Edited version of private advice

Authorisation Number: 1052159834230

Date of advice: 7 September 2023

Ruling

Subject: Return of capital

Question 1

Will any part of the Proposed Capital Return be treated as a dividend within the meaning of subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

Question 2

Will the Commissioner seek to make a determination under section 45B of the ITAA 1936 that section 45C of the ITAA 1936 applies to deem any part of the Proposed Capital Return to be a dividend paid out of profits?

Answer

No

This ruling applies for the following period:

A particular income year

The scheme commenced:

Prior to a particular income year

Relevant facts and circumstances

Entity A is the provisional group head of a multiple entry consolidated (MEC) group that consists of a number of subsidiaries.

Entity A's sole shareholder is Entity B, a foreign resident company.

Entity B's cost base of the shares in Entity A (Shares) is more than the amount of the Proposed Capital Return.

Entity B does not have any capital losses.

Prior to a particular income year, Entity A provided a certain amount of capital via a subscription for shares to Entity C (Capital Injection), which is a subsidiary member of the MEC group, to enable Entity C to meet certain regulatory requirements. Entity C invested the Capital Injection in a term deposit.

Entity A sourced the funds to provide the Capital Injection from Entity B, via a subscription for shares in Entity A.

The regulatory requirements subsequently changed, and Entity C determined that it had excess capital.

Accordingly, Entity C returned the excess capital to Entity A by way of a return of share capital. Entity A did not credit this amount to its share capital account.

Entity C funded the capital return to Entity A via excess operating cash. At all times during the relevant period from the initial Capital Injection to the time of return of capital to Entity A, Entity C's cash and cash equivalents balance did not fall below the capital return amount.

As a result of receiving the return of capital from Entity C, Entity A is now seeking to return this capital (Proposed Capital Return) to its sole shareholder, Entity B. The Proposed Capital Return will be debited against Entity A's share capital account.

The share capital account of Entity A is not a tainted share capital account within the meaning of Division 197 of the Income Tax Assessment Act 1997 (ITAA 1997).

Entity A does not have a pattern of distribution of dividends to its shareholder.

Entity A has sufficient franking account balance to pay fully frank dividends to an amount exceeding the Proposed Capital Return.

While the MEC group had retained profits, Entity A's stand-alone financial accounts show accumulated losses, prior to the Proposed Capital Return.

The Proposed Capital Return does not involve the provision (and later disposal) of ownership interests or an increase in the value of ownership interests (and later disposal of those interests).

The Proposed Capital Return does not coincide with any disposal of assets or changes in the structure to the MEC group.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 45C

Reasons for decision

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

Question 1

A 'dividend' is defined for income tax purposes under subsection 6(1), which states that 'dividend' includes any distribution made by a company to any of its shareholders. However, paragraph (d) of the definition of dividend excludes a distribution from the meaning of dividend 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 ITAA 1997 as an account which the company keeps of its share capital, or any other account created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital.

Subsection 975-300(3) of the ITAA 1997 provides that if a company's share capital account is 'tainted' (as defined in Division 197 of the ITAA 1997), that account is taken not to be a share capital account for certain purposes of the income tax legislation (including the definition of 'dividend').

The Proposed Capital Return will be debited against the untainted share capital account of Entity A, hence it will satisfy the exclusion in paragraph (d) of subsection 6(1).

However, subsection 6(4) states that paragraph (d) of the definition of dividend in subsection 6(1) 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.

When Entity C returned excess capital to Entity A by way of a return of share capital, this amount was not credited to Entity A's share capital account. Therefore, subsection 6(4) will not apply to prevent the operation of the exclusion in paragraph 6(1)(d).

In conclusion, the Proposed Capital Return will not be a 'dividend' within the meaning of subsection 6(1).

Question 2

Section 45B applies where certain capital payments are made in substitution for dividends. Specifically, subsection 45B(2) provides that section 45B applies where:

(a) there is a scheme under which a 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 the capital benefit, obtains a tax benefit; 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.

Where these requirements are met, the Commissioner may make a determination in writing that section 45C applies to all or part of the capital benefit (subsection 45B(3)(b)). The effect of a determination made under section 45C is that part or all of the capital benefit will be an unfranked dividend paid to the relevant taxpayer out of profits (subsections 45C(1) and (2)).

Scheme

Subsection 45B(10) provides that 'scheme' for the purposes of section 45B has the same meaning given by subsection 995-1(1) of the ITAA 1997. Subsection 995-1(1) provides that a scheme means:

(a) any arrangement; or

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

Given the wide definition of 'scheme', the Proposed Capital Return should constitute a scheme for the purposes of section 45B. This is confirmed in Practice Statement Law Administration 2008/10 Application of section 45B of the Income Tax Assessment Act 1936 to share capital reductions which states at paragraph 41 that "a share capital reduction would normally constitute either a scheme or a part of a scheme for the purposes of section 45B."

Capital benefit

The phrase 'provided with a capital benefit' is defined in subsection 45B(5). It states that a reference to a person being provided with a capital benefit is a reference to any of the following:

(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 in relation to an ownership interest that has the effect of increasing the value of an ownership interest (which may or may not be the same interest) that is held by the person.

As a result of the Proposed Capital Return, the sole shareholder of Entity A, being Entity B, will receive a distribution of share capital, which constitutes provision of a capital benefit under paragraph 45B(5)(b).

This view is also confirmed in PS LA 2008/10 at paragraph 44, which states that a share capital reduction by way of a return of share capital to the shareholder will constitute a capital benefit within the meaning of paragraph 45B(5)(b).

As such, paragraph 45B(2)(a) is satisfied, as the Proposed Capital Return is a 'scheme' under subsection 45B(10) and Entity A's shareholder will be provided with a 'capital benefit' within the meaning of subsection 45B(5).

Tax benefit

Pursuant to subsection 45B(9), the relevant taxpayer obtains a tax benefit from a return of share capital if the amount of tax payable, or any other amount payable under ITAA 1936, by the relevant taxpayer would, apart from section 45B, 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.

In this case, the relevant taxpayer is also the person provided with a capital benefit, being Entity B.

Ordinarily, a return of capital would give rise to CGT event G1 (section 104-135 of the ITAA 1997). However, unless the amount of the capital distribution per share exceeds the cost base of the share, there will only be a cost base reduction (subsection 104-135(4) of the ITAA 1997). Furthermore, for a foreign resident shareholder, Division 855 of the ITAA 1997 will operate to disregard any capital gain from CGT event G1 provided that the CGT asset is not 'taxable Australian property'.

As Entity B's cost base of the Shares is more than the amount of the Proposed Capital Return, it is expected that Entity B will merely reduce its cost base by the amount of the Proposed Capital Return and there will be no immediate CGT tax consequences. As such, the Proposed Capital Return will not be immediately assessable as income for Entity B.

If the capital benefit had been an unfranked dividend, Entity B as a foreign resident would be subject to dividend withholding tax under section 128B. The liability to withholding tax on an unfranked dividend compared with the delay or reduction of tax payable on a return of capital means that the amount of tax payable by Entity B on the capital benefit would, apart from section 45B, be less than the amount that would have been payable if the capital benefit had been an assessable dividend (paragraph 1.26 of the Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998 (Explanatory Memorandum)). Accordingly, the requirements of 'tax benefit' as defined under subsection 45B(9) will be satisfied.

If Entity A uses its available franking credits to fully frank the cash distribution so that it is a fully franked dividend, the dividend would not be subject to dividend withholding tax (subparagraph 128B(3)(ga)(i)). However, those franking credits would no longer be available for use in future income years as they would have been if a capital benefit had been paid instead of a dividend. As explained in paragraph 1.27 of the Explanatory Memorandum and paragraph 49 of PS LA 2008/10, the preservation of franking credits for the use at a future time (and therefore reduce tax payable in those years) would still constitute a tax benefit within the meaning of subsection 45B(9).

Therefore, by making a distribution of share capital in circumstances where Entity A has available franking credits, the preservation of those franking credits for use at a future time by a shareholder would mean that a relevant taxpayer obtains a tax benefit within the meaning of subsection 45B(9).

As such, for any or all of the reasons listed above, a relevant taxpayer obtains a tax benefit under the scheme and paragraph 45B(2)(b) is satisfied.

More than incidental purpose

For the purposes of paragraph 45B(2)(c), the Commissioner is required to consider the 'relevant circumstances' of the scheme set out under subsection 45B(8) to determine whether any part of the scheme was entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit. The list of relevant circumstances in subsection 45B(8) is not exhaustive and requires a consideration of both the circumstances of the company as well as the tax profile of the shareholders who receive the demerger benefit or capital benefit.

The test of purpose is an objective one. The question is whether, objectively, it would be concluded that a person who entered into or carried out the scheme did so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit (paragraph 1.29 of the Explanatory Memorandum). The purpose does not have to be the most influential or prevailing purpose, but it must be more than an incidental purpose (paragraph 1.31 of the Explanatory Memorandum).

Having regard to the relevant circumstances of the scheme, it cannot be objectively concluded that a person entered into or carried out any part of the scheme for a more than incidental purpose of enabling a taxpayer to obtain a tax benefit. The Proposed Capital Return will be carried out for genuine commercial reasons, being to return part of the capital that is no longer required due to a change in regulatory requirements. Any tax benefit obtained under the scheme appears to be incidental to the commercial reason.

Conclusion

Accordingly, as the requirements in subsection 45B(2) have not been met, the Commissioner will not make a determination under paragraph 45B(3)(b) that section 45C applies in relation to any part of the Proposed Capital Return.

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