Private ruling: Application of demerger relief and section 45B of proposed demerger of SubCo from HeadCo
Date of advice: 28 June 2016
Published: October 2016
Ruling period: Years ending 30 June 20XX and 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: If Shareholder chooses to obtain the demerger rollover, is any capital gain arising to him or her pursuant to step 3 of the proposed transaction disregarded under section 125-80 of the Inco me Tax Assessment Act 1997 ? | A1: Yes | Q2: Will Shareholder's cost base in their newly-issued shares in SubCo be the same as the cost base for their shares in HeadCo? | A2: Yes | Q3: Is any dividend paid to Shareholder as a result of the demerger not assessable and not exempt under subsections 44(3) to (5) of the Income Tax Assessment Act 1936 (Cth)? | A3: Yes | Q4: Will section 45B of the Income Tax Assessment Act 1936 (Cth) apply to the demerger? | A4: No | Q5: Will section 109RA of the Income Tax Assessment Act 1936 (Cth) apply to prevent any demerger dividend from being a dividend to which Division 7A applies? | A5: Yes

Relevant facts and circumstances: Background Entities • HeadCo holds a shareholding of between 20% and 50% in SubCo. • HeadCo's only other asset is a small amount of cash on hand. • SubCo operates a business involving the use of land, plant and employees, from which it derives substantial profits. • SubCo is a private company. There is no established market for its shares. • An individual ('Shareholder') holds less than 10% of the shares in HeadCo. • Shareholder does not have any capital losses or carried-forward tax losses. HeadCo's influence over SubCo, and the influence of HeadCo shareholders • HeadCo's shareholding in SubCo allows HeadCo to exercise a degree of control over SubCo, including holding a veto over the decisions of the board. • The voting power of HeadCo shareholding in SubCo is exercised as a block by the directors of HeadCo, none of whom are also directors of SubCo. • Shareholders in HeadCo have no say in how HeadCo votes in relation to SubCo, unless they were to organise to vote to replace the directors of HeadCo. However, the two directors of HeadCo, along with their related entities, control between 40% and 50% of the units, making their removal as directors highly unlikely. • In particular, shareholders of HeadCo who are in a minority in relation to a particular decision in relation to SubCo have no influence at all, despite the fact that their shares effectively represent an investment in a specific number of shares in SubCo. Current management issues • The directors of HeadCo effectively act as a second board of directors for SubCo, preventing the actual directors of SubCo from applying their own judgment to business decisions in relation to SubCo. • It is generally recognised as unhealthy for one shareholder in a widely-held company to hold a stake which allows them to exercise significant control without actually buying out the entire company. This is reflected in the prohibition in the Corporations Act 2001 (Cth) on anyone acquiring such an interest in listed companies and companies with more than 50 shareholders. • SubCo has fewer than 50 shareholders. While the Corporations Act's prohibition on a shareholder acquiring a substantial interest does not apply, the underlying principle is nonetheless engaged. This is demonstrated by a series of ongoing conflicts between the directors of HeadCo and other shareholders and the directors of SubCo. • Conflicts exist or have occurred in relation to the appointment of directors, capital raising, expansion, of the business and alterations of the company's constitution. • Furthermore, there is an ongoing conflict between the board of SubCo and the directors of HeadCo over SubCo's dividend policy: the board of SubCo wishes to retain profits for use in the business, while the directors of the HeadCo wish for SubCo to continue to distribute its profits and rely on debt finance. The board of SubCo are of the opinion that this dividend policy is stifling growth. • The current ownership structure makes it impractical to offer equity in SubCo to key employees in order to attract and retain those key employees. The attraction and retention of employees is important to SubCo's business for reasons including cost efficiency, productivity and customer relationships. The anomalous nature of SubCo's current ownership structure prevents employees from feeling like true owners, which is counter to the objective of an employee equity scheme. Inability to buy back shares to allow HeadCo shareholders to exit their investment • A number of shareholders in SubCo and shareholders in HeadCo have small shareholdings or are elderly, and have expressed a desire to sell out. • However, there is no market for shares in SubCo or HeadCo. • Selling the shares would require a valuation of SubCo to be conducted, the cost of which would be an unfair burden on small shareholders. • Accordingly, the fairest and most efficient way for these investors to exit their investment would be for SubCo to conduct a voluntary buy back of their shares, with SubCo bearing the cost of the necessary valuation. • The current structure unfairly cuts the shareholders in HeadCo out of this opportunity. Proposed transaction • HeadCo will distribute the shares it holds in SubCo to its shareholders in-specie, as a return of paid-up share capital.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 6. | Income Tax Assessment Act 1936 Section 45B. | Income Tax Assessment Act 1936 Section 109RA. | Income Tax Assessment Act 1997 Section 125-70. | Income Tax Assessment Act 1997 Section 125-80. | Income Tax Assessment Act 1997 Section 125-155.

Reasons for decision: Summary: All legislative references are to the Income Tax Assessment Act 1997 (Cth) ( 'ITAA97' ) unless otherwise specified. | Detailed Reasoning - Overview of the relevant law: Demerger relief provides a rollover for CGT purposes so that a parent company can spin out a subsidiary to its owners without triggering a taxing point. Where demerger relief under Division 125 applies, the original owner is entitled to disregard a capital gain arising from their disposal of their original interest in the head entity (Question 1). The original owner's cost base for the new interest they receive in the demerged entity is the same as their cost base for the original interests (Question 2). If a demerger involves the payment of a dividend, it is not assessable and not exempt income (Question 3). However, there is an integrity provision to address the specific risk that a 'demerger' may be manufactured in order to obtain an exemption for the payment of a dividend; this integrity provision is found in section 45B of the Income Tax Assessment Act 1936 (Cth) (Question 4). Furthermore, section 109RA of the Income Tax Assessment Act 1936 (Cth) provides that a demerger dividend is not picked up under Division 7A (which would undo part of the intended benefit of demerger relief), unless section 45B applies, in which case demerger relief is not intended to apply (Question 5). Question 5 is straightforward: if the answer to question 4 is no, then the answer to question 5 is yes, and vice versa. | Detailed Reasoning - Is the transaction a demerger for the purposes of Division 125?: Yes, the transaction is a demerger. It meets the requirements set out in subsections 125-70(1) and (2) as follows: • There is a demerger group, consisting of HeadCo as the head entity and SubCo as a demerger subsidiary. SubCo is a demerger subsidiary because HeadCo owns at least 20% of the shares in it. • There is a restructuring of the demerger group, namely the removal of HeadCo so that the shareholders hold shares in SubCo directly. • Under the restructuring, a member of the demerger group (HeadCo) disposes of at least 80% (actually 100%) of its ownership interests in another member of the demerger group (SubCo) to owners of original interests in the head entity (being the HeadCo shareholders, including Shareholder). • No CGT event occurs for the original owner (Shareholder) in relation to an original interest in the head entity of the group (because they retain their shares in HeadCo) and the original owner acquires a new interest (in SubCo) and nothing else. • The acquisition of the new interests (the shares in SubCo) happens only because the original owners owned shares in the head entity (HeadCo). • The head entity (HeadCo) is a company and the new interests are shares in a company (SubCo). • Neither HeadCo nor SubCo is a non-complying superannuation fund. • Each original owner (e.g. Shareholder) receives interests in the demerged entity (SubCo) in the same proportion as their interests in the head entity (HeadCo) just before the demerger. | Detailed Reasoning - What CGT events occur, and what is the effect of demerger relief on them?: In short, the effect of demerger relief is that any capital gains or losses arising from the proposed demerger are disregarded. Under the proposed transaction, HeadCo shareholders such as Shareholder will each receive shares in SubCo in satisfaction of a return of paid-up share capital declared by HeadCo. This will constitute a payment by HeadCo to those respective shareholders in respect of their shares in HeadCo, which is CGT event G1. This payment will not be a dividend and therefore not otherwise included in the shareholders' assessable income. A taxpayer makes a capital gain from CGT event G1 if the non-assessable component of the payment is more than the share's cost base. However, any capital gain or loss which a HeadCo shareholder such as Shareholder makes under the transaction will be disregarded under subsection 125-80(1) if they elect to obtain a roll-over. CGT event A1 may happen when HeadCo disposes of its shares in SubCo to the HeadCo shareholders. This would result in a capital gain to the extent to which the market value of those shares exceeds their cost base in HeadCo's hands. However, any capital gain or loss which a demerging entity (such as HeadCo) makes from CGT event A1 happening in relation to its ownership interests in a demerged entity (such as the SubCo shares) is disregarded under section 125-155 if they elect to obtain a rollover. | Detailed Reasoning - What is the cost base of the new interests (the SubCo shares) in Shareholder's hands?: Under Division 125, the total of all of the cost bases of the original interests are spread over new interests and remaining original interests based on proportionate market value after a demerger. In this case, since shares in HeadCo were replaced with shares in SubCo, Shareholder's total cost base for the new shares in SubCo will be the same as his total cost base for their shares in HeadCo. | Detailed Reasoning - Is any dividend from HeadCo a demerger dividend?: A dividend is ordinarily assessable income under section 44. However, a 'demerger dividend' is not assessable and not exempt income under section 44(4). The term 'demerger dividend' refers to the part of a 'demerger allocation' that is assessable as a dividend under section 44. A 'demerger allocation' includes, relevantly, the market value of the ownership interests disposed of under a demerger. Therefore, in the context of this ruling, if the distribution of the shares in SubCo by HeadCo to its shareholders was characterised as a dividend, it would be a demerger allocation and therefore a demerger dividend. In the proposed transaction, no dividend is expected to arise. However, if one did arise, it would be a demerger dividend and therefore non-assessable non-exempt income. | Detailed Reasoning - Does section 45B apply?: Section 45B is an integrity provision which applies when a demerger is motivated by the pursuit of the exemption from tax of demerger dividends, rather than any other commercial or business considerations. In particular, section 45B is concerned with: • the structuring of a transaction as a dividend instead of a return of capital, in order to exploit the exemption of demerger dividends while preserving the cost base of shares in the head entity; and • the structuring of a transaction as a return of capital instead of a dividend, in order to soak up capital losses. The point is that the attribution of any property release under a demerger, as between capital and profits, should reflect the extent to which the head entity has retained profits. Section 45B applies where: • there is a scheme under which a 'demerger benefit' or 'capital benefit' is provided by a company (in this case HeadCo); • a taxpayer obtains a tax benefit specifically from the fact that the demerger benefit or capital benefit (as the case may be) is not an assessable dividend; and • having regard to specified factors, it could be concluded that someone entered into the scheme for a purpose (other than an incidental purpose) of allowing a taxpayer to obtain a tax benefit. Both 'demerger benefit' and 'capital benefit' include the provision of an ownership interest such as a share, regardless of whether it is paid for. In this case, the provision of the SubCo shares to Shareholder is therefore both a 'demerger benefit' and a 'capital benefit'. (However, it is not a 'capital benefit' because it is a demerger dividend.) A taxpayer obtains a tax benefit under the proposed transaction, but not from the fact that the provision of the SubCo shares (the demerger benefit/capital benefit) is not an assessable dividend. No retained profits are released. At the start of the scheme, HeadCo has no retained profits; at the end of the scheme, SubCo's retained profits remain intact. When, at some point in the future, SubCo's profits are released, they will still be dividends. The scheme does not give rise to a tax benefit that is relevant for the purposes of section 45B. Even if such a tax benefit were found, the clear purpose of the demerger is to relieve SubCo from the management problems caused by its ownership structure and, incidentally, to allow the HeadCo shareholders to participate in any share buyback that SubCo may enter into. This purpose has nothing, even incidentally, to do with obtaining the exemption of a dividend from tax. Accordingly, section 45B does not apply.