With the release of Taxation Determination TD 2020/6, the ATO has finalised its position regarding the meaning of the word ‘restructuring’ for the purposes of the of s.125-70(1) in the demerger relief rules.
As expected, the ATO has maintained the views previously expressed in Draft Taxation Determination TD 2019/D1, which have been criticised for not reflecting the policy objectives of the demerger relief rules. Absent a legislative fix, we expect TD 2020/6 will preclude demerger relief applying to all but the most plain vanilla demerger transactions in the future, impeding transaction structures that would otherwise facilitate commercial objectives such as capital raisings.
On 22 July 2020 the ATO released Taxation Determination TD 2020/6, finalising its views regarding the meaning of the word ‘restructuring’ for the purposes of s.125-70(1) in the demerger relief rules.
TD 2020/6 has been the subject of much debate and discussion following the initial release by the ATO of Draft Taxation Determination TD 2019/D1 on 20 March 2019. We prepared a submission in response to TD 2019/D1’s invitation for comment on the issues it raised, which can be accessed here.
A brief background
The events that led to TD 2020/6 being published are briefly summarised below:
- Prior to the enactment of Division 125 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) in 2002, members in an entity that reorganised its business operation by splitting them into separate entities, and the entities undertaking the reorganisation, were exposed to capital gains tax (CGT) and/or income tax consequences depending on the mechanics of the transactions. These consequences were an impediment to restructures that did not affect the economic ownership of the restructured operations and had the capacity to reduce the overall efficiency of the economy.
- Following recommendations from the Ralph Review of Business Taxation, Division 125 was enacted to increase efficiency by allowing greater flexibility in structuring businesses. It was intended that this objective be achieved by facilitating the demerging of entities by ensuring that income tax considerations are not an impediment to restructuring a business. Division 125 and associated provisions are referred to in this Tax Insight as the ‘demerger relief rules’.
- Following the enactment of the demerger relief rules, it was not uncommon in the context of M&A and capital raisings to utilise demerger relief to facilitate a reorganisation prior to, or after, the relevant transaction taking place. The ATO accepted that transactions structured this way could access demerger relief. The ATO issued favourable Class Rulings in various instances, most recently in the Sundance Australia / Texon Petroleum / Talon Petroleum deal in 2013 where Texon Petroleum demerged its subsidiary Talon Petroleum prior to Sundance Australia acquiring Texon Petroleum for scrip in Sundance Australia.
- In April 2018, the ATO was perceived to have adopted a different position after refusing to rule favourably in respect of the proposed AMA / Blackstone transaction. The transaction structure was effectively identical to the Sundance / Texon / Talon deal (i.e. a demerger followed by an acquisition) and, in the absence of public guidance from the ATO, the market was left in uncertain waters.
- On 20 March 2019, the ATO released TD 2019/D1 which effectively confirmed the market’s expectation that the ATO would no longer apply the law in the manner previously seen in the Sundance / Texon / Talon transaction. We understand the ATO’s invitation for comment on TD 2019/D1 was widely accepted by industry stakeholders, many of whom expressed concern that the ATO’s position would undermine the efficacy of the demerger relief regime. As set out in our submission (referred to above), arguably TD 2019/D1 hailed the beginning of a new era in which the demerger provisions would cease to operate effectively in a variety of innocuous demerger situations which, in our view, are intended to be afforded relief from tax impediments.
The issue: what is a ‘restructuring’?
The fundamental condition for demerger relief is that “a demerger happens to the demerger group”. An element of that condition is that there must be a “restructuring of the demerger group”. Additionally, it must be shown that, “under the restructuring”:
- at least 80% of the demerger group’s ownership interests in the demerging entity become owned by members of the demerger group’s head entity; and
- original interest holders acquire new interests and nothing else under the restructuring.
The ‘restructuring’ concept is also relevant to requirements regarding proportionality (by number and market value) of new interests after the relevant subsidiary is demerged. In this regard, the ATO states that:
Subsection 125-70(2) talks about proportionality 'under', 'just before' and 'just after' the 'demerger'. Since under paragraph 125-70(1)(a) a demerger happens if there is a restructuring, the scope of the restructuring (including when it begins and ends) is also relevant to the proportionality conditions in subsection 125-70(2).
There is no doubt that the restructuring of a demerger group will include the transaction or transactions which result in the head entity ceasing to hold, and the original interest holders starting to hold, at least 80% of the membership interests in the demerged entity. However, if the relevant ‘restructuring’ incorporates other transactions which occur before or after the separation transaction, satisfying the requirements for demerger tax relief, particularly the ‘proportionality’ and ‘nothing else’ requirements, can be problematic.
TD 2020/6 sets out the ATO views on what constitutes a ‘restructuring’ of a demerger group for the purposes of s.125-70(1) of the ITAA 1997. While much of the substance of TD 2019/D1 remains unchanged in TD 2020/6, there are few notable amendments (summarised below) that businesses and participants in M&A and capital raising activities will need to be wary of.
In essence, TD 2020/6 maintains the ATO’s interpretative views regarding the demerger relief provisions that prevented the AMA / Blackstone transaction from proceeding. Absent a legislative fix, we expect TD 2020/6 will prevent all but the most plain vanilla demerger transactions from occurring in the future. In circumstances where the Federal Government is looking to boost the Australian economy to facilitate a bounce-back from the COVID-19 crisis, the need for a legislative fix is all the more pressing.
New issues raised by TD 2020/6
Timing issues: when does the ‘restructuring’ begin?
Determining whether the demerger proportionality (by number and market value) tests are satisfied requires a comparison of ownership before and after the demerger happens.
As noted above, the definition of ‘demerger’ begins by stating that there must be a ‘restructuring’ of the demerger group. It would seem to follow that, because the ‘restructuring’ is part of the ‘demerger’, the comparison of ownership should be tested before and after the restructure. As such, the test time for the purpose of the ownership comparison:
- starts no later than the first step in the restructuring; and
- ends no earlier than the last step in the restructuring.
In a new Example 7 added in TD 2020/6, the ATO states that the ‘restructuring’ starts several months prior to the actual separation transaction. The Example contemplates a listed construction and property development company taking steps to separate its residential property development business months in advance of the actual demerger. In particular, the company:
- incorporates a new subsidiary;
- transfers land, cash and other assets to the subsidiary in return for scrip; and
- substitutes the subsidiary as the applicant in various council applications, and novates certain employment contracts to it.
The ATO accepts that demerger relief would apply when the demerger transaction occurs.
What is notable about new Example 7 is that the ATO states that the “preparatory steps and transactions .. will form part of the restructuring of the demerger group”. In this regard, the ATO states that the fact that transactions or steps are separated in time by several months does not automatically mean that they cannot form part of the same restructuring, and that temporal proximity is a relevant, but not determinative, factor when establishing the objectively inferred plan for the reorganisation of a demerger group.
The ATO states that preparatory steps that do not change the economic position of original interest holders should not jeopardise the availability of demerger relief, but flags that steps or transactions that effect such a change may cause of failure of certain of the conditions necessary for demerger relief to be available. These views are qualified by a statement that:
… the mere fact that ownership interests are transferred due to an independent decision by owners during the period of the restructuring (for example, through ordinary trading on a securities exchange) will not generally affect any of the conditions in subsections 125-70(1) and (2) as such transfers do not happen under the restructuring itself.
Applying the ATO’s views on when the restructure commences means that in the context of a scheme of arrangement the test time could start months before the scheme record date. This is a further departure from ATO practice, which has previously accepted that preparatory steps are ‘pre-restructuring’ and the scheme record date constituted the relevant objective reference point. If the restructuring commences at the time, for example, when the demerged entity is incorporated, then in our view the ownership test time commences at that time. The practical implication is that a listed entity will never be able to satisfy the ownership test.
Amendments in TD 2020/6 as compared to the draft TD imply the ATO is now of the view that the time ‘just before the demerger’ is potentially different to the time ‘just before the restructuring begins’ (the latter words having been deleted from new paragraph ). However, the ATO does not outline the basis for drawing this distinction or explain when the demerger is meant to commence for the purposes of applying the proportionality test. It is difficult to reconcile the ATO’s interpretation with the words or purpose of the legislation. The incoherence in the position is further evidence of the ATO tying itself in knots by using Division 125 and the concept of ‘restructuring’ as the main integrity provision rather than s.45B.
In our view, the position is an overly restrictive interpretation of the demerger relief provisions which will constrain demerger activity.
Demergers and capital raisings
In addition to including a new Example in TD 2020/6, the ATO has amended some of the examples previously included in TD 2019/D1.
Example 2 contemplates the Board of a listed public company deciding to demerge a subsidiary that conducts a separate business unrelated to the business conducted by the public company. The subsidiary will be listed on the ASX after the demerger has completed and subsequently undertake a minor capital raising to allow it to pursue growth opportunities. Prior to the separation, the head company negotiates for an unrelated third-party to acquire a ‘significant proportion’ of the shares that the subsidiary will issue under the capital raising. Certain shareholders in the subsidiary will not be eligible to participate in the capital raising (for example, because they do not hold a number of shares in the subsidiary above a certain threshold).
The ATO has made two notable amendments in Example 2:
- The number of hypothetical facts have been reduced such that Example 2 no longer contemplates that (a) the capital raising equals half of the value of the subsidiary; (b) prior to the separation, the subsidiary distributes 50% of its net assets by way of a return of capital or dividend; (c) the subsidiary does not have sufficient operating profits or adequate cash flows from its operations to fund its business; and (d) the third party acquires a 50% stake in the subsidiary under the capital raising. The reference to certain shareholders not being eligible to participate in the capital raising is a new hypothetical fact. What is ‘significant’ for these purposes is not explained.
- The ATO has also refined its reasoning in its explanation of why demerger relief would not be available in a fact scenario such as that contemplated in Example 2. In particular, the ATO states that:
"[t]he fact that the capital raising has one or more features that are certain to alter the shareholdings in Sub Co is significant. It suggests that the plan involves more than a capital raising that coincides with the separation of Sub Co, and is designed to change the economic position of shareholders in Sub Co.”
It appears that the ATO’s amendments to the facts are intended to broaden the class of transactions to which Example 2 will be relevant, further limiting the availability of demerger structures in the context of capital raisings. Additionally, Example 2 indicates that, if negotiations with the third-party acquirer occurred after the demerger transaction had completed, demerger relief may be available. From a policy perspective, this appears to be an arbitrary and irrelevant distinction. It should not matter whether negotiations occur before or after the demerger happens, particularly given that the efficient separation of a listed company’s business through a demerger is much more likely to be achieved if a third-party can be locked in prior to the transaction being put to shareholders. The ATO position is especially perplexing because the perceived mischief in raising capital at market value is not obviously apparent.
TD 2020/6 confirms that the ATO does not intend to devote resources to a specific compliance project to examine claims for demerger roll-over under Division 125 for CGT events occurring before the release of TD 2019/D1 (i.e. before 20 March 2019). However, if the issues arises as part of the usual compliance activity undertaken by the Commissioner (which would include the ongoing streamlined assurance reviews), or as a result of a request for a ruling, a request to amend an assessment, an objection against an assessment or in submissions by the Commissioner in litigation, the ATO will act consistently with the views set out in TD 2020/6.
The prospect of retrospective reviews is probably not something that will concern most taxpayers given that public company transactions involving a demerger are highly unlikely to have proceeded without first obtaining an ATO ruling, which should be binding even if the ruling reflects views that are not consistent with TD 2020/6. However, private companies that have relied on guidance from prior Class Rulings, rather than obtaining a private ruling, may be exposed in the event that the ATO become aware of the transaction as part of a routine review.
Evidence of the scope of the plan of reorganisation
Finally, TD 2020/6 adds further guidance around the type of evidence the ATO would look at for the purposes of determining the scope of a plan of reorganisation. In particular, the ATO highlights that they will review all of the facts and circumstances, including contracts and deeds executed by or affecting the relevant entities (including contracts and deeds that are given legal effect by a court decision, for example, pursuant to a scheme of arrangement under Part 5.1 of the Corporations Act 2001), statements in documents filed with regulators, commercial factors, internal deliberations by a company’s directors or the directors of a trustee company, statements by directors or influential owners and announcements to any relevant securities exchange.
Potential legislative fix?
In December 2019 the Federal Assistant Treasurer announced that the Board of Taxation (BoT) would undertake a review of the CGT roll-over rules with a view to “identify and evaluate opportunities to rationalise the existing CGT rollovers and associated provisions into a simplified set that have a substantially similar practical effect, but are easier to use and interpret.”
The review provides an opportunity for the BoT to consider the effect that the ATO’s positions in TD 2020/6 are likely to have on business reorganisation activity and whether TD 2020/6 is inconsistent with the policy objectives of the demerger relief regime.
It is hoped that the BoT will recommend an appropriate legislative fix to expand demerger relief beyond the impact of the ATO’s interpretation, which will deny demerger relief for all but the most plain vanilla demergers. Given other jurisdictions such as the US allow multi-faceted transactions involving demergers (eg Lockheed Martin Corporation’s split-off and merger of its Information Systems & Global Solutions business with Leidos Holdings Inc as a Reverse Morris Trust transaction) it is not clear why Australia would limit the options for restructures which can create economic value.
Options for legislative reform might include confining the ‘restructuring’ concept to the transactions that occur between the group head company and its shareholders, or removing the ‘restructuring’ concept from the legislation altogether.