholder, the Trustee.

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).

Subsection 975-300(3) provides that if a company's share capital account is 'tainted' (as defined in Division 197 of the ITAA 1997), that account is taken not to be a share capital account for most purposes of the income tax legislation (including the definition of 'dividend'). Head Co's share capital account is not tainted.

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, as the above requirements are satisfied, the dividend paid to the Trustee as shareholder of Head Co under the demerger would satisfy the conditions necessary to be a demerger dividend and would therefore be neither assessable income nor exempt income pursuant to subsections 44(3) and 44(4) of the ITAA 1936.

Question 4

Summary

The Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45BA or section 45C will apply.

Detailed reasoning

The purpose of section 45B of the ITAA 1936 is to treat amounts as dividends where either the capital/profit split of a demerger dividend does not reflect the circumstances of a demerger, or certain payments, allocations and distributions are substituted for dividends.

Subsection 45B(2) of the ITAA 1936 sets out when this applies:

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

(b)          under the scheme, a taxpayer ('the relevant taxpayer'), who may or may not be the person provided with the demerger benefit or capital benefit, obtains a tax benefit, and

(c)           having regard to the relevant circumstances of the scheme, it would be (objectively) concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of it did so for a purpose of enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit. The requisite purpose may or may not be the dominant purpose, but does not include an incidental purpose.

The Commissioner may make a determination in writing that section 45BA of the ITAA 1936 applies to all or part of the demerger benefit, or that section 45C applies to all or part of the capital benefit (subsection 45B(3) of the ITAA 1936) In the latter case, the Commissioner may make a further determination under subsection 45C(3) of the ITAA 1936 that all or part of the capital benefit was paid under a scheme for which a non-incidental purpose was to avoid franking credits arising.

The effect of applying section 45BA of the ITAA 1936 is that all or part of the demerger benefit is taken for the purposes of the income tax law not to be a demerger dividend. Where the benefit is the provision of ownership interests, the amount of the demerger benefit is the market value of the interests at the time they were provided. This means that all or part of what would otherwise have been the demerger dividend is brought to tax in the hands of the company's shareholders under subsection 44(1) of the ITAA 1936 as subsections 44(3) and (4) would not apply.

The effect of section 45C of the ITAA 1936 applying to a capital benefit is that the amount of the capital benefit, or part of the benefit, is taken to be an unfranked dividend paid by the company to the shareholder or relevant taxpayer at the time that the shareholder or relevant taxpayer is provided with the capital benefit.

The effect of a determination under subsection 45C(3) of the ITAA 1936 is that on the day the notice of the determination is served in writing on the company, a franking debit of the company arises in respect of the capital benefit. The amount of the debit is the amount of the franking credit on a dividend of an amount equal to the capital benefit or the part of the benefit had the company paid such a dividend at the time it provided the capital benefit, and fully franked it.

A scheme means any arrangement; or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. (Subsection 45B(10) of the ITAA 1936 and subsection 995-1(1) of the ITAA 1997) An arrangement means any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings (section 995-1 of the ITAA 1997).

Subsection 45B(4) of the ITAA 1936 provides that a person is provided with a demerger benefit if in relation to a demerger:

•                     a company provides the person with ownership interests in that or another company; or

•                     something is done in relation to an ownership interest owned by the person that increases the value of an ownership interest (whether or not the same one) owned by the person.

Subsection 45B(5) provides that a person is provided with a capital benefit if:

•                     they are provided with ownership interests in a company

•                     share capital or share premium is distributed to them; or

•                     something is done in relation to an ownership interest that increases the value of an ownership interest (whether or not the same one) that is held by the person.

However, to the extent that the provision of interests, the distribution or the thing done involves the person receiving a demerger dividend, the person is not provided with a capital benefit (subsection 45B(6) of the ITAA 1936).

A relevant taxpayer obtains a tax benefit if an amount of tax payable, or any other amount payable under the income tax law, by the relevant taxpayer would, apart from section 45B of the ITAA 1936, 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 or the capital benefit had been an assessable dividend (subsection 45B(9) of the ITAA 1936).

The relevant circumstances of the scheme that the Commissioner must have regard to in order to determine whether or not the requisite purpose exists include those set out in subsection 45B(8) of the ITAA 1936, paragraphs (a) to (k):

(a)          The extent to which the demerger benefit or capital benefit is attributable to capital or to profits (realised and unrealised) of the company or an associate of the company (within the meaning of section 318). [It is the Commissioner's view that where it is not possible to precisely trace the amount of capital contributed by the head entity's shareholders that is invested in the demerged entity, that amount should be determined in accordance with the relative market value of the demerged entity to the corporate group (Practice Statement PS LA 2005/21, paragraph 57).]

(b)          The pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or an associate.

(c)           Whether the relevant taxpayer has capital losses that, apart from the scheme, would be unutilised (i.e. not utilised according to the meaning of 'utilise' in section 960-20) at the end of the relevant year of income.

(d)          Whether some or all of the ownership interest in the company or in an associate of the company held by the relevant taxpayer were acquired, or are taken to have been acquired, by the relevant taxpayer before 20 September 1985.

(e)          Whether the relevant taxpayer is a non-resident.

(f)            Whether the cost base of the relevant ownership interest is not substantially less than the value of the applicable demerger benefit or capital benefit.

(g)          repealed

(h)          If the scheme involves the distribution of share capital or share premium - whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital or share premium.

(i)            If the scheme involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests:

(i) the period for which the ownership interests are held by the holder of the interests; and

(ii) when the arrangement for the disposal of the ownership interests was entered into

(j)            In the case of a demerger:

(i) whether the profits of the demerging entity and demerged entity are attributable to transactions between the entity and an associate of the entity; and

(ii) whether the assets of the demerging entity and demerged entity were acquired under transactions between the entity and an associate of the entity; and

(k)           Any of the matters referred to in subsection 177D(2).

The matters referred to in subsection 177D(2) of the ITAA 1936 are:

(a)          the manner in which the scheme was entered into or carried out

(b)          the form and substance of the scheme

(c)           the time at which the scheme was entered into and the length of the period during which the scheme was carried out

(d)          the result in relation to the operation of the Act that would be achieved by the scheme, if not for section 45B

(e)          any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme

(f)            any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result, or may reasonably be expected to result, from the scheme

(g)          any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out

(h)          the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f).

Application to the proposed demerger

The definition of 'scheme' is sufficiently broad to encompass the sequence of steps required to carry out the demerger. Under the demerger, Head Co provides the Trustee with ownership interests in a company, being shares in Demerger Subsidiary.

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, but for subsection 104-135(5) of the ITAA 1997, the market value of Demerger Subsidiary shares provided to the Trustee constitutes a demerger benefit.

The provision of 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, but for subsection 104-135(5) of the ITAA 1997, the market value of Demerger Subsidiary shares distributed under the demerger less the demerger dividend is a capital benefit provided to the Trustee.

As a result of the demerger, the Trustee 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 Demerger Subsidiary 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 the Trustee on the demerger would be higher if the demerger benefit was an assessable dividend. Accordingly, the Trustee will obtain a tax benefit for the purposes of section 45B.

It is noted that the Trustee will lose the benefit of the pre-CGT status of the shares under the proposed arrangement as it relates to the issuing of the additional shares - that may otherwise have been retained under a share splitting arrangement (including the potential tax free treatment on the disposal of pre-CGT shares - section 112-25(2) of ITAA 1997 provides that the splitting of a CGT asset into 2 or more assets is not a CGT event: Taxation Determination TD 2000/10 Income tax: capital gains: what are the CGT consequences for a shareholder if a company converts its shares into a larger or smaller number of shares? considers the consequences for a shareholder if a company converts its shares into a larger or smaller number of shares, and amongst other things, explains that the converted shares have the same date of acquisition as the original shares to which they relate (for example, if the original shares were acquired before 20 September 1985 (pre-CGT shares), the converted shares have the same acquisition date)).

It is noted that the Head Co may disregard any capital gain it makes under CGT event A1 on the disposal of Demerger Subsidiary shares to the Trustee that are pre-CGT assets.

Relevant circumstances

Having regard to the relevant circumstances of the scheme as set out in subsection 45B(8) of the ITAA 1936:

•                     Paragraph (a) does not incline for, or against, a conclusion as to the requisite purpose as the proposed demerger will result in a return of capital and a demerger dividend sourced from profits which are considered to be attributable to share capital and profits in accordance with PSLA 2005/21.

•                     Paragraph (b) inclines against the requisite purpose as the history of Head Co evidences a consistent pattern of paying out the majority of its profits to shareholders in the form of dividends, rather than accumulating the profits to be distributed all at once in a tax effective manner.

•                     Having regard to the Trustee's profile, and noting that the Trustee has effectively been the sole shareholder at all times, paragraphs (c) to (f) are neutral, or at most incline only slightly toward the requisite purpose.

•                     Paragraph (h) is not a relevant factor given that the proportion tests in subsection 125-70(2) of the ITAA 1997 would be satisfied in relation to the demerger.

•                     Paragraph (i) does not incline toward the requisite purpose as there is no arrangement for a later disposal of Demerger Subsidiary shares that the Trustee's receive.

•                     Paragraph (j) does not incline for, or against, a conclusion as to the requisite purpose as Head Co has not concentrated assets or profits in Demerger Subsidiary so as to effect a tax-free distribution of assets and profits to the Trustee through their ownership of Demerger Subsidiary shares beyond that required for Demerger Subsidiary to continue carrying on its own businesses in a viable manner. Nor is Head Co to be drained of the resources it needs to continue its remaining businesses in a viable manner.

As for the factors in paragraphs 177D(2)(a) to (h) of the ITAA 1936 referred to in paragraph 45B(8)(k):

•                     The manner in which Head Co proposes to carry out the scheme is to effect a business restructure by means of a demerger of Demerger Subsidiary. There are commercial reasons for the demerger:

-        The distinct differences between the businesses resulting in differing operational and strategic requirements.

-        Asset protection - quarantining risks associated with the other entity

-        Funding, future investment and growth.

•                     The form of the scheme is the steps involved in carrying out the demerger in accordance with the conditions in subsection 125-70(1) of the ITAA 1997. The economic substance of the scheme is that the Trustee will continue to own directly shares in Demerger Subsidiary that they had previously owned indirectly through Head Co, and Head Co will have reduced its share capital proportionately with the relative market value of Demerger Subsidiary. Head Co and Demerger Subsidiary will be able to concentrate on their respective businesses.

•                     Apart from section 45B of the ITAA 1997, the results in relation to the operation of the Act that would be achieved by the scheme are that:

-        The Trustee will be able to choose roll-over in relation to CGT event G1 that happens to their shares under the demerger - noting that any gain may be disregarded as they relate to pre-CGT assets (section 125-55 of the ITAA 1997).

-        The Trustee will not be taxed on the dividend component of the distribution they receive (subsections 44(3) and (4) of the ITAA 1936).

-        The Trustee will receive new pre-CGT interests in Demerger Subsidiary with respect to their pre-CGT shares in Head Co (section 125-80 of the ITAA 1997)

-        Head Co will disregard any capital gain or capital loss on the disposal of Demerger Subsidiary shares under the demerger - noting that there are pre-CGT assets.

•                     The demerger delivers to the Trustee direct ownership of interests in Demerger Subsidiary that they previously owned indirectly through Head Co, in theory leaving them in the same economic position as before. In practice, direct ownership of the Demerger Subsidiary shares provides the Shareholders with a choice to dispose of or exchange the shares or use them as a financial security.

•                     The demerger will result in a diminution of Head Co's assets, as it will cease to own 100% of Demerger Subsidiary shares.

•                     The nature of the relevant connections are the relationships between Head Co and the Trustee is that the Trustee is a shareholder - the significance of the relationship for income tax purposes is that distributions of Head Co's profits are assessable income of its shareholders. The proposed demerger will preserve the economic substance of these relationships. It will not make special provision for some shareholders as against others: rather, it will provide benefits to the Trustee in proportion to their shareholding.

Conclusion

Taking into account the relevant circumstances above, there are undoubtedly tax benefits to the Trustee (particularly in preservation of the pre-CGT status of Demerger Subsidiary shares), the main reasons for carrying out the demerger are commercial in nature.

Given the commercial reasons for the demerger, it is considered that an essential object of the proposed demerger is to achieve the separation of each business for the commercial reasons outlined above. Therefore, the tax benefit that the Trustee would receive is an incidental object of the demerger: 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.

Accordingly, the Commissioner will not make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA applies in relation to the demerger benefit identified above, and will not make a determination under paragraph 45B(3)(b) that section 45C applies to the capital benefit identified above. Since no determination will be made under paragraph 45B(3)(b), it follows that the Commissioner will make no additional determination under subsection 45C(3).