Edited version of your written advice

Authorisation Number: 1013087833428

Date of advice: 12 September 2016

Ruling

Subject: Return of capital

Question 1

Does CGT Event G1 happen when X Company, makes a payment to A Company as trustee of the B Trust under the proposed share capital reduction?

Answer

Yes

Question 2

Is any part of the payment under the proposed share capital reduction a dividend, as defined in section 6(1) of the Income Tax Assessment Act 1936 ('ITAA 1936'), and for the purposes of section 44 of that Act?

Answer

No

Question 3

Will the Commissioner make a determination under section 45C of the ITAA 1936 that either sections 45A or 45B of that Act apply, to treat some of the payment to be made to the Taxpayer as an unfrankable dividend under the proposed share capital reduction?

Answer

No

Question 4

Will Division 7A of the ITAA 1936 apply to deem any part of the payment of the proposed share capital reduction to be an unfrankable dividend under section 109C of the ITAA 1936?

Answer

No

Question 5

To the extent that a capital gain arises to the Taxpayer from CGT event G1, will it be a 'discount capital gain' under Subdivision 115 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer

Yes

This ruling applies for the following periods:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company A as trustee for the B trust is one of three holders of ordinary shares in X Company.

Over a three year period, X Company issued a number of Class A shares to Z Company. Z Company is also one of the three ordinary shareholders.

The Class A shares had nominal rights and the purchase of the Class A shares by Company Z was a method to inject capital to fund the business.

X Company has grown significantly and generates significant business income. The directors of X Company have decided the business is able to be funded by business income and the share capital is surplus to its requirements.

X Company bought back all of the Class A shares for a nominal amount. The share buy-back reserve was credited with an amount which was the difference between the original purchase price of the Class A shares and the nominal amount.

X Company proposes a capital return by way of an equal share capital reduction under section 256B of the Corporations Act 2001. There will be no cancellation of ordinary shares.

The proposed capital reduction will be made to all shareholders equally and on the same terms.

The payment will be debited to the share capital account of Company X.

Relevant legislative provisions

Income Tax Assessment Act 1936

• subsection 6(1)

• subsection 6(4)

• section 45A

• section 45B

• section 45C

• section 109C

• section 109L

Income Tax Assessment Act 1997

• section 104-135

• section 115-25

• section 975-300

Reasons for decision

Question 1

Summary

Capital Gains Tax (CGT) event G1 under section 104-135 of the ITAA 1997 will happen when Company X makes a payment to the shareholders under the proposed share capital reduction.

Detailed reasoning

CGT event G1 is set out in section 104-135 ITAA 1997 happens when a Company makes a payment to a shareholder in respect of a share they own and some or all of the payment (the non-assessable part) is not a dividend as defined in subsection 995-1(1) of the ITAA 1997 or an amount that is taken to be a dividend under section 47 of the ITAA 1936.

CGT event G1 will happen when Company X pays the return of capital amount to the taxpayer in respect of the Company X shares that the taxpayer owns.

The taxpayer will make a capital gain if the return of capital is more than the cost base of the taxpayer's share. The amount of the capital gain is equal to the excess (subsection 104-135(3) of the ITAA 1997).

Question 2

Summary

The proposed return of capital will not be a dividend as defined in subsection 6(1) of the ITAA 1936.

Detailed reasoning

The term 'dividend' is defined in subsection 6(1) of the ITAA 1936 and includes a distribution made by a Company to any of its shareholders. However, paragraph (d) of the definition of 'dividend' excludes a distribution that is debited against an amount standing to the credit of the share capital of the Company.

'Share capital account' is defined in section 975-300 of the ITAA 1997 as an account which the Company keeps of its share capital, or any other account created after 1 July 1998 where the first amount credited to the account was an amount of share capital.

The operation of paragraph (d) is subject to subsection 6(4), which states that paragraph (d) does not apply if, under an arrangement:

(a) a person pays or credits any money or gives property to the Company and the Company credits its share capital account with the amount of the money or the value of the property, and

(b) the Company pays or credits any money, or distributes property to another person, and debits its share capital account with the amount of the money or the value of the property so paid, credited or distributed

'Arrangement' for the purposes of subsection 6(4) is not defined and therefore it takes its ordinary meaning according to its context.

The term has not been ruled on judicially in regard to subsection 6(4), however it has been considered in the context of other provisions of the Income Tax Assessment Act 1936, notably subsection 44(2D) in the case FC of T v Lutovi Investment (Lutovi). In this case, Gibbs and Mason JJ (with whom Murphy J agreed) stated that:

It is, however, necessary that an arrangement should be consensual, and that there should be some adoption of it. But in our view it is not essential that the parties are committed to it or are bound to support it. An arrangement may be informal as well as unenforceable and the parties may be free to withdraw from it or to act inconsistently with it, notwithstanding their adoption of it.

Furthermore, an arrangement can be inferred from the circumstances or the conduct of the parties. Their Honours stated that:

But what of an arrangement which is implied or inferred from the circumstances or the conduct of the parties? Is it excluded? We do not think so.

Their Honours further stated that an arrangement can be entered into or adopted by resolutions of directors or shareholders, which is explained further as follows

The subject matter and purpose of sec. 44(2D) indicate that arrangements entered into by directors or shareholders by means of resolutions providing for the transactions dealt with by the subsection fall within its reach. Decisions for the issue of bonus shares, the redemption, purchase or cancellation of shares and the reduction of capital are necessarily made by meetings of directors or shareholders. It is not rational to suppose that Parliament intended to exclude from the operation of sec. 44(2D) arrangements constituted or adopted by resolutions of directors or shareholders. Certainly the language of the provision evinces no evidence of such an intention.

Lastly, in Federal Commissioner of Taxation v Ball, Bowen CJ, Northrop and Lockhart JJ, in applying Lutovi, held that an earlier proposal can merge with a later proposal to form an arrangement. Their Honours stated:

It is not a case of two contemporaneous parallel arrangements, one to reduce capital and the other to make a bonus issue and consolidate capital. They were all part of but one arrangement entered into by the directors of Henry Jones. It is true that the directors did not turn their mind to the question of bonus issue until early 1973 and that they had before then for some time intended to take the necessary steps for the reduction of the Company's capital and the return of capital to shareholders. But those earlier proposals merged with the later proposals merged with the later proposals for the bonus issue and the consolidation of share capital. It is commercially unreal for these steps to be treated otherwise than as one overall plan.

We therefore respectfully disagree with the conclusion of the primary Judge that the decision to issue bonus shares was separate from and subsidiary to the previously existing arrangement and that neither the decision to make a bonus issue nor the issue itself nor any step leading up to it made Henry Jones able or more able to pay money or facilitated it or was otherwise necessary to the payment of money consequent upon the reduction of capital.

Subsection 6(4) and tax avoidance purpose

The Commissioner has published a view that there is no 'purpose requirement' under subsection 6(4). Taxation Ruling TR 2012/1 states:

167. There is no 'purpose requirement' under subsection 6(4) of the ITAA 1936 beyond the terms of the subsection. What the subsection requires is that in addition to an amount being paid to the Company and credited to its share capital account, the amount is later paid or distributed by the Company (being a debit to its share capital account) such as to another set of shareholders, with the payment to and by the Company being common elements 'under an arrangement'. This is sufficient for subsection 6(4) to apply.

TR 2012/1 further shows that subsection 6(4) can apply to an arrangement where all the relevant parties deal with each other at arm's length pursuing their own interest.

On this occasion, subsection 6(4) would not apply as based on the submitted facts, there is no arrangement because the series of events occurred over a number of years and the applicant had no knowledge or awareness that the Class A shares would be later bought back and the capital returned to the ordinary shareholders.

Tainted share capital account

Subsection 975-300(3) of the ITAA 1997 states that an account is generally taken not to be a share capital account if it is tainted.

The return of capital will be entirely debited to Company X's share capital account. As Company X's share capital account is not tainted within the meaning of Division 197 of the ITAA 1997, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 applies. Accordingly, the return of capital will not be a dividend as defined in subsection 6(1).

Question 3

Summary

The Commissioner will not make a determination that section 45C of the ITAA 1936 applies to the proposed return of capital.

Detailed reasoning

Sections 45A and 45B of the ITAA 1936 are two anti-avoidance provisions which, if they apply, allow the Commissioner to make a determination that section 45C of the ITAA 1936 applies to treat all or part of the return of share capital received by Company X's shareholders as an unfranked dividend paid by the Company out of profits.

Section 45A - streaming of dividends and capital benefits

Section 45A of the ITAA 1936 applies in circumstances where capital benefits are streamed to some shareholders (the advantaged shareholders) who would derive a greater benefit from the capital benefits than the other shareholders (the disadvantaged shareholders) and it is reasonable to assume that the disadvantaged shareholders have received, or will receive, dividends.

Although Company X will provide its shareholders with a 'capital benefit' (as defined in paragraph 45A(3)(b) of the ITAA 1936), the circumstances of the return of capital do not indicate that there is a streaming of capital benefits to advantaged shareholders and dividends to disadvantaged shareholders.

Accordingly, the Commissioner would not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the return of capital to the taxpayer.

Section 45B - scheme to provide capital benefits

Section 45B of the ITAA 1936 applies where certain payments are made to shareholders in substitution for dividends. Specifically, the provision applies where:

• there is a scheme under which a person is provided with a capital benefit by a Company (paragraph 45B(2)(a) of the ITAA 1936), and

• under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with the capital benefit, obtains a tax benefit (paragraph 45B(2)(b) of the ITAA 1936), and

• 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 a taxpayer (the relevant taxpayer) to obtain a tax benefit (paragraph 45B(2)(c) of the ITAA 1936

The arrangement involving the return of capital to the taxpayer constitutes a scheme for the purposes of section 45B of the ITAA 1936.

The return of capital will be debited to the share buy-back reserve account and the taxpayer will receive a distribution of $X per share. The taxpayer will be provided with a capital benefit under paragraph 45B(5)(b) of the ITAA 1936.

Paragraph 45B(2)(c) of the ITAA 1936 sets out an objective purpose test for the Commissioner to consider having regard to the 'relevant circumstances' of the scheme as set out in subsection 45B(8) of the ITAA 1936.

Company X is operating profitably and making distributions to its shareholders. These distributions are substantially all of its annual profits. The return of capital to shareholders is sourced entirely from the Share buy-back reserve and no part of the payment will be debited to an account recording Company X's retained earnings or profits.

Based on the information provided, the return of capital reflects circumstances where the share capital to be distributed is genuinely surplus to Company X's needs. Company Z will not contribute further capital in the form of Class A shares as the business is now profitable.

Having regard to the relevant circumstances, it could not be concluded that the scheme was entered into or carried out for a more than incidental purpose of enabling the taxpayer to obtain a tax benefit.

The Commissioner does not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the payment for the return of capital.

Question 4

Summary

Division 7A of the ITAA 1936 will not apply to deem any part of the payment under the proposed return of capital to be a dividend under section 109C of the ITAA 1936.

Detailed reasoning

Subsection 109L(2) of the ITAA 1936 relevantly provides that a private Company is not taken under section 109C to pay a dividend because of a payment the private Company makes to an entity, to the extent that a provision of the ITAA 1936 has the effect that the payment would not be included in the entity's assessable income even though it would otherwise be included.

Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined in subsection 6(1) of the ITAA 1936, paid to the shareholders out of profits derived by the Company from any source (if the shareholder is a resident of Australia) and from an Australian source (if the shareholder is a non-resident of Australia).

The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a Company to any of its shareholders. However, paragraph (d) specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the Company.

As the proposed return of capital is excluded from being assessable as a dividend due to the operation of subsection 6(1) of the ITAA 1936, it is also not assessable under Division 7A of the ITAA 1936 due to the operation of subsection 109L(2) of the ITAA 1936.

Question 5

Summary

To the extent that a capital gain arises to the Taxpayer from CGT event G1, will it be a 'discount capital gain' under Subdivision 115 of the ITAA 1997.

Detailed reasoning

A capital gain made when CGT event G1 happens is eligible to be treated as a discount capital gain under Division 115 of the ITAA 1997 provided that the Company X ordinary shares were acquired at least 12 months before the payment of the return of capital (subsection 115-25(1) of the ITAA 1997) and the other conditions of that Division are satisfied.

From the facts available, the taxpayer has held the shares for more than 12 months.

The taxpayer has stated that they hold Company X shares in its capacity as trustee of a trust. The capital gain may be treated as a discount capital gain under subdivision 115.

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