As reported in our demerger update of November 2018, the Australian Taxation Office (ATO) has been developing guidance on the meaning of “restructuring” for the purposes of the demerger rules in Division 125. Although initially marked for release in December 2018, the ATO released Draft Taxation Determination 2019/D1 “Income tax: what is ‘restructuring’ for the purposes of subsection 125-70(1) of the Income Tax Assessment Act 1997?” (the Ruling) on 21 March 2019. In doing so, the ATO set its first goal post on demergers. The second goal post is expected to be set in May 2019 when the ATO is due to provide guidance on the availability of capital gains tax (CGT) roll-overs in sequential planned transactions where a CGT roll-over is claimed for each transaction and the first roll-over contains a “nothing else” condition. We expect the goal posts to be set close to each other, hence confirming the ATO is making it harder to score a demerger that qualifies for demerger relief.
A demerger broadly involves a restructuring of a corporate group by splitting it into two corporate groups. Both the demerger group and the demerged group will be owned directly and in the same proportions by the existing shareholders (Shareholders) of the pre-demerger group.
If the demerger rules apply:
- The demerger group is not subject to CGT on the disposal of the demerged group; and
- Shareholders are not subject to tax on receiving shares in the demerged group (the receipt may otherwise be subject to tax as a capital return subject to CGT or a dividend subject to ordinary income tax).
In order for demerger relief to apply, a “demerger” must happen, which requires:
- A “restructuring” of the demerger group;
- Under the restructuring, the demerger group must dispose of at least 80% of the shares in the demerged group to the Shareholders;
- The Shareholders must acquire shares in the demerged group, and nothing else (the nothing else requirement); and
- The Shareholders must acquire the same proportion of demerged shares and proportionate market value in the demerged group as it had in the demerger group (the proportionality requirement).
Key points from the Ruling
As expected, the ATO has taken a broad view of what a “restructuring” is for the purposes of the demerger rules. Consequently, the requirements to qualify for demerger relief are more difficult to satisfy.
Based on the examples the ATO has provided in the Ruling, the ATO considers that the following public markets transactions will not qualify for demerger relief:
- Demerger followed by a capital raising – Head Co demerges Sub Co by way of in specie distribution and Sub Co subsequently undertakes a capital raising to fund its business. Prior to the demerger Head Co had negotiated with an unrelated third party to acquire the shares in Sub Co that would be issued under the capital raising. The ATO considers that the capital raising is part of the restructuring for the purposes of the demerger rules. Consequently, the proportionality requirement in the demerger rules cannot be satisfied.
- Sale of head entity after the demerging of a subsidiary – Head Co demerges Sub Co following a proposal for Bid Co to acquire Head Co after the Sub Co is demerged. Prior to the demerging of Sub Co, Head Co discusses the takeover proposal with Bid Co and Head Co’s board makes an announcement in this regard. The demerging of Sub Co is a condition precedent to Bid Co acquiring Head Co. The ATO considers that the sale of Head Co is connected to the demerging of Sub Co and the acquisition of Head Co is hence part of the restructuring. Consequently, the proportionality requirement and nothing else requirement in the demerger rules cannot be satisfied.
- Demerger with a sale facility – Head Co demerges Sub Co. Sub Co is listed on the Australian Securities Exchange immediately after the demerger and Sub Co’s shareholders can use a sale facility to dispose of their new shares in Sub Co. Under the sale facility, a sale agent will sell the relevant shares and remit the sale proceeds which will be adjusted to include a 5% premium (funded by Sub Co) to the five day, post-separation, volume-weighted average price of Sub Co shares. The ATO considers that the use of the sale facility including the subsequent payment to the shareholders from that facility forms part of the restructuring. Consequently, the proportionality requirement and nothing else requirement in the demerger rules cannot be satisfied.
We are not surprised by the first two examples, noting that the second example is in essence the AMA transaction we reported on in our demerger update of November 2018. However, we are surprised by the third example. The inequity of the ATO’s view is that the selling shareholders will trigger taxing events when they sell, but the demerger group and other shareholders are penalised by not allowing demerger relief. We note that ATO ID 2003/1053 (the ID) provided that the “nothing else” requirement was not precluded from being satisfied as a consequence of shareholders in the demerger group being offered the opportunity to sell shares via a sale facility. The ID was withdrawn on 19 February 2010 on the basis it was “a straight application of the law and did not contain an interpretative decision” (using the ATO’s words). Noting that sale facilities have been a common feature of demerger transactions, we find it concerning that what was understood to be a settled area of the law is now being viewed in a different light by the ATO. There is a pattern of behaviour here, noting that the ATO has previously issued class rulings allowing demerger relief in the same fact pattern that the second example addresses. See for example, Class Ruling 2013/23 and Class Ruling 2008/74.
Perhaps in an effort to justify its views, the ATO highlights the policy underpinning the demerger rules in the Ruling, which are:
- In the absence of demerger relief, members in an entity that reorganises its activities may face a range of tax consequences which act as an impediment to entities restructuring their operations; and
- Where an entity undertakes a reorganisation of its operations, leaving members in the same economic position as they were immediately before the reorganisation, there should be no taxing event.
Against that policy backdrop, the ATO says that CGT consequences are expected where there is both a legal and economic change in the ownership of the property resulting from a transaction (referring to the second bullet point). We do not dispute that proposition, but we consider the ATO is taking too broad a view of the term “restructuring”. This is seen in the second and third of the ATO’s examples above – CGT consequences will arise to the shareholders in Head Co when they dispose of their shares to Bid Co in example 2, and CGT consequences will arise to shareholders in Sub Co when they dispose of their shares via the sale facility in example 3. We also find it hard to reconcile the ATO’s approach with the stated policy objective above, noting that the ATO caused the AMA transaction not to proceed (as it may have other transactions).
Despite it taking the ATO 17 years to provide this guidance in narrowing the demerger goal posts (the demerger rules were introduced in 2002), taxpayers can take some comfort that they now better understand the way the ATO will apply the demerger rules. The ruling is in draft form and open for comment until 30 April 2019. Please contact one of our tax experts if you want to discuss the impact of this draft ruling or if you would like assistance in providing comments to the ATO.
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