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Information about this fact sheet
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This fact sheet explains the operation of some key concepts in the share capital tainting rules in the income tax law. The share capital tainting rules are integrity measures designed to prevent a company from making tax preferred capital distributions from a share capital account to which the company has transferred profits. The status of this fact sheet will provide users with protection from interest and penalties where a person reasonably relies in good faith on the statements in the publication. Where the fact sheet does not provide sufficient guidance or certainty to assist a taxpayer in relation to their particular circumstances, consideration should be given to applying to the Tax Office for a private ruling. The Tax Office has published its Compliance program for 2007 / 2008. Share capital tainting is not an issue which will be specifically targeted. However, share capital tainting issues may arise in the course of other compliance activities and if they do the share capital tainting provisions will be applied in accordance with the law. |
Fact sheet
Share capital tainting rules
This fact sheet explains the operation of some key concepts in the share capital tainting rules in Division 197 of the Income Tax Assessment Act 1997 (ITAA 1997).1
The information contained in this fact sheet is general in nature and does not address all the possible ways and circumstances in which the law might apply to you. You must choose whether and how to apply the information to your own specific circumstances. If you want to be certain about the application of the share capital tainting rules to your particular circumstances you should seek a private ruling. If, however, you follow information contained in this fact sheet and make a genuine mistake as a result of something that is wrong or misleading in this fact sheet then you will not be charged a penalty although, depending on the circumstances of your case, you may have to pay interest.
If you feel that this publication does not fully cover your circumstances, please seek help from the Tax Office or a professional tax adviser.
The share capital tainting provisions
The share capital tainting rules are contained in Division 197 of the ITAA 1997. Division 197 was introduced with effect from 26 May 2006.
The existing share capital tainting rules replace, with some modifications, the share capital tainting rules formerly contained in Division 7B of Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936).
The share capital tainting rules are integrity rules designed to prevent a company from making tax-preferred capital distributions from a share capital account to which the company has transferred profits. The rules operate by treating a company's share capital account as having been tainted if the company has transferred an amount from another account to the share capital account, other than where the amount transferred is an excluded amount (eg. an amount of share capital or an amount transferred under a debt for equity swap).
If a company taints its share capital account, a franking debit arises in the company's franking account. Once tainted, the company’s share capital account remains tainted until it is untainted. Distributions from a tainted share capital account are treated as unfrankable dividends rather than returns of capital.
A company which has tainted its share capital account can elect to untaint the account with the result that an additional franking debit may arise and untainting tax may be payable.
What is a share capital account?
A share capital account is2:
- any account which the company keeps of its share capital; or
- any other account (whether it is called a share capital account or not) that was created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital.
If a company has more than one share capital account, those accounts are taken to be a single account for the purposes of the tax law (including Division 197)3.
What is share capital?
’Share capital’ is not defined in the ITAA 1997.
Based on its ordinary meaning, share capital is capital raised by a company by issuing shares. In particular, the notion of ‘share capital’ for Div 197 purposes includes amounts received by a company in consideration for the issue of shares4. That is, amounts a member or a prospective member has provided or contracted to provide to a company, in money or money’s worth, in return for the right to be issued a share or shares in the company are amounts that come within the concept of share capital.
Does ‘share capital’ include amounts that are unpaid on shares?
Yes. ‘Share capital’ includes amounts of ‘share capital’ that have been paid or credited as paid to the company for the issue of shares (paid-up share capital) and amounts that have not been paid or credited as paid to the company but which represent presently existing liabilities owed by members in respect of issued shares (unpaid capital)5.
Are premiums received by a company in return for it issuing options share capital?
No. Premiums received by a company in return for the issue by the company of options over its shares are not amounts of share capital. This is because the premiums received are not amounts received by the company from an entity in return for the issue of shares to that entity.
Will a company raise share capital if it issues shares in exchange for property or services provided to the company?
Yes. The consideration required for an issue of shares does not have to be provided in a cash form. For example, a company which issues shares in return for the transfer of property or for the provision of services will be taken to have received money’s worth for the issue of shares. The amount of share capital will be the value of the property or services provided to the company6.
What is the significance of the name given to an account in determining whether the account is (or is part of) a company’s share capital account?
Whether an account of the company is a share capital account (or part of a share capital account) will depend on whether it is an account of ‘share capital’ or, if the account was created after 1 July 1998, whether it is an account to which the first amount credited was an amount of ‘share capital’.
The name given to an account will not determine whether the account is, (or is part of), the share capital account and not all items of shareholder’s equity will constitute share capital.
Example 1 – Equity Reserves | ||
DR |
Shares |
$100 |
CR |
Cash |
$100 |
If there was a subsequent increase in the fair value of the shares by $20, the accounting entries would be: | ||
DR |
Shares |
$20 |
CR |
Equity Reserve |
$20 |
The $20 fair value increase in the shares which is credited to the Equity Reserve is not an amount of share capital as it is not an amount received by the company in return for the issue of its shares. If the $20 is the first amount credited to the ‘Equity Reserve’ then the ‘Equity Reserve’ will not be a share capital account nor form part of such an account. | ||
Even where an account is labelled an account of ‘contributed equity’ it will not necessarily follow that the account will satisfy the statutory description of a ‘share capital account’.
Example 2 – Notional Equity Contributions in Tax Consolidated Groups UIG 1052 also requires the subsidiary to treat the net tax amount assumed by the head company as a notional equity contribution by the head entity to the subsidiary to the extent the amount is not dealt with under a Tax Funding Arrangement (TFA)7. Companies A and B have formed a tax consolidated group with Company A being the head company. No TFA has been entered into between the two companies. Company B has in its books of account a current tax liability with a credit of $1,000. UIG 1052 requires Company B to remove the current tax liability from its accounts and replace the liability with an amount of ‘equity’ contributed by the head company. Company B posts the following entries in its books of account: | ||
DR |
Current tax liability |
$1,000 |
CR |
Other contributed equity |
$1,000 |
The ‘other contributed equity’ account to which the $1,000 of notionally contributed equity is credited is a newly created account. The amount of notionally contributed equity is not an amount of share capital as it is not an amount received by the company in return for the issue of its shares. As such, the ‘other contributed equity’ account of the company is not a share capital account of the company nor does it form part of such an account. It follows from the principles below that the entries posted by Company B in its books of account do not result in a tainting of the company’s share capital account. | ||
Nor is the fact that, for financial presentation purposes, the balance of an account in the general ledger is aggregated with the balances of other accounts determinative of the character of the account for tax purposes.
Example 3 – Presentation of accounts
The balance of the contributed equity account represents amounts received by the company in consideration for the issue of shares. When the balance sheet for the financial year is prepared the ‘contributed equity’ account and the ‘options premium reserve’ are aggregated and presented as a single ‘equity’ account with a balance of $1,000. The makeup of the equity account is detailed in the notes accompanying the balance sheet. The fact that the end of year balances of the contributed equity account and option premium reserve have been aggregated for presentation purposes does not assist in determining whether the option premium reserve forms part of the company’s share capital account. |
When will a company’s share capital account become tainted?
A share capital account of a company will become tainted if8:
- there is a transfer of an amount to the share capital account that is not an excluded amount, and
- the company is an Australian resident immediately before the transfer took place.
Entries posted by a company in its books of account cannot give rise to tainting if the entries:
- do not effect a transfer of an amount
- effect a transfer of an amount but not to the share capital account of the company, or
- effect a transfer of an amount from one account of the company to another account where each account is part of the company’s share capital account for tax purposes. (If a company has more than one account that satisfies the statutory description of a share capital account then the accounts are taken, for tax purposes, to be a single account9.)
Transfers
What constitutes a transfer between accounts?
An amount is transferred from one account to another where the amount is moved from one account to another. This, in turn, requires the balance of the first account to be reduced, while the balance of the second account is increased by the same amount10.
An amount is not transferred from one account to another where the particular accounting entries result in the balances of both accounts increasing (or decreasing) in size. For example, an accounting entry in the form 'debit asset, credit share capital account' would not represent a transfer in the relevant sense; to the contrary, such an entry would reflect an accretion to the company’s assets which would occur where the company issues shares to an entity in return for the entity subscribing for capital in the company11. Nor would an accounting entry in the form ‘debit expense, credit share capital account’ represent a transfer in the relevant sense; to the contrary, such an entry would record the fact that an expense of the company had been met by an entity in consideration for the company issuing shares to that entity.
Example 4 – Redemption of redeemable preference of shares Under section 254K of the Corporations Act 2001 a company that redeems RPS is required to redeem the shares out of either profits or proceeds from a fresh issue of shares. In accordance with this section, the company redeems 500 of its RPS on issue out of profits. Prior to the redemption, the company’s share capital account is untainted. Australian Securities & Investments Commission Regulatory Guide 68, (formerly Practice Note 6812) sets outs the accounting prescribed by ASIC in connection with the redemption of RPS out of profits. Consistent with the Regulatory Guide, the company makes the following entries in its books of account: | |
DR |
Retained profits |
CR |
Share capital account |
DR |
Share capital — redeemable preference shares (liability) |
CR |
Cash |
The first pair of entries record a transfer of an amount to the company’s share capital account from one of its other accounts (namely its retained profits reserve): the balance of the share capital account is increased at the expense of the balance of the retained profits reserve. Such a transfer results in the company tainting its share capital account. | |
Example 5 – Costs of raising share capital | ||
DR |
Cash |
$900 |
DR |
Deferred tax asset |
$30 |
CR |
Share capital account |
$930 |
An entry of this nature would not cause a tainting of the share capital account because no amount is transferred to the company’s share capital account. The balance of each of the three accounts to which entries are made is increased and there is no corresponding reduction to another account. The accounting treatment ensures the after tax value of what is received by the company for the issue of shares is reflected in the share capital account.
| ||
In determining whether the transfer of an amount from one account to another has triggered the operation of the share capital tainting rules it is the entries which a company makes to its general ledger that will be determinative. As such, it may be in the interests of a company to maintain separate accounts of equity (rather than, for example, a single equity account labelled ‘contributed equity’) to ensure that it can demonstrate that amounts of share capital have not been mixed with amounts of a different character.
When will a transfer take place?
A transfer of an amount from one ledger account to another occurs at the date on which the journal entry giving rise to the transfer takes effect for accounting purposes13.
Example 6 – Transitioning to AIFRS based accounting A company commences to apply AIFRS on 1 July 2005 (the beginning of its first reporting period commencing on or after 1 January 2005). In recording its transition to an AIFRS based system of accounting the company makes a journal entry in the form: | |
Dr |
Liability |
Cr |
Equity |
The journal entry, whist made on 15 June 2006 as part of the process of preparing the company’s financial statements for the 2006 year, is effective for accounting purposes as at the date of transition to AIFRS (i.e. as at 1 July 2005). The date of effect for accounting purposes is also the date on which the transfer from the liability account to the equity account will be taken to have occurred for tax purposes. It follows that entries of this sort could not taint the company’s share account: share capital tainting rules were not in force in the Australian income tax law between 1 July 2002 (when the former Div 7B of Part IIIAA of the ITAA 1936 ceased to have operation) and 26 May 2006 (when Div 197 of the ITAA 1997 commenced to apply). | |
Division 197 sets out a number of circumstances in which the transfer of an amount to a share capital account will not result in the tainting of the share capital account. These include exclusions for transfers of amounts that could be identified as share capital, for transfers under debt/equity swaps, and for transfers from option premium reserves14.
Transfers of share capital
The share capital tainting provisions will not apply to a company where an amount is transferred from an account other than a share capital account to the company’s share capital account provided the amount transferred could, at all times prior to transfer, be identified in the books of the company as an amount of share capital15.
This exclusion is designed to apply where share capital received on the issue of shares is not initially credited by the company to its share capital account but, in accordance with accounting standards, is credited to another pre-existing account such as a liability account.
The question whether an amount recorded in the books is capable of being identified as share capital is one which must be answered substantively by having regard to the circumstances in which the amount is first recognised in the accounts. The amount must be capable of being identified as share capital when the amount is first recognised and it must remain of that character until it is transferred to the share capital account.
Transfers under debt/equity swaps
An exception to the tainting rule also applies where an amount is transferred to a share capital account under a debt for equity swap16.
A debt for equity swap includes an arrangement where a taxpayer discharges, releases, or otherwise extinguishes the whole or part of a debt owed to the taxpayer in return for the issue by the debtor to the taxpayer of shares (other than redeemable preference shares) in the debtor.
The exclusion does not, however, apply to the full amount transferred to the share capital account if the amount transferred exceeds the lesser of the market value of the shares issued to the creditor and the amount of the debt discharged. In this situation the exclusion does not apply to the excess.
Transfers from ‘option premium reserves’
A further exception exists for certain transfers made by a company from an option premium reserve to its share capital account17:
This exclusion from the tainting rules was introduced when Division 197 of the ITAA 1997 replaced the former Division 7B of the ITAA 1936 (with effect from 1998).
When will the exclusion for transfers of option premiums apply?
Under this exclusion, a company will not taint its share capital account if it transfers an amount to its share capital account from an option premium reserve where:
- the transfer is made because an option to acquire shares in the company has been exercised; and
- premiums in respect of those options were credited to the option premium reserve.
The exclusion will not apply where the amount is transferred and there has been no exercise of an option to acquire shares in the company.
What is an ‘option premium reserve’?
The term ‘option premium reserve’ is not defined in the ITAA 1997.
For accounting purposes, a ‘reserve’ is ordinarily understood to be an equity account which records items of owners’ equity other than share capital. On that basis, an ‘option premium reserve’ would be an equity account in which a company records amounts of money or moneys worth which another entity has agreed to provide the company in return for that entity acquiring a right to be issued an option over the company’s shares.
The question whether a reserve contains amounts which have been provided to the company for issuing options must be determined substantively. That is, the characterisation of the amount must be determined having regard to the legal rights and obligations which arise under the arrangement in respect of which the amount is to be provided.
The name given to an account will not determine whether the account is an option premium reserve.
Example 7 – Transferring option premiums The $200 cash provided to the company was the consideration for the issue of the options; it was an option premium. The option premium was credited to an equity reserve which the company labelled an ‘option premium reserve’. The accounting entries were: | ||
Dr |
Cash |
$200 |
Cr |
Option Premium Reserve |
$200 |
Subsequently, the option holder exercised all of the options and the company issued 100 shares to the option holder. At this time the total of the exercise amount received, plus the option premiums, were credited to the company’s share capital account. The accounting entries were: | ||
Dr |
Option Premium Reserve |
$200 |
Dr |
Cash |
$100 |
Cr |
Share Capital Account |
$300 |
Under the former share capital tainting rules, the transfer of the $200 from the option premium reserve would have resulted in a tainting of the share capital account. That is because, the $200 standing to the credit of the option premium reserve did not represent an amount of share capital when the amount was first credited to option premium reserve. However, under the current rules, the fact that the amount transferred represents premiums credited to the reserve when the options were issued means that the transfer upon the exercise of the options is not a transfer to which the share capital tainting provisions would apply. Note, however, the exclusion would not apply if the $200 was transferred from the option premium reserve to the share capital account and there had been no exercise of the options. For example, a transfer of an option premium to the share capital account either before the options were exercised or after they had lapsed would result in a tainting of the share capital account. | ||
Footnotes
1 Unless otherwise indicated all references in this fact sheet are to the Income Tax Assessment Act 1997
2 See subsection 975-300(1)
3 See subsection 975-300(2)
4 See paragraph 4.10 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 3) Bill 2006.
5 Compare the definition of ‘paid-up share capital’ in subsection 995-1(1). Also note, for accounting purposes share capital is generally recorded in the balance sheet when the consideration for issuing the share is due and receivable.
6 To illustrate, see ‘Example 4.1’ in the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 3) Bill 2006
7 See Paragraph 43 UIG 1052
8 Refer section 197-5 and subsection 197-50(1)
9 See subsection 975-300(2)
10 See Paragraph 4.12 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.3) Bill 2006
11 See Paragraph 4.13 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.3) Bill 2006
12 From 5 July 2007, Regulatory Guides replace all Practice Notes. For more information see www.asic.gov.au
13 See Paragraph 4.12 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.3) Bill 2006
14 There are also exclusions for amounts transferred leading to there being no shares with a par value (see section 197-20) and exclusions for transfers associated with various forms of demutualisations (see sections 197-30 – 197-40).
15 See section 197-10.
16 See section 197-15.
17 See section 197-25
Last Modified: Monday, 25 May 2009
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