Demutualisation of mutual entities other than insurance companies: continuity of beneficial interest test

Can a mutual entity other than an insurance company satisfy the 'continuity of beneficial interest test' measures under subparagraph 326-60(2)(c)(i) of Schedule 2H of the Income Tax Assessment Act 1936 (ITAA 1936) if the membership history is not taken into account and the entity allocates equal numbers of shares to its existing members on demutualisation?

Yes. The 'continuity of beneficial interest test' measures under subparagraph 326-60(2)(c)(i) of the ITAA 1936 can still be satisfied even if membership history is not taken into account and a mutual entity other than an insurance company allocates equal numbers of shares to its existing members on demutualisation.

A non insurance mutual entity limited by guarantee proposes to demutualise. Each existing member of the entity is given the opportunity to take up shares in the demutualised entity and at least 90% of the shares issued in connection with the demutualisation are issued to existing members.

Each member's guarantee is limited to $10. The members pay a once-off joining fee and a monthly administration fee. In addition, metropolitan members pay an annual advertising levy. The fees and levies throughout the entity's history have more than covered its expenses and an accumulated surplus exists on the demutualisation resolution day.

The existing members joined the entity at different times so each member's contribution to the entity's accumulated surplus varies. The entity's constituent documents provide that each member has equal membership rights. Also, each existing member has the right to share equally in any surplus after satisfaction of the entity's debts or obligations on winding up.

The entity asked whether an equal allocation of shares to its existing members would still satisfy the 'continuity of beneficial interest test' measures as set out in subparagraph 326-60(2)(c)(i) of the ITAA 1936.

The 'continuity of beneficial interest test' that must be satisfied under section 326-60 of the ITAA 1936 requires that the accumulated surplus of the mutual entity is allocated or distributed in the form of shares, or cash from the sale of shares to existing members in proportions that broadly accord with any one or more of the three following measures: • the respective amounts contributed by the members to the entity • the respective values of the membership rights of the members • the respective rights of the members on the winding up of the entity.

As the members of the mutual entity joined at different times, their contributions to the entity's accumulated surplus vary. If amounts they contributed to the surplus are proportional with their history of membership, and their periods of membership are taken into account in the allocation of shares or cash from the sale of shares, this would satisfy subparagraph 326-60(2)(c)(i) of the ITAA 1936.

However, where it is difficult to ascertain members' contributions to the accumulated surplus from their membership history, the continuity of beneficial interest test could still be satisfied in the allocation of shares to existing members. Other alternatives are to allocate the shares or cash from the sale of shares in quantities that are in proportion to the respective values of the membership rights and/or the respective rights of the members on the entity's winding up.

As the mutual entity's constituent documents provide that each member has equal voting rights and each existing member has the right to share the surplus equally on winding up, an equal allocation of shares or cash from the sale of shares would still satisfy the 'continuity of beneficial interest test'.

The Explanatory Memorandum to the Taxation Laws Amendment (Demutualisation of Non-insurance Mutual Entities) Bill 1999 provides the following example: The members of a sporting club which is a company limited by guarantee pass a resolution to demutualise. Under the constituent of the sporting club, there are several classes of membership rights. Class A members pay a joining fee of $20 and have access to all the facilities of the club. Class B members pay a joining fee of $10 and have access only to the bar and restaurant facilities. The winding up clause in the club constituent documents provides that, on winding up, any surplus assets are to be transferred to an association with similar objects as the sporting club. On demutualisation, Class A members are issued with 200 shares each and Class B members are issued with 100 shares each. This allocation of shares is in proportions broadly consistent with members' mutual participation because shares have been allocated according to the level of contributions made by members.

The example demonstrates that the 'continuity of beneficial interest test' provides flexibility for non insurance demutualising entities to adopt a process most appropriate for their membership.

Therefore, the 'continuity of beneficial interest test' will be satisfied without reference to the history of membership if it broadly accords with any one or more of the other measures provided under paragraph 326-60(2)(c) of the ITAA 1936.

Note: When all the conditions for its operation are met, Division 326 of the ITAA 1936 ensures that a mutual entity's members receiving shares as a result of the entity's demutualisation are not subject to capital gains tax (CGT) until they dispose of those shares and the cost base for shares issued to members as a result of the entity's demutualisation is specified.