Edited version of private advice

Authorisation Number: 1051758173362

Date of advice: 23 September 2020

Ruling

Subject: Return of capital

Question

Will Company A be required to give a notice under section 45D of the Income Tax Assessment Act 1936 (ITAA 1936), on the basis that the Commissioner has made a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole, or a part, of the capital benefit under the proposed Capital Component of the Distribution?

Answer

No

This ruling applies for the following period:

Income year ended 31 March 20XX

The scheme commences on:

During the income year ended 31 March 20XX

Relevant facts and circumstances

Company A is an Australian resident proprietary company.

Company A is the holding company of Company B, which is also a proprietary company registered and operating in Australia.

The immediate holding company of Company A is Company F, a company incorporated overseas.

The ultimate parent entity is company J, a company incorporated overseas.

Company A has subsidiaries in Australia, New Zealand, and other Asian countries.

Company A has carried forward capital losses.

Company B is one of the 100% held subsidiaries of Company A.

Company B conducted a return of share capital to Company A several years ago. Company A in turn conducted a return of share capital of the same amount to its shareholder, Company F at the same time several years ago.

As a result of the return of capital return of capital several years ago, Company A 's cost base of its Company B shares was reduced accordingly.

Company A does not own taxable Australian real property as defined in section 855-20 of the Income Tax Assessment Act 1997 (ITAA 1997), nor do the shares of Company B comprise indirect Australian real property interests as defined in section 855-25 of the ITAA 1997.

The Proposed transaction include the following steps:

-            Step 1: Company A disposes of its subsidiary Company B to Company F at its market value.

-            Step 2: Company A makes a share capital reduction of an amount representing the tax cost base of the Company B shares. This share capital reduction does not involve a share cancellation (sections 256B to 256E of the Corporations Act 2001).

The journal entries to record the capital return will be as follows:

A capital gain is estimated for the Company B shares. However, no additional Australian tax is anticipated to be paid by Company A on disposal of its shares in Company B due to its carried forward capital losses.

The profit on sale will be held in cash by Company A. it may be used to provide working capital to subsidiaries. Alternatively, if it were ever paid as a dividend, it would be unfranked.

Company A has no operational activities which require cash funding as a holding company.

The proposed return of capital satisfies the requirements of the Corporations Act 2001 and Company A 's company constitution.

The return of share capital will be debited against the share capital account of Company A.

The reasons for the return of capital include return excess funding that Company A no longer needs, achieve a commercial group structure and a more streamlined reporting system.

There have not been any transfers to the share capital accounts of Company A and Company B which would cause the share capital accounts to be tainted for the purposes of Division 197 of the ITAA 1997.

Company A and Company B have not formed an Australian income tax consolidated group.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 45B.

Income Tax Assessment Act 1936 Section 45C.

Income Tax Assessment Act 1936 Section 177A.

Income Tax Assessment Act 1936 Section 177D.

Income Tax Assessment Act 1997 Section 104-135.

Reasons for decision

Section 45B of the ITAA 1936 is a specific anti-avoidance provision. The section is designed to prevent companies from effectively distributing company profits as preferentially taxed capital rather than taxable dividends.

Section 45B of the ITAA 1936 applies where certain payments are made to shareholders in substitution for dividends. It allows the Commissioner to make a determination that section 45C of the ITAA 1936 applies to a capital benefit. The effect of such a determination is that all or a part of the distribution of capital received by the shareholder under the return of capital is treated as an unfranked dividend.

Subsection 45B(2) of the ITAA 1936 sets out the conditions under which the Commissioner will make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITA 1936 applies. In broad terms, these conditions are:

(a)       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

(b)       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

(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 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).

Each condition is considered below.

Scheme

For paragraph 45B(2)(a) of the ITAA 1936 to be satisfied, a taxpayer must be provided with a capital benefit by a company under a scheme.

A scheme for the purposes of section 45B of the ITAA 1936 has the meaning given by subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) (subsection 45B(10) of the ITAA 1936). A scheme is broadly defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a)  any arrangement; or

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

The phrase 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936. Relevantly, it includes the provision of ownership interests in a company to a person, and the distribution to a person of share capital (paragraphs 45B(5)(a) and (b) of the ITAA 1936). A return of share capital would normally constitute a scheme for the purposes of section 45B.

Company A 's proposed return of capital to Company F constitutes a 'scheme' for the purposes of section 45B of the ITAA 1936. Further, as this return of capital will be debited against the untainted share capital account of Company A, it will provide Company F with a capital benefit.

Therefore, paragraph 45B(2)(a) of the ITAA 1936 will be satisfied in respect of Company A 's return of capital to Company F.

Tax Benefit

For paragraph 45B(2)(b) of the ITAA 1936 to be satisfied, a taxpayer must obtain a tax benefit. Pursuant to subsection 45B(9) of the ITAA 1936, a 'tax benefit' will be obtained if the amount of tax payable by the relevant taxpayer would, apart from this section, be less than the amount that would have been payable if the capital benefit had been a dividend. Generally, where there is a distribution of share capital, a tax benefit will arise as a shareholder or the relevant taxpayer will pay less tax on the distribution than they would have if the amount had instead been a 'dividend'.

Ordinarily, a return of capital would be subject to the CGT provisions of the income tax law. Unless the amount of the distribution exceeds the cost base of the shares, there will only be a cost base reduction under CGT event G1 (section 104-135 of the ITAA 1997). It is only to the extent (if any) that the distribution exceeds the cost base of the shares that a capital gain arises. By contrast, a dividend would generally be included in the assessable income of a resident shareholder.

In the present case, the return of capital by Company A to Company F is not subject to Australia income tax. However, if the amount was paid as a dividend by Company A, it would be subject to Australian dividend withholding tax and give rise to a prima facie dividend withholding tax liability.

It follows that the amount of tax payable by Company F on the return of capital may be less than the amount that would have been payable, if the return of capital was instead a dividend.

For this reason, Company F will obtain a tax benefit as defined in subsection 45B(9) of the ITAA 1936. Therefore, paragraph 45B(2)(b) of the ITAA 1936 will be satisfied in respect of Company A 's return of capital.

Purpose

Paragraph 45B(2)(c) of the ITAA 1936 sets out an objective purpose test, having regard to the relevant circumstances of the scheme under which a tax benefit is provided. Paragraph 45B(2)(c) of the ITAA 1936 requires the Commissioner to objectively consider the 'relevant circumstances of the scheme' pursuant to subsection 45B(8) of the ITAA 1936 as to whether any part of the scheme would be entered into for a purpose, other than an incidental purpose, of enabling a taxpayer to obtain a 'tax benefit'. The test is not satisfied if the purpose (of obtaining a tax benefit) is only incidental, notwithstanding this, the purpose does not have to be the dominant purpose of the scheme. That is, the test is satisfied so long as the purpose of obtaining a tax benefit is not incidental.

In the application of the purpose test consideration is given to the relevant circumstances of the scheme as set out in paragraphs 45B(8)(a) to (k) of the ITAA 1936. However, the list of relevant circumstances in subsection 45B(8) is not exhaustive and regard may be had to other circumstances on the basis of their relevance.

For the purposes of this specific ruling, the relevant circumstances of Company A and the tax profile of its shareholder Company F are addressed below.

(a)   Extent to which the capital benefit is attributable to profits of the company

Paragraph 45B(8)(a) of the ITAA 1936 refers to the extent to which the capital benefit is attributable to capital or profits (realised and unrealised) of the company or an associate (within the meaning of section 318 of the ITAA 1936) of the company. Whether the return of capital is attributable to profit is essentially concerned with determining whether there is a discernible connection between the amount distributed as share capital and the share capital and profits that are available for distribution.

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) states that a distribution of profit would normally be expected to be a relatively ordinary business occurrence, whereas a distribution of capital would be a relatively extraordinary one. Paragraphs 63 and 68 of PS LA 2008/10 state:

63. A capital distribution that is attributable to share capital should reflect circumstances which show that the share capital distributed is genuinely surplus to the company's need of it and that it is not merely a cash distribution debited against share capital on the basis of shareholder tax preference. For instance, the capital distribution may coincide with the disposal of a significant part of the business structure which can be identified as releasing share capital. However, if the disposal also realises a profit the ensuing distribution should, subject to all the other relevant circumstances, be considered in terms of its attribution to both share capital and the profit from the disposal.

68 ... A decision to reduce capital would generally be expected to coincide with and be influenced by some other commercial circumstance. For example, a release of the capital from a disposal of part of the business structure, some other business structural change, or in some circumstances its replacement with debt capital where it is shown to be more profitable for shareholders...

In the present case, the decision of Company A to return capital coincide with the commercial decision to dispose of its investments in Company B. Company A will have surplus capital which it no longer needs subsequent to the disposal of its main investment in Company B.

The proposed return of capital from Company A to Company F can be attributed to the disposal of its interest in Company B.

There is a nexus between the amount being distributed as a return of share capital and the share capital balance that is directly attributable to disposal of Company B for the same amount.

Further, at the time of the capital distribution, Company A will not have any relevant profits, other than the dividend reserves. As such, the proposed return of share capital should be solely ascribed to the share capital of Company A.

As a result, the proposed return of capital will not be in substitution for a distribution of profits. This circumstance tends towards the capital return being a genuine return of capital to shareholders as a result of rebalancing the company's funding structure, and not to any realised or unrealised profits.

This factor does not incline towards the requisite purpose.

(b)                   Pattern of distributions

Paragraph 45B(8)(b) of the ITAA 1936 refers to 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 ITAA 1936) of the company. The Commissioner has explained in paragraph 77 of PSLA 2008/10 that a pattern of making capital distributions (with the capital performing the function of dividends) may point towards the company engaging in dividend substitution.

Company A has consistently distributed its profits as dividends in past years. Further, as previously noted, Company A returned share capital to its shareholder several years ago after re-assessing its cash requirements.

Company A follows a policy of distributing profits to its shareholders as and when earned by Company A and re-assessing its cash requirements on an as needed basis returning share capital to its shareholder.

It is accepted that the return of capital is an additional return to Company F in excess of the profits of Company A. In addition, Company A 's dividend distributions are not disturbed by the paying of the return of capital.

Consequently, the above circumstances do not suggest that the proposed capital return is being paid in substitution of dividends to its shareholders:

This factor does not incline towards the requisite purpose.

(c)                   Capital losses

Paragraph 45B(8)(c) of the ITAA 1936 refers to whether shareholders have capital losses, that, apart from the scheme, would be carried forward to a later year of income.

The return of capital is exempt from Australian income tax on the basis it will be made to a non-resident shareholder on shares that are not taxable Australian property.

This circumstance is not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(d)                   Pre-CGT ownership interests

Paragraph 45B(8)(d) of the ITAA 1936 refers to whether any of the ownership interests in the company or an associate of the company were held by the shareholders before 20 September 1985.

Company A was incorporated after 20 September 1985, therefore Company F's ownership interest in Company A is not a pre-CGT asset.

This circumstance is not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(e)                   Residency of the owners of Company A

Paragraph 45B(8)(e) of the ITAA 1936 directs attention to whether the relevant taxpayer is a non-resident.

The implication of non-residency is that it would normally point towards a tax preference for a distribution of capital rather than of profits because a distribution of capital to a non-resident shareholder would not be assessable to that shareholder.

In the present case, Company F is a non-resident of Australia for income tax purposes, therefore it is not exposed to capital gains on the disposal of shares given that the shares of Company B are not indirect Australian real property interests as defined in section 855-25 of the ITAA 1997. However, if the amount was paid as a dividend by Company A, it would be subject to Australian dividend withholding tax and give rise to a prima facie dividend withholding tax liability.

Also, capital has been contributed by Company F to Company A for investment in Company B which is now being returned upon the disposal of Company B, as it is no longer required to fund the operation of Company A being a holding company.

Therefore, this circumstance is indicative as to purpose, but no conclusion is drawn in relation to this circumstance.

(f)                    Cost base of the ownership interests - whether the cost base is not substantially less than the capital benefit

For the purposes of paragraph 45B(8)(f) of the ITAA 1936, if the cost base of the relevant ownership interest is substantially less than the return of capital, this circumstance may be indicative of purpose.

The return of capital is exempt from Australian income tax given that it will be made to a non-resident shareholder on shares which are not an indirect Australian real property interest.

Therefore, this circumstance does not indicate a purpose of obtaining a tax benefit.

(g)                   repealed

(h)                   Nature of interest after the return of capital

An equal share capital reduction under which no shares are cancelled (often called a pro-rata return of capital) does not affect the shareholder's substantive interests, either individually or inter se and thus the interests remain the same as if a dividend had been paid instead. From the shareholders' perspective a reduction of capital without a cancellation of shares is not dissimilar economically to a special dividend in that cash is distributed to them while they retain the share with all of its rights intact.

In the present case, Company F is the sole shareholder of Company A, and no change will occur in the nature of Company F's ownership interest as a result of the return of capital. Therefore, the return of capital is not dissimilar from the payment of a dividend.

This factor does not incline towards the requisite purpose.

(i)                    Scheme involving the later disposal of ownership interest

The proposed return of capital does not involve provision of any ownership interest to Company A or its associated entity.

This circumstance is therefore not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(j)                    For demergers only

This factor is not relevant to this case.

(k)                   Any matters referred to in s 177D(2) of the ITAA 1936

Paragraph 45B(8)(k) also includes any matters referred to in subsection 177D(2) of the ITAA 1936 to be a relevant circumstance of the scheme. The matters provided in subsection 177D(2) are:

(a)  the manner in which the scheme was entered into or carried out;

(b)  the form and substance of the scheme;

(c)   the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

(d)  the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

(e)  any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

(f)    any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

(g)  any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out;

(h)  the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f).

(a)  Manner Scheme Carried Out

The return of capital is proposed to be carried out in a simple, transparent and commercial manner.

Company A and Company B intend to take steps to clean up their intercompany transactions prior to the disposal, being the payment of an intercompany dividend and the forgiveness of the intercompany debt between the two entities. Given both companies are Australian resident taxpayers, this will allow for simplicity rather than creating artificial or contrived steps in the proposed transaction.

An alternative to implement the return of capital would be a share buy-back, of which the capital benefit provided to Company A would be identical in all respects. Company A could also loan the excess funds to a related party or invest the excess funds.

Therefore, this circumstance does not indicate a purpose of obtaining a tax benefit.

(b)  The form and substance of the scheme

The form and substance of the return of capital are congruent in all respects. Therefore, this circumstance does not indicate a purpose of obtaining a tax benefit.

(c)   Timing of the Scheme

The timing of the return of capital by Company A to Company F is determined by the additional funds being received by Company A from the disposal of Company B. On the basis the return of share capital is motivated by Company A having excess funds, which is expected as a result of the sale of Company B.

Therefore, this circumstance does not indicate a purpose of obtaining a tax benefit.

(d)  Tax Outcome Where Section 45B Determination Not Made

This factor requires consideration on identifying the tax results of the scheme if section 45B were not to apply. In its absence, the relevant taxpayer receives the distribution of share capital which will attract the CGT event G1 and will not be treated as a dividend paid out of profit and subject to the dividend or withholding tax assessing provisions under the ITAA 1936.

As previously noted, Company A is provided with a tax benefit in relation to the return of capital. This is due to the difference between the tax treatment of dividends and capital payments and is an automatic consequence of the amount paid being a return of capital which has previously been contributed.

(e)  Changes to the Financial Position of the Taxpayer from the Scheme

As previously noted, Company F is the sole shareholder of Company A, and therefore no change will occur in the nature of Company F's ownership interest as a result of the return of share capital.

Company A is required to debit its share capital account in relation to the return of capital. This circumstance does not indicate a purpose of obtaining a tax benefit.

(f)    Other Consequences of the Scheme

It is clear that Company A has a history of distributing its profits to its shareholders in the year it was earned or the subsequent year. It is not expected that this will change following the proposed return of share capital.

Further, Company A returned share capital to its shareholder, after re-assessing its cash requirements several years ago. Company A follows a policy of distributing profits to its shareholder and re-assessing its cash requirements as needed. The proposed return of capital is an amount that is excess to Company A 's funding requirements.

There are no other relevant consequences of the return of capital and therefore this circumstance does not indicate a purpose of obtaining a tax benefit.

(g)  The Nature of the Connection Between the Taxpayer and its Shareholders

In the present case, the connection between Company A and Company F is of a shareholder seeking a return of its capital contributed which is no longer required by the subsidiary company.

This circumstance does not indicate a purpose of obtaining a tax benefit.

On balance it is considered that the matters raised in paragraphs 177D(2)(a) to 177D(2)(h) of the ITAA 1936 do not lead to a conclusion that a purpose, other than an incidental purpose, of obtaining a tax benefit exists in relation to the entering of the scheme.

Conclusion

Company A has provided factors supporting commercial objectives for the return of share capital and distribution to its shareholder.

These are considered against the factors that would incline towards the conclusion that the scheme is being implemented for a more than incidental purpose for the relevant taxpayer to obtain a tax benefit.

Notwithstanding that paragraphs 45B(2)(a) and 45B(2)(b) of the ITAA 1936 are satisfied, having regard to the relevant circumstances of the scheme as stipulated within subsection 45B(8) of the ITAA 1936, it cannot be concluded that the scheme will be implemented for a more than incidental purpose of enabling the relevant person to obtain a tax benefit for the purposes of paragraph 45B(2)(c) of the ITAA 1936.

Therefore, the return of share capital to Company F will not be a dividend as defined in subsection 6(1) of the ITAA 1936.

The Commissioner will not make a determination under section 45C of the ITAA 1936 because subsection 45B(3) of the ITAA 1936 will not apply to any part of the return of share capital. Accordingly, Company A will not be required to give notice to Company F under section 45D.

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