Private ruling: Demerger
Date of advice: 5 October 2015
Published: November 2015
Ruling period: Year ending 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Questions and Answers | Will the Commissioner make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 will apply to the whole or any part of the demerger benefit of the shareholders of Company A Corporation Pty Ltd? | No

Relevant facts and circumstances: As part of an acquisition of 50% of Company A by Company B, Company A was required to dispose of all of its ownership interest (shares) in Company C (an Australian private company). The shares were transferred to the shareholders of Company A in proportion to each shareholder's interest in Company A. Company A, the head entity of the demerger group, is an Australian private company that carries on the business Z. Company B is an Australian Securities Exchange (ASX) Listed company that carries on the business of Y. On dd/mm/yyyy, Company B acquired all of the shares held by shareholders in Company A, giving Company B a 50% shareholding in Company A: On dd/mm/yyyy, Company A distributed its Company C shares in specie to the shareholders of Company A immediately before Company B acquired 50% of Company A. This was completed proportionate to the shareholding percentages of the respective shareholders. The demerged entity, Company C carried on (and continues to carry on) business as an X. The business was not seen as being sufficiently synergistic with that of Company B. The total shareholder cost base of the Company A shares immediately before the demerger event was $. At the time of the demerger transaction the market value of the Company C shares distributed to shareholders of Company A was estimated to be $. This reflected the accounting carrying value of the Company C shares in the hands of Company A. Company A debited the market value of the Company C shares wholly against its retained earnings on the basis that it reflected the profits of Company C being paid out to shareholders using the Company C shares as consideration. All of the above entities are Australian tax residents and none of them have carried forward capital losses. Further, all entities continue to hold their shares in Company C. No arrangement has been made for future disposal of the original owners' interests in Company C. Following the demerger, Company C will continue to be a viable, independent entity, which will conduct the same business in its own right. The business has a number of ongoing contracts to provide services to many of Australia's large mining companies. Company A and Company C have, separate management structures post demerger with separate boards and separate executive teams. There is no concentration of assets or profits of the corporate group in the demerging entity beyond that which is explicable by the business restructure. No other connections exist between those persons (relevant taxpayers) and any person referred to in paragraph 177D(2)(f) of the ITAA 1936.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 44(1) | Income Tax Assessment Act 1936 Section 45B | Income Tax Assessment Act 1936 Subsection 45B(1) | Income Tax Assessment Act 1936 Subsection 45B(2) | Income Tax Assessment Act 1936 Paragraph 45B(2)(c) | Income Tax Assessment Act 1936 Subsection 45B(3) | Income Tax Assessment Act 1936 Paragraph 45B(3)(a) | Income Tax Assessment Act 1936 Subsection 45B(4) | Income Tax Assessment Act 1936 Subsection 45B(8) | Income Tax Assessment Act 1936 Paragraph 45B(8)(a) | Income Tax Assessment Act 1936 Paragraph 45B(8)(b) | Income Tax Assessment Act 1936 Paragraph 45B(8)(c) | Income Tax Assessment Act 1936 Paragraph 45B(8)(d) | Income Tax Assessment Act 1936 Paragraph 45B(8)(e) | Income Tax Assessment Act 1936 Paragraph 45B(8)(f) | Income Tax Assessment Act 1936 Paragraph 45B(8)(g) | Income Tax Assessment Act 1936 Paragraph 45B(8)(h) | Income Tax Assessment Act 1936 Paragraph 45B(8)(i) | Income Tax Assessment Act 1936 Paragraph 45B(8)(j) | Income Tax Assessment Act 1936 Paragraph 45B(8)(k) | Income Tax Assessment Act 1936 Subsection 45B(9) | Income Tax Assessment Act 1936 Section 45BA | Income Tax Assessment Act 1936 Section 45C | Income Tax Assessment Act 1936 Subsection 177A(1) | Income Tax Assessment Act 1936 Paragraph 177D(2)(a) | Income Tax Assessment Act 1936 Paragraph 177D(2)(b) | Income Tax Assessment Act 1936 Paragraph 177D(2)(c) | Income Tax Assessment Act 1936 Paragraph 177D(2)(d) | Income Tax Assessment Act 1936 Paragraph 177D(2)(e) | Income Tax Assessment Act 1936 Paragraph 177D(2)(f) | Income Tax Assessment Act 1936 Paragraph 177D(2)(g) | Income Tax Assessment Act 1936 Paragraph 177D(2)(h) | Income Tax Assessment Act 1997 Division 125 | Income Tax Assessment Act 1997 Subsection 125-70(2)

Reasons for decision: Summary: Subsection 45B(1) of the Income Tax Assessment Act 1936 (ITAA 1936) states that: The purpose of this section is to ensure that relevant amounts are treated as dividends for taxation purposes if: (a) components of a demerger allocation as between capital and profit do not reflect the circumstances of a demerger; or (b) certain payments, allocations and distributions are made in substitution for dividends. Subsection 45B(1) of the ITAA 1936 provides that the purpose of section 45B of the ITAA 1936 is to ensure that relevant amounts are treated as dividends for tax purposes if the capital and profit components of a demerger allocation do not reflect the circumstances of the demerger, or certain payments, allocations or distributions are made in substitution for dividends. The conditions that must be met in order for section 45B of the ITAA 1936 to apply are set out in subsection 45B(2) of the ITAA 1936: 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. Where the requirements of subsection 45B(2) of the ITAA 1936 are met, subsection 45B(3) of the ITAA 1936 empowers the Commissioner to make a determination under either or both of section 45BA of the ITAA 1936 in relation to a demerger benefit and section 45C of the ITAA 1936 in relation to a capital benefit. The effect of a determination made under paragraph 45B(3)(a) of the ITAA 1936 is that part, or all of a demerger benefit, will be treated as not being a demerger dividend (subsection 45BA(1) of the ITAA 1936). Each of the key terms referred to in subsection 45B(2) of the ITAA 1936 is considered below. Scheme A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided in subsection 177A(1) of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan, or proposal. In particular, a scheme is anything that satisfies any of the terms in the statutory definition. In the present circumstances, it is considered that the transfer of Company C shares under a demerger to Company A shareholders constitutes the relevant scheme for the purposes of section 45B of the ITAA 1936. Demerger benefit and capital benefit Whilst ordinarily a payment to a shareholder out of profits of a company is a dividend, and is assessable to the shareholder as ordinary income under subsection 44(1) of the ITAA 1936, subsection 45B(4) of the ITAA 1936 operates to ensure that the provision of ownership interests to a shareholder under a demerger constitutes the shareholder being provided with a demerger benefit. The distribution of the Company C shares was paid wholly out of retained earnings and thus it is not a capital benefit. The market value of the Company C shares transferred to Company A shareholders is the demerger benefit. Tax benefit Subsection 45B(9) of the ITAA 1936 provides that a taxpayer 'obtains a tax benefit' if an amount of tax payable by that taxpayer would, apart from the operation of section 45B of the ITAA 1936, be less than the amount that would have been payable if the 'demerger benefit' had been an assessable dividend or the capital benefit had been a dividend. As a result of the demerger, X Pty Ltd, Y Pty Ltd, XY Holdings Pty Ltd as trustee for the XY Trust, X as trustee for the X Family Trust and Y as trustee for the Y Family Trust would, apart from the operation of section 45B of the ITAA 1936, receive a demerger dividend equal to the market value of the Company C shares 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 these taxpayers on the demerger would be higher if the demerger benefit was an assessable dividend. Accordingly, these taxpayers will obtain a tax benefit for the purposes of section 45B of the ITAA 1936. Relevant circumstances Given that the proposed demerger is a scheme that provides a tax benefit to the Company A shareholders, the operation of section 45B of the ITAA 1936 turns on the objective purpose test in paragraph 45B(2)(c) of the ITAA 1936. The question is whether it would be concluded that a person who enters into or carries out the scheme does so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit. The purpose does not have to be the most influential or prevailing purpose, but it must be more than an incidental purpose. Paragraph 45B(2) of the ITAA 1936 requires the Commissioner to consider the 'relevant circumstances' of the scheme as set out in subsection 45B(8) of the ITAA 1936. PS LA 2005/21 Application of section 45B of the Income Tax Assessment Act 1936 to demergers provides specific guidance to tax officers regarding the application of this subsection. A consideration of these circumstances determines whether any part of the scheme will be entered into for a purpose, other than an incidental purpose, of enabling the relevant taxpayer (an ordinary shareholder of the taxpayer) to obtain a tax benefit. Each of the circumstances must be considered in order to determine whether or not, individually or collectively, they reveal the existence of the requisite purpose. Paragraph 45B(8)(a) Appropriate capital and profit allocation Paragraph 51 of PS LA 2005/21 states that: Paragraph 45B(8)(a) of the ITAA 1936 directs attention to the composition, as between share capital and profits (realised and unrealised), of the demerger benefit provided to the head entity's owners. If the composition of the demerger benefit is inconsistent with the substance (that is, the capital and profit it is attributable to) this would tend to a conclusion that the requisite purpose exists. Similarly, paragraph 50 states, in part that: Unrealised profits would ordinarily be identified as the accretions to the value of corporate assets from the time of their acquisition. Paragraph 13 of Taxation Ruling TR 2003/8 states, in part, that where the account from which a distribution is made '…does not represent share capital, it would, for subsection 44(1) purposes, represent profits derived by the company…. irrespective of whether or not the account or reserve is termed a "profit and loss" account.' It is further stated in paragraph 13 that: Where a company's assets exceed its liabilities, the excess must represent profits to the extent that it does not represent share capital. …Therefore any account representing the whole or part of such excess, other than the share capital account, is an account of profits. Paragraph 13 identifies an 'asset revaluation reserve' as a potential source of the profit used to distribute property. There was no capital component in the demerger dividend paid by Company A to its owners. Company A debited the market value of the Company C shares wholly against its retained earnings as this transaction was a dividend, being a 'demerger dividend' on the basis that it reflected the profits of Company C being paid out to shareholders using the Company C shares as consideration. Paragraph 45B(8)(b) Pattern of distributions Paragraph 59 of PS LA 2005/21 states, in part, that: When a company accumulates all its profits, a subsequent distribution of profit, if it occurs, is more likely to occur as a single, extraordinary payment. It may in such cases be tempting to seek to secure a tax-effective mode of distribution. There is no credible evidence of a 'no dividend policy' having been adopted by Company A. Company A has not established a regular pattern of payment of dividends to its shareholders. One dividend was paid during the current financial year to prepare the company balance sheet for subsequent acquisition of 50% of Company A by Company B. This factor inclines towards the requisite purpose. In explaining the over-arching purpose of paragraphs 45B(8)(c) to 45B(8)(f), paragraph 60 of PS LA 2005/21 states that: Paragraphs 45B(8)(c) to (f) of the ITAA 1936 require that consideration be given to the tax characteristics of the owners of the head entity and thus to determining the tax effects of the scheme. If the tax characteristics of the owners of the head entity are such as to indicate there is a tax preference for one form of distribution (capital or profit) over another, this may be suggestive of a more than incidental purpose of delivering a tax benefit, particularly if the composition of the distribution does not follow the substance of what was provided. Paragraph 45B(8)(c) Capital losses The relevant taxpayers have no capital losses at the time of the transaction. Paragraph 45B(8)(d) Pre CGT ownership interests Company A and Company C were incorporated after 19 September 1985. Paragraph 45B(8)(e) Residency All the shareholders are residents for income tax purposes. Paragraph 45B(8)(f) Cost base of ownership interests The total shareholder cost base of the Company A shares immediately before the demerger event was $. As there is no capital component in the demerger dividend paid by Company A, the cost base of each relevant ownership interest is not substantially less than the value of the applicable capital component of the demerger benefit or the capital benefit. This factor inclines towards the requisite purpose. Paragraph 45B(8)(g) repealed Paragraph 45B(8)(h) Nature of interest after the demerger Paragraph 71 of PS LA 2005/21 notes that: 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. In this case there has been no distribution of share capital or share premium. Further, the relative interests of each of the shareholders in Company C will not change as a consequence of the demerger. Paragraph 45B(8)(i) Provision of ownership interests and later disposal Paragraph 73 of PS LA 2005/21 states that: 'It is a question of fact whether or not the scheme of demerger involves the later disposal of the ownership interests.' According to paragraph 74: If a demerger is merely a preparatory step for disposal, the moving of the ownership interests to the owners of the head entity in a tax effective way is a key incident of the scheme and thus may be suggestive of a more than incidental purpose of enabling the head entity's owners to obtain a tax benefit. Paragraph 75 suggests, for example, that: …a prearranged disposal of the demerged interest or the interest in the head entity by the head entity's owners, may suggest the demerger was undertaken to transfer corporate assets to the shareholder, rather than restructure the business. The primary purpose of the demerger of Company C from Company A was to facilitate the sale of 50% of Company A to Company B. The original shareholders in Company A remain owners of their Company C shares. No arrangement has been made for future disposal of the original owners' interests in Company C. Paragraph 45B(8)(j) Transactions between entity and associates Paragraph 82 of PS LA 2005/21 suggests that: If it is established that part of the profits or assets of the demerging entity are referrable 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 concentration of assets or profits of the corporate group in the demerging entity beyond that which is explicable by the business restructure. The profits or assets of Company C are explainable by its need to be a viable, stand-alone entity, in the face of the anticipated sale of 50% of Company A to Company B. Paragraph 45B(8)(k) Part IVA matters This factor takes into account the 'dominant purpose' test contained in Part IVA. However, as stated in paragraph 83 of PS LA 2005/21, ' …in the context of section 45B they facilitate the 'more than incidental purpose test' and do not introduce a different purpose test . 'Paragraph 177D(2)(a) In part, paragraph 86 of PS LA 2005/21 suggests that: In considering section 45B of the ITAA 1936, it will be more likely to apply to a demerger where the decision to execute such a restructure cannot be explained by reasons other than the tax-free distribution to shareholders. For example, previous Class Rulings have concluded that section 45B of the ITAA 1997 would not apply where: …it is apparent that a substantial purpose of the demerger was to achieve the geographic separation of two distinct businesses which, following their separation, will apply independent business strategies tailored to their own specific commercial objectives. A further Class Ruling concluded that section 45B did not apply to a separation of two distinct businesses based on: their different asset and risk profiles, their separate management requirements, their different business strategies and their discrete commercial objectives. As part of an acquisition of 50% of Company A by Company B, Company A was required to dispose of all of its shares in Company C. The shares were transferred to the shareholders of Company A in proportion to each shareholder's interest in Company A. Each business continued its business operation independent of each other after the demerger. Paragraph 177D(2)(b) Form and substance Paragraph 88 of PS LA 2005/21states, in part, that: A scheme which takes the form of a demerger scheme is one which accords with the description of a demerger in Division 125 of the ITAA 1997. However, the substance of a scheme is a reference to its essential nature which, in the case of a demerger, would normally be determined from the effects of the scheme on the commercial and economic circumstances of all of the parties involved in the demerger; including the head entity, the head entity's owners, the companies in which the ownership interests are transferred and other members of the corporate group. The substance of the demerger of Company C is that it enabled the Company A shareholders to assume proprietorship control of Company C and ensure that they could carry on that business as an independent and viable entity capable of conducting the business in its own right. The demerger of Company C also satisfied certain preconditions of the Company B offer to purchase and thus facilitated the eventual sale of 50% of Company A to Company B. Paragraph 177D(2)(c) Timing According to paragraph 88 of PS LA 2005/21, this: …includes a reference to the timing of the scheme from the point of view of the scheme's coincidence with events or circumstances beyond the scheme itself. In particular, whether the scheme was designed to take advantage of events or changes of a tax or non-tax nature that were taking place at the time. The demerger of Company C happened on dd/mm/yyyy and 50% of Company A was subsequently acquired by Company B on dd/mm/yyyy. There were no changes or events of either a tax or non-tax nature that this timing would have particularly advantaged. Paragraph 177D(2)(d) Result in relation to the Act but for this Part In part, paragraph 92 of PS LA 2005/21 suggests that: ' …regard must be had to the totality of the scheme's relevant tax consequences, to reliably determine the extent to which the scheme did or did not advantage the shareholders tax-wise .' But for the application of section 45B of the ITAA 1936, the proposed scheme would result in the Company A shareholders receiving a demerger dividend tax free. This is an immediate consequence that prima facie, would point objectively to the requisite purpose of enabling the Company A shareholders to obtain a tax benefit. Paragraph 177D(2)(e) Change in financial position of the relevant taxpayers In considering any change in the shareholders financial position, paragraph 94 of PS LA 2005/21 notes that: Clearly, …a demerger of itself provides the head entity's owners with an ownership interest which, prior to the demerger, was owned by the corporate group and in which they had only the economic interest of an 'underlying owner'. In financial terms, the demerger delivers to the head entity's shareholders an asset which they can liquidate, exchange or use as financial security. Furthermore, depending on the strength of the business outcomes of the demerger, the head entity's owners are likely to be in an improved position in regard to an investment return on their equity interests. The essential benefit to the Company A shareholders' financial position from the proposed scheme is that they will obtain direct ownership of the Company C shares, having received them free of tax via a demerger dividend that is neither assessable income nor exempt income. The acquisition by way of direct ownership free of tax represents an advantage to the Company A shareholders' financial position. Paragraph 177D(2)(f) Any change in financial position of any person other than the relevant taxpayers Paragraph 95 of PS LA 2005/21 notes that: It is not likely…that parties connected with the head entity's owners that are not members of the group would be affected financially as a result of the restructure. But perhaps the group's creditors, if not considered too remote from the head entity's owners, might also be included in the class of persons covered by this subparagraph. There is no evidence to suggest that the business operations of Company A or Company C will be altered. Upon the demerger happening the activities of both entities will, without evidence supporting otherwise, remain as they are pre demerger. Company C will continue to operate as an X and Company A will continue to provide Z. Given the lack of change in the business operations of Company A and Company C post demerger, this factor would point toward a more than incidental purpose of obtaining a tax benefit. Paragraph 177D(2)(g) Any other consequence for the relevant taxpayers or any other person Whilst paragraph 100 of PS LA 2005/21 states, in part, that: 'It is not feasible to devise an exhaustive list of such changes', it is noted that: For example, a demerger that divides a public company business into two discrete corporate enterprises would be expected to incur changes to infrastructure, personnel and operations of a kind unlikely to occur in a simple demerger of a private company business aimed at concentrating or rationalising its management and control. Company A and Company C will have separate management structures post demerger with separate boards and separate executive teams. Company B requested that Company A dispose of its interest in Company C as a condition of sale as it did not add value to its core operations and brought an element of risk that Company B did not want to entertain. The Company A shareholders were not going to receive any value for Company C under the Company B acquisition proposal and therefore demerged the business from the Company A business. The separation of the two businesses enabled compliance with the conditions of sale of 50% of Company A to Company B. Paragraph 177D(2)(h) Connection between the relevant taxpayers and any person referred to in (f) above Paragraph 101 of PS LA 2005/21 states that: Subparagraph 177D(b)(viii) [now paragraph 177D(2)(h) of the ITAA 1936 requires consideration of the nature of any connection (whether of a business, family or other nature) between the head entity's owners and any person referred to in subparagraph (vi) [now paragraph 177D(2)(f)]- ordinarily that would be the members of the demerging group of companies. The connection between the head entity's owners and members of the group is essentially the relationship of shareholder and company, the significance of which for tax purposes is defined by the principle that a distribution of corporate profit is assessable income of the shareholder. Indeed, the requirement for demerger to preserve the economic substance of the relationship between the group and its underlying ownership forecloses its use as a means to make provision for shareholders individually. There are no other connections exist between those persons (relevant taxpayers) and any person referred to in paragraph 177D(2)(f) of the ITAA 1936. | Detailed Reasoning - Conclusion: Having regard to the relevant circumstances of the scheme set out in subsection 45B(8) of the ITAA 1936, it would not be concluded that any of the parties to the scheme entered into or carried out the scheme for more than an incidental purpose of obtaining a tax benefit in the form of a demerger benefit and a capital benefit. It follows that the tax benefit, whilst substantial, is an outcome that occurs incidentally to the commercial purposes. Accordingly, the Commissioner will not make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the 'demerger benefit' provided under the proposed scheme.