Demerger: original pre-CGT interests - consequences for shareholders under Division 725 if new interests in demerged entity are issued at a discount

If a direct value shift happens under a demerger because new interests in a demerged entity are issued at a discount, can the cost bases and reduced cost bases of those interests be increased under section 725-250 of the Income Tax Assessment Act 1997 (ITAA 1997) if they were issued in respect of pre-CGT original interests?

Yes. The cost bases and reduced cost bases of the new interests in the demerged entity can be increased under section 725-250 of the ITAA 1997 as no adjustments are made to the cost base and reduced cost base of both the new interests and the original interests under Division 125 of the ITAA 1997.

There are three Australian resident shareholders (original interest holders) in Company A, an Australian resident company. Each shareholder is an associate of the other shareholders. All of the shares were acquired before 20 September 1985.

Company A is the owner of the only share (a post-CGT share) on issue in subsidiary Company B. Company A has not made a choice to form a consolidated group.

Under an arrangement, Company B (the demerged entity) issues shares to the shareholders in Company A, in the same proportions as their Company A shareholdings. No consideration is to be provided to Company B for the shares. The arrangement satisfies the definition of a demerger in section 125-70 of the ITAA 1997.

As a result of the issue of shares at a discount by Company B, there is a reduction in the market value of the share that Company A holds in Company B, resulting in a direct value shift. The conditions set out in section 725-50 of the ITAA 1997 for there to be consequences under Division 725 of the ITAA 1997 as a result of the direct value shift are satisfied.

Division 725 of the ITAA 1997 does not apply to an original interest holder where the specific terms of section 125-95 of the ITAA 1997 apply. That section provides that where cost base and reduced cost base adjustments are required under sections 125-80, 125-85 or 125-90 of the ITAA 1997, no further cost base and reduced cost base adjustments are required to be made under the Act as a result of something that happens under the demerger. Cost base and reduced cost base adjustments are required under sections 125-80, 125-85 or 125-90 of the ITAA 1997 where the original interests were acquired on or after 20 September 1985. No adjustments are required under those sections where the original interests were acquired before 20 September 1985.

Accordingly, as the new interests are issued in respect of the three shareholders' original interests that were acquired before 20 September 1985, and the conditions in section 725-50 of the ITAA 1997 are satisfied, increases may be made to the cost bases and reduced cost bases of those new interests under section 725-250 of the ITAA 1997 as a result of the direct value shift. Note: If the new interests are taken to be acquired before 20 September 1985, then the increase adjustments under section 725-250 of the ITAA 1997 will only have practical consequences for shareholders that are companies (for example, a company required to calculate an unrealised net loss under Subdivision 165-CC of the ITAA 1997).