Edited version of private ruling

Authorisation Number: 1011712550009

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Ruling

Subject: Share Capital Tainting

Question 1

Prior to the vesting of the relevant employee shares, and the journal entries identified by the Company (the Applicant), was the Applicant's share based payments reserve part of the Applicant's share capital account within the meaning of section 975-300 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No

Question 2

Did the grant and vesting of shares in the Applicant under its Trust Plan and Share Plan, which gave rise to the identified credits to the Applicant's paid up capital constitute the transfer of an amount or amounts to the Applicant's share capital account from another account within the meaning of section 197-5 of the ITAA 1997?

Answer: No

Question 3

If there were transfers associated with these transactions, were those transfers of amounts that at all times could be identified as share capital pursuant to section 197-10 of the ITAA 1997?

Answer: Not applicable

Relevant facts and circumstances

The Applicant is a resident Australian public company.

The Applicant operates a number of employee share schemes for its employees. The two plans of relevance to this Ruling are the Applicant's Trust Plan and the Applicant's Share Plan.

The Trust Plan was established to provide share based performances incentives to the Applicant's senior executives. The Share Plan was established to provide share based incentives for most employees of the Applicant.

The terms of the Trust Plan are set out in deeds between the Applicant and Trustee (Trust Plan Deeds).

Clause 5.1 of the Trust Plan Deeds provides for the Applicant's Board (the Board), in its absolute discretion, to make offers to all or some of its employees to participate in the Trust Plan.

Clause 6.1 of the Trust Plan Deeds provides that at each offer date, certain "performance standards" to be satisfied over the following three years will be established, and the Board can determine the number of shares to which a participant may be entitled on satisfaction of those performance standards.

The Applicant provides irretrievable cash contributions to the Trustee to be used in accordance with the Trust Plan Deeds for the sole purpose of subscribing for and/or acquiring shares for the benefit of employees of the Applicant. For the periods to which this Ruling applies, the Applicant's shares subscribed for by the Trustee of the Trust Plan were allotted for no monetary consideration. Accordingly, no funds were required to be provided by the Applicant to the Trustee. The only consideration received by the Applicant for the issue of shares to employees during the relevant period was the services of the employees.

Prior to 31 July 2009, and in accordance with the way in which the Applicant complied with the requirements of Accounting Standard AASB 2 - Share-based Payment (AASB 2), once the entitlement to shares was granted to the employees, the Applicant accrued amounts on a monthly basis, representing their fair value, over the vesting period. This was over a 3 year period in the case of the Trust Plan. Ownership entitlement to shares under the Share Plan vested in the same year in which the shares were offered to employees.

The Applicant recorded the accruals for both the Trust Plan and Share Plan by debiting Share based expense (profit and loss) and crediting Share based payments reserve (balance sheet).

Once the shares vested in the employee, the Applicant debited the amount from the Share based payments reserve and credited it to Paid-up capital. In relation to the Trust Plan, this movement happened in full following the issue of shares to the Trustee and there were no subsequent movements of amounts to Paid-up capital.

The Share based payments reserve is the only reserve account maintained by the Applicant. It forms part of the Applicant's equity, although it is not recognised as part of the Applicant's Paid-up capital.

In situations where the shares did not vest as a result of the relevant vesting conditions not being met, the relevant amount in the Share based payments reserve was reversed so the amount was debited from the Share based payments reserve and credited to the Shares based expense.

In cases where the failure to vest arose due to market conditions not being met, the amount was debited to the Share based payments reserve and credited to Retained earnings.

No adjustments were made to the value of shares recognised as part of the Share based payments reserve after the grant date. The amounts recognised in the journal entry, that recognises the shares vesting in the employees, always matched the amounts accrued in respect of those shares over the vesting period.

Detailed Reasoning

Question 1

Summary

Prior to the vesting of the relevant employee shares, and the journal entries identified by the Applicant, the Applicant's share based payments reserve was not part of the Applicant's share capital account within the meaning of section 975-300 of the ITAA 1997.

Detailed reasoning

'Share capital account' for the purposes of Division 197 of the ITAA 1997 is defined in subsection 975-300(1) as:

(a) an account that the company keeps of its share capital; or

(b) any other account (whether or not called a share capital account) that satisfies the following conditions:

(i) the account was created on or after 1 July 1998;

(ii) the first amount credited to the account was an amount of share capital.

The share capital account represents a liability owed to the shareholders by the company and appears with other liability accounts on the liabilities side of a balance sheet in traditional accounting: it is not to be confused with an asset account. The accounts to which Division 197 of the ITAA 1997 refers are not asset accounts. A 'negative' asset account, however, is a liability account and vice versa.

'Share capital' is not defined for the purposes of Division 197. It is therefore necessary to consider the ordinary meaning of the term 'share capital'.

The concept of share capital was considered in the High Court case of Archibald Howie Proprietary Ltd & Ors v. Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 where Williams J stated, at 157:

A company obtains capital by the issue of its shares....The amount payable may be satisfied by the payment of money or by some other proper consideration. But all shares must be paid for in full by money or money's worth. When the person to whom the shares are allotted pays or assumes the liability to pay for the shares in money or money's worth, full consideration in money or money's worth moves from him to the company for all the rights which he acquires under the memorandum and articles of association.

The Full Court of the Federal Court in St George Bank Ltd v. Federal Commissioner of Taxation (2009) 176 FCR 424; [2009] FCAFC 62; 2009 ATC 20-103; (2009) 73 ATR 148 considered share capital as follows, per Perram J at paragraph 90:

…If the subscription consideration is money then the company obtains money; if it is land, it obtains land; if the share is not fully paid then the company acquires a right to call upon the unpaid portion. The 'capital' of the company is the money or money's worth derived by the company from the issue of shares: Re The Swan Brewery Co Ltd (1976) 3 ACLR 164 at 166 per Gillard J.

As stated above, once the shares vest in the employee under the relevant employee share plans, the Applicant debited the amount from the Share based payments reserve and credited it to Paid-up capital.

The amounts credited to the Applicant's Share based payment reserve are the value of services received in anticipation of the future issue of shares.

The amounts entered in the reserve account represent the Applicant's best estimate of the consideration received for the number of shares that are expected to be issued in the future. However, the amounts are not amounts that are known to have been received in return for shares. In future years, adjustments are made to the total value of services provided by entering higher or lower amounts based on changed assessments of the likely number of shares that will vest. This, in effect, changes the value of services recorded in the earlier year. It will also reflect any fair value increases in the equity instrument following modifications in market conditions.

While the amounts recorded in the Applicant's Share based payment reserve are values attributed to the services that are provided in return for the future issue of shares, subject to the vesting conditions being satisfied, the uncertainty that any particular amount will in fact be for the issue of shares means that the amounts are not share capital. Therefore, the Applicant's Share based payment reserve is not a share capital account.

Consequently, amounts debited to the Share based payments reserve are not part of the 'share capital account' of the Applicant.

Question 2

Summary

The granting and vesting of shares in the Applicant under the Trust Plan and Share Plan, which gave rise to the identified credits to the Applicant's paid up capital did not constitute the transfer of an amount to the Applicant's share capital account from another account within the meaning of section 197-5 of the ITAA 1997.

Detailed reasoning

Division 197 of the ITAA 1997 provides for a company's share capital account to become 'tainted' if an amount is transferred to the share capital account from another account.

Subsection 197-5(1) of the ITAA 1997 provides:

Subject to subsection (2), this Division applies to an amount (the transferred amount) that is transferred to a company's *share capital account from another of the company's accounts, if the company was an Australian resident immediately before the time of the transfer. [subsection (2) is not relevant for present purposes]

The purpose of Division 197 is to prevent profit being distributed as share capital. This is consistent with the purpose of the share capital tainting rules explained in paragraph 4.4 of the Explanatory Memorandum to the Taxation Laws Amendment (2006 Measures No 3) Bill 2006 (the EM) which states:

… The share capital tainting rules are integrity rules designed to prevent a company from disguising a distribution of profits as a tax-preferred capital distribution by transferring profits into its share capital account and subsequently making distributions from that account.

The purpose of Division 197 is therefore to prevent the transfer of profit to share capital, and prevent the tax preferred distribution of capital out of what is actually profit.

In the present case, the amounts in the Share based payments reserve, though not share capital, represent the value of services received from employees in consideration for the potential future issue of shares. Upon the corresponding issue of shares, that consideration forms part of the consideration received for their issue, and hence forms part of share capital.

Further, in the case of the Applicant's employee share arrangement, fair value of services is provided in return for the issue of shares. The situation is akin to paying an employee cash for their services, and the employee then committing to pay cash for an equivalent number of shares, in that the services are expensed and paid for by way of subsequent share issue.

Therefore, the crediting of an amount to the Share capital account did not constitute a transfer of an amount within the meaning of section 197-5 of the ITAA 1997, in relation to both of the Trust Plan and Share Plan.

Question 3

Summary

As the granting and vesting of shares in the Applicant under the Trust Plan and the Share Plan, which gave rise to the credits to the Applicant's paid up capital did not constitute the transfer of an amount to the Applicant's share capital account from another account within the meaning of section 197-5 of the ITAA 1997, it is not necessary for the Commissioner to determine if the relevant amounts could at all times could be identified as share capital pursuant to section 197-10 of the ITAA 1997.

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