Edited version of private advice

Authorisation Number: 1051848450101

Date of advice: 8 June 2021

Ruling

Subject: Direct value shifting rules

Question

Will the direct value shifting rules in Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the reclassification of the existing ordinary shares in Company A to Preference Shares?

Answer

No

This ruling applies for the following periods:

Income year ending 30 June 20XX

Income year ending 30 June 20XX

The scheme commenced:

1 July 20XX

Relevant facts and circumstances

1.            Company A is a professional firm in which a Principal, when appointed, is invited to acquire shares in Company A. Certain non-principal staff such as Associates and Senior Associates have also acquired shares. As at 30 June 20XX, Principal staff hold approximately X% of the Company A shares, whilst non-principal staff hold X% of the shares. There are no former employees who are Current Shareholders.

2.            Non-principals of Company A receive a market-based salary, and all Principals receive market-based salary which ranges from $XX0,000 to $XXX,000. The Founding Principals are paid a salary of $XXY,000 per annum.

3.            Between 20XX and 20XX, an additional X individuals acquired shares in Company A (via controlled entities), via a total of X different shareholding entities i.e. some individuals acquired their shares in Company A via X separate shareholding entities.

4.            None of the shareholders in Company A are associates of each other (as defined in section 318 of the Income Tax Assessment Act 1936 (ITAA 1936)).

5.            The succession plan included Company A and its shareholders entering into a Shareholders' Deed dated 1 July 20XX (which replaces previous Shareholders' Deeds). The current Shareholders' Deed includes the terms and obligations in relation to the shareholdings in Company A and the conduct of the business. An objective of the shareholders entering into the Shareholders' Deed is (among other things) to create an opportunity for key employees to acquire equity in Company A.

6.            Each share entitles the holder to a distribution as per the distribution policy and each shareholder is entitled to exercise the same number of votes on any decision or resolution as the number of shares that the shareholder holds. The distribution policy is that dividends be based on the annual results and be paid monthly or as agreed.

7.            The Shareholders' Deed notes the purchase price for Shares in Company A is based on the Established Formula ("Existing Valuation Methodology"). Based on the Existing Valuation Methodology, and its financial statements, Company A was worth approximately $XXXXX as at 30 June XXXX ("Practice Value").

8.            Since the Shareholders' Deed was prepared in XXXX, all disposals, acquisitions and buy-backs of Shares have been based on the Existing Valuation Methodology.

Summary of the Proposed Restructure

9.            The Proposed Restructure steps are as follows:

(a)          All of the existing ordinary shares in Company A that are held by the Current Shareholders are reclassified into Preference Shares.

(b)          The terms of the Preference Shares will be such that the Current Shareholders would, subject to available accounting profits and cash flow, be provided with financial benefits with an aggregate value equal to the Practice Value. Company A will determine the buy-back price per Preference Share as at 30 June XXXX (or any other date on which the Proposed Restructure is implemented).

(c)          Company A would then issue new ordinary shares (New Company A Shares) based on the market value of the assets of Company A, other than goodwill.

(d)          The entitlement of the Current Shareholders to Practice Value will be satisfied by way of share buy-backs.

(e)          Company A is expected to utilise its available profits to buy back the Preference Shares held by the Current Shareholders, as well as pay ordinary dividends to the owners of the New Company A Shares. It is anticipated that it may take between X to X income years for all the Practice Value to be returned to the Current Shareholders by way of share buy-back of the Preference Shares ("the Transition Period"). However, the actual length of the Transition Period will ultimately depend on a number of factors, such as the financial performance of Company A and the relative proportion of after-tax profits that are used to buy back the Preference Shares, and the proportion used to pay dividends on the New Company A Shares. The buy-back price per Preference Share will equal their value as at 30 June XXXX (or any other date on which the Proposed Restructure is implemented).

(f)           Once all the Preference Shares have been bought back, the only Shares on issue will be the New Company A Shares (i.e. ordinary shares).

(g)          Any New Company A Shares will either be issued, bought-back or sold between the holders of the New Company A Shares, on the basis of the net assets of Company A other than goodwill. This will be reflected in terms of the updated Constitution and shareholder governing documents.

10.         From an income tax perspective, the realisation of Practice Value to the Current Shareholders via share buy-backs will be subject to income tax under the off-market share buy-back rules found within Division 16K of the ITAA 1936. As Company A has a relatively small amount of paid-up capital, the consideration for the share buy-back should predominantly consist of a dividend component, rather than a capital component.

11.         Based on a company tax rate of X% for Base Rate Entities for income years commencing from 1 July 20XX, the effective tax rate for a fully franked dividend that is distributed to an individual on the top marginal tax of X% is approximately X%, calculated as follows:

Amount of cash dividend $X

Add franking credits $X

Total assessable income $X

Tax @ X% $X

Less franking credit ($X)

Total tax payable $X

Effective Tax Rate $X/$X = X%

12.         Consequently, the realisation of Practice Value to the Current Shareholders should provide an equivalent income tax outcome to the situation where the Current Shareholders disposed of their Shares to a third-party purchaser.

13.         Company A is to undertake a restructure to transition from a goodwill practice model to a no goodwill practice model. Essentially, the intention of the proposed restructure is to compensate the Current Shareholders for the growth in the Company A business, by returning the current Practice Value to the Current Shareholders based on their relative shareholding percentages.

Assumption

None of Company A's Current Shareholders will have received or acquired ordinary shares in Company A during the income year ending 30 June XXXX which would result in any Current Shareholder (alone or with their associates) to hold an interest greater than X% in Company A.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 16K

Income Tax Assessment Act 1936 section 318

Income Tax Assessment Act 1997 section 104-250

Income Tax Assessment Act 1997 Division 725

Income Tax Assessment Act 1997 section 725-50

Income Tax Assessment Act 1997 paragraph 725-50(b)

Income Tax Assessment Act 1997 section 725-55

Income Tax Assessment Act 1997 subsection 725-145(1)

Income Tax Assessment Act 1997 subsection 725-145(2)

Income Tax Assessment Act 1997 subsection 725-145(3)

Income Tax Assessment Act 1997 section 727-355

Income Tax Assessment Act 1997 subsection 727-355(1)

Income Tax Assessment Act 1997 subsection 727-355(2)

Income Tax Assessment Act 1997 subsection 727-355(3)

Reasons for Decision

Summary

The direct value shifting rules in Division 725 of the ITAA 1997 will not apply to the reclassification of the existing ordinary shares in Company A to Preference Shares.

Detailed reasoning

Division 725 of the ITAA 1997 provides that the direct value shifting rules apply if, under a scheme, value is shifted from equity or loan interests in a company or trust to other equity or loan interests in the same company or trust. A direct value shift may result from issuing new shares or trust units at a discount, buying back shares at less than market value or changing the voting rights attached to shares.

The rules are designed to prevent losses or gains from arising on realisation of the interests by:

•                    adjusting the value of those interests for income tax purposes to take account of material changes in market value that are attributable to the value shift; and

•                    treating the value shift as a partial realisation to the extent that value is shifted either between interests held by different owners, from post-CGT to pre-CGT assets or between interests of different characters.

Where the direct value shifting rules apply, they can operate to either adjust the value (e.g. cost base) of those equity or loan interests, or by treating the value shift as a partial realisation, which in turn may give rise to a taxable capital gain to the holder of the interest pursuant to CGT event K8 under section 104-250 of the ITAA 1997.

A direct value shift is defined at subsection 725-145(1) of the ITAA 1997 as follows:

There is a direct value shift under a scheme involving equity or loan interests in an entity (the target entity) if:

(a) there is a decrease in the market value of one or more equity or loan interests in the target entity; and

(b) the decrease is reasonably attributable to one or more things done under the scheme, and occurs at or after the time when that thing, or the first of those things is done; and

(c) either or both of subsections (2) and (3) are satisfied.

Examples of something done under a scheme are issuing new shares at a discount, buying back shares or changing the voting rights attached to shares.

Subsection 725-145(2) of the ITAA 1997 states:

One or more equity or loan interests in the target entity must be issued at a discount. The issue must be, or must reasonably be attributable to, the thing, or one or more of the things, referred to in paragraph 1(b). It must also occur at or after the time referred to in that paragraph.

Subsection 725-145(3) of the ITAA states:

Or, there must be an increase in the market value of one or more equity or loan interests in the target entity. The increase must be reasonably attributable to the thing, or to one or more of the things, referred to in paragraph (1)(b). It must also occur at or after the time referred to in that paragraph.

In the present case, there is to be a variation in the rights under the Company A Shares of the Current Shareholders as these are to be reclassified into Preference Shares that carry a right, subject to available profits and free cash flow, to be bought back at a price equivalent to the Practice Value.

However, section 725-50 of ITAA 1997 provides that a direct value shift has consequences under Division 725 of the ITAA 1997 when all of the below conditions are satisfied:

A *direct value shift under a *scheme involving *equity or loan interests in an entity (the target entity) has consequences for you under this Division if, and only if:

(a) the target entity is a company or trust at some time during the *scheme period; and

(b) section 725-55 (Controlling entity test) is satisfied; and

(c) section 725-65 (Cause of the value shift) is satisfied; and

(d) you are an *affected owner of a *down interest, or an *affected owner of an * up interest, or both; and

(e) neither of sections 725-90 and 725-95 (about direct value shifts that are reversed) applies.

One of the five requirements is the Controlling entity test which is found in section 725-55 of the ITAA 1997:

An entity (the controller) must control (for value shifting purposes) the target entity at some time during the period starting when the scheme is entered into and ending when it has been carried out.

The concept of 'control (for value shifting purposes) of a company' is defined in section 727-355 of the ITAA 1997. There are three control tests contained within section 727-355, which are:

•                    The 50% stake test in subsection 727-355(1) of the ITAA 1997 - this test will be satisfied where an entity and its associates between them have at least 50% of the voting power, rights to dividends or rights to capital of the company;

•                    The 40% stake test in subsection 727-355(2) of the ITAA 1997 - this test will be satisfied where an entity and its associates between them have at least 40% of the voting power, rights to dividends or rights to capital of the company, unless another entity (alone or with its associates) actually controls the company; and

•                    The actual control test in subsection 727-355(3) of the ITAA 1997 - this test will be satisfied where an entity (alone or with its associates) in fact controls the company.

In the present matter, none of the three control tests are satisfied. The largest Current Shareholders are the entities associated with the Founding Principals, each of which own approximately X% of the shares in Company A. The entities are not associates of each other, and none of the other shareholders in Company A are associates with them. Consequently, neither the 50% stake test nor the 40% stake test are satisfied. Furthermore, as the largest Current Shareholder in Company A only holds X% of the total shares in Company A, no single Current Shareholder actually controls Company A. On this basis, the actual control test is not satisfied.

As no shareholder has control of Company A, neither the controlling entity test under section 725-55 of the ITAA 1997 and (consequently) the condition under paragraph 725-50(b) of the ITAA 1997 are satisfied. Therefore, Division 725 of the ITAA 1997 will not apply to the direct value shift in relation to the existing ordinary shares being reclassified to Preference Shares.

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).