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Ruling

Subject: Distributions to shareholders in the form of dividends

Question 1

Will the distribution by Company A to its Shareholder in the form of a pro-rata return of capital be considered a dividend for the purposes of subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No. However, a portion of the purchase price will be a dividend.

Question 2

Having regard to the relevant circumstances, would the Commissioner of Taxation (the Commissioner) conclude that section 45B of the ITAA 1936 would apply to all or part of the capital component of the proposed share buy-back by Company A pursuant to subsection 45B(2) of the ITAA 1936?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2013

Relevant facts and circumstances

All entities mentioned are residents for Australian tax purposes.

The Shareholder acquired 100% of the shares in Company B.

The Shareholder also acquired 100% of the shares in Company C.

The Shareholder funded the acquisition of Company C as follows:

· a loan from Company C to the Shareholder;

· a loan from Company B to the Shareholder; and

· a loan from an external financial institution (the Bank) to the Shareholder.

The above structure is known as the ABC Group.

The loans from Company B and Company C listed above (the Shareholder Loans) have been made subject to written loan agreements, provide for commercial rates of interest to be charged and principal repayments over 7 years to comply with the requirements of Division 7A of the ITAA 1936.

It was envisaged at the time of acquiring Company B and Company C that the operating profits from the ABC Group would be sufficient to pay annual dividends to enable the Shareholder to make its minimum principal and interest payments under the relevant loan agreements of the Shareholder Loans.

The opportunity arose for the ABC Group to make a further acquisition of three companies known as the XYZ Group.

The opportunity to acquire the XYZ Group was offered to several other potential buyers.

After discussions and negotiations, the Bank agreed to provide finance to the ABC Group via additional loans and a convertible note to assist in funding the acquisition of the XYZ Group (to the extent the bid was successful).

An important requirement of the Bank's investment was its preference to invest in the ABC Group and the XYZ Group via a single investment point rather than investing in five separate companies.

Further, a condition in the original term sheet entered into between the ABC Group and the Bank was that the maximum amount of loans between the ABC Group and related parties be no more than $X at the time of the investment.

As part of the acquisition structure, it was decided that a new holding company would be established to own 100% of the shares in Company B and Company C and to the extent the bid for the XYZ Group would be successful, the newly incorporated company would also acquire 100% of the shares (directly or indirectly) in the companies in the XYZ Group.

Accordingly, Company A was a company incorporated, which was owned 100% by the Shareholder.

Company A acquired all the shares in Company B in exchange for issuing shares in itself to the Shareholder.

Company A acquired all the shares in Company C in exchange for issuing shares in itself to the Shareholder.

The Shareholder qualified for capital gains tax (CGT) roll-over relief in respect of the transactions described above, such that any capital gain or capital loss that would otherwise have been realised by the Shareholder has been disregarded.

Company A issued ordinary shares to the Shareholder in consideration for acquiring the Shareholder's shares in Company B.

Company A issued ordinary shares to the Shareholder in consideration for acquiring the Shareholder's shares in Company C.

The total number of shares issued by Company A were all held by the Shareholder.

Based on the average capital per share method, the capital component of each share in Company A is $Y.

The ABC Group was then identified as the preferred bidder for the XYZ Group.

It was identified that there were significant impediments to reducing the Shareholder Loans to $X as agreed by the ABC Group and the Bank. Specifically, the Shareholder did not have the funding capacity to repay the outstanding balances and the forgiveness of such loans would result in significant tax liabilities for the Shareholder.

As a key investor, the Bank was insistent that the loans be reduced to the agreed minimum as it was concerned that the Shareholder would not be able to draw the previously expected dividend stream to make the expected principal and interest payments due to the changed capital structure of the Group which included a greater level of debt in the business.

Further, the Bank was concerned that the Shareholder did not have external financial capacity to raise finance to make the necessary interest and principal repayments on the Shareholder Loans which is likely to give rise to a significant income tax issue for the Shareholder in future years.

It was also agreed that the proposed buy-back would not be undertaken without receiving a positive Private Ruling from the Commissioner to ensure no adverse income tax implications are triggered for the Shareholder.

To the extent an unfavorable ruling is received, the parties will look to leave the Shareholder Loans in place and explore alternatives that would allow the Shareholder to make its minimum interest and principal repayments under the existing loan agreements without triggering any adverse income tax implications

After working through some other commercial issues, the ABC Group acquired the XYZ Group.

The Bank provided debt funding for the entire purchase price for the acquisition of the XYZ Group.

Company A has never paid any dividends.

Company C paid a dividend in relevant year, prior to the acquisition of the company by the Shareholder.

Company B paid an unfranked dividend to the Shareholder in subsequent year out of retained earnings generated by Company B up to this date.

It is expected that Company A will have sufficient franking credits to attach to any dividends paid as part of the proposed buy-back.

The Shareholder has carried forward tax losses as at the end of the subsequent financial year.

The proposed buy-back

It is proposed to undertake the following steps to effect the proposed buy-back:

a) Company B and the Shareholder agree to assign the outstanding loan balance payable by the Shareholder to Company A, such that Company A will owe Company B the same amount previously owed by the Shareholder. In consideration for agreeing to repay Company B, a loan will be created between the Shareholder and Company A for the same amount.

b) Similarly, Company C and the Shareholder agree to assign the outstanding loan balance payable by the Shareholder to Company A, such that Company A will owe Company C the same amount previously owed by the Shareholder. In consideration for agreeing to repay Company C, a loan will be created between the Shareholder and Company A for the same amount.

c) As a result of steps (a) and (b) above, the Shareholder will now owe Company A the loan amount.

d) Company A will undertake a share buy-back for the same amount of loan, which equates to $Z per share.

e) In consideration for buying back shares from the Shareholder, the loan owing by the Shareholder to Company A will be reduced to nil.

The market value of each share in Company A is $D.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 159GZZZK

Income Tax Assessment Act 1936 section 159GZZZM

Income Tax Assessment Act 1936 section 159GZZZP

Income Tax Assessment Act 1936 section 159GZZZQ

Income Tax Assessment Act 1936 subsection 177A(1)

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 paragraph 202-45(c)

Reasons for decision

Question 1

Summary

The distribution by Company A to the Shareholder in the form of a pro-rata return of capital is not considered a dividend for the purposes of subsection 6(1) of the ITAA 1936. However, the purchase price of the buy-back is deemed to be $1.24 per share, which includes a dividend component of $0.24 per share.

Detailed reasoning

All legislative references are to the ITAA 1936 unless otherwise indicated.

A 'dividend' is defined in subsection 6(1) to include:

(a) any distribution made by a company to any of its shareholders, whether in money or other property; and

(b) any amount credited by a company to any of its shareholders as shareholders.

Subsection 159GZZZP(1) relevantly provides that, for the purposes of the ITAA 1936 and the Income Tax Assessment Act 1997 (ITAA 1997), where a buy-back of a share by a company is an 'off-market purchase', the difference between:

(a) the purchase price; and

(b) the part (if any) of the purchase price in respect of the buy-back of the share which is debited against amounts standing to the credit of the company's share capital account,

is taken to be a dividend paid by the company:

(c) to the seller as a shareholder in the company; and

(d) out of profits derived by the company; and

(e) on the day the buy-back occurs.

An 'off-market purchase' occurs when a company that is not listed on any official stock exchange buys a share in itself from a shareholder in the company (paragraph 159GZZZK(d)). When the off-market purchase occurs, it is a 'buy-back' and the shareholder is the seller (paragraphs 159GZZZK(a) and (b)).

The purchase price for the purposes of the off-market buy-buy provisions is defined in paragraph 159GZZZM(a) to include the amount of money that the seller has received or is entitled to receive as a result of or in respect of the buy-back.

Accordingly, as Company A is not listed on any official stock exchange, the proposed purchase of $Z per share from the Shareholder is an off-market buy-back and the Shareholder is the seller. Subject to the operation of subsection 159GZZZQ(2) (discussed below), the purchase price will be $Z per share, which is used to reduce the loans owing to Company A by the Shareholder to nil.

However, the amount of the purchase price that is treated as a dividend under section 159GZZZP is only the amount that is not debited against the company's share capital account. The amount of the purchase price that is debited against the share capital account is essentially a 'split' between the return of capital and dividend paid to the shareholder.

The provisions of the ITAA 1936 do not prescribe how the company is to allocate the buy-back purchase price against the share capital account. However, the Commissioner will have regard to the various anti-avoidance and integrity rules. The Commissioner 'considers that there are a number of acceptable methodologies for ascertaining the capital/dividend split, although not all have equal applicability in every case, which are outlined in Law Administration Practice Statement PS LA 2007/9 Share buy-backs (PS LA 2007/9) at paragraph 61.

The most appropriate methodology for Company A is the average capital per share (ACPS) method. This 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 (PS LA 2007/9 at paragraph 62).

Based on the average capital per share method, the capital component of each share in Company A is $X.

Under the proposed share buy-back, Company A will purchase the shares back from the Shareholder for $Z per share. The capital component of the proposed share buy-back will be $X per share. The balance of the purchase price, per share, is therefore the prima facie dividend component.

However, subsection 159GZZZQ(2) provides that if the purchase price in respect of the buy-back is less than what would have been the market value of the share at the time of the buy-back, if the buy-back did not occur and was never proposed to occur, then the amount of the consideration that the seller is taken to have received in respect of the sale of the share is equal to its market value.

The market value of each share in Company A is $D. The $Y per share that Company A will pay for the shares under the proposed buy-back is therefore $E less than each share's market value. Accordingly, subsection 159GZZZQ(2) will apply to deem the purchase price in the proposed share buy-back by Company A to be $1.24 per share.

As the capital component of the proposed share buy-back will be $X per share (as discussed above), and the buy-back amount is deemed to be $D per share, the balance of the purchase price iper share. Therefore, the dividend component of the buy-back is $E per share.

It is noted that paragraph 202-45(c) of the ITAA 1997 provides that where the purchase price on the buy-back of a share by a company from one of its members (such as a shareholder) is taken to be a dividend under section 159GZZZP, so much of that purchase price that exceeds the market value of the share is unfrankable.

Therefore, if the purchase price on the buy-back of the Company A shares is above market value, so much of that purchase price that exceeds the market value of the share is unfrankable. However, as the purchase price is below market value, the dividend component of the purchase price will be frankable.

It is expected that Company A will have sufficient franking credits to attach to any dividends paid as part of the proposed buy-back.

Question 2

Summary

Having regard to the relevant circumstances, the Commissioner concludes that section 45B does not apply to all or part of the capital component of the proposed share buy-back by Company A pursuant to subsection 45B(2).

Detailed reasoning

Application of section 45B

Paragraph 45B(1)(b) provides that a purpose of section 45B is to ensure that relevant amounts are treated as dividends for taxation purposes if certain payments, allocations and distributions are made in substitution for dividends. According to subsection 45B(2), the section will apply if:

a) there is a scheme under which the person is provided with a demerger benefit or a capital benefit by a company; and

b) under the scheme, a taxpayer (the 'relevant taxpayer'), who may or may not be the person provided with the demerger benefit or capital benefit, obtains a tax benefit; and

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

Section 45B will apply only if, having regard to the relevant circumstances of the scheme, it would be concluded that the person(s) who entered into the scheme did so for the purpose of enabling a person to obtain a tax benefit. The purpose need not be a dominant purpose, but must be more than an incidental purpose.

A more than incidental purpose includes a main or substantial purpose, but does not need to be the 'most influential or prevailing purpose': Law Administration Practice Statement PS LA 2008/10 Application of section 45B of the Income Tax Assessment Act 1936 to share capital reductions (PS LA 2008/10) at paragraph 54. It is therefore necessary to consider and apply each paragraph within subsection 45B(2) to the facts in the proposed share buy-back by Company A.

It is noted that the use of the ACPS method to determine the capital component of the buy-back gives rise to a strong presumption that section 45B would not apply to the buy-back (PS LA 2007/9 at paragraph 62). Nevertheless, it is still necessary to consider and apply the provisions of the section to the facts to confirm the presumption.

A scheme with a capital benefit

A 'scheme' is defined in subsection 177A(1) to mean:

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.

Having regard to this broad definition, the proposed buy-back of the shares in Company A is a 'scheme' for the purposes of section 45B.

Paragraph 45B(5)(b) provides that a reference to a person being 'provided with a capital benefit' includes a reference to the distribution to the person of share capital or share premium.

Accordingly, the proceeds in respect of the shares bought back by Company A from the Shareholder under the proposed buy-back would constitute the provision of a capital benefit to the Shareholder for the purposes of section 45B, as the amount will represent the provision of share capital.

Obtains a tax benefit

Subsection 45B(9) relevantly provides that a relevant taxpayer "obtains a tax benefit" for the purposes of section 45B:

'… if an amount of tax payable, or any other amount payable … by the relevant taxpayer would, apart from this section, be less than the amount that would have been payable, or would be payable at a later time than it would have been payable, if … the capital benefit had been an assessable dividend.'

As the capital component of the share buy-back is not included in the assessable income of the Shareholder, a tax benefit is obtained by the Shareholder and the Shareholder is therefore the 'relevant taxpayer' for the purposes of section 45B.

Regard to the relevant circumstances to determine purpose

As the Shareholder (the relevant taxpayer) obtains a tax benefit under a scheme in which it is provided a capital benefit, it is necessary to consider whether the parties to the proposed buy-back would enter into the scheme for the purpose of obtaining a tax benefit 'having regard to the relevant circumstances' as defined in subsection 45B(8). Subsection 45B(8) lists the relevant circumstances.

The Commissioner's approach in applying the relevant circumstances in subsection 45B(8) to share buy-back arrangements is set out in detail in PS LA 2008/10.

In coming to our decision, we have considered and applied PS LA 2008/10 to the proposed buy-back of the Company A shares.

Having regard to the relevant circumstances surrounding the share buy-back to be undertaken by Company A, it cannot be concluded that Company A or the Shareholder will enter into or carry out the share buy-back for the purposes of enabling the Shareholder to obtain a capital benefit. As a result, section 45B will not apply to all or part of the capital component of the proposed Company A share buy-back.

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