Demerger Tax Relief. Martin Fry Partner Allens Arthur Robinson December mafm M v Page 1

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1 Demerger Tax Relief Martin Fry Partner Allens Arthur Robinson December 2002 mafm M v Page 1

2 Demerger Tax Relief The rules for demerger tax relief are primarily contained in Division 125 of the Tax Act 1997 and sections 44 and 45B of the Tax Act The following is a summary of the rules as they apply to corporate entities. 1. Criteria for CGT Relief Demerger tax relief is available for ownership interests (called the original interests) in a company that is the head entity of a demerger group, where: a demerger happens; and under the demerger: the original interests suffer a CGT event; and the holders of the original interests acquire new interests or replacement interests (called the new interests) in the demerged entity. Each of these concepts is discussed below. 1. The ownership interests of a company are: shares; rights to acquire shares. DLC voting shares are ignored, provided there are no more than 5 DLC voting shares and those shares carry no rights to financial entitlements (other than ordinary dividends and returns of capital). 2. A demerger group comprises the head entity and one or more demerger subsidiaries. 3. It is necessary to identify the head entity of the demerger group. A company is the head entity of a demerger group if there are no ownership interests in the head entity held by other members of the demerger group. This requirement effectively means that a company cannot be the head entity of a demerger group if that company is in fact a demerger subsidiary, ie because an entity owns more than 20% of the shares in that company (refer to the definition of demerger subsidiary next). However there is a concession that can be applied when selecting listed public companies to be the head entity of a demerger group. The concession allows listed public companies to ignore entities which hold (alone or together with others) more than 20% but less than 80% of the shares in that listed public company. mafm M v Page 2

3 By taking advantage of the concession, a listed public company can choose to be the head entity of a demerger group despite the fact that other entities alone or together hold more than 20% but less than 80% of the shares in the listed public company. In the absence of the concession, where entities alone or together hold more than 20% of the shares in a listed public company, that listed public company would likely qualify as a demerger subsidiary and would therefore be ineligible to be selected as a head entity. For example: Company A Company B public shareholders 10% 21% Listed Co demerger subsidiaries Listed Co can choose to ignore the shares held by Company A and Company B and can therefore be the head entity of a demerger group. In the absence of the concession, Listed Co would be a demerger subsidiary of the Company A demerger group. 4. A demerger subsidiary is a company in which another company (being a member of a demerger group) owns or has the right to acquire (alone or together with other members of the demerger group) ownership interests that carry more than 20% of: the right to receive distributions of income or capital; or the right to vote (or control of the vote). This means that the demerger group is a group of companies in which a shareholding of more than 20% is held by the head entity or a demerger subsidiary. As such, the demerger group can demerge/spin-out companies in which more than 20% interests are held. mafm M v Page 3

4 Head entity 100% 21% Demerge sub Demerge sub 5. A demerger happens if, under a restructuring of the demerger group: there is a qualifying restructure refer below; there is eligible consideration provided refer below; the 50% Australian CGT requirement is met refer (c) below; proportionate interests are replicated refer (d) below; there is a demerged entity refer (e) below; and none of the exceptions apply refer (f) below. The Restructure There must be a restructure which satisfies one of to (iv). (iii) (iv) transfer case: members of the group dispose of at least 80% of their total ownership interests in another member of the group to owners of original interests in the head entity; or cancellation case: at least 80% of total ownership interests of members of the group in another member end and new interests are issued to owners of original interests in the head entity; or swamping case: the demerged entity issues sufficient new ownership interests in itself with the result that owners of original interests in the head entity own at least 80% of the total ownership interests in the demerged entity; or combination case: some combination of, and (iii) with the effect that the group ceases to own at least 80% of the total ownership interests in another member of the group. Note that: It is necessary for the demerger group to cease to own at least 80% of the ownership interests in the demerged entity. How is the 80% to be calculated? As a result of amendments made in the House of Representatives, it is not necessary to take account of the number and value and nature of the ownership interests. Usually the test will be satisfied if there is divestment of at least 80% of the number of ownership interests in the demerged entity. However the 80% divestment will not always be determined by the number of ownership interests only in mafm M v Page 4

5 different cases it will be appropriate to judge the 80% divestment by reference to the value of ownership interests, or by reference to a mix of number, value and nature of ownership interests (refer para 1.8 of Supplementary EM). The demerger group must divest at least 80% of its total interests in the demerged entity, which may or may not represent 80% of the demerged group if the group owns 21% of a company, it must divest at least 80% of its 21% shareholding. Under the swamping case, owners of original interests in the head entity must end up owning at least 80% of the demerged entity this is not a necessary condition in the cancellation case or transfer case. Is this an anomaly or an intended outcome? There is a danger in relying on the combination case if the combination involves swamping, because the combination case requires the group to cease to own at least 80% of the demerged entity the cease to own may mean it is necessary to transfer or cancel ownership interests (ie a legal event that causes the group to cease to own ownership interests) which does not occur to the extent that new interests are issued only. The Consideration (iii) In consideration of the demerger, the holders of original interests in the head entity must receive new interests in the demerged entity and nothing else hence, subject to the following Note, the transaction will not qualify if the shareholders in the head entity receive cash, shares (other than shares in the demerged entity) or other consideration under the demerger. This can be contrasted with scrip for scrip relief, where shareholders can receive a mix of scrip and cash, and the CGT relief applies to the extent of the scrip. The new interests in the demerged entity must be acquired only because of the ownership of original interests in the head entity. Where the head entity is a company, the new interests in the demerged entity must be ownership interests in a company and not some other type of entity. This means that where the head entity is a company, that company cannot spin out a trust, and the holders of shares and rights to acquire shares must receive new interests being shares in a company or rights to acquire shares in a company. Note: The practical problems arising from the requirement that the original interest holders acquire new interests are alleviated by some common sense rules. Specifically, the holders of original interests are taken to acquire new interests in the demerged entity in cases where: mafm M v Page 5

6 the new interest is sold by a nominee at the direction of the owner hence it seems that a sale facility may not cause the transaction to fall outside the rules, subject to the dividend anti-avoidance rules; the new interests are sold by a nominee as a result of the fact that the owner is a non-resident and the demerger scheme provides for these nonresidents to receive the cash equivalent following the sale by nominee eg foreign shareholders may reside in jurisdictions where it would be necessary to issue a prospectus (or like obligation) if and when new shares in the demerged entity are issued to those shareholders. This nominee sale exception addresses the problem (the scrip for scrip rollover rules have a similar technical problem which is not addressed in the provisions by a nominee sale exception); the new interest is held by a nominee pending the owner being located. (c) The 50% Australian CGT Requirement It must be reasonable for the head entity to assume that, immediately before the restructuring, more than 50% of original interests in the head entity are owned by: Australian residents; or foreign residents, where the new interests in the demerged entity acquired by them will be inside the Australian CGT net, ie at least 10% shareholding in an Australian resident public company or any shareholding in an Australian resident private company. The reasonable to assume test means that the focus is on legal ownership, not ultimate beneficial ownership (refer Supplementary EM). Hence, it seems that the test is satisfied by the shareholder listed on the register we do not trace through nominee companies, trusts, super funds, investment funds. (d) Replicating the Proportionate Interests It must be the case that each owner of original interests in the head entity: acquires the same proportion (or as nearly as practicable as the same proportion) of new interests in the demerged entity as each owner had in the head entity just before the demerger; and has, just after the demerger, the same proportionate total market value of ownership interests in the head entity and demerged entity, as each owner had in the head entity just before the demerger. In testing whether this is achieved: an anticipated reasonable approximation of market value of ownership interests is sufficient this can include valuations provided to shareholders in the scheme documents, or the price selected for use under a sale facility, and it may be judged by long term value; disregard shares acquired under a qualifying employee share scheme where the shares are not fully paid ordinary shares and the shares mafm M v Page 6

7 represent 3% or less than the total ownership interests in an entity (judged by reference to number and/or value); disregard certain adjusting instruments issued by listed public companies, provided these instruments represent 10% or less (or such other amount prescribed, but not exceeding 17%) of the ownership interests in the listed public company. These adjusting instruments are instruments for which the value is protected if the impact of the demerger on other ownership interests adversely affects the value of the instrument (ie the interests benefit from anti-dilution rights). The examples listed are: convertible preference shares, including reset preference shares; convertible notes; partly paid shares where the paid up amount is adjusted to reflect a capital reduction; disregard DLC voting shares (as these are not ownership interests ); fractional interests will generally not affect eligibility for demerger rollover relief. Regulations may be issued which broaden the type of ownership interests that can be ignored in determining whether the demerger replicates proportionate ownership interests and market values, but the total of disregarded interests must not exceed 20% of ownership interests in each case. (e) The Demerged Entity There must be a demerged entity. The demerged entity is defined in section (6) to be the entity in which the new interests are acquired. (f) Exceptions (iii) An off market buy back of shares under Division 16K of the Tax Act 1936 is not a demerger. The transaction will not qualify as a demerger if the original interests in the head entity or the new interests in the demerged entity are interests in a trust that is a superannuation fund. There is no demerger if owners of original interests can obtain rollover for the transaction under other provisions. 2. Nature of CGT Relief If the holders of original interests choose the rollover: a capital gain or capital loss from a CGT event happening under the demerger is disregarded; mafm M v Page 7

8 the total cost bases of the original interests (post-cgt) is spread over the new interests in the demerged entity and the remaining original interests in the head entity in such proportions as are reasonable having regard to: the market values of the original interests and the new interests immediately after the demerger; or an anticipated reasonable approximation of those market values. The rules anticipate that the demerger group will advise shareholders of the anticipated relative market values. For example, head entity advises shareholders that the spin out entity is anticipated to represent 5% of the total market value of the group as a whole the total cost bases immediately before the demerger is spread across the remaining shares and the new shares post demerger on a 95%/5% basis; (c) (d) where some or all of the original interests immediately before the demerger are pre-cgt the holders of original interests are taken to acquire pre-cgt new interests in the demerged entity in proportion with the pre-existing pre-cgt shareholding; where the demerger does not involve a CGT event happening to original interests (eg a swamping case), the same cost base adjustments as per above apply. If rollover relief is not chosen (eg so as to claim a capital loss on shares cancelled under the demerger), the same cost base adjustments apply as per above. Once the cost base adjustments have been made under the demerger rules, there are no other cost base adjustments to be made as a result of the demerger ie the general value shifting rules do not have additional application as the demerger rules are considered to contain rules which will ensure that value shifting transactions will not qualify. 3. Consequences for the Corporate Group The consequences for the corporate group where the transaction qualifies as a demerger are: we disregard any capital gain or capital loss arising from CGT Events A1, C2, C3 or K6 happening to the ownership interests held by the group companies in the demerged entity. Note that these consequences arise if the arrangement qualifies as a demerger transaction. The corporate group does not choose to apply these consequences. As a result, the corporate group cannot crystallise capital losses from a transaction that qualifies as a demerger; CGT Event J1 does not happen to the demerged entity or a member of the group under the demerger hence there is no recapture of CGT which has been sheltered from tax by applying CGT rollover when assets have been transferred into the demerged entity this is a permanent saving of tax, not a mere timing benefit; mafm M v Page 8

9 (c) there are value shifting rules which can operate to reduce losses or reduce cost bases where the demerger transaction involves a value shift: sections , and Dividend relief for shareholders A demerger dividend is not assessable income and not exempt income, and is taken not to have been paid out of profits: provided the head entity has not elected for sections 44(3) and (4) to not apply; provided immediately after the demerger, at least 50% (by market value) of all the CGT assets owned by the demerged entity (and its subsidiaries) are used directly or indirectly in business carried on by those entities. The Explanatory Memorandum contains the following remarkable statement: This rule ensures that the demerged entity is a viable, independent entity, capable of conducting business in its own right. A demerger dividend is the part of the demerger allocation that would be an assessable dividend under section 44 in the absence of exclusion provided by sections 44(3) and (4) The demerger allocation is: (c) the market value of the ownership interests issued by the demerged entity in itself to holders of original interests under the demerger; or the market value of the ownership interests disposed of by a member of a demerger group to owners of original interests under the demerger; or the total of these market values. 5. Section 45B: Dividend Treatment for Demergers which are not Genuine New section 45B is an integrity measure which is designed to apply to demerger transactions which are not considered to be genuine. In the words of the EM: The demerger dividend exemption is supported by an integrity rule that is aimed at limiting the exemption to genuine demergers, rather than demergers that are directed at obtaining the dividend exemption. Hence, if the demerger transaction offends section 45B, the distribution which is made to shareholders under the demerger will be taxed as an assessable dividend rather than being excluded from assessable income under sections 44(3) and (4). New section 45B has the following key elements in relation to demerger transactions. (Note: section 45B now has dual operation it retains its old function of attacking distributions which are designed to provide capital benefits to shareholders (ie it attacks disguised dividends ) and it has the new function of attacking demerger dividends paid as part of non genuine demerger transactions. The following discussion deals only with the demerger aspects of new section 45B.) mafm M v Page 9

10 1. Purpose The purpose of section 45B is to ensure that amounts are taxed as assessable dividends if (section 45B(1)): components of a demerger allocation as between capital and profit do not reflect the circumstances of a demerger. This provision seems to require us to: identify the source of the distribution to shareholders under the demerger ie the extent to which the distribution to shareholders under the demerger was in fact debited to share capital or profits of the head entity; and compare this allocation to the circumstances of a demerger which suggests that there is a hypothetical genuine demerger under which the distribution to shareholders is funded from capital and profits in a way which is representative of a genuine demerger. In crude terms, if too much of the distribution to shareholders is funded from profits available for distribution of the head entity, it seems that there will be a suspicion that the demerger distribution is not genuine. 2. Application Section 45B applies if there is a scheme under which a person is provided with a demerger benefit, and a taxpayer will obtain a tax benefit, and having regard to the relevant circumstances of the scheme it would be concluded that the scheme was entered into for a more than incidental purpose of enabling a taxpayer to obtain a tax benefit. The Commissioner may make a determination identifying that some or all of the demerger benefit is to be taxed as an assessable dividend. 3. Provided with a demerger benefit A person is provided with a demerger benefit if, in relation to a demerger, the person is provided with ownership interests in a company or something is done which increases the value of ownership interests. 4. Relevant Circumstances The relevant circumstances of the scheme are listed in section 45B(8) and are as follows. The extent to which the distribution to shareholders is attributable to capital or profits (realised or unrealised) of the company. Refer 1 above it seems that underlying section 45B is a suspicion that the transaction is not a genuine demerger if too much of the distribution is funded from profits. The reference to unrealised profits is important, as it permits the Commissioner to postulate whether the alternative transaction would be for the company to sell the demerged entity and distribute the then realised profits as a dividend to shareholders. mafm M v Page 10

11 The pattern of distributions of dividends, bonus shares and returns of capital. Again, a build up of undistributed profits in the company will raise the suspicion of a non-genuine demerger distribution. (c) Whether the relevant taxpayer has capital losses that would otherwise be carried forward. Clearly, any such capital losses could not be used against the distribution if it were to be a dividend. (d) Whether the relevant taxpayer holds pre-cgt ownership interests. The issue here is obvious. (e) (f) (g) (h) Whether the relevant taxpayer is a non-resident. Whether or not the relevant taxpayer s cost base in the ownership interests is substantially less than the distribution. Whether the relevant taxpayer would have obtained a section 46F rebate on the distribution. Whether the distribution causes the taxpayer s interest to change in a way which would not occur if the distribution were a dividend. If the scheme involves both the provision of ownership interests and the later disposal of those interests: (iii) the period until the disposal; when the disposal arrangements were entered into; whether there have been transactions between associates (section 318) involving the demerger group. This factor raises the critical question of whether section 45B will apply where: (A) (B) as part of the demerger transaction, there is a sale facility in place which permits shareholders to immediately sell the shares acquired in the demerged entity and thereby convert the demerger distribution to cash (ie akin to a cash dividend) the BHP Steel demerger had a sale facility in place, but did not rely on these new rules providing tax relief for demergers; the demerger occurs at a time when it has been announced or it is likely that there will be a takeover offer made for the shares in the demerged entity it is noted that the WMC demerger obtained a favourable class ruling on section 45B, notwithstanding the fact that WMC stated publicly that a purpose of the demerger was to facilitate takeover offers for the two demerged entities. 12 December mafm M v Page 11