Edited version of your written advice

Authorisation Number: 1051227309781

Date of advice: 19 May 2017

Ruling

Subject: Application of section 45B of the Income Tax Assessment Act 1936 to share capital reduction

Question 1

Will the distribution by AU Sub Co to its shareholders as a return of capital constitute a dividend as defined in section 6(1) of the 1936 Act?

Answer

No

Question 2

Will the Commissioner make a written determination under subsection 45B(3) of the 1936 Act that section 45C applies either in whole, or in part, to the return of capital paid to Parent Co?

Answer

No

Question 3

Will the Commissioner make a further determination under section 45C of the Income Tax Assessment Act 1936 in respect of the whole or a part of the return of capital that the capital benefit, or part of the capital benefit, was paid under a scheme for a purpose for which a purpose, other than an incidental purpose, was to avoid franking debits arising in relation to the distribution from AU Sub Co?

Answer

No

This ruling applies for the following periods:

1 January 2016 to 31 December 2016

The scheme commences on:

1 January 2016

Relevant facts and circumstances

Overview of the Group ('the Group’)

Group structure prior to the sale of AU Sub Co to Purchaser Co.

Ultimate Holding Co owns Company X;

Company X owns Parent Co;

Parent Co was the non-resident parent company of AU Sub; and

Company Y, an entity incorporated overseas, is a sister entity of AU Sub Co.

AU Sub Co

Since incorporation, AU Sub Co has been operating a business.

AU Sub Co does not have any Australian real property for the purposes of Division 855 of the Income Tax Assessment Act 1997.

The company has paid fully franked dividends to its shareholder consistently.

The balance of the franking account of AU Sub Co at the end of the 2016 financial year was sufficient to enable the AU Sub Co to pay a fully franked dividend equivalent to the relevant return of capital payment made to Parent Co.

The share capital account of AU Sub Co is not tainted within the meaning of section 197-50 of the 1997 Act.

Sale to Purchaser Co

Prior to the distribution of the return of capital payment to Parent Co, Ultimate Holding Co advised AU Sub Co that shares in AU Sub Co were to be sold as part of a global sale to Purchaser Co.

The sale was effected in accordance with a Purchase Agreement entered into by Purchaser Co, New Co (a newly created entity owned by Purchaser Co) and Ultimate Holding Co.

The Agreement allows for the interests of Ultimate Holding Co in its subsidiaries, including AU Sub Co, and certain assets, to be transferred ultimately to Purchaser Co. The various steps involved in the sale and restructuring of the Group are outlined in further detail below.

Asset transfers pursuant to the Purchase Agreement

Prior to the sale of the Group’s business to Purchaser Co, Company X would transfer certain assets and liabilities to New Co. These assets include all rights under contracts, all receivables, all IP used in the business, plus the global subsidiaries of Parent Co (including AU Sub Co). The agreements contemplate that Purchaser Co would, ultimately, own all of the interests in New Co and its global subsidiaries.

Reduction of the surplus working capital in AU Sub Co

Before the closing date of the acquisition of AU Sub Co and the other global subsidiaries by Purchaser Co, Ultimate Holding Co advised AU Sub co that it was necessary to return surplus cash and working capital in AU Sub Co to its shareholder Parent Co, being assets that were to be retained by the Group rather than transferred to Purchaser Co.

Before the closing date, the Directors of AU Sub Co made a resolution as follows:

● To undertake a share capital reduction (without the cancellation of any AU Sub Co ordinary shares) and to return capital of $X amount;

● To pay a fully franked dividend of $X amount out of retained profits;

● To accept AU Sub Co’s six month financial accounts as at 30 June 2016 as final accounts and to confirm the balance of retained profits to be $X amount.

The payment of the return of capital was debited against the share capital account.

The payment of the dividend and return of capital represented an amount that was considered to be surplus to AU Sub Co’s working capital needs and arose from the repayment of a loan receivable from Parent Co before the closing date.

The payment of the dividend and return of capital was financed by surplus cash within AU Sub Co and a short term loan from Company Y.

The loan was required to pay out all excess working capital being cash and debtors. Given the strict time frame in which the deal was to occur, it was necessary to finance the payment for the surplus debtors to ensure that the appropriate level of working capital was achieved. The loan was repaid to Company Y using cash from trading and collecting the accounts receivable.

The Balance Sheet at 30 June 2016 indicates that AU Sub Co had significant assets, including the loan to Parent Co (repaid in full before the closing date). The amount paid as a fully franked dividend represented the amount of retained earnings as at 30 June 2016. There was sufficient share capital from which the return of capital payment in question could be made.

There was no asset revaluation reserves amount credited to the accounts of AU Sub Co as at 30 June 2016. The assets of AU Sub Co included cash, accounts receivable, computer equipment and related software and furniture and fixtures.

Relevant legislative provisions

Income Tax Assessment Act 1936 (ITAA 1936)

Subsection 6(1)

Section 44

Section 45B

Section 45C

Section 128B

Section 177A

Section 177D

Income Tax Assessment Act 1996 (ITAA 1997)

Section 197-50

Section 855-10

Section 855-15

Section 855-20

Section 855-25

Section 855-30

Section 975-300

Section 995-1

Reasons for decision

Question 1

The distribution by AU Sub Co to its shareholders as a return of capital will not constitute a dividend as defined in section 6(1) of the 1936 Act.

Detailed reasoning

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

The term 'dividend' in subsection 6(1) of the 1936 Act includes any distribution made by a company to any of its shareholders. Paragraph (d) of the definition of dividend excludes a distribution if the amount of the distribution is debited against an amount standing to the credit of the company's share capital account.

The term 'share capital account' is defined in section 975-300 of the 1997 Act 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.

Subsection 975-300(3) states that an account is not a share capital account if it is tainted.

The return of capital was debited against an amount standing to the credit of AU Sub Co's share capital account. As the share capital account of AU Sub Co is not tainted within the meaning of section 197-50 of the 1997 Act, paragraph (d) of the definition of 'dividend' in subsection 6(1) applies.

Accordingly, the return of capital does not constitute a dividend under subsection 6(1) of the 1936 Act.

Question 2

The Commissioner confirms that he will not make a determination under section 45B(3) that section 45C applies to the return of capital paid to Parent Co.

Detailed reasoning

A determination will be made by the Commissioner pursuant to subsection 45B(3) of ITAA 1936 that section 45C applies in relation to the whole, or a part, of a capital benefit where it is necessary to ensure that such distributions are treated as dividends for taxation purposes.

In broad terms, the object of section 45B, in so far as it relates to a capital benefit, is concerned with ensuring that companies do not distribute what are effectively profits to shareholders as preferentially-taxed capital rather than dividends.

Subsection 45B(2) provides that section 45B applies where:

there is a scheme under which a person is provided a capital benefit by a company;

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, 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 the relevant taxpayer to obtain a tax benefit.

Each requirement, as it applies to AU Sub Co’s circumstances, is considered in further detail in the following paragraphs.

Is there a relevant scheme under which a person is provided a capital benefit?

A 'scheme’ for the purposes of section 45B of the ITAA 1936 is taken to have the meaning as provided in subsection 995-1 of the ITAA 1997: subsection 45B(10) of the ITAA 1936.

'Scheme’ is defined in subsection 45B(10) as follows:

(a) any arrangement; or

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

The arrangement involving the distribution of a franked dividend and share capital by AU Sub Co to Parent Co would therefore constitute a scheme for the purposes of section 45B.

Subsection 45B(5) explains that a reference to a person being provided with a capital benefit is a reference to:

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

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

(c) something that is done that increases the value of their ownership interest.

As the distribution in the amount of $1.7 million was debited against the share capital account of Parent Co, there was a provision of a capital benefit within the meaning of paragraph 45B(5)(b).

Does the relevant taxpayer, who may or may not be the person provided with the capital benefit, obtain a tax benefit?

Subsection 45B(9) provides that the relevant taxpayer obtains a tax benefit if an amount of tax payable, or any other amount payable under the ITAA 1936 and 1997, by the relevant taxpayer would, apart from section 45B, be less than the amount that would have been payable, or payable at a later time, if the capital benefit had been a dividend.

Under a share capital reduction or non-share capital reduction, the relevant taxpayer will ordinarily be one or more of the owners or shareholders of the company, as it is they who are provided with the capital benefit, and thus, potentially a tax benefit. However, there is no requirement that the relevant taxpayer be the person who is provided with the capital benefit: paragraph 45B(2)(b).

In determining whether the taxpayer has obtained a tax benefit, the tax payable (or any other amount payable under the Act) on the notional dividend is ascertained in a continuum and not just for the year in which the dividend is received. Subsection 45B(9) acknowledges that the notional dividend might not give rise to an amount payable for the year in which it is received due to the dividend being franked; but the provision also acknowledges that the use of those franking credits means they are not available in future years to reduce tax in those years, as they would have been if a capital benefit had been paid instead of a dividend. Thus, the preservation of franking credits for use in the future would ordinarily mean that a tax benefit is obtained within the meaning of subsection 45B(9).

AU Sub Co has expressed the view that there would be little or no tax benefit to Parent Co if the return of capital had been paid as a dividend. As Parent Co is a foreign resident and does not have any Australian real property for the purposes of Division 855 of the ITAA 1997 (and therefore, its shares in AU Sub Co are not taxable Australian property), any capital gain arising to Parent Co in respect of the capital payment received would be disregarded under section 855-10. If the distribution had been made as a dividend instead, to the extent that the notional dividend would have been franked and would, therefore, be exempt from withholding tax under section 128B(3)(ga), the tax outcome would be similar.

Whilst the Commissioner acknowledges the taxpayer’s argument, he has formed the view that AU Sub Co is the relevant taxpayer who obtains a tax benefit. Fully franking the entire distribution would have used franking credits and would have resulted in those franking credits not being available to AU Sub Co for use in future years to reduce tax in those years. Accordingly, the Commissioner concludes that AU Sub Co obtains a tax benefit if the distribution is paid as a return of capital rather than as a dividend.

Would it 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?

In determining whether there was a more than incidental purpose of enabling AU Sub Co to obtain a tax benefit, regard must be had to the relevant circumstances of the scheme as outlined in subsection 45B(8), as follows:

Paragraph 45B(8)(a)

This paragraph provides that the relevant circumstances include:

the extent to which the capital benefit is attributable to capital or the extent to which the capital benefit is attributable to profits (realised and unrealised) of the company or of an associate;

The fully franked dividend component of the distribution has been paid to the maximum extent of the balance of retained profits as at 30 June 2016. In this regard, it was necessary to debit the remainder of the payment against the share capital account to reduce the company’s net assets to the appropriate level of working capital.

There was no asset revaluation reserves amount credited to the accounts of AU Sub Co as at 30 June 2016, from which the remainder of the payment could be paid as a dividend.

Therefore, the capital benefit is not attributable to the realised and unrealised profits of AU Sub Co.

Paragraph 45B(8)(b)

This paragraph provides:

the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or by an associate (within the meaning in section 318) of the company;

As outlined in the relevant facts and circumstances, AU Sub Co has paid fully franked dividends to its shareholders consistently since the 2011 financial year. Whilst AU Sub Co had not undertaken a return of capital on any previous occasion, the return of capital was effected in the 2016 financial year to reduce surplus working capital in the company in preparation for the sale to Purchaser Co.

Paragraphs 45B(8)(c) to (f)

These paragraphs require an examination of the tax characteristics of the particular shareholder in question in order to determine the tax effects of the scheme. The following considerations in paragraph 45B(8)(c) to (f) relate to whether or not the tax characteristics of the shareholders of AU Sub Co are indicative of a tax preference for a capital distribution over a distribution in the form of a dividend.

It is noted that Parent Co is a non-resident shareholder of AU Sub Co. As Parent Co’s shares are not indirect Australian real property interests for the purposes of Division 855 of the ITAA 1997, the capital distribution in respect of its shares would not expose Parent Co to a capital gain. Paragraph 87 of PS LA 2008/10 expresses the following view:

The implication of non-residency is that it would normally points towards a tax preference for a distribution of capital over profit. Non-residents are normally taxed on dividends at the rate of 15%, but they are not exposed to capital gains on the disposal of shares unless those shares are 'indirect Australian real property interests’ as defined in section 855-25 of the ITAA 1997.

The above is not determinative of this issue but is taken into consideration as part of the assessment of the scheme as a whole.

Paragraph 45B(8)(h)

This paragraph requires that regard be had to whether the interest held by the shareholders after the share capital reduction is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of the share capital. This matter requires a comparison of the respective interests held by shareholders after the distribution. As noted earlier, the fully franked dividend component was paid to the maximum extent of the balance of the retained profits as at 30 June 2016. Thus, no further dividend (the 'equivalent dividend’ as referred to in paragraph 45B(8)(h)) could have been paid by the company.

Paragraphs 45B(8)(i) and 45B(8)(j) are not relevant to AU Sub Co as the scheme will not involve the provision of ownership interests and is not considered to be a demerger.

Paragraph 45B(8)(k)

This paragraph requires that regard be had to 'any of the matters referred to in subsection 177D(2)’. The matters referred to subsection 177D(2) are matters prescribed for the purposes of determining the 'dominant purpose’ test in Part IVA. In the context of section 45B, however, they facilitate the 'more than incidental purpose test’ specific to the provision.

The factors prescribed in subsection 177D(2) are matters by reference to which one is able to examine a return of capital from a broad, practical perspective in order to identify and compare its tax and non-tax objectives. It is recognised that many of the considerations taken into account under subsection 177D(2) may overlap with those already mentioned above.

The circumstances which the Commissioner considers to be relevant to the assessment of the scheme in question in the context of factors outlined in subsection 177D(2), as follows:

Paragraph 177D(2)(a)

This paragraph refers to the manner in which the scheme was entered into or carried out and requires consideration of the decisions, steps and events that combine to make up the scheme. In this case, AU Sub Co was directed by Ultimate Holding Co to return surplus cash and reduce the company’s working capital to the maximum extent possible. It is accepted that the distribution to Parent Co - which comprised the fully franked dividend and return of capital - was a precondition to the sale of AU Sub Co to Purchaser Co, as they were intended to remain in Parent Co and did not form part of the assets to be subsequently transferred to Purchaser Co.

Paragraph 177D(2)(b)

This paragraph refers to the form and substance of the scheme. The form of the scheme in this case is the distribution of a franked dividend paid from the retained earnings of AU Sub Co and a return of capital paid to Parent Co. The return of capital distribution in question was debited against the share capital account of AU Sub Co, and in light of the circumstances of this case, it is considered that the return of capital is attributable to the share capital invested in the business. Accordingly, the substance of the scheme accords with its form.

Paragraph 177D(2)(c)

This paragraph refers to the time at which the scheme was entered into and the length of the period during which the scheme was carried out to enable consideration of the extent to which the timing and duration of the scheme go towards delivering the relevant tax benefit or are related to commercial opportunities or requirements. The timing at which the scheme was entered into was largely determined by the impending sale of the shares in AU Sub Co to Purchaser Co. The timing of the steps carried out in the scheme, including entering into a loan arrangement with Company Y to finance the distributions in question and making the distribution immediately prior to the closing date, point to a non-tax purpose driven by the commercial requirements of the sale of the global business.

Paragraph 177D(2)(d)

This paragraph requires that consideration be given to 'the result in relation to the operation of this Act that, but for this Part would have been achieved by the scheme’. In the context of section 45B, 'this Part’ refers to the Part III which includes both sections 44 and section 45B.

Whilst it is arguable that enabling AU Sub Co to preserve its franking credits is a tax consequence of the share capital reduction, the Commissioner is satisfied that the share capital reduction represents a bona fide return of capital and was undertaken in furtherance of the commercial objective of returning the surplus cash and working capital to the parent company of AU Sub Co to facilitate the sale of the global business to Purchaser Co.

Paragraphs 177D(2)(e) to (h)

Paragraphs 177D(2)(e) to (h) require consideration of the change in the financial position of, or other consequences, to the shareholders or any person who has a connection with the shareholders, as a result of the scheme. They also require a consideration of the nature of the relationship between the shareholders and such a person.

In the present case, the return of capital paid to Parent Co results in an increase in the cash position of Parent Co by the amount of the return of capital and a decrease in the value of its investment in the shares of AU Sub Co.

This was effected without a reduction in its franking credits as the distribution was in the nature of a return of capital as opposed to a distribution of profits. However as noted above it is accepted that this accurately reflected the nature of the amounts distributed to Parent Co. There is no change to the financial position of Purchaser Co as a result of the scheme, as the distribution to Parent Co that represented the amount of surplus working capital in AU Sub Co did not form part of the assets purchased by Purchaser Co.

Having regard to the abovementioned circumstances, the Commissioner is of the view that the scheme was not carried out for a more than incidental purpose of enabling a taxpayer to obtain a tax benefit under paragraph 45B(2)(c).

Accordingly, the Commissioner will not make a determination under subsection 45B(3) that 45C applies in respect of this scheme.

Question 3

The Commissioner will not make a determination under subsection 45C(3) of the ITAA 1936 that the whole or any part of the capital return was paid under a scheme for the purpose of avoiding franking debits arising in relation to the distribution from the company.

Detailed reasoning

For the reasons set out above in Question 2, the Commissioner will not make a determination under subsection 45C(3) of the ITAA 1936 that the whole or any part of the capital return was paid under a scheme for the purpose of avoiding franking debits arising in relation to the distribution from the company.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).