Capital Gains Tax consequences of a demerged entity

In relation to a capital gain transferred by a company to the taxpayer pursuant to Subdivision 126-B of the Income Tax Assessment Act 1997 (ITAA 1997), will section 125-160 of the ITAA 1997 apply so that CGT event J1 does not happen as a result of a proposed demerger arrangement?

Yes, section 125-160 of the ITAA 1997 will apply so that CGT event J1 does not happen to the taxpayer as a result of the proposed demerger arrangement.

The taxpayer is a member of a large Group which proposes to restructure via a demerger arrangement. Under the proposed arrangement, the ultimate holding company (the 'Holding Company') will dispose of its shares in the taxpayer to its shareholders. The Holding Company will then undertake a notional 'cash' distribution to the shareholders equal to the purchase price of the taxpayer. This distribution will partly be a return of capital and partly a dividend. The shareholders will agree to purchase the shares in the taxpayer and will be obliged to apply the notional 'cash' amount to acquire those shares.

One of the earlier steps in the proposed demerger arrangement will effect the transfer of subsidiaries of the Holding Company such that they are held by the taxpayer. The taxpayer will issue scrip or nominal consideration to the Holding Company to purchase these subsidiaries for fair value. The Holding Company would, prima facie, based on these fair values, expect to crystallise capital gains as a result of the transfer of some of the subsidiaries to the taxpayer. The Holding Company intends to roll-over the gains to the taxpayer under Subdivision 126-B of the ITAA 1997.

When the Holding Company disposes of its ownership interests in the taxpayer to its shareholders under the proposed demerger arrangement, they will no longer be members of the same wholly-owned group. As a result, CGT event J1 would normally be triggered.

The requirements for CGT event J1 to happen are contained in section 104-175 of the ITAA 1997. CGT event J1 happens if there is a roll-over under Subdivision 126-B for a CGT event (the 'roll-over event') that happens in relation to a CGT asset (the 'roll-over asset') involving two companies that are members of the same wholly-owned group and, the company (the 'recipient company') that owns the roll-over asset just after the roll-over, stops being a 100% subsidiary of a company in the group in certain circumstances (subsection 104-175(1) of the ITAA 1997).

One of these circumstances is where there has been only one roll-over within the wholly-owned group under Subdivision 126-B involving the 'roll-over asset'. The recipient company must stop, at a time (the 'break-up time') when it still owns the 'roll-over asset', being a 100% subsidiary of a member of the group (the 'ultimate holding company') that is not a 100% subsidiary of any other member of the group at the time of the 'roll-over event' (subsection 104-175(2) of the ITAA 1997).

It is accepted that there will be a roll-over under Subdivision 126-B in relation to the capital gain made by the Holding Company on the transfer of the subsidiaries to the taxpayer (the 'roll-over event'). It is also accepted that at the time of the 'roll-over event', the Holding Company (the 'originating company') and the taxpayer (the 'recipient company') will be members of the same wholly-owned group and that the taxpayer will be a 100% subsidiary of the Holding Company. As a consequence of the proposed demerger arrangement (the 'break-up time'), the taxpayer will stop being a 100% subsidiary of the Holding Company (the 'ultimate holding company') and CGT event J1 will be triggered.

However, section 125-160 of the ITAA 1997 ensures that CGT event J1 does not happen to a 'demerged entity' or a member of a demerger group under a 'demerger'.

The requirements for a 'demerger' to happen are contained in section 125-70 of the ITAA 1997 and are satisfied by the proposed demerger arrangement. The taxpayer will be the 'demerged entity' as the shareholders of the Holding Company will acquire ownership interests in the taxpayer under the 'demerger' (subsection 125-70(6) of the ITAA 1997).

Therefore, CGT event J1 will not happen to the taxpayer (being the 'demerged entity') at the time of the proposed demerger, in respect to the subsidiaries proposed to be rolled over by the Holding Company pursuant to Subdivision 126-B of the ITAA 1997.