ATO ID 2004/635: Demerger: direct value shift - consequences for demerging entity under Division 725
Date of decision: 16 July 2004
Year of income: Year ended 30 June 2005
Business line: Public Groups and International

Issue
Are there capital gains consequences for a demerging entity under Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) if, under a demerger as defined in section 125-70 of the ITAA 1997, a direct value shift happens as a result of new interests in the demerged entity being issued at a discount?

Decision
No. There are no capital gains consequences for the demerging entity under Division 725 of the ITAA 1997 as a result of the direct value shift that happens under the demerger. The consequences for the demerging entity are instead determined exclusively under Division 125 of the ITAA 1997.

Facts
There are three Australian resident shareholders in Company A, an Australian resident company. Each shareholder is an associate of the other shareholders. Company A is the owner of the only share (a post-CGT share) on issue in subsidiary Company B. Company A has not made a choice to form a consolidated group. Under an arrangement, Company B (the demerged entity) issues shares to the shareholders in Company A (the demerging entity), in the same proportions as their Company A shareholdings. No consideration is to be provided to Company B for the shares. The arrangement satisfies the definition of a demerger in section 125-70 of the ITAA 1997. As a result of the issue of shares at a discount by Company B, there is a reduction in the market value of the share that Company A holds in Company B, resulting in a direct value shift. The conditions set out in section 725-50 of the ITAA 1997 for there to be consequences under Division 725 of the ITAA 1997 as a result of the direct value shift are satisfied.

Reasons for decision
Summary: Sections 125-165 and 125-170 of the ITAA 1997 are specific provisions which determine the consequences for the demerging entity as a result of any value shift, whether indirect or direct (as in this case), which happens under a demerger. This is confirmed by the note to subsection 125-170(2) of the ITAA 1997 which states: The rules in section 125-165 and this section deal with any value shift that might occur under the demerger (emphasis added) and avoid the need for the general value shifting regime to apply. The interpretation is also supported by the explanatory material for New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002 where it is stated at paragraph 15.67 of the revised Explanatory Memorandum: Other cost base adjustment rules do not apply if a CGT asset's reduced cost base is reduced, because of a demerger. Accordingly, the demerging entity Company A will not be required to make cost base and reduced cost base adjustments under Division 725 of the ITAA 1997 and will not make a capital gain under capital gains tax (CGT) event K8 in section 104-250 of the ITAA 1997 as a result of the direct value shift. However, a capital loss that is later realised on the interest that Company A holds in the demerged entity Company B will be reduced to the extent to which it is reasonably attributable to a reduction in value that happens under the demerger (section 125-165 of the ITAA 1997).

Legislative references: Income Tax Assessment Act 1997 section 104-250 Division 125 section 125-70 section 125-165 section 125-170 subsection 125-170(2) Division 725 section 725-50
Related ATO interpretative decisions: ATO ID 2004/636 | ATO ID 2004/637
Other references: Revised Explanatory Memorandum to the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002
Subject references: Capital loss reduction for value shift CGT demerger exemption CGT exemptions Cost base adjustments for value shift Demerger subsidiary