ABL Paper Tuesday 9 – Thursday 11 August 2007 Section 45B: Dealing with Frankenstein’s creature Written by Paul Sokolowski, FTIA, Partner, and Ben Hayward, Articled Clerk, for the Taxation Institute of Australia, Western Australia State Convention. Contents Introduction ..................................................................................................................................................... 3 Background..................................................................................................................................................... 3 It’s alive! Section 45B is born ........................................................................................................................ 6 Section 45B – operative provision, key concepts and mechanics.............................................................. 7 Section 45B purpose and capital returns ................................................................................................... 14 Section 45B purpose and demergers ......................................................................................................... 18 The Commissioner’s application of section 45B – capital benefits........................................................... 22 The Commissioner’s application of section 45B – demerger benefits ..................................................... 24 Conclusion .................................................................................................................................................... 31 Section 45B: Dealing with Frankenstein’s creature | Page 2 Introduction 1 Mary Shelley’s Frankenstein – part gothic horror story, part morality tale, part political treatise – tells the story of Victor Frankenstein, the “monster” he created and the ensuing horror of a force unleashed that takes on a destructive life of its own. 2 In the novel, Victor Frankenstein, although sickened by it, denies responsibility for what he has created, whereas the “creature” comes to realises what he is, and has done, and apologises for his actions: Once I falsely hoped to meet with beings who, pardoning my outward form, would love me for the excellent qualities which I was capable of unfolding. I was nourished with high thoughts of honour and devotion. … No guilt, no mischief, no malignity, no misery, can be found comparable to mine. When I run over the frightful catalogue of my sins, I cannot believe that I am the same creature whose thoughts were once filled with sublime and transcendent visions of the beauty and the majesty of goodness. But it is even so; the fallen angel becomes a malignant devil.1 3 The story of Victor Frankenstein and his “creature” cannot seriously be considered a metaphor for the creation and use of a provision, any provision, of a tax statute. However, for some tax practitioners, having to consider section 45B of the Income Tax Assessment Act 1936 (ITAA 1936), the nightmarish story of the selfish and irresponsible Victor Frankenstein and the horror and destruction caused by his “creature” is irresistible. 4 Those contemplating corporate group demergers, capital reductions or share buy-backs (or some other form of extracting money from companies) must consider (and ignore at their peril) section 45B of the Income Tax Assessment Act 1936 (ITAA 1936). How much, though, is section 45B “sublime and transcendent vision” or “malignant devil”? How much has the lofty ambition of section 45B’s creator overreached its limitations? 5 This paper will first consider the normal tax outcomes of group demergers, capital reductions or share buy-backs, absent section 45B. The “form of the monster” will then be examined (ie, the elements of section 45B, especially the question of purpose). It will then consider some private binding rulings (PBRs) made by the ATO in the context of private corporate groups and SMEs to illustrate how the Commissioner approaches section 45B – both in terms of its demerger benefit limb and its more general capital benefit limb. Background “Some miracle might have produced it, yet the stages of the discovery were distinct and probable. After days and nights of incredible labour and fatigue, I succeeded in discovering the cause of generation and life; nay, more, I became myself capable of bestowing animation upon lifeless matter.”2 6 1 2 3 As we know, a company has a legal personality separate and distinct from the persons who own it. This general law concept grafted into our tax regime means that a company is taxed as a separate entity on its taxable income and its shareholders are separately taxed (or given some other benign treatment) on what comes out. That may seem a trite observation but it is a matter our clients (and sometimes ourselves) may on occasion forget.3 Of course, we shouldn’t forget, and it is something we must fully appreciate, because it is this separation of personality which gives rise to the tax rules with which we have to deal. The point is, simply, that our tax system ensures that a company is not a personal bank account or cash box to be dipped into as and when required without tax implications (whether we understand them or not). There can be no issue with this design feature. Mary Wollstonecraft Shelley, Frankenstein, Chapter 24. Id, Chapter 4. Especially when personal funds are required! Section 45B: Dealing with Frankenstein’s creature | Page 3 7 Private family company structures are rarely planned out completely in advance. It is often the case that capital is contributed and entities and activities are added on without any real thought of the long-term consequences. Unfortunately, returning excess funds to shareholders or restructuring a private family group (for example, to facilitate the retirement of founders or to separate family interests) will invariably result in unwanted tax implications. 8 Excess funds can be retuned by way of special dividends, loans or returns of capital. Generally, dividends are immediately assessable in the hands of shareholders and in the case of loans, the company and shareholders become subject to the clunky Division 7A rules. 9 When compared to the alternatives, the release of capital is often seen as the most tax efficient. In the context of private groups, returns of capital (whether to simply liberate excess funds or to facilitate changes in ownership and control) can occur by way of selective capital reductions (with or without the cancellation of shares), an off-market share buy-back or via a group demerger. On the face of it, using a demerger to extract wealth from a family company may be more tax effective than simply selling equity in the parent entity, returning capital or conducting a share buy-back. Taxation – capital reductions 10 Subsection 6(1) of the ITAA 1936 relevantly provides that a: "Dividend includes: (a) any distribution made by a company to any of its shareholders whether in money or other property; and (b) any amount credited by a company to any of its shareholders as shareholders; … but does not include: (d) 11 moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company;” Subsection 6(4) of the 1936 Act provides as follows: "Paragraph (d) of the definition of dividend in sub-section (1) does not apply if, under an arrangement: 12 4 (a) a person pays or credits any money or gives property to the company and the company credits its share capital account with the amount of the money or the value of the property; and (b) the company pays or credits any money, or distributes property to another person, and debits its share capital account with the amount of the money or the value of the property so paid, credited or distributed." Whereas a return of capital (cash or property) will clearly fall within paragraph (a) of the subsection 6(1) definition of the dividend, such a return of capital would be excluded from the definition of dividend by virtue of paragraph (d) where the dividend is debited against the share capital account of the company and the share capital account has not been “tainted”4 (broadly, where the account did consist entirely of amounts contributed by shareholders). The old share capital tainting rules in section 160ARDM of the ITAA 1936 were repealed with effect from 1 July 2002. The new tainting rules are contained in Division 197 of the ITAA 1997 and apply to transfers made to a company's share capital account after 25 May 2006. Therefore, amounts transferred to a company's Section 45B: Dealing with Frankenstein’s creature | Page 4 13 Accordingly, subject to the application of a suite of anti-avoidance rules (including section 45B), a reduction of capital will have no assessable dividend implications for the company nor any dividend franking issues, provided that the amounts returned to shareholders are debited to the (untainted) share capital account and subsection 6(4) does not apply. However, where the amount paid or credited is not debited to the share capital account for any reason, including the fact that the amount paid or credited exceeds the amount debited against the share capital account, then the distribution is a dividend and is assessable to the shareholder under section 44 of the ITAA 1936 if paid out of profits of the company (income or capital). 14 If a return of capital is made and the shareholder retains its shares (and those shares are post-CGT shares), CGT event G1 applies. Subsection 104-135(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that CGT event G1 happens if a company pays an amount, in respect of a share owned in the company, that is not a dividend or taken to be a dividend under section 47 of the ITAA 1936. If the non-dividend payment exceeds the cost base of the shares, subsection 104-135(3) of the ITAA 1997 specifies that a capital gain equal to the excess arises. Further it operates to reduce the cost base and reduced cost base of the shares to nil. A capital loss is not made. 15 If a return of capital is made and the shares are cancelled (and those shares are post-CGT shares held on capital account), CGT event C2 applies. Paragraph 104-25(1)(a) of the ITAA 1997 provides that CGT event C2 happens if a taxpayer's ownership of an intangible CGT asset ends because it is redeemed or cancelled. The cancellation of shares will trigger CGT event C2. A capital gain will be made if the capital proceeds (ie, the returned capital) received or to be received on the happening of the CGT event exceed the cost base (reduced cost base) of the shares.5 A capital loss will be made where the capital proceeds are less than the shares’ reduced cost base.6 Under subsection 116-30(2), where the capital proceeds received for the shares are more or less than market value of the shares, the actual capital proceeds will be replaced with the market value of the shares 7 for the purposes of calculating the capital gain. Taxation – share buy-backs 16 The tax implications of share buy-backs are governed initially by Division 16K of Part III of the ITAA 1936 and then the normal taxing rules. 17 Apart from the franking of dividends, Division 16K does not create tax implications for the company (capital gains, ordinary income or deductions)8: it is directed at the shareholders. Under Division 16K, the purchase price in respect of a buy-back can be divided into two components: an assessable deemed dividend and a capital component. In respect of the capital component, the Division 16K rules operate, in effect, to fix the consideration for the buy-back which then feeds into the CGT rules and/or the ordinary income rules. Taxation – demergers 18 A demerger is essentially a group business restructure whereby the underlying owners (usually shareholders of the head entity) acquire direct ownership of a group entity in similar proportion to their original underlying economic interests in the head entity. 19 There is no defined mechanism for a demerger. It might occur via: 5 6 7 8 19.1 a capital reduction of a head company that is satisfied by the transfer, to the shareholders in the head company, of ownership interests in the subsidiary that is being spun out of the group; 19.2 a declaration of a dividend by a head company to its shareholders that is satisfied by the transfer of ownership interests in the demerged entity; share capital account between 1 July 2002 and 25 May 2006 will not cause the share capital account to be tainted. Subsection 104-25(3) of the ITAA 1997. Ibid. Determined as if the shares had not been cancelled: subsection 116-30(3A). Subsection 159GZZZP(2) of the ITAA 1936. Section 45B: Dealing with Frankenstein’s creature | Page 5 20 21 19.3 an arrangement where there is no distribution of property from the head entity (as capital or a dividend) to its owners but shares in a demerged entity are issued directly to owners of the head entity; or 19.4 some combination of these mechanisms. Absent special rules, CGT taxing points and assessable dividends generally arise in a demerger arrangement. The three elements of demerger relief are as follows: 20.1 a CGT-rollover for owners of interests in the head company of a demerger group (Subdivision 125-B of the ITAA 1997); 20.2 a CGT exemption for members of a demerger group (Subdivision 125-C of the ITAA 1997); and 20.3 a dividend exemption for the owners of the head entity (broadly, the dividend paid by the head company to its shareholders under the demerger will be neither assessable income nor exempt income as a result of the application of subsections 44(3) to (5) of the ITAA 1936). There are a number of dividend streaming and dividend substitution rules that must be considered when contemplating a share buy-back (and a capital reduction). Other than section 45B, particular consideration would have to be given to: 21.1 section 45A of the ITAA 1936 (the capital streaming rules); 21.2 section 204-30 of the ITAA 1997 (anti-dividend streaming rules); and 21.3 section 177EA of the ITAA 1936 (franking credit benefit anti-avoidance rule). 22 Broadly, these rules were designed to prevent companies either streaming capital benefits to some shareholders and dividends to others or distributing profits to shareholders as preferentially taxed capital rather than dividends. If breached, these rules permit the Commissioner to treat payments made by a company as unfranked dividends in the hands of shareholders. In addition, debits may be made to the company’s franking account to the extent that the deemed dividends would have been franked. 23 The “malignant devil” this paper is concerned with is section 45B. It’s alive! Section 45B is born “With an anxiety that almost amounted to agony, I collected the instruments of life around me, that I might infuse a spark of being into the lifeless thing that lay at my feet. … by the glimmer of the half-extinguished light, I saw the dull yellow eye of the creature open; it breathed hard, and a convulsive motion agitated its limbs.” 9 24 Historically, transactions affecting the company’s share capital were either prohibited or very closely regulated. Under the Corporations Act 2001 (the Corporations Act), transactions affecting share capital are still more closely regulated than other transactions. Chapter 2J of the Corporations Act provides rules to be followed by a company for reduction of share capital and for share buy-backs. 25 In 1998, and by successive changes up to that time, the Corporations Law (the predecessor to the Corporations Act) was changed to make it easier for companies to distribute their capital – either by way of reductions or share buy-backs. Further, in the 1998 amendments, the concept of share par value was abolished, along with the related concepts of share premium, share premium accounts and paid-up capital. What was created was a single share capital account (previously divided into paid-up capital and share premiums). 9 Note 1, Chapter 5. Section 45B: Dealing with Frankenstein’s creature | Page 6 26 Until the 1998 changes to the Corporations Law, the restrictions placed on a company seeking to return capital acted as a de facto “capital-last” rule:10 a position with which the revenue would have felt reasonably comfortable. The corporate law landscape after the 1998 changes was, however, something that made the revenue distinctly uncomfortable. According to the Explanatory Memorandum accompanying the Taxation Laws Amendment (Company Law Review) Bill 1998 (at paragraph 1.8): “Without an appropriate taxation framework [the changes to the Corporations Law] could result in revenue loss or deferral because of the greater ease with which companies may stream capital to shareholders in circumstances where this will minimise tax. To combat this, anti-avoidance provisions in the taxation legislation designed to prevent companies distributing profits to shareholders as preferentially taxed capital are to be strengthened.” 27 Broadly, then, section 45B, in its original form, was introduced to counter schemes seeking to substitute a tax free capital amount for the payment of assessable dividends to shareholders. Interestingly, as we understand it, section 45B was conceived and drafted as a temporary legislative “patch” to deal with the situation until Entity Taxation was introduced (with its profits-first rule and other features which would have made section 45B functionally redundant). Well, the idea of Entity Taxation came and went and the rest is history. 28 However, the flirtation with Entity Taxation did leave something behind. On the one hand, it is clear that section 45B is not, and is not to be applied, as a “profits-first rule by stealth”.11 In other words, when considering the question of the purpose of a scheme (see below), the fact that profits are not fully pumped out before capital is not to be regarded as a negative factor. On the other hand, it has been suggested that section 45B may be said to have implemented a “slice approach”.12 Those with sufficiently long memories will recall that under Entity Taxation, it was proposed that where a distribution arose from the extinguishment of an ownership interest in an entity (for example, a share buy back) the “slice approach” was to apply and treat the distribution as consisting of the slice of contributed capital and taxed and untaxed profits relevant to the member’s ownership interest. In the context of section 45B, this translates to an expectation (in the consideration of purpose) that one should see both a dividend and a return of capital, particularly if there is a distribution of the cash proceeds from the sale of business assets. 13 Working with this expectation, the challenge is working out how big each respective slice should be. 29 In 2002, when the demerger tax relief rules were introduced, section 45B was retro-fitted to cater for the more specific tax mischief that was thought to be possible (perhaps inevitable) in the context of demergers. Section 45B – operative provision, key concepts and mechanics "Like one who, on a lonely road, Doth walk in fear and dread, And, having once turned round, walks on, And turns no more his head; Because he knows a frightful fiend Doth close behind him tread."14 30 The purpose of section 45B is set out in subsection 45B(1). That subsection provides as follows: “The purpose of this section is to ensure that relevant amounts are treated as dividends for taxation purposes if: 10 11 12 13 14 Walmsley, P., Streaming and Company Distributions, TIA Small Business Intensive Seminar, WA Division, 14 May 1999, at page 25. Id., at page 26. Id., at page 28. Id., at page 28. From Coleridge's Ancient Mariner, quoted in Frankenstein, Note 1, Chapter 5. Section 45B: Dealing with Frankenstein’s creature | Page 7 31 (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.” It is apparent from this purpose provision that section 45B serves two objects. First, section 45B is concerned with “demerger benefits” – an object pertaining only to demergers within the meaning of section 125-70 of the ITAA 1997. Second, section 45B is concerned with “capital benefits” – an object not exclusively concerned with demergers and thus having a somewhat broader application. Operative provision 32 Subsection 45B(2) of the ITAA 1936 provides that section 45B of the ITAA 1936 will apply when: 32.1 there is a scheme under which a person is provided with a demerger benefit or a capital benefit by a company15; 32.2 under the scheme a taxpayer, who may or may not be the person provided with the demerger benefit or the capital benefit, obtains a tax benefit16; and 32.3 having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into the scheme 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 to obtain a tax benefit17. Determinations under subsection 45B(3) 33 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 that either or both of section 45BA (in relation to a demerger benefit) and section 45C (in relation to a capital benefit) apply. 34 The effect of a determination made under paragraph 45B(3)(a) of the ITAA 1936 (that section 45BA applies) is that some or all of a demerger benefit will be treated as not being a demerger dividend18, thus exposing the dividend to taxation. 35 The effect of a determination made under paragraph 45B(3)(b) of the ITAA 1936 (that section 45C applies) is that some or all of a capital benefit will be an unfranked dividend paid to the relevant taxpayer out of profits 19. Key concepts 36 It is evident from subsection 45B(2) that there are a number of distinct elements to the application of section 45B. Specifically: (a) (b) (c) (d) 37 15 16 17 18 19 there must be a “scheme”; under that scheme, a person must be provided with either a demerger benefit or a capital benefit; under that scheme, a taxpayer must obtain a tax benefit; and considered objectively, there must be a not incidental purpose of enabling a taxpayer to obtain that identified tax benefit. The remainder of this part of the paper will consider the requirements of each of these elements. Section 45B(2)(a) of the ITAA 1936 Section 45B(2)(b) of the ITAA 1936 Section 45B(2)(c) of the ITAA 1936 Subsection 45BA(1) of the ITAA 1936 Subsections 45C(1) and (2) of the ITAA 1936 Section 45B: Dealing with Frankenstein’s creature | Page 8 Scheme 38 39 A “scheme”, for the purposes of section 45B, is taken to have the same broad meaning as provided in Part IVA of the ITAA 1936. The definition in subsection 177A(1) of the ITAA 1936 provides that a ‘scheme’ is: 38.1 any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable by legal proceedings; and 38.2 any scheme, plan, proposal, action, course of action or course of conduct. This definition of “scheme” encompasses a wide range of undertakings. A “scheme” will be readily identifiable in most cases of capital reductions or share buy backs. Further, a scheme will be readily identifiable in most, if not all, demergers. In that regard, PS LA 2005/21 states: “It is expected that a demerger, or part of a demerger, would constitute either a scheme or part of a scheme for the purposes of section 45B of the ITAA 1936. A demerger may be part of a wider scheme which includes a subsequent transaction such as a share buy-back, liquidation or proposed sale of either the demerged entity or the head entity to a third party. Similarly, the scheme may include a transaction precedent to the demerger, such as the transfer of assets or addition of a new company to the group. Alternatively, the demerger itself or part of the demerger may constitute the scheme.”20 Provision of a demerger benefit 40 41 The term demerger benefit is defined in subsection 45B(4) of the ITAA 1936. That subsection provides a person is provided with a demerger benefit if in relation to a demerger: 40.1 a company provides the person with ownership interests in that or another company; or 40.2 something is done in relation to an ownership interest owned by the person that has the effect of increasing the value of an ownership interest (which may or may not be the same ownership interest) owned by the person. It has been suggested that a demerger will always involve the provision of a demerger benefit. For example, PS LA 2005/21 states: “Under a demerger, it is expected that a person will always be provided with a demerger benefit. The definition of a demerger under section 125-70 of the ITAA 1997 requires there to be a disposal of ownership interests or an issue of ownership interests to the owners of the head entity. This means the owners of the head entity will invariably be provided with a demerger benefit. Nevertheless, at this point it is pertinent to acknowledge that whilst every demerger will involve the provision of a demerger benefit, it may not involve a demerger dividend.”21 Provision of a capital benefit 42 The term capital benefit is defined in subsection 45B(5) of the ITAA 1936. That subsection provides as follows: “A reference to a person being provided with a capital benefit is a reference to any of the following: 20 21 (a) the provision of ownership interests in a company to the person; (b) the distribution to the person of share capital or share premium; (c) something that is done in relation to an ownership interest that has the effect of increasing the value of an ownership interest (which may or may not be the same interest) that is held by the person.” PS LA 2005/21, paragraph 28. PS LA 2005/21, paragraph 30. Section 45B: Dealing with Frankenstein’s creature | Page 9 43 By their very nature, in all cases involving a capital reduction there will be a capital benefit for the purposes of section 45B. Share buy-backs with a capital component will also give rise to a capital benefit. 44 Capital benefits can also arise in the case of a demerger. Given that the concepts of demerger benefit and capital benefit are defined by reference to the provision of ownership interests, there is an element of overlap in their meanings. In this regard, PS LA 2005/21 explains: “In a demerger, subsection 45B(5) of the ITAA 1936 includes in the provision of a ‘capital benefit’ that part of a ‘demerger benefit’ that is not a dividend. As the concepts of ‘demerger benefit’ and ‘capital benefit’ are both defined by reference to the provision of ownership interests, to some extent their meanings overlap. The overlap of the two concepts is confirmed and explained by subsection 45B(6) which stipulates that a person is not provided with a capital benefit to the extent that the provision of interests to them involves their receiving a ‘demerger dividend’. Thus, the effect of subsections 45B(5) and (6) is that to the extent that the provision of a ‘demerger benefit’ is not a ‘demerger dividend’ it will also constitute the provision of a ‘capital benefit’.” 22 Obtaining a tax benefit 45 Subsection 45B(9) of the ITAA 1936 provides that a taxpayer “obtains a tax benefit” where the amount of tax payable, or any other amount payable under the ITAA 1936 or ITAA 1997, by the taxpayer would, apart from the operation of section 45B: 45.1 be less than the amount that would have been payable; or 45.2 be payable at a later time than it would have been payable; if the demerger benefit had been an assessable dividend or the capital benefit had instead been a dividend. 46 In determining whether a tax benefit has been obtained, the task, then, is to compare what the tax position would have been if the payment had been a “dividend” with the actual tax position of the person receiving the demerger or capital benefit, ignoring section 45B. This is, of course, conceptually similar to the notion of “tax benefit” for the purposes of Part IVA. 47 There is no de minimus exclusion in subsection 45B(9) and, in that regard, there will be a tax benefit as defined even if the difference in the actual tax position and the assumed tax position is nominal or immaterial. Furthermore, there will be a tax benefit even though only a small proportion of shareholders will receive a relevant tax benefit. However, in those cases, the lack of material difference or the disproportionate benefit may go to the question of purpose (see below). 48 In most cases of capital reductions and share buy-backs, a tax benefit can be readily identified. The Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998, which introduced section 45B into the ITAA 1936, provides the following examples of a tax benefit for the purposes of section 45B (at paragraphs 1.27 and 1.28): “For example, obtaining a tax benefit would include circumstances where the amount of tax assessed as being payable by the relevant taxpayer in respect of the capital benefits is substantially the same as would have been the case had the relevant taxpayer received a dividend, but the relevant taxpayer has income tax losses, or the company providing the capital benefits has franking credits, which are preserved for future income years (and therefore reduce tax in those years). Obtaining a tax benefit also includes circumstances where the amount of a refund payable to the relevant taxpayer would, but for this section, be increased.” 49 Further examples where a tax benefit is likely to arise in a capital reduction context include: 49.1 22 individual shareholders who would be entitled to the CGT discount on the sale of the share; PS LA 2005/21, paragraph 104. Section 45B: Dealing with Frankenstein’s creature | Page 10 50 51 49.2 shareholders under a capital reduction who suffer an erosion to the cost base of their shares as a result of the return of capital; 49.3 resident shareholders in a non-resident company returning capital to shareholders, which would not be assessable but would be fully assessable if it was a dividend;23 Circumstances where, arguably, there can be no tax benefit in the context of capital reductions include: 50.1 a return of capital by a company with only corporate shareholders, which has a history, and intention, of only paying franked dividends (ie, the gross-up and tax offset will not give rise to any tax payable by the company); and 50.2 a return of capital by a company with only non-resident shareholders, which has a history, and intention, of only paying franked dividends (ie, if a fully franked dividend is paid to a non-resident shareholder, no liability to withholding tax arises pursuant to paragraph 128B(3)(ga) of the ITAA 1936). In most demerger cases, since: 51.1 the provision of a demerger benefit does not constitute the receipt of assessable income to the head entity shareholders (as a result of subsections 44(4) and (5) of the ITAA 1936 and section 125-80 of the ITAA 1997) and will not, in the future represent assessable income; and 51.2 the tax payable on the demerger benefit and the capital benefit will be less than it would be if it had been an assessable dividend and a dividend respectively, it follows that head entity shareholders will almost always obtain a tax benefit under a demerger. 52 Even if a head entity has franking credits that would enable the demerger benefit to be fully franked if it was an assessable dividend, and assuming the taxpayer has a low marginal tax rate, those franking credits are still preserved under a demerger as an offset against the shareholders income in future years, which constitutes a tax benefit. A tax benefit is also obtained by the relevant taxpayer if the amount of refund payable would be less than if the demerger benefit was an assessable dividend24. The same principle applies in relation to the preservation of taxpayer losses under a demerger25. More than incidental purpose – juggling the 19 factors 53 It all comes down to purpose. 54 In order for section 45B to apply, the Commissioner is required to consider the circumstances set out in subsection 45B(8) of the ITAA 1936 to determine whether any part of the scheme was entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit. 55 The question posed by paragraph 45B(2)(c) is whether, objectively, it would be concluded that a person who entered into or carried out the scheme (whether or not that person is the person receiving the capital benefit), did so for the purpose of obtaining the identified tax benefit in respect of the capital benefit. The taxpayer’s, or anyone else’s, subjective motives are irrelevant. 56 On the question of the requisite purpose, the following observations may be made: 56.1 23 24 25 26 Paragraph 45B(2)(c) is not concerned with the purpose of the scheme. What is relevant is the purpose, objectively determined, of any person or persons who entered into or carried out the scheme.26 See Class Ruling CR 2004/74. PS LA 2005/1, para 37 PS LA 2005/1, para 38 Relevant to the present context, Gummow and Hayne JJ, in FC of T v Hart (2004) 206 ALR 207 (at 225) made a similar point in relation to section 177D. Section 45B: Dealing with Frankenstein’s creature | Page 11 56.2 If a taxpayer enters into a scheme with another taxpayer for the purpose of enabling either of the taxpayers to obtain a tax benefit, the fact that the second taxpayer does not share that purpose will not prevent the rule from applying. 56.3 Paragraph 45B(2)(c) requires “a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit”. In that regard, the Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998 stated (at paragraph 1.31 and 1.32) that: “The words in parentheses are inserted for more abundant caution; a reference to a purpose of a scheme is usually understood to include any main or substantial purpose of the scheme, and the words in parentheses clarify that this is the intended meaning here. Thus while new section 45B does not require the purpose of obtaining a tax benefit to be the ruling, most influential or prevailing purpose, neither does it include any purpose which is not a significant purpose of the scheme. A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with one of the main or substantial purposes of the scheme, or merely follows that purpose as its natural incident.” 56.4 Paragraph 45B(2)(c) simply requires “a purpose”. If it comes down to more than one not incidental purpose, the question, unlike for Part IVA, of which purpose is the “ruling, prevailing or most influential”27 purpose is an irrelevant one. It is sufficient that there is simply a purpose. As the Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998 stated (at paragraph 1.30): “… if a taxpayer enters into such a scheme with two or more purposes, neither of which is merely incidental, the fact that one purpose is not that of obtaining a tax benefit relating to a capital benefit will not prevent the section from applying.” 57 In order for section 45B to apply, the Commissioner is (and taxpayers and their advisors are) required to consider the 19 matters set out in subsection 45B(8) – ie the 11 matters identified in subparagraphs 45B(8)(a) to (j) plus the eight “Part IVA matters” referred to in subparagraphs 177D(b)(i) to (viii), which are brought into consideration by subparagraph 45B(8)(k) – to determine whether any part of the scheme would be entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit. In essence, these 19 matters seek to test the extent to which demerger benefits are referable to profits and the capital benefit is a substitute for dividends. 58 By way of observation, we note that in the field of memory and higher brain function, there is a working theory that human beings (or ordinary ones at least) can only retain in their mind at any one time 7 things, plus or minus two. Under section 45B we are required to mentally juggle and weigh up 19 things (more if you consider that the list of things in section 45B(8) are inclusive – ie the Commissioner might think of a few more). No wonder we struggle! 59 The circumstances, listed in subsection 45B(8), which are relevant in determining whether any person has the requisite purpose are: 27 “(a) the extent to which the demerger benefit or capital benefit is attributable to capital or the extent to which the demerger benefit or capital benefit is attributable to profits (realised and unrealised) of the company or of an associate (within the meaning in section 318) of the company; (b) the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or by an associate (within the meaning in section 318) of the company; (c) whether the relevant taxpayer has capital losses that, apart from the scheme, would be carried forward to a later year of income; FC of T v Spotless Services Ltd (1996) 186 CLR 404 at 416, per Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ. Section 45B: Dealing with Frankenstein’s creature | Page 12 (d) whether some or all of the ownership interests in the company or in an associate (within the meaning in section 318) of the company held by the relevant taxpayer were acquired, or are taken to have been acquired, by the relevant taxpayer before 20 September 1985; (e) whether the relevant taxpayer is a non-resident; (f) whether the cost base (for the purposes of the Income Tax Assessment Act 1997) of the relevant ownership interest is not substantially less than the value of the applicable demerger benefit or capital benefit; … (h) if the scheme involves the distribution of share capital or share premium – whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital or share premium; (i) if the scheme involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests: (j) (i) the period for which the ownership interests are held by the holder of the interests; and (ii) when the arrangement for the disposal of the ownership interests was entered into; for a demerger only: (i) whether the profits of the demerging entity and demerged entity are attributable to transactions between the entity and an associate (within the meaning in section 318) of the entity; and (ii) whether the assets of the demerging entity and demerged entity were acquired under transactions between the entity and an associate (within the meaning in section 318) of the entity; (k) any of the matters referred to in subparagraphs 177D(b)(i) to (viii).” 60 28 In their original legislative context (ie, Part IVA) the eight paragraph 177D(b) factors are considered in order to form a view about the “dominant purpose” of a scheme. The incorporation of the Part IVA factors into section 45B does not introduce a different purpose test into section 45B – they are applied in the context of section 45B’s “not incidental purpose” test.28 The eight Part IVA factors set out in paragraph 177D(b) are as follows: “(i) the manner in which the scheme was entered into or carried out; (ii) the form and substance of the scheme; (iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out; (iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme; (v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme; (vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme; PS LA 2005/21, paragraph 84. Section 45B: Dealing with Frankenstein’s creature | Page 13 (vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and (viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi).” 61 The Commissioner has noted the possible interpretational difficulty of the reference to “this Part” in subparagraph 177D(b)(iv), given in its original context the reference is to Part IVA of the ITAA 1936.29 However, the Commissioner suggests that the incorporation by reference in paragraph 45B(8)(k) demonstrates an intention to apply subparagraph (iv) in the context of section 45B, and suggests “the most sensible construction of the words of subparagraph 177D(b)(iv) is to read ‘this Part’ to mean ‘this section’.”30 This is an approach with which the authors agree. 62 The list of 19 factors is not exhaustive. Rather, the list is inclusive “and the Commissioner may have regard to other circumstances which he regards as relevant.”31 Another circumstance which may be relevant is whether the particular shareholder has revenue losses (which is a circumstance mentioned in section 45A). Apart from that, it is difficult to envisage what those other circumstances might be but, theoretically, they can be relied on if identified. 63 We will now consider separately the purpose test in the context of capital returns and demergers. Section 45B purpose and capital returns “The form of the monster on whom I had bestowed existence was forever before my eyes, and I raved incessantly concerning him.”32 64 Section 45B can apply to share buy-backs with capital components and selective capital reductions (with or without a share cancellation). Relevant to the provision of such capital benefits (as opposed to demergers benefits) the following comments can be made in relation to some of the subsection 45B(8) factors. 65 Paragraph 45B(8)(a) – the matter to consider is the extent to which the distribution is attributable to profits of the company (or an associate of the company, for example, a subsidiary or a parent). If so attributable, this weighs in favour of a finding of the requisite purpose. This is the “heart” of section 45B.33 In that regard: 29 30 31 32 33 34 35 65.1 If a company makes a profit from a transaction, for example the disposal of business assets, and then returns capital to shareholders equal to the amount of the profit, that would suggest that the distribution of capital is a substituted dividend.34 65.2 Where a company has generated greater than usual profits in the year prior to the year the capital is returned and had used surplus cash to repay borrowings, it may be considered that the distribution is effectively sourced from the profits that had produced surplus funds to repay earlier borrowings. If the company's business structure had remained intact and its recent operations had not included any significant divestment, this may suggest that no surplus equity capital had been generated.35 Thus, the capital benefits are attributable to profits. PS LA 2005/21, paragraph 91. PS LA 2005/21, paragraph 92. PS LA 2005/21, paragraph 46. Note 1, Chapter 5. Note 10, at 24. The Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998, paragraph 1.35. See also PBR 64868. See ATO ID 2004/654. Section 45B: Dealing with Frankenstein’s creature | Page 14 65.3 On the other hand, if a company disposed of a substantial part of its business at a profit and distributed an amount of share capital which could reasonably be regarded as the share capital invested in that part of the business, the distribution of capital would not be seen as a substituted dividend because no amount would be attributable to profits.36 65.4 If a company wishes to raise fresh capital by issuing shares to a new cornerstone investor, and part of the equity received from that share issue is to be returned to existing shareholders (either by a selective capital reduction or buy-back), then, to the extent that the return of capital is attributable to the new equity, it should not be regarded as attributable to profits (thus a substitute for dividends). The proposition is that contributions by shareholders that result in an increase in equity do not, by definition (and under accounting standards) contribute to profits.37 65.5 Where: (a) a company is lowly geared; (b) the business operations of the company currently generate sufficient “free cash flows” to enable it to service a higher level of external debt; (c) the current capital and debt structure of the company is not conducive to achieving the desired rate of return for the shareholders, if that company obtains debt finance and uses the funds received to make a pro-rata share capital reduction to the shareholders it is unlikely that any part of the capital reduction will be attributable to specific profits, realised or unrealised, of the company.38 65.6 66 36 37 38 39 40 41 42 If a company is not doing particularly well and has accumulated realised and unrealised losses, a return of available cash treated as a debit to the share capital account will properly be regarded as entirely capital and not a dividend substitute.39 Paragraph 45B(8)(b) – the pattern of distributions by the company. In that regard: 66.1 This factor invites an examination of a company’s pattern of distributions. If this examination shows a capital benefit replacing or supplementing the regular distributions, this would point to an unfavourable conclusion as to purpose.40 66.2 If dividends of a certain amount are normally paid year to year, but then the company instead makes proportionate returns of capital, this suggests that the capital benefit is actually a substitute for dividends.41 66.3 Similarly, if a company had a regular pattern of dividend payments, had recently accumulated substantial retained profits but the most recent dividend (which coincided with the capital payment and could be considered part of the relevant “scheme”) was not commensurate with the increased level of profits, this may suggest the requisite purpose (ie to obtain the tax benefit).42 Ibid. See also PBR 64868. The assumption here is that subsection 6(4) would not apply to effectively convert the debit to the share capital account to a dividend. See CR 2004/46. PBR 61244. See also Note 10, at 28. Note 10, at 24. Note 34. Se also PBR 64868. Note 35. Section 45B: Dealing with Frankenstein’s creature | Page 15 67 66.4 If a company has never paid a dividend, nor intending to commence to pay dividends, this would tend to indicate that the capital payment is not a substitute for dividends.43 However, it may be problematic if the company in that situation regularly undertakes share buy-backs (accompanied by share splits) to allow shareholders to get excess cash.44 66.5 Where a company has not previously paid dividends or undertaken any capital reductions and there is an intention to pay future dividends so that frankable profits are distributed equally to the same shareholders that are to receive the return of capital, this suggests that the capital benefit is not a substitute for dividends.45 Paragraph 45B(8)(c) – the relevant taxpayer has capital losses which, but for the receipt of the capital benefit, will be able to be applied against future capital gains. In that regard: 68 69 43 44 45 46 47 48 67.1 Paragraphs 45B(8)(c) to (f) concern the particular taxation status of shareholders. If a company has a diverse range of shareholders, the factors in these paragraphs would tend neither toward nor against the existence of the requisite purpose if the capital reduction or buy-back was not especially targeted in intention or (perhaps) effect.46 67.2 The enquiry here is whether the capital benefit will erode losses or not (ie, by offsetting a capital gain against available capital losses). If losses would be eroded by the capital benefit, this would tend against the existence of the requisite purpose. 67.3 Conversely, if losses were not eroded, this would tend toward the existence of the requisite purpose. So for example, if a capital reduction gives rise to CGT event G1 (see above), a capital gain will only arise if the payment made exceeds the shareholders’ cost base for each share. If in the particular circumstances, the cost base of each share will be reduced by the amount of the capital reduction under subsection 104-135(4) and a capital gain will not arise there will be no utilisation of available capital losses. Accordingly, those capital losses can still be carried forward to a later income year.47 Paragraph 45B(8)(d) – the capital benefit is provided in respect of pre-CGT shares. In that regard: 68.1 If all the shares in the company were post-CGT shares, this factor cannot suggest the requisite purpose. Indeed, it would weigh against the requisite purpose. 68.2 Further, if only a small minority of shares are pre-CGT shares, this should not tend toward the existence of the requisite purpose. However, if a substantial part of shares are pre-CGT shares, this tends to suggest the impermissible purpose.48 Paragraph 45B(8)(e) – the relevant taxpayer receiving the capital benefit is a non-resident. The enquiry here is whether non-residents gain a greater tax benefit from receiving capital benefits rather than dividends. In that regard: 69.1 If all the shares in the company were held by residents, this factor cannot be invoked to suggest the requisite purpose. Indeed, it would weigh against the requisite purpose. 69.2 Further, if only a small minority of shareholders were non-residents and they were not being targeted for the capital benefit, this should not tend toward the existence of the requisite purpose. PBR 61244. Vann, R., The New Definition of Dividend, Taxation Institute of Australia, Corporate Noosa Retreat, August 1998, at 22. Note 38. Note 35. Note 38. PBR 64868 Section 45B: Dealing with Frankenstein’s creature | Page 16 69.3 Factors that are relevant in determining whether non-residents gain a greater tax benefit from receiving capital benefits rather than dividends include the amount of profits available for distribution, the inefficient use of franking credits on entering into the arrangement and the extent to which dividend distributions are capable of being franked and will therefore be free from withholding tax.49 Thus, if: (a) it is not expected that any dividends will be paid in the near future; (b) it is intended that non-resident shareholders will participate equally in future dividends; and/or (c) the company has capacity to fully frank dividends out of anticipated retained earnings, this should not tend toward the existence of the requisite purpose. 69.4 70 71 72 Paragraph 45B(8)(f) – the capital benefit is provided in respect of shares for which the cost base is not substantially less than the capital benefit. In that regard: 70.1 How relevant this factor is depends on the uniformity of the shareholders CGT position in terms of when the shareholders acquired shares. If there is no uniformity amongst the shareholder, this factor will tend to be neutral. 70.2 Clearly, if the person receiving the capital benefit has a cost base in the shares, prior to the capital reduction, that is substantially higher than the value of the benefit provided by the capital reduction (so that the cost base absorbs the capital proceeds), this will tend toward the existence of the requisite purpose. Paragraph 45B(8)(h) – in the case of a scheme involving the distribution to the relevant taxpayer of share capital, whether the interest held by the taxpayer in the company has been affected, or whether that interest remains the same as if a dividend has been paid instead. Paragraph 45B(8)(h) of the ITAA 1936 requires a comparison of the respective interests held by shareholders before and after the distribution. It is particularly relevant to share buy-backs. In that regard: 71.1 If the proportionate voting and other interests held by the taxpayer are less than the taxpayers pre-reduction interest this would suggest a genuine return of capital.50 In a share buy-back or a selective capital reduction with a cancellation of shares, the shareholders’ proportionate capital, dividend and voting rights would fall relative to shareholders who chose not to participate. 71.2 On the other hand, where the proportional interests held by the shareholders after the distribution of capital will be the same as that that would have been held had an equivalent dividend been paid instead of the capital benefit, this will tend toward the existence of the requisite purpose (ie, it is indicative of the capital benefit being in substitution for a dividend). Paragraph 45B(8)(i) – in the case of schemes involving the issue of shares and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests. This factor is concerned with the sale proceeds from the disposal of shares (or a transaction effectively amounting to disposal eg, a variation of rights), which provides the equivalent to a cash dividend in a more tax-effective form. In that regard: 72.1 49 50 If Australian shareholders, hold a relatively small proportion of the equity in a nonresident company, this would weigh against the existence of the requisite purpose. If the shares were sold (or rights varied) shortly after the capital benefit was provided, this would tend toward the existence of the requisite purpose. Of course, if the shares are held for a long time before being sold, query whether the sale of the shares is actually part of the identified scheme. Note 38. Note 34. Section 45B: Dealing with Frankenstein’s creature | Page 17 72.2 73 If the arrangement for the sale of the shares occurs contemporaneously with the provision of the benefit, this weighs in favour of a finding of the requisite purpose. Paragraph 45B(8)(k) – any of the matters referred to in subparagraphs 177D(b)(i) to (viii). These are the circumstances that are to be considered in determining whether a scheme was entered into for the purpose of obtaining a tax benefit under Part IVA of the ITAA 1936 (see above). Considering the inclusion in subsection 45B(8) of the section 177D(b) factors, it seems difficult to see how Part IVA could have any application to a share buy-back or capital reduction if, for whatever reason, section 45B could not apply. Section 45B purpose and demergers Oh! No mortal could support the horror of that countenance. A mummy again endued with animation could not be so hideous as that wretch. I had gazed on him while unfinished; he was ugly then; but when those muscles and joints were rendered capable of motion, it became a thing such as even Dante could not have conceived.51 74 We are told that the full extent of demerger tax relief will only apply to “genuine demergers”. That is, the scheme of a demerger should be driven by genuine commercial imperatives which have business merit, as opposed to merely a means to deliver value from company to shareholder in a tax effective manner52. The retro-fitted section 45B is the instrument given to the Commissioner to sort out the wheat from the chaff. It is a very blunt instrument (and to some an instrument of torture). 75 What constitutes a “genuine demerger” (indeed, the very notion of a “genuine demerger”) is not referred to or defined in Division 125 of the ITAA 1997 or in section 44 of the ITAA 1936. Importantly, it is not referred to in section 45B. It must be borne in mind that the mechanical rules in Division 125 and section 44 are not made to depend on a notion of a “genuine demerger” – all you need is a demerger (as defined) and then satisfy the other technical rules. The consideration of whether something is a “genuine demerger” arises through section 45B, which like Part IVA (its conceptual mother ship), stands menacingly over the mechanical rules (like Frankenstein’s creature). 76 Whilst the Ralph Review of Business Taxation demerger relief recommendation was limited to widely held entities, Division 125 of the ITAA 1997 places no such restrictions and accordingly the relief is available to privately owned entities 53. However, we think it is fair to say that, on the ATO’s view of the law, it is generally more difficult (but not impossible) for private groups to satisfy the requirements of a “genuine demerger” – thus section 45B. The basis for this difficulty appears to be a belief that the driving factors for private group demergers are not ”commercial imperatives” but, rather, tend to be estate planning, family business relationships, divorce and marriage, or simply unravelling structures which have passed their use by date54. Inherent in this belief is the notion that these latter factors and “business imperatives” and mutually exclusive. 77 It is important to understand that, in the context of demergers, section 45B has two distinct but related strands. The first strand, a demerger specific rule (achieved by amendments to section 45B when the demerger rules were introduced in 2002) looks at the section 44(3) and (4) dividend exemption. Essentially, the demerger specific rule tests whether the components of the demerger allocation (ie, capital and dividends) are weighed impermissibly (that is to say with a tax purpose) in favour of receiving a non-assessable dividend. 51 52 53 54 Note 1, Chapter 5. PBR 45642 PBR 45642 PBR 45642 Section 45B: Dealing with Frankenstein’s creature | Page 18 78 The second strand is the more general capital benefits rule (or the dividend substitution rule), which we have had on the books since 1998. Thus, that part of a demerger allocation that is not a dividend (either it is a distribution of capital from the head entity to its shareholders or the issue of shares by the demerged entity directly to the head entity shareholders) can be tested to ensure that owners do not impermissibly receive tax preferred capital over assessable dividends. It looks to see if the receipt of shares by the head entity shareholders is, in substance, attributable to realised and unrealised profits in the group – thus should be a dividend. 79 The point is that even if a demerger does not involve a distribution of a dividend from a head entity to shareholders – for example, where the demerged entity issues shares directly to the shareholders of the head entity – the receipt of the shares can be deemed to be an unfranked dividend, thus potentially wiping away, with more pain, the benefits of CGT relief under Division 125. 80 Put another way, in the context of demergers, section 45B can deny tax benefits in two ways. First, under the demerger specific rule the Commissioner can make a determination under 45BA, the effect of which is to deny a demerger dividend of that status, thus exposing the dividend to taxation. Secondly, that part of a demerger allocation (see above) that is not a dividend may be subject to the general section 45B capital benefits rule (ie, where a capital payment is treated as an unfranked dividend). 81 As the Commissioner has pointed out, in the context of the relationship between a company and its shareholders, the distribution of capital and profit that constitutes the interest held in the demerged entity is an immediate and unescapable result of a demerger. The Commissioner’s view, with which we agree, is that only if the essential purpose of the demerger is sufficiently independent of that relationship will the distribution of profit be regarded as an incidental purpose of the transaction. However, the Commissioner then works on the basis that it is only when the demerger is undertaken as a scheme to enhance business efficiency (at the demerger group level) that the delivery of a tax benefit will be a merely incidental purpose of the scheme55. 82 It has been suggested that a purpose of obtaining a tax benefit will be almost invariably present in a demerger, and that the real question in the demerger context will be whether it is a more than incidental purpose. In this regard, PS LA 2005/21 states as follows: “It is expected that most, if not all, schemes of demerger will have a purpose of enabling taxpayers (that is, the head entity’s shareholders) to obtain a tax benefit. Whether it constitutes a more than incidental purpose of the scheme is a matter to be determined objectively from the relevant circumstances of the scheme. If the business or commercial purpose for the scheme is not sufficiently cogent, it is likely that the tax purpose will be more than incidental. But if the tax purpose merely follows the commercial purpose as its natural incident, the tax purpose will be incidental. However, a person (or persons) could be found objectively to have two or more purposes, none of which is merely incidental and one of which is to obtain a tax benefit (either as a demerger benefit or a capital benefit), in which case section 45B of the ITAA 1936 would apply. The fact that they have other substantial purposes would not prevent the section from applying. To avoid the application of section 45B, the tax purpose must be objectively subordinate to the other substantial purposes.56 83 The first of the above extracted paragraphs may be accepted. cogency, like beauty, is in the eye of the beholder. 84 It seems to us that in assessing purpose for the two separate strands of section 45B, you are treading a narrow path. On the one hand you can’t pay too much out as a dividend because you may be denied the dividend exemption. On the other hand, you can’t pay too much out as capital as it may be treated as an unfranked dividend. 55 56 However, sufficient PBR 42806 PS LA 2005/21, paragraphs 44-45. Section 45B: Dealing with Frankenstein’s creature | Page 19 85 On reading PBR’s (and anecdotally) it appears that the Commissioner has, in the context of demergers, reduced the section 45B “purpose” test to whether there is a “genuine demerger”. For example, in PBR 46979, it is stated that “section 45B effectively determines whether the demerger is genuine and that an appropriate mix has been adopted by identifying and weighing the relevant circumstances of the demerger proposal in order to determine whether the object of delivering a tax free dividend into the hands of the owners is a more than incidental purpose of the demerger.” As noted above, the concept of “genuine demerger” is not something set out in the legislative regime. Further, the Commissioner’s conception of a “genuine demerger” is, it seems, a narrow one. A sense of this can be obtained from the following passages from PBR 45642: “The scheme of a demerger should be driven by genuine commercial imperatives and therefore has business merit, or if it is merely a means to deliver value from company to shareholder tax free as an end in itself and merely an incidental aspect of a business restructure. This view supports the recommendations (Recommendation 19.4) made by John Ralph in his Review of Business Taxation report, July 1999, whereby there should be no taxing impediment to entities restructuring their operations which would otherwise lead to a reduction in the overall efficiency of the economy. What constitutes a ‘genuine demerger’ (or for that matter a ‘demerger’) is not well illustrated in either legal or accounting principles or concepts, nor is the term defined in the Explanatory Memorandum to the Legislation. Whilst the Ralph Review of Business Taxation demerger relief recommendation was limited to widely held entities, Division 125 of the ITAA 1997 places no such restrictions and accordingly the relief is available to privately owned entities. However, it is difficult to concede, except in exceptional circumstances, situations whereby a privately held entity demerges in order to promote the ‘overall efficiency of the economy’. Generally, such driving factors are estate planning, family business relationships, divorce and marriage, or simply unravelling structures which have past their used by date. It is also difficult to concede that the demerger concessions be available to the shareholders in those circumstances described above in light of the comments made by the Ralph Committee … It appears that at the time of lodging their application for a private binding ruling the applicant’s view of demerger tax relief, and one somewhat widely shared, was that it was available to simply shrink corporate groups; the rationale being that the head entity’s shareholders still had only paper interests and were no closer to corporate property than their original interest put them. However, the rationale overlooks that the new interests represent a transfer of value from corporation to shareholder which but for demerger relief would normally involve a taxing event for the shareholder to the extent that corporate profits are involved.” (emphasis added)57 86 Similarly, in PBR 46979, it is stated: “Section 45B would normally apply where the scheme of demerger merely affects a group restructure without the essential object of enhancing the efficiency of businesses run by the group. This enhancement of business efficiencies is the stated policy object of demerger tax relief. The second reading speech of Mr Slipper, Parliamentary Secretary to the Minister of Finance and Administration, included the following: 57 PBR 45642. Section 45B: Dealing with Frankenstein’s creature | Page 20 “The final important business tax measure in the bill introduces provisions to provide tax relief for corporate or trust demergers. The tax relief will apply to only genuine demergers and is achieved by requiring underlying ownership to be maintained pre and post a demerger and requiring the head entity to demerge at least 80 per cent of its ownership in the demerging entity. Providing tax relief for demergers will increase business efficiency by allowing greater flexibility in restructuring a business and ensuring tax considerations are not an impediment to such restructures. This will provide an overall benefit to the economy and enhance the competitiveness of Australia’s business sector through greater opportunities to increase shareholder value by creating more efficient business structures.” Further, in her Press Release of 6 May 2002 in regard to demerger tax relief Senator Helen Coonan, the Minister for Revenue stated: “Tax relief for demergers will increase efficiency by allowing greater flexibility in restructuring businesses, providing an overall benefit to the economy. The Government has implemented this latest measure in business tax reform to enhance the competitiveness of Australia’s business sector.” Senator Coonan also discussed section 45B and 'genuine demergers' in the following terms: “An exemption from the dividend rules in the tax law will be provided for genuine demergers of a business or business assets. Integrity rules will support this exemption. A key rule will be modelled on section 45B of the Income Tax Assessment Act 1936 and will be designed to deny the dividend exemption if the demerger was only entered into to convert what would be normally be an assessable dividend into an exempt demerger dividend. In considering the possible application of this integrity rule, certain factors will be taken into account in determining whether the dividend exemption should be available. These factors could include, inter alia, the treatment in the shareholders funds (including the share capital accounts) of the demerging entity, the pattern of distribution of dividends, bonus shares and returns of capital by the demerging entity, the effect on the entity’s capacity to pay dividends in the future and whether the shareholders of the demerged entity have entered into any agreement or understanding at the time of the demerger that they will subsequently sell their shares in the demerged entity to a third party. As a general principle, this integrity rule is unlikely to apply to a demerger of an active business where there is a reasonable proportionate allocation of the shareholders funds (including the share capital accounts) of the demerging entity, unless the particular circumstances of the demerger suggest otherwise.” 87 So we can see that the notion of a “genuine demerger” is taken to mean a process that not only enhances the efficiency of the underlying business being carried on by a group but to the Australian economy in general. Support for this is expressed to be the Ralph Report, the second reading speech of Mr Slipper in introducing the relevant legislation into Parliament and the Press Release of 6 May 2002 in regard to demerger tax relief by Senator Helen Coonan, the then Minister for Revenue. 88 Notwithstanding what is said to be the policy behind section 45B and demerger tax relief, section 45B provides that the requisite purpose is to be determined having regard to the relevant circumstances of the scheme which are set out in subsection 45B(8). Accordingly, the purpose test (in the context of demergers) should not be reduced to what is or is not a “genuine demerger”. It is not a statutory criterion, and in any event, what does it really mean? Just as the Commissioner eschews reducing the purpose test in Part IVA to whether a scheme was “blatant, artificial or contrived” he should not seek to badge an arrangement as a “genuine demerger” as a proxy for satisfying the purpose test. As the Commissioner acknowledges: Section 45B: Dealing with Frankenstein’s creature | Page 21 “[t]he purpose test is therefore a matter of identifying and weighing those of the listed circumstances, and perhaps other unlisted circumstances, relevant to the scheme at hand. In this way, an objective conclusion is reached as to whether the delivery of the tax benefit is a substantial purpose of the scheme or merely a natural incident of it.”58 89 In the context of demergers, the key subsection 45B(8) matters are: 89.1 Paragraph 45B(8)(a) – the extent to which the demerger benefit or capital benefit is attributable to profits – thus, if on an overall economic analysis a demerger dividend does not relate to realised or unrealised profits, this suggests a not incidental (and impermissible) tax purpose; 89.2 Paragraph 45B(8)(b) – the pattern of distributions (dividends versus returns of capital) – so if there is a regular pattern of paying dividends, a capital demerger allocation suggests a dividend substitution purpose. Conversely, if a company has for a long time not paid any dividends, a demerger dividend may suggest a impermissible purpose – the inference is that an interruption to the normal pattern of profit distribution and its replacement with a distribution under a demerger would suggest a not incidental (and impermissible) tax purpose; 89.3 Paragraphs 45B(8)(c) to (e) – whether the shareholders hold pre-CGT shares, are non-residents or have high cost bases; 89.4 Paragraphs 45B(8)(h) – whether the interests held are the same before and after the distribution; 89.5 Paragraphs 45B(8)(j) – whether the profits of the demerging entity and demerged entity are attributable to (and whether assets are acquired under) transactions between the entity and an associate (within the meaning in section 318) of the entity; and 89.6 Paragraphs 45B(8)(k) – the eight Part IVA matters in subsection 177D(b) – substance of scheme, timing, financial outcome etc. As we shall see, when we analyse some private rulings, the Part IVA matters can take on particular importance in the context of demergers. The Commissioner’s application of section 45B – capital benefits Learn from me, if not by my precepts, at least by my example, how dangerous is the acquirement of knowledge, and how much happier that man is who believes his native town to be the world, than he who aspires to become greater than his nature will allow.59 90 Before looking at some specific PBR’s, a note of caution must be sounded about PBR’s published on the ATO website. The ATO makes it clear that any given published ruling (invariably in edited form): [is] not a publication approved in writing by the Commissioner. It is not intended to provide you with advice, nor does it set out the Tax Office’s general administrative practice. Therefore a record on this Register [of PBR’s] is non-binding and provides you with no protection (including from any penalty or interest). In addition, a record on the Register [of PBR’s] is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances.60 91 58 59 60 Nonetheless, as windows to the ATO’s soul, they are instructive. PBR 46979. Note 1, Chapter 4. Australian Taxation Office, “Disclaimer”, Register of <http://www.ato.gov.au/rba/disclaimer.asp> (accessed 26 July 2007). Section 45B: Dealing with Frankenstein’s creature Private Binding Rulings, | Page 22 92 The Commissioner has considered the operation of section 45B in the context of capital benefits in various PBR’s. A survey of the PBR’s in this area suggests a much more structured approach taken than that with respect to demerger benefits. Rather than considering whether the proffered purposes satisfy the vague requirement of a “genuine demerger”, the Commissioner appears (generally) to set out the objective purpose criteria and to individually address each one.61 Example 1 – section 45B does not apply62 Facts 93 A Company wanted to refinance its operations. The Company intended to raise debt from third party lenders and use those funds to undertake a capital reduction and cancellation of its redeemable preference shares. Having classified the redeemable preference shares as debt for taxation purposes under the debt/equity rules, the Company was essentially going to replace one form of debt with another. There was to be no reduction of equity in the company. 94 The redeemable preference shares could be redeemed at par at any time prior to their scheduled dates of redemption. Any redeemable preference shares not redeemed by their due dates were to be automatically rolled over on the same terms and in the same manner as the original issue. Decision 95 The Commissioner ruled that there was a relevant scheme, that under that scheme a capital benefit would be provided, and that the Company’s shareholder would be provided with a tax benefit upon cancellation of the redeemable preference shares. 96 However, the Commissioner ruled there was not a more than incidental purpose of obtaining a tax benefit. Important considerations supporting this determination were: 97 61 62 96.1 That the funds for the cancellation were being sourced from new third party debt with no reduction of outstanding shareholder’s funds. Thus there was no suggestion that the capital benefit was attributable to profits of the company (paragraph 45B(8)(b)). 96.2 The Company had in practice paid both franked and unfranked dividends to its shareholders, and would continue to do so in the future. Thus the pattern of distributions when considered with the share cancellation did not suggest the impermissible purpose of dividend substitution (paragraph 45B(8)(b)). 96.3 After the cancellation of the redeemable preference shares there was to be no change in the ordinary share capital of the company and all of the participating preferred shares, and no change in interests (paragraph 45B(8)(h)) 96.4 Both the form and the substance of the scheme was that the company was replacing one form of debt with another (paragraph 45B(8)(k) – subparagraph 177D(b)(ii)). 96.5 The change in the financial position of shareholders whose shares are subject to cancellation would be a reduction in their cost base in the Company’s shares equal to the amount of the cancellation (paragraph 45B(8)(k) – subparagraph 177D(b)(v)). 96.6 The Company’s overall debt position would be unchanged and there would be no change in its equity. The Commissioner concluded: See, eg, PBR’s 28579, 31365, 49487, 62911 and 69089. Taken from PBR 62911. Section 45B: Dealing with Frankenstein’s creature | Page 23 “The factors considered above support the conclusion that the cancellation of the [redeemable preference shares] should not be considered to have been undertaken for the main or substantial purpose of conferring a tax benefit to the shareholder. Accordingly section 45B should not apply in relation to the cancellation of [the redeemable preference shares] by the company.”63 Example 2 – section 45B does apply64 Facts 98 A Company carried on a family business. The trustee of the family trust held all the shares in the Company. The Company had substantial unappropriated profits, and a substantial franking surplus. 99 The Company proposed to have its paid up capital reduced by 50% over a period of three to four years by instalments. The Company intended to cancel 50% of the shares and return 50% of the paid-up capital to the trustee. The whole amount would then be distributed to an individual beneficiary of the family trust. The Company had made no capital distributions and had paid no dividends to the trustee over the past five years. The trustee did not have any current or carried forward losses, and the market value of the Company’s shares was estimated to be just over twice its paid-up amount. Decision 100 The Commissioner ruled that there was a relevant scheme, that under that scheme a capital benefit would be provided, and that the trustee obtained a tax benefit. 101 The Commissioner also found a not incidental purpose of obtaining a tax benefit. After reciting the matters to consider as set out in subsection 45B(8) of the ITAA 1936, the Commissioner concluded: “We consider that the capital reduction is attributable to profits given that: • • • • • The Company’s unappropriated profit as at 31 December 2002 is close to the proposed amount of capital benefit. The valuation suggests that Company will derive future profits. The capital reduction will be made by instalments. There is no significant change to the business structure. There are no planned major asset sales or borrowings. Further, there will be no changes in the relative interests of the trustee shareholder being the sole shareholder of the Company. And the cost base of the shares being cancelled is not substantially less than the value of the capital benefit. In fact, the cost base will be the same as the value of the capital benefit. Having considered the above, we conclude that the proposed return of share capital would be carried out for a purpose of enabling a taxpayer to obtain a tax benefit. And we consider that purpose is not merely incidental. Paragraph 45B(2)(c) would be satisfied. Consequently, section 45B would apply to the proposed return of capital.”65 The Commissioner’s application of section 45B – demerger benefits I was answered through the stillness of night by a loud and fiendish laugh. It rung on my ears long and heavily; the mountains reechoed it, and I felt as if all hell surrounded me with mockery and laughter. … The laughter died away; when a well-known and abhorred voice, apparently close to my ear, addressed me in an audible whisper--"I am satisfied: miserable wretch! you have determined to live, and I am satisfied."66 63 64 65 66 PBR 62911. Taken from PBR 36592. PBR 36592. Note 1, Chapter 24. Section 45B: Dealing with Frankenstein’s creature | Page 24 102 As noted above, on the Commissioner’s view, it is only those demergers which are driven by strictly “genuine” commercial imperatives and have as their essential object the enhancing of the efficiency of businesses run by a group of companies that will not attract section 45B. Anecdotally, there is a view that the ATO are less inclined to treat privately held company group demergers as being driven by genuine commercial imperatives at the entity/group level. Such views are reinforced by statements such as those set out in PBR 45642 (see paragraph 85 above), that privately held entities are unlikely to demerge in order to promote the overall efficiency of the economy. 103 In our view, there is no inherent inconsistency between estate planning, family business relationships, matrimonial breakups or unravelling cumbersome and out of date structures on the one hand and business efficiency on the other. 104 The point is that sorting out, for instance, the paralysing effects of squabbling principals of a private group by a demerger can lead to efficiencies in the operating entities. Similarly, the desire to spin out non-core assets for asset protection purposes can drive efficiencies in the core business. 105 It may be true to say (based on anecdotal evidence) that family group restructures involving demergers will be treated with more scepticism by the ATO than demerger schemes involving listed companies. The general explanation for this is the notion that there is less chance (or incentive) for tax shenanigans with widely held entities (which is, of course, debatable). 106 Anecdotally, key matters which tend to be problematic (perhaps fatal) for private groups are the existence of pre-CGT ownership interests and the sale of new interest shortly after the demerger.67 107 Whatever the attitude of the ATO is, it is clear that favourable rulings are given for private groups. 108 At a formal level, the shining beacon of hope is embedded in Practice Statement PSLA 2005/21. Of the six case studies presented in the Statement, three of them (Case Studies 2, 5 and 6) involve private groups in circumstances where the Commissioner says he would be unlikely to apply section 45B. 109 The Commissioner has considered the application of section 45B in various private rulings. The essential theme is that as long as you can identify not insignificant efficiencies at the business level, as opposed to efficiencies at the ultimate owner level, you are in with a chance. 110 In various private rulings the following matters were not considered by the ATO to be genuine reasons for a demerger (thus the requisite purpose was more likely to exist): 110.1 where shareholders want to deal directly with demerger subsidiary’s shares 68; 110.2 the fact that the head entity performs no function other than to hold shares in the demerger subsidiary and that after the demerger it is intended to liquidate the head entity 69; 110.3 where a shareholder of the head entity would like to dispose of his or her interest in the demerged entity while retaining his or her interest in the head entity 70; 110.4 where a person wishes to acquire equity in the demerged entity but not the head entity 71; 110.5 simplifying the asset structure of the shareholders of the head entity 72; 110.6 reducing administrative costs 73; 67 68 69 70 71 72 73 See, for example, Case Study 4 in PSLA 2005/21. PBR 42806; 64808 PBR 42806 PBR 64808 PBR 64808 PBR 63027 PBR 63027 Section 45B: Dealing with Frankenstein’s creature | Page 25 110.7 allowing management decisions to be made by shareholders directly, rather than through the head entity 74; and 110.8 facilitate a more straightforward transfer of some of the ultimate ownership interests in the demerged entity 75. 111 On the other hand, in various private rulings the following factors were accepted by the ATO to be genuine reasons for a demerger: 111.1 where the group wishes to raise additional capital to expand its core business76; 111.2 enhanced business efficiency77; 111.3 allowing entities to “stand alone” in open markets so as to enable a true representation of trading performance78; 111.4 reducing management conflicts and allowing for a more focused approach79; and 111.5 increased flexibility regarding business acquisitions, sales, mergers and joint ventures 80. 112 There are two point to make at this stage. First, the negative features of private group restructures referred to earlier can be drivers for the matters the ATO considers favourably. Secondly, when you look at the private rulings, the ATO often examine and advert to the reasons offered by the taxpayer’s as to why a demerger is being done and why it is being in the way it is done. Of course, as noted, the actual purpose of the taxpayers is irrelevant to the consideration of purpose (thus whether there is a “genuine demerger”). 113 Once again, it must be reiterated that PBR’s carry no precedential value. However, once again, a survey of PBR’s in this area is instructive. Example 3 – section 45B does not apply81 Facts 114 The taxpayer was the ultimate owner of Head Co, an Australian resident company. The taxpayer was an Australian resident who began a manufacturing business with the incorporation of Head Co. There were a number of preference shares held by the trustee of the taxpayers family trust in Head Co. 115 All the ordinary shares in Head Co were held by the taxpayer either directly or through a nominee company. Head Co owned 100% of the shares in A Co and its closely held subgroup of companies. The operations of the sub-group were centred on product development and manufacturing. 116 Head Co also owned 100% of the shares in B Co, a pastoral company. 117 The applicant had submitted that the demerger of the product development and manufacturing business (A Co) from the pastoral business interest of the taxpayer and Head Co was desirable in that it would have enabled both businesses to operate separately and independently, and enable commercial and family decisions to be taken in the light of an ongoing permanent structure. 118 That is, according to the applicant, the intention of the demerger was to free up the businesses, one from another, in order to make them more focused and competitive in the interests of the shareholders and the country’s overall economic performance.82 74 75 76 77 78 79 80 81 82 PBR 63027 PBR 63027 PBR 53967 PBR 42233 - by demerging the investment from the trading activities each entity will be forced to run on a “stand alone” basis; 43061 PBR 42233 PBR 42233 & 56053 PBR 42233 & 56053 Taken from PBR 45642. It certainly pays to read the Ralph Report. Section 45B: Dealing with Frankenstein’s creature | Page 26 119 It was intended to demerge the manufacturing business sub-group from Head Co such that the shareholders of Head Co (comprising the taxpayer and the taxpayer’s trust) would become the shareholders of A Co. The proposed arrangement was as follows: 119.1 the new manufacturing business would issue ordinary shares to the taxpayer and redeemable preference shares to the taxpayers trust. The consideration for such issues were to be nominal; 119.2 the rights attaching to the shares issued were to be the same as the rights attaching to the equivalent shares issued by Head Co; 119.3 the ordinary shares held by Head Co in A Co were to be cancelled for no consideration; and 119.4 cancellation by A Co of its own shares followed by the fresh issue of new shares was to be treated as both a credit and a debit to share capital for accounting purposes. The parent resident company was to account for the cancellation of its shareholding in the manufacturing business sub group as a debit to the profit and loss statement for accounting purposes creating an accounting loss and a corresponding credit to its investment in its subsidiary. 120 Following implementation of the demerger, the taxpayer and the taxpayer’s trust were to be the sole shareholders of A Co. Decision 121 The Commissioner ruled that a demerger would happen to the Head Co demerger group for the purposes of Division 125 of the ITAA 1997 in relation to the restructuring described under the arrangement. The taxpayer and the taxpayers Trust as shareholders were able to choose to obtain a CGT roll-over under Division 125 of the ITAA 1997. 122 According to the Commissioner, in these circumstances, it could be concluded, for the purposes of section 45B of the ITAA 1936, that the ownership interests provided to Head Co’s shareholders, to the extent to which they represented profit (realised or unrealised) of Head Co, were not provided for a more than incidental purpose of enabling them to obtain a tax benefit. The essential purpose of the demerger was to create two discrete, viable, independent businesses: a manufacturing business and a farming business which was to be managed, controlled and developed independently of each other.83 123 The Commissioner concluded: “Accordingly, it is considered after having regard to the relevant circumstances of the proposed scheme, that is, to free up business, one from another, in order to make them more focused and competitive in the interests of the shareholders and the country’s overall economic performance, that it would not be concluded that the parties to the scheme entered into or carried out the scheme for a more than incidental purpose of enabling the shareholders of the parent resident company to obtain a tax benefit from the provision of the ‘capital benefit’ that is the shares in the manufacturing business sub group.” 84 Example 4 – section 45B does apply85 Facts 124 83 84 85 Subco was an Australian resident private company and carried on the core business of the corporate group. More than 50% of the market value of all of Subco assets were used in the carrying on of its business. Subco had 50 ordinary shares on issue carrying equal voting and dividend rights. There were no other types of ownership interests on issue. There were 3 Subco shareholders: Headco (holding 30 shares), Company X (holding 10 shares) and Company Y (holding the remaining 10 shares). These companies were all Australian residents who acquired their Subco shares after 19 September 1985. Contrast this outcome to that in Case Study 4 in PSLA 2005/21. PBR 45642. Taken from PBR 63027. Section 45B: Dealing with Frankenstein’s creature | Page 27 125 Headco was an Australian resident private company. Headco had two ordinary shares on issue carrying equal voting and dividend rights. There were no other types of ownership interests on issue. There were two Headco shareholders: the A Trust (holding one share) and the B Trust (holding the remaining one share) (the “A & B Trusts”). They were both resident trusts who acquired their Headco shares after 19 September 1985. Since its incorporation, Headco had not made any distributions of share capital. 126 Headco’s main assets were: 126.1 money on deposit; 126.2 loans to related entities; 126.3 shares in Subco; and 126.4 land and buildings (subject to a lease to Subco). 127 The A & B Trusts were both discretionary trusts. Neither Trust had carry forward capital losses. Mr A and Mrs A were discretionary objects of the A Trust and the B Trust respectively. 128 Headco was to undertake a demerger of all its 30 shares in Subco. These shares were to be transferred to the Headco shareholders as an in specie dividend and a capital return. The A & B Trusts were to each receive 15 shares in Subco under the demerger. Headco was to write its investment in the Subco shares out of its books of account by debiting its asset revaluation reserve and the share capital account. Headco was to debit its share capital account by an amount that reflected the proportion of the value of the Subco shares relative to the value of all of Headco’s assets. 129 Following the demerger, each of the A & B Trusts were to sell 5 of their shares in Subco (representing in each case 10% of the total number of shares on issue in Subco). The A & B Trust’s combined ownership of Subco shares was to be reduced from 60% to 40% of the issued shares of Subco. These shares were to be acquired by the other Subco shareholders: 129.1 Company X acquiring 5 shares for their market value; and 129.2 Company Y acquiring 5 shares for their market value. 130 Following this share sale, the A & B Trusts were to own 10 shares each in Subco. Company X and Company Y were to own 15 shares each. The shareholders of Company X were Mr B and Mrs B and the shareholders of Company Y were Mr C and Mrs C. These entities, the A & B Trusts and Mr A (who was one of the beneficiaries and effective controllers of the A & B Trusts) were all related entities. 131 The applicant disclosed the following reasons for the demerger and sale of Subco shares: 131.1 it would simplify the shareholding structure of Subco for the shareholders (by removing Headco as a shareholder); 131.2 it would simplify the asset structure of the shareholders of Headco; 131.3 it would remove one layer of ownership (Headco) and therefore reduce administrative costs for the relevant entities. For example, future Subco dividends were to be paid directly to the shareholders rather than flowing through Headco; 131.4 management decisions were to be able to be made by the shareholders directly rather than through Headco; 131.5 it would facilitate a more straightforward transfer of some of the ultimate ownership interests in Subco; and 131.6 Mr A was intending to take a less active role in the management of Subco. Consequently, the controllers of Company X and Company Y were to take a more active management role. The transfer of shares in Subco to Company X and Company Y was designed to ensure that the ownership structure of Subco reflected its management structure. Section 45B: Dealing with Frankenstein’s creature | Page 28 Decision 132 The Commissioner ruled that a demerger would happen to the Headco demerger group for the purposes of Division 125 of the ITAA 1997 in relation to the restructuring described under the arrangement and: 132.1 any capital gain or capital loss under CGT event A1 happening on the disposal by Headco of its shares in Subco would be disregarded under section 125-55 of the ITAA 1997; 132.2 the shareholders of Headco would be entitled to rollover pursuant to section 125-55 of the ITAA 1997 such that the demerger of Subco from Headco would have the effect that any capital gain or capital loss that arises would be disregarded; 132.3 the return of share capital to the Headco shareholders would not be assessable income of the shareholders of Headco for the purposes of subsection 44(1) of the ITAA 1936; and 132.4 all of the in specie distribution of Subco shares received by Headco shareholders would constitute a demerger dividend and would not be assessable income to the shareholders of Headco because of the application of subsections 44(3) to 44(5) of the ITAA 1936. 133 However, the Commissioner then ruled that he would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applied to the demerger benefit provided under the scheme. The effect of such a determination would be that the whole or part of the demerger benefit would be taken to not be a demerger dividend – ie. the dividend paid would be assessable to the A Trust and the B Trust. In this case the ATO applied only the demerger specific rule and not the general capital benefit rule (ie. the capital reduction was not considered a capital payment in substitution for a dividend and thus not deemed to be an unfranked dividend). 134 According to the Commissioner, there was a scheme and the provision of the Subco shares constituted the Headco shareholders receiving a demerger benefit and a capital benefit. Further, having regard to the relevant circumstances of the scheme, the Commissioner considered that, when viewed objectively, a substantial object of entering into or carrying out the scheme was to enable the Headco shareholders to obtain a tax benefit. In the language of the object statement contained in subsection 45B(1) of the ITAA 1936, it was considered that the demerger benefit provided to the Headco shareholders was in substitution for an (assessable) dividend. 135 Importantly, the Commissioner acknowledged that the relevant circumstances enumerated in paragraphs 45B(8)(a) to (h) and paragraph 45B(8)(j) of the ITAA 1936 tender to neither incline for nor against a conclusion as to the relevant purpose. However, the eight matters described in paragraph 177D(b) of the ITAA 1936 (incorporated as relevant circumstances by reference in paragraph 45B(8)(k) of the ITAA 1936) sunk the taxpayer. Those Part IVA matters, in the Commissioner’s view, tended to incline for the relevant purpose. 136 It is interesting to observe that what brought the taxpayer undone was not the new fangled section 45B (retro-fitted for demergers) but effectively good old fashioned Part IVA! On one level it is somewhat unsettling that Part IVA was held, in essence, to apply (with the lower section 45B purpose test threshold) to a transaction that was undertaken by utilising the demerger provisions in the manner provided for in Division 125 of the ITAA 1997. 137 The Commissioner made the following observations in coming to the objective conclusion as to purpose: 137.1 under the scheme the A & B Trusts were to dispose of 20% of the total shares in Headco (or ⅓ of their total holding) as soon as practicable after the demerger; 137.2 the disposal (at market value) was to be made to related parties; 137.3 a capital gain would have arisen to the extent the proceeds exceeded the cost base of the relevant shares; Section 45B: Dealing with Frankenstein’s creature | Page 29 137.4 the two beneficiaries of the A & B Trusts who were to be assessed on the capital gain would have been entitled to reduce that gain by 50% by using the CGT discount method of calculating capital gains (Division 115 of the ITAA 1997); 137.5 the substance of the scheme, determined by examining the effects of the scheme on the commercial and economic circumstances of all the parties involved in the restructuring, was that of a disposal attracting significant tax and financial benefits that the beneficiaries of the A & B Trusts were ultimately to derive; 137.6 the applicant provided a range of purposes for undertaking the demerger, however, when viewed objectively, these were of lesser significance when compared to the financial benefits arising from the tax treatment applied to the beneficiaries of the A & B Trusts under the scheme (leaving aside the application of section 45B of the ITAA 1936); 137.7 the purposes identified by the applicant for undertaking the demerger did not disclose why a demerger was an appropriate element of the scheme (other than to allow the A & B Trusts to dispose of the relevant demerged entity shares in a tax effective manner). Those purposes disclosed no change or improvement to the business of the demerger group (apart from managerial changes which are not dependant on the undertaking of a demerger); and 137.8 some of the purposes for the scheme as described by the applicant were directed at describing the effect of the demerger (for example the reduction of administrative costs relating to the payment of dividends, simplification of the A & B Trust’s asset structure, management decisions being made through a trust rather than a holding company) and these appear to be relatively insignificant. 138 The Commissioner ultimately concluded that: “In the absence of substantial business reasons for a demerger, the income tax benefits it provides for shareholders will assume greater significance. In the present circumstances, although the applicant submits that the reasons provided are more than incidental reasons for undertaking the demerger, an objective examination of these and the tax benefits which the demerger delivers results in a determination that the provision of a tax benefit to the A & B Trust beneficiaries of the Head Co shareholders is not a mere incidence of the scheme but rather a significant purpose of it. In other words, it is apparent that the demerger is explicable, or has as its substantial purpose, the facilitation of a sale of the Subco shares by the A & B Trusts on capital account. Objectively, it is considered that this is done for a purpose of ensuring the A & B Trusts beneficiaries receive the proceeds from sale having been taxed as an assessable capital gain calculated using the CGT discount method. This leads to the conclusion that the demerger is a distribution made in substitution for a dividend. In this regard, it is also relevant to note that a receipt in the character of a capital sum attracts significantly less tax than would the alternative of a dividend fully assessable at the A & B Trusts beneficiary’s marginal tax rates. In other words, the same commercial effect and key elements of the scheme could have been achieved by way of disposal of the relevant Subco shares directly by Head Co , with the following less favourable tax outcomes: Head Co would have derived an assessable capital gain; and the distribution of the proceeds of sale (after corporate tax) would then be distributed to the A & B Trusts as a dividend (and only partly franked) to be assessed at marginal tax rates of the A & B Trusts beneficiaries. The practical effect of such a transaction would be that the full proceeds of the sale of the Subco shares would be subject to the beneficiary’s marginal tax rates. In contrast, under the relevant scheme, it is only the capital gain that is subject to tax, and only after the application of the CGT discount concession. ” 86 • • 86 PBR 63027. Section 45B: Dealing with Frankenstein’s creature | Page 30 Conclusion 139 The novel Frankenstein concludes with the creature saying he will build a funeral pyre and immolate himself. The creature then disappears, "lost in darkness and distance". 140 I am sure there would be a fair number of tax practitioners (and perhaps a few tax officers) who would wish a similar fate for section 45B. 141 However, section 45B may well have been conceived as a temporary legislative “patch” but it has shown resilience, it has been renovated and it is probably here to stay. We have to live with it and work with it. In that regard, as always, the last word on the matters canvassed in this paper should be a judicial one: “Almost anything, I suppose, is arguable in tax cases.”87 142 87 I suspect a sense of irony in the judge’s words but it is always useful to keep them in mind in moments of darkness. For there can be no doubt that the one advantage for tax practitioners when faced with complex legislative provisions, such as section 45B, is that an argument can always be made. Whether it succeeds or not is, of course, another matter. Galland v FC of T (1984) 15 ATR 200, per Hunt J at 208. Section 45B: Dealing with Frankenstein’s creature | Page 31 If you have any questions regarding the content of this paper, please contact Paul Sokolowski, Partner, (03) 9229 9344. About Arnold Bloch Leibler Arnold Bloch Leibler is a leading commercial law firm with offices in Melbourne and Sydney. The firm represents a wide range of individuals and corporate clients, including high-net-worth individuals and entrepreneurs, large family businesses and blue-chip corporations. Arnold Bloch Leibler also has a dedicated pro bono practice providing advice on social, environmental and cultural issues to more than 100 charitable and not-for-profit organisations. Arnold Bloch Leibler is particularly known for its expertise in commercial law, litigation and dispute resolution, taxation and property. The firm also has an expanding presence in trade practices law. In these areas, the firm has been involved in many landmark matters and transactions. Level 21 333 Collins Street Melbourne VIC 3000 Australia Telephone 61 3 9229 9999 Facsimile 61 3 9229 9900 Level 24 Chifley Tower 2 Chifley Square Sydney NSW 2000 Australia Telephone 61 2 9226 7100 Facsimile 61 3 9226 7120 www.abl.com.au