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Ruling

Subject: Off market share buy-back

Question 1

Will section 45B of the Income Tax Assessment Act 1936 (ITAA 1936) apply in relation to the buy-back price?

Answer

No. Section 45B of the ITAA 1936 will not apply to the buy-back price.

Question 2

Will section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the share buy-back scheme?

Answer

No. The Commissioner has concluded that section 177EA of the ITAA 1936 will not apply to the share buy-back scheme.

Question 3

Will section 204-30 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the franked dividend component of the buyback price?

Answer

No. Section 204-30 of the ITAA 1997 will not apply. Any benefits are merely an incidental result from the share-buy back process.

This ruling applies for the following periods:

1 July 2010 to 30 June 2012

Relevant facts and circumstances

The company has bought back X% of its shares over two years in an off market buyback. The buyback was not a selective buyback. The company is undergoing the share buyback due to a change in directors/shareholders and the minimum amount of shares that is required to be held by directors under their shareholders agreement.

The company underwent two share buy-backs. One occurred during June 2011. On this date the company bought back X shares - X% of its share capital. During July 2011 the second buy-back occurred. On this date X shares were bought back which was X% of the company's shares. The shareholders of the company are the company directors and some employees. Some shares are held by associated entities such as a trust and a self managed superannuation fund. All of the shareholders are Australian resident entities. All of the shares in the company are post-CGT shares.

The share buy-back occurred to reduce the amount of shareholding everyone held. This is due to a substantial change in directors of the company and under their agreement directors have to hold over 10% of the company's shares. The share buy-back took place to make the 10% holding more affordable to the new directors.

The funds for the buy-back have come from retained profits that have been in the company for a number of years. The dividend component of the share buy-back price will be fully franked. The shares have been bought back at their market value of $X. The market value of the shares was determined by an independent valuer. A copy of the valuation report has been provided.

After discussions with the tax agent it was agreed that the Average Capital Per Share method (ACPS) would be used to determine the capital / dividend split, as provided for in Practice Statement PS LA 2007/9.

The company's balance sheet as at 30 June 2011 shows that there were X issued shares with a value of $X. Accordingly the company's share capital is $X. Using the ACPS method, the capital component of the buy-back price will be $X and the dividend component will be $X.

Relevant legislative provisions

Income Tax Assessment Act 1936

Section 45B

Division 16K

Section 177EA

Income Tax Assessment Act 1997

Subdivision 204D

Section 204-30

Reasons for decision

Division 16K of the Income Tax Assessment At 1936 (ITAA 1936) - Effect of buy-backs of shares

Division 16K of Part III of the ITAA 1936 applies where a company buys a share (or a non-share equity) in itself from a shareholder and cancels the share. On-market and off-market share buybacks are defined in section 159GZZZK of the ITAA 1936. If the share is listed on a stock exchange and the purchase is made in the ordinary course of business of that stock exchange, the buy-back will be an on-market purchase. All other buy-backs are treated as off-market buy-backs for taxation purposes.

The purchase price paid by the company to the shareholder is the amount of money and/or the market value of any property the shareholder receives as consideration for the buy-back - refer section 159GZZZM of the ITAA 1936.

There are no income tax or capital gains tax consequences for the company that carries out the buy-back - refer section 159GZZZN of the ITAA 1936. However a company may be required to debit its franking account balance in respect of the buy-back.

In an off-market buy-back of shares, the difference between the purchase price and the part of the purchase price in respect of the buy-back which is debited against the company's share capital account is taken to be a dividend paid by the company to the seller. This dividend is paid to the seller as a shareholder out of profits derived by the company on the day the buy-back occurs - refer section 159GZZZP of the ITAA 1936. Franking credits may be available in respect of this dividend.

Under the ACPS method the capital component of the buy-back will be $X per share and the remaining $X of the purchase price will be a franked dividend.

The dividend/capital split

In an off-market share buy-back the consideration paid to the vendor shareholder will generally comprise a return of capital and a fully, partly or unfranked dividend.

An essential aspect of any off-market share buy-back is the 'split' between the return of capital and dividend paid to participating shareholders. Although the 'split' is nominated by the company, the ATO must consider the various anti-avoidance and integrity rules that may apply. For example, a 'split' that has too low a capital component will both stream dividends and artificially increase capital losses to vendor shareholders. Conversely, a capital component that is too high will provide or stream capital benefits at the expense of dividends.

The preferred ATO methodology for determining the dividend/capital 'split' is the average capital per share method (ACPS). The ACPS is obtained by dividing a company's ordinary issued capital by the number of shares on issue. The amount so derived is a reasonable estimate of any capital component of the split. The balance of any buy-back price would be a dividend.

Application to your circumstances

Under section 159GZZZK of the ITAA 1936, where a company buys a share in itself from a shareholder in the company (a share buy-back), the share is not a share that is listed on a stock exchange and the buy-back is not made in the ordinary course of trading on that stock exchange, the buy-back is an off-market purchase.

As the shares sold to the company were not listed on the stock exchange the buy-back by the company is an off-market purchase.

Under paragraph 159GZZZM(a) of the ITAA 1936, the purchase price in respect of a buy-back is, if the seller as a shareholder has received or is entitled to receive an amount or amounts of money as a result of or in respect of the buy-back, that amount or the sum of those amounts.

Under subsection 159GZZZP(1) of the ITAA 1936, where a buy-back of a share is an off-market purchase, the difference between the purchase price and the part (if any) of the purchase price which is debited against amounts standing to the credit of the company's share capital account, is a dividend. The dividend is taken to be paid by the company to the seller in the company out of profits derived by the company on the day the buy-back occurs. The dividend is required to be included in the seller's assessable income under section 44 of the ITAA 1936.

Question 1

Schemes to provide capital benefits - section 45B of the Income Tax Assessment Act 1936 (ITAA 1936)

Section 45B of the ITAA 1936 is an anti-avoidance provision which ensures that capital paid in substitution for dividends (capital benefit) is treated as unfranked dividends in the hands of the shareholders for income tax purposes under subsection 45C(1) of the ITAA 1936.

Subsection 45B(2) of the ITAA 1936 sets out the conditions under which the Commissioner will make a determination under subsection 45B(3) that section 45C(1) of the ITAA 1936 applies. These conditions are:

(a) there is a scheme under which a company provides a person with a capital benefit - refer paragraph 45B(2)(a)

(b) a taxpayer (the relevant taxpayer), who may or may not be the person provided with the capital benefit, obtains a tax benefit under the scheme - refer paragraph 45B(2)(b); and

(c) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme did so for a purpose (other than an incidental purpose) of enabling the relevant taxpayer to obtain a tax benefit - refer paragraph 45B(2)(c)

The meaning of 'provided with a capital benefit' is found in subsection 45B(5) of the ITAA 1936. A person is provided with a capital benefit if:

(5)  A reference to a person being provided with a capital benefit is a reference to any of the following:

(a)  the provision of ownership interests in a company to the person;

(b)  the distribution to the person of share capital or share premium;

(c)  something that is done in relation to an ownership interest that has the effect of increasing the value of an ownership interest (which may or may not be the same interest) that is held by the person.

Application to your circumstances

Section 45B of the ITAA 1936 is specifically aimed at dividend substitution arrangements, that is, payments that are made in substitution for dividends. For the section to apply there must be a scheme under which a capital benefit is provided to a person by a company.

In this case the relevant scheme is the buy-back of shares by the company. In exchange for the shares the company will pay a capital amount of $X for each share and a franked dividend of $X to the vendor shareholders. The capital amount paid is equivalent to the cost base of the shares which means that there will be no capital gain or loss to the shareholders.

Under paragraph 45B(5)(b) of the ITAA 1997 the buy-back will result in a capital benefit being provided to the shareholders as there is a distribution of share capital.

Section 45B of the ITAA 1936 will apply where a capital benefit is provided under a scheme for a 'more than incidental purpose' of conferring a tax benefit. Whether the requisite 'more than incidental purpose' exits is to be inferred from the circumstances of the arrangement.

Having regard to the 'relevant circumstances' of the scheme, as set out in subsection 45B(8) of the ITAA 1936, it is apparent that the inclusion of the capital component as part of the buy-back price is not inappropriate.

Also the use of the ACPS method to determine the capital/dividend split of the buy-back price gives rise to a strong presumption that section 45B of the ITAA 1936 will not apply to the buy-back.

Having regard to the relevant circumstances of the buy-back, it is considered that section 45B of the ITAA 1936 will not apply to the scheme.

Question 2

Application of section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936)

Section 177EA of the ITAA 1936 targets franking credit trading and dividend streaming schemes where one of the purposes (other than an incidental purpose of the scheme) is to obtain an imputation benefit. The reason for its introduction was set out in the Explanatory Memorandum to the Taxation Laws Amendment (No. 3) Act 1998.

8.5 Two of the underlying principles of the imputation system are, firstly, that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves and, secondly, that tax paid at the company level is in broad terms imputed to shareholders proportionately to their shareholdings.

8.6 Franking credit trading schemes allow franking credits to be inappropriately transferred by, for example, allowing the full value of franking credits to be accessed without bearing the economic risk of holding the shares. These schemes undermine the first principle.

8.7 Companies can also engage in dividend streaming (i.e. the distribution of franking credits to select shareholders), which undermines the second principle by attributing tax paid on behalf of all shareholders to only some of them. Generally this entails the streaming of franking credits to taxable residents and away from non-residents and tax-exempts.

The preconditions for the application of section 177EA of the ITAA 1936 are listed in subsection 177EA(3) and apply if:

(a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and

(c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d) except for this section, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

(e) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

The definition of scheme in subsection 177A(1) of the ITAA 1936 includes:

a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

Practice Statement PS LA 2007/9 makes the following comments about the application of section 177EA of the ITAA 1936:

113. Accordingly, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that, on the part of a company, its shareholders or any other relevant party, there is a purpose more than merely an incidental purpose of conferring an imputation benefit under the scheme. Under this arrangement the relevant taxpayer is the participating shareholder and the scheme comprises the circumstances surrounding the buy-back.

114. In arriving at a conclusion, the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed there encompass a range of circumstances which taken individually or collectively could indicate the requisite purpose. Due to the diverse nature of these circumstances some may not be present at any one time in any one scheme.

Application to your circumstances

In this instance the conditions in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 have been satisfied.

Accordingly, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that, on the part of the company and the participating shareholders, there is a purpose, which is more than merely an incidental purpose, of obtaining an imputation benefit under the buy-back scheme.

In arriving at a conclusion, the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17) of the ITAA 1936. The circumstances listed in that subsection encompass a range of circumstances which taken individually or collectively indicate the requisite purpose. Due to the diverse nature of these circumstances some may not be present at any one time in any one scheme.

Circumstances which may attract the operation of section 177EA of the ITAA 1936 can include:

§ the delivery of franking credits in excess of what would have otherwise been distributed in the ordinary course of dividend declaration

§ the greater attraction of the buy-back to resident shareholders who could fully utilise the franking credits than to non-resident shareholders who could not

§ the greater attraction of the buy-back to some resident shareholders with a low marginal tax rate than other resident shareholders; and

§ that participating shareholders were more likely than not to make an economic gain, but a loss for taxation purposes, from their participation.

The Commissioner has come to the view that section 177EA of the ITAA 1936 does not apply in relation to the buy-back. In coming to this conclusion the Commissioner had regard to all relevant circumstances of the arrangement as outlined in subsection 177EA(17) of the ITAA 1936 including the fact that none of the participating shareholders are non residents or exempt entities.

Question 3

Application of section 204-30 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 204-30 of the ITAA 1997 concerns the streaming of dividends in such a way as to give imputation benefits to shareholders who would derive a greater benefit from imputation credits than other shareholders. The section allows the Commissioner to make a determination that no imputation benefit is to arise in respect of a distribution made to a favoured member if the conditions in subsection 204-30(1) are met. The subsection states that:

(1)  This section empowers the Commissioner to make determinations if an entity streams one or more *distributions (or one or more distributions and the giving of other benefits), whether in a single *franking period or in a number of franking periods, in such a way that:

(a)  an *imputation benefit is, or apart from this section would be, received by a *member of the entity as a result of the distribution or distributions; and

(b)  the member would *derive a *greater benefit from franking credits than another member of the entity; and

(c)  the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

The member that derives the greater benefit from franking credits is the favoured member. The member that receives the lesser imputation benefits is the disadvantaged member.

In order for a determination to be made under section 204-30 of the ITAA 1997 the Commissioner must be satisfied that an entity has streamed one or more distributions. The expression "streaming" is not defined in the ITAA 1997. However the Explanatory Memorandum to the New Business Tax System (Imputation) Act 2002 explains what is meant by "streaming":

What is streaming?

3.28 Streaming is selectively directing the flow of franked distributions to those members who can most benefit from imputation credits.

3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming.

3.30 Thus, streaming is unlikely to occur when a corporate tax entity, in making franked distributions, distinguishes between 2 classes of members, both of which comprise members who can and who cannot benefit from imputation credits. However, where one class is predominantly able to use imputation credits, and the other is predominantly not, it may be apparent that an arrangement is streaming, notwithstanding the presence in each class of a small minority of the other type of member.

3.31 Broadly speaking, any strategy directed to defeating the policy of the law by avoiding wastage of imputation benefits through directing the flow of franked distributions to members who can most benefit from them to the exclusion of other members, may amount to streaming. While it is not possible to specify in detail every combination of circumstances which can constitute the streaming of franking credits (which in some cases may involve questions of degree), some guidance is given below.

3.32 In the simplest case of streaming, the members who can benefit from imputation credits receive a franked distribution, while members who cannot benefit to the same degree (e.g. non-residents) or who receive no benefit (e.g. tax-exempt organisations) simultaneously receive an unfranked distribution (normally adjusted in amount for the lack of franking).

3.33 However, it is not necessary for there to be 2 distributions by the corporate tax entity for streaming to occur. For example, in more complex cases of streaming, while the members who benefit most from imputation credits will receive a franked distribution from the entity, the other members may receive benefits from persons other than the entity, or they (or the entity) may defer the realisation of their share of the profits derived by the entity. Benefits may also be directed to associates of members. In some cases where the member less able to benefit from imputation is a corporate tax entity, trust or partnership, streaming may involve by-passing the member in favour of its ultimate owners.

3.34 Members less able to benefit from imputation credits may not receive unfranked distributions at the time the other members get franked distributions, and instead realise their interest in the corporate tax entity's profits in some other way, either at the same time or in the future. In this case, streaming will occur where it is apparent that the corporate tax entity or the members less able to benefit from imputation credits have deferred or avoided the distribution of their interest in profits as part of a strategy to avoid the wastage of imputation benefits.

On the other hand, it would not be streaming if there is merely a deferred distribution of profits to one group of members which it is reasonable to expect will be franked (to a similar percentage) when it is distributed, or, if it is unfranked, will not be unfranked as the result of any strategy to direct franking to members most able to benefit from franking. In these cases it is appropriate to look to the intentions of the entity and members, and to the pattern of distributions among the members.

Subsection 204-30(8) of the ITAA 1997 provide a non-exhaustive list of circumstances where a shareholder would be considered to derive a greater benefit from franking credits than another shareholder. Specifically a shareholder will be a 'favoured member' in relation to another shareholder where any of the following circumstances exist for the other shareholder but not the 'favoured member':

§ The other shareholder is not an Australian resident

§ The other shareholder would not be entitled to any tax offset under Division 207 of the ITAA 1997 because of the distribution;

§ The amount of income tax that would be payable by the shareholder because of the distribution is less than the tax offset to which they are entitled;

§ The other shareholder is a corporate tax entity at the time the distribution is made but no franking credit arises for that shareholder as a result of the distribution;

§ The other shareholder is a corporate tax entity, but cannot use franking credits received on the distribution to frank distributions to its own members because it is not a franking entity or is unable to make frankable distributions; and

§ The other shareholder is an exempting entity.

Application to your circumstances

For section 204-30 of the ITAA 1997 to apply, shareholders to whom distributions are made must derive a greater benefit from imputation benefits than the shareholders who do not participate in the share buy-back. The words 'derives a greater benefit from franking credits' (imputation benefits) are defined in subsection 204-30(8) by reference to the ability of the shareholders to fully utilise imputation benefits. The participating shareholders will be entitled to tax offsets under Division 207 of the ITAA 1997. There are no members who are exempting entities or foreign residents. Therefore there are no favoured shareholders who may derive a greater benefit from franking credits.

The facts demonstrate that although there is a significant alteration in shareholder ownership arising from the off-market share buy-back process, there is no targeting of members most able to benefit from imputation credits.

Any benefits are merely an incidental result from the share-buy back process. The Commissioner considers that section 204-30 of the ITAA 1997 will not apply to the buy-back.

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