Demerger relief is a vital provision within Australian tax law that allows businesses (large and small) to restructure their operations without incurring immediate capital gains tax (CGT) liabilities. It is particularly valuable for companies aiming to enhance operational efficiency or strategically separate business segments into independent entities. However, the eligibility for demerger relief is governed by a series of stringent conditions, with a key focus on the concept of “restructuring.” This article provides an in-depth analysis of demerger relief, focusing on the Australian Taxation Office’s (ATO) interpretation of “restructuring” and how it impacts the application of these provisions.
Overview of Demerger Relief
The demerger relief provisions in Division 125 of the Income Tax Assessment Act 1997 (ITAA 1997) has the following main features:
1. Tax Relief for Capital Gains: Demerger relief allows the demerger group and its shareholders to disregard or roll over capital gains or losses on ownership interests in the head entity.
2. Demerger Dividend: Any ‘demerger dividend’ paid to shareholders is treated as non-assessable, non-exempt income.
3. Disregarding Capital Gains/Losses: Members of the demerger group can disregard certain capital gains or losses resulting from the disposal of their ownership interests in the demerged entity.
4. Cost Base Apportionment: There is a rule for apportioning the original cost base of shareholders’ shares in the head entity across those shares and the new shares in the demerged entity. This rule applies even if the shareholder does not choose or is not eligible for rollover relief.
Key Concepts in Demerger Relief
The availability of demerger relief depends on several critical concepts, each of which must be carefully considered:
- Ownership Interest: This refers to a share in a company, a unit in a trust, or other similar interests like options or rights to acquire such shares or units.
- Demerger Group: A demerger group consists of a ‘head entity’ and one or more ‘demerger subsidiaries.’ The head entity is the entity where no other group member holds ownership interests, while a demerger subsidiary is an entity in which the group holds significant ownership interests (at least 20%).
Strict Requirements for Demerger Relief
1. Restructuring Requirement (Paragraph 125-70(1)(a)): The fundamental requirement for demerger relief is that there must be a “restructuring” of the demerger group. This restructuring serves as the basis for determining whether a demerger has occurred under Division 125. According to the ATO, “restructuring” should be understood in its ordinary business sense—a reorganization of a group of companies or trusts that forms part of a single, coherent plan.
2. 80% Ownership Condition (Paragraph 125-70(1)(b)): For demerger relief to apply, at least 80% of the ownership interests in the demerged entity must be distributed to shareholders of the head entity. This condition is designed to ensure that the restructuring maintains continuity of ownership, consistent with the principle that demerger relief should only apply when the economic ownership of the business remains substantially unchanged.
3. Nothing Else Condition (Paragraph 125-70(1)(c)): Another critical requirement is that shareholders must receive only new ownership interests in the demerged entity—nothing else. This condition ensures that the restructuring does not alter the economic position of the shareholders by introducing additional considerations, such as cash or other assets.
4. Proportionality Tests (Subsection 125-70(2)): The proportionality tests ensure that shareholders maintain the same proportionate ownership interests in the head entity and the demerged entity before and after the restructuring. These tests are crucial in preserving the economic position of the original owners and are a fundamental part of the demerger relief framework.
ATO’s Interpretation of ‘Restructuring’
The ATO’s interpretation of “restructuring” set out in Taxation Determination TD 2020/6 is critical to understanding the application of demerger relief. The term “restructuring” is broad, encompassing all steps and transactions connected to the reorganisation. The ATO emphasises that restructuring involves more than just the steps outlined in Paragraphs 125-70(1)(b) and (c); it includes all relevant actions that are part of the reorganization plan, whether they occur before, during, or after the main demerger event.
For example, preparatory steps such as transferring assets, incorporating new entities, or shifting employees to the demerged entity are considered part of the restructuring. Even though these steps are taken before the formal demerger, they are necessary for the demerged entity to function as a viable independent business and, therefore, form part of the restructuring.
Conversely, transactions that occur independently of the restructuring plan, such as voluntary sales of shares by shareholders post-demerger, are not considered part of the restructuring. The ATO’s interpretation ensures that only those steps integral to the restructuring plan are considered when determining eligibility for demerger relief.
Section 45B and Genuine Restructures
Section 45B Considerations:
An important aspect of demerger relief is the application of Section 45B of the Income Tax Assessment Act 1936. Section 45B is an anti-avoidance provision designed to prevent schemes where a company seeks to deliver tax-free dividends to shareholders through capital distributions rather than through dividends that would typically be taxable.
Under Section 45B, if the Commissioner determines that a scheme, such as a demerger, was entered into for the purpose of obtaining a tax benefit, the demerger dividend (or part of it) could be treated as an unfranked dividend and thus become assessable income for the shareholders. This means that even though a demerger might otherwise qualify for relief under Division 125, the application of Section 45B could alter the tax treatment of the demerger dividend, particularly if the assets of the demerged entity are not primarily used in carrying on a business.
The ATO’s Practice Statement Law Administration (PS LA 2005/21) emphasises that Section 45B is intended to apply only to genuine demergers—those conducted with substantive business purposes, rather than for obtaining tax advantages. For example, if a demerger is undertaken solely to distribute profits tax-free to shareholders, Section 45B could be applied to deny the tax benefits typically available under Division 125.
Examples of Restructuring in Practice
- Preparatory Steps as Part of Restructuring:
Consider a company, Buckle Ltd, which plans to separate its residential property business by creating a new subsidiary, Elysian Fields Pty Ltd. Over several months, Buckle Ltd transfers assets, shifts employees, and novates contracts to prepare Elysian Fields Pty Ltd to function as an independent entity. These preparatory steps, although taken before the formal demerger, are integral to the restructuring and form part of the demerger plan.
- Post-Separation Transactions and Their Relevance:
In another scenario, a public company, Head Co, separates a subsidiary, Sub Co, via an in-specie distribution of shares to its shareholders. After the demerger, Sub Co undertakes a capital raising to fund its operations. If this capital raising is independent of the demerger plan and is conducted at market value, the ATO would likely view it as separate from the restructuring. However, if the capital raising was pre-planned and integral to the separation, it could be considered part of the restructuring, affecting the availability of demerger relief.
- Sale of Head Entity After Demerger:
Another complex scenario involves a situation where, after a demerger, the head entity (e.g., Food Co) is sold to another company (e.g., Giant Co). If the sale was planned as part of the demerger, the ATO might consider it a continuation of the restructuring, potentially disqualifying the demerger from relief. Conversely, if the sale occurs independently and was not part of the original demerger plan, it might not affect the availability of relief.
Implications for Businesses
Understanding the ATO’s broad interpretation of “restructuring” is crucial for businesses planning a demerger. Companies must carefully plan and document all steps in the reorganisation process to ensure that they qualify as part of the restructuring. Any missteps or failure to include integral steps within the restructuring could disqualify the entire transaction from demerger relief, resulting in significant tax liabilities. Additionally, companies should be mindful of the potential application of Section 45B, which could impact the tax treatment of demerger dividends if the Commissioner believes a tax benefit was a driving purpose behind the scheme.
Employee Share Schemes (ESS) and Demergers:
In cases where employees hold shares or options under an Employee Share Scheme (ESS), a demerger can trigger significant tax implications. If a demerger leads to an ESS deferred taxing point, the market value of the ESS interests at the time may become assessable income. However, specific rollover relief provisions may apply, allowing employees to defer the taxing point under certain conditions, particularly where the new interests match the old ones. Businesses should carefully consider these implications and seek guidance to avoid unintended tax consequences for their employees.
Conclusion
Demerger relief under Division 125 offers significant tax advantages for businesses looking to restructure. However, the strict requirements, particularly around the concept of “restructuring,” necessitate meticulous planning and documentation. By understanding the ATO’s interpretation of restructuring, the implications of Section 45B, and ensuring that all conditions are met, businesses can successfully navigate the complexities of demerger relief and achieve their restructuring objectives without incurring unnecessary tax liabilities. Seeking professional advice is crucial to ensuring compliance and optimising the tax outcomes of a demerger and in most instances a ruling from the ATO is recommended.