Decision impact statement
Commissioner of Taxation v McNeil
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 HCA 5
2007 ATC 4223
64 ATR 431
(2007) 233 ALR 1
(2007) 229 CLR 656
Venue: High Court
Venue Reference No: S56/2006
Judge Name: Gummow ACJ, Hayne, Callinan, Heydon and Crennan JJ
Judgment date: 22 February 2007
Appeals on foot:
Impacted AdviceRelevant Rulings/Determinations:
Derivation of income
Respondent acquired shares which were later the subject of a buy-back arrangement that gave the respondent "sell-back rights"
|This document is not a public ruling, but provides a statement of the Commissioner's position in relation to the decision and how the law will be administered as a consequence of the decision. Any proposals for changes in the law are matters for government and it is not appropriate for the Commissioner to comment.|
Outlines the Tax Office's response to this case which concerned the assessability of the value of sell-back rights provided to a shareholder of St George Bank Limited. This statement takes account of the effect of amending legislation on the application of the case.
Brief summary of facts
In McNeil the High Court (Gummow ACJ, Hayne, Heydon, and Crennan JJ, with Callinan J dissenting) decided that the value of sell-back rights issued by St George Bank Ltd (SGL) to Mrs McNeil, a shareholder, was income according to ordinary concepts, derived by her at the time of the granting of the rights.
In February 2001, SGL issued to its shareholders, including Mrs McNeil, one sell-back right for every twenty shares they held. The rights permitted the holder of the rights to sell back some of their shares at a price somewhat above their market value at the time the rights were granted to SGL shareholders. For any right, the shareholders could exercise their right and sell back a share of theirs to SGL for a sum in excess of its market value; sell the right on market, enabling another shareholder to sell back a share of their own to SGL for a sum in excess of its market value; or do nothing, in which case their right would be sold and they would receive payment from the price.
Under the arrangement, shareholders were advised that they did not have to sell any of their shares to SGL. Conversely, shareholders could purchase additional sell-back rights on the Australian Securities Exchange (ASX) and increase the number of shares they could oblige SGL to acquire.
Mrs McNeil chose to do nothing, and her sell back rights were sold and the money realised paid over to her. The sell-back right had a value when issued to Mrs McNeil, which was agreed between the parties to the case to be $1.89.
All of the purchase price of the SGL shares bought back on exercise of sell-back rights issued under the arrangement was debited by SGL to the SGL share capital account, and was funded from existing cash resources of SGL.
The Tax Office issued Class Ruling CR 2001/75 stating that those shareholders who received sell-back rights would be liable to pay income tax on the value of the rights when granted to them.
St George funded litigation on behalf of shareholders to challenge the class ruling.
The income tax laws were amended by Tax Laws Amendment (2008 Measures No 3) Act 2008, Schedule 1, with application to rights issued on or after 1 July 2001, and these amendments must be taken into account in understanding the effect of McNeil.
Issues decided by the court
On 22 February 2007 the High Court allowed the Commissioner's appeal from the Full Federal Court that the value of share sell-back rights granted to SGL shareholders in 2001 are considered income and therefore assessable.
The sell-back rights, and the embedded value of the right to sell back SGL shares for more than their market value, were not dividends for the purposes of the income tax law. The majority decided that this did not preclude the rights being income according to general concepts.
In coming to their decision that the sell back rights were income in Mrs McNeil's hands though not dividends, the majority relied on established principles that determine the character of income. The first principle holds that whether a particular receipt has the character of the derivation of income depends upon its quality in the hands of the recipient and not the character of the expenditure by the other party.
In applying this first principle it is critical to appreciate that those characteristics of a receipt which determine its income nature must be present at the point of derivation. They do not include characteristics that may be acquired thereafter when the receipt has already become the taxpayer's asset to be used or enjoyed as they see fit. It did not matter in this case that the sell-back rights held for Mrs McNeil arose out of the decision by SGL to undertake a share buyback or that the buyback involved capital restructuring by SGL.
The second principle is that a gain derived from holding property has the character of income and this includes a gain to an owner who has waited passively for that return from property. The sell-back rights which had value represented some sort of financial gain to Mrs McNeil. The deeds poll were the means by which the gain was realised and conveyed to Mrs McNeil, as she did not exercise or sell her rights herself. But the gain on receiving her rights was a gain from property (from her shares), something of value proceeding from the property and that was received by Mrs McNeil for her separate use. In these circumstances, the gain is to be regarded as income.
The question for the Court then became whether the sell back rights enjoyed by Mrs McNeil represented a gain to her from property rather than a realisation of or of part of the property. In other words, the question was whether the rights were severed from, and were a product of, her shareholding in SGL which she retained after receiving her rights. If the grant to her of the sell-back rights were for giving up part of the profit-yielding structure represented by her shareholding, or were carved out of that structure, the grant would not have left her shareholding intact and untouched but might have represented merely a re-expression of the rights which constituted the share. In such circumstances the sell-back right would not constitute a gain from property in her hands but rather a receipt of capital.
The majority of the Court did not see the receipt of the sell back rights as altering the capital structure that was Mrs McNeil's shareholding in SGL. Rather,
"[t]he issue of the 272 sell-back rights for the taxpayer and what then ensued did not involve any return of capital paid up on her shares, nor any variation or re-expression of her rights as a shareholder."
Their Honours dismissed the taxpayer's submission that SGL issued the sell-back rights '"in partial satisfaction of the shareholders' right to participate in reductions of capital" being "within the congeries of rights comprising the shares."' Rather, the majority pointed out, "[i]t is the character of grant of rights to the shareholders that ... is decisive. It is not the reduction of capital effected by SGL pursuant to the new statutory process provided by the Corporations Law." In other words, the sell-back rights were characterised as something of independent value which was the product of and severed and detached from Mrs McNeil's shareholding in SGL and thus constituted her income according to ordinary concepts, as income from the property constituted by her shares.
The majority concluded:
"the sell-back rights which the taxpayer enjoyed and which were turned to account on her behalf did not represent any portion of her rights as a shareholder under the constitution of SGL."
Consequently, in becoming entitled to the rights, the taxpayer derived income.
Tax Office view of Decision
Application of the McNeil decision to call options
The McNeil decision applied established principles for determining the character of income to a specific set of facts, in this case, in relation to rights issued that were not (and the value of which was not) a dividend for income tax purposes. Those rights were for shareholders in a company to sell back their shares to the company for a sum in excess of the market value of the shares.
The value of the rights issued in McNeil was income from property constituted by shares. In particular, the majority focused on the specific relationship between a company and shareholder, and on the specific right issued to that shareholder by the company in relation to equity in the company.
For 'put' options, that is, for rights to a shareholder to sell back shares in their company, under section 112-37 of the Income Tax Assessment Act 1997 (the ITAA 1997) the first element of their CGT cost base is the sum of any amount included in assessable income as ordinary income as a result of the shareholder acquiring the right, and any amount paid to acquire the right. So any amount of income for such 'put' options will be included in the cost base for the rights. The legislation also provides by paragraph 104-155(ea) that a shareholder has no CGT event H2 from such a right, and by item 7 of the table to subsection 112-20(3) that the market value substitution rule does not apply to a shareholder getting such a right. (Specific provisions relating to unit holders are not needed in relation to provisions that do not apply to unit holders.)
The McNeil decision is equally applicable in determining the character of the value of other rights where not a dividend for income tax purposes. Where those rights are for shareholders in a company to subscribe for shares in the company at less than their market value, the value of those rights ('call' options) will be income on ordinary concepts in the same way as in relation to the 'put' options considered in McNeil itself.
The High Court made it clear that, in characterising the derivation from issue of the right in the hands of the shareholders, it did not matter that the option, if exercised, would result in a reduction of share capital by the company. That suggests that it also does not matter that an option to subscribe for shares at less than their market value, if exercised, results in a further contribution of share capital to the company on subscription if the value of the right otherwise leads to the derivation of assessable income.
In Class Ruling CR 2007/42, the Tax Office applied the principles outlined in the McNeil decision to options issued to shareholders of Hutchison Telecommunications (Australia) Limited (HTAL) to acquire further shares in HTAL under an arrangement relating to the raising of additional equity funding. Under the terms of the arrangement the call options were issued to shareholders at no cost, were tradable on the ASX, and shareholders could choose whether to exercise the options, trade them or let them lapse. The call options were for $0.21 per share acquired, below the market value of HTAL shares, and so were themselves of value.
For 'call' options, that is, for rights to a shareholder to acquire further shares in their company or to a unit holder to acquire additional units in their trust, section 59-40 of the ITAA 1997 may now apply to treat the value of the rights at the time of issue as non-assessable and non-exempt income of the shareholder or unit holder. The section will apply where conditions are met, including that the rights are issued to the equity holder because of their ownership of the equity, that the original equity and the rights be neither revenue assets nor trading stock at the time the rights issue, that the rights not be acquired under an employee share scheme, that the original equity be neither traditional securities nor convertible interests for tax purposes, and that the rights not be traditional securities for tax purposes.
The amendments also provide by paragraph 104-135(1)(b) that the value of a 'call' option will be disregarded in working out a capital payment for shares giving rise to CGT event G1, under section 104-135. Such payments arise in relation to shares when a company pays a shareholder certain amounts which are non-assessable. (Specific provisions relating to unit holders are not needed in relation to provisions that do not apply to unit holders.)
Application of the McNeil decision to dividends
The McNeil decision may apply to some dividends, in that even if they were not dividends they would be income on general principles by application of the decision. However, where a right (or the value of a right), or compensation when a right is unavailable or is not exercised, is a dividend, the McNeil decision does not operate in substitution for the application of the income tax law to dividends.
Application of the McNeil decision to other types of rights
The essence of McNeil is that a person who owns property, derives a gain from that property, and does not dispose of, or otherwise 'affect', the property by deriving the gain, derives income. However, the decision in McNeil relies upon established principles of characterising income (see Commissioner of Taxation v Montgomery (1999) 198 CLR 639), and those wider principles will apply on their terms whether or not there is an option involved, and whether or not the gain arises in an arrangement involving a company and its shareholders. An arrangement that is structured in such a way as to provide the owner of property with a gain from that property which is severed from and does not affect the property will result in the gain being treated as income of the recipient, in accordance with McNeil and the wider principles which it applies.
Such an arrangement can only result in the participant deriving income at the time of granting of rights in relation to the property if the terms on which the rights may be exercised, taking account of the cost of acquiring them, is such that the rights have value. This will be true if the exercise of the rights is on non-market-value terms. In the McNeil case the sell-back rights had value for SGL shareholders because the terms of the rights permitted shareholders to sell their shares to SGL at a price that exceeded the market value of the shares at the time the rights were granted.
It is impossible to make general statements about the application of the principles expressed in Montgomery and McNeil to materially different facts. However, in the closely analogous case of a unit trust estate conducted for the purpose of profit, and in which units are held by unit holders for the purpose of deriving income from those units as items of property, where the trustee issues put back rights to unit holders in respect of units entitling unit holders to redeem units in the trust at above market values, in corresponding circumstances the same result would follow as in McNeil: the issue of the rights would result in the unit holders deriving income of the value of the rights.
In the same way, issuing rights to unit holders to subscribe for units in the trust at less than their market value would result in the unit holders deriving income of the value of the rights. As noted above and for similar rights issued to shareholders, section 59-40 of the ITAA 1997 may now apply to treat the value of the rights at the time of issue as non-assessable and non-exempt income of the unit holder. The section will apply where conditions are met, including that the rights are issued to the unit holder because of their ownership of the units, that the original units and the rights be neither revenue assets nor trading stock at the time the rights issue, that the rights not be acquired under an employee share scheme, that the original units be neither traditional securities nor convertible interests for tax purposes, and that the rights not be traditional securities for tax purposes.
'Renounceable' and 'non-renounceable' rights
The decision in McNeil does not depend on a distinction between 'renounceable' and 'non-renounceable' rights. As a matter of commercial terminology, different rights are likely to be described as renounceable or as non-renounceable in circumstances which do not necessarily correspond to the principles applied in McNeil. Nor are the terms used commercially with a single consistent meaning.
Rights issued to a shareholder or unit holder which can be traded, assigned or otherwise dealt with as commercial objects in their own right by or for the holder (as well as being exercised or being allowed to lapse), and which are received by a shareholder or unit holder by reason of their share or unit holding, will be income according to ordinary concepts. This follows from the fundamental principles articulated in Montgomery and McNeil concerning income from property. For 'call' options, that is, for rights to a shareholder to acquire further shares in their company or to a unit holder to acquire additional units in their trust, section 59-40 of the ITAA 1997 may now apply to treat the value of the rights at the time of issue as non-assessable and non-exempt income of the shareholder or unit holder, as noted above.
Where a right issued to a shareholder or unit holder cannot be traded, assigned or otherwise dealt with as a commercial object in its own right by or for the holder, but can only be exercised by the shareholder or unit holder or allowed to lapse without compensation or consideration to the shareholder or unit holder, the value of the right issued will not be income from the share or unit and will not be derived when the right is granted. In such a case any gain embodied in the right is not severed from the shareholding or unit holding but can be realised only by selling back the equity holder's share or unit (for a sell-back right) or by the equity holder themselves acquiring more shares or units and selling them (for a call right). This situation is analogous to that of entitlements to bonus shares.
Where such a right is issued to a shareholder or unit holder under arrangements which provide that the shareholder or unit holder is to be compensated should the rights neither be exercised nor dealt with, or should arrangements provide compensation to a shareholder or unit holder for not being issued such a right, that compensation will be income accruing to the shareholder or unit holder. So far as the value of the right has already been included in assessable income on issue of the right, the compensation will not be assessable again, so the compensation is included in income only to the extent that it exceeds the amount included in assessable income arising from issue of the right. To the extent that this compensation is less than the income arising from the issue of the right, the shareholder or unit holder will be entitled to a deduction. The value of the rights in McNeil was itself income, with the shareholder's rights being sold for the shareholder for more than the value of the rights when issued and the net proceeds paid to the shareholder; the High Court did not need to decide the consequences of the disparity between them. Tax consequences in a case where the shareholder was entitled to compensation rather than to the proceeds were not explored in the judgments.
Where a shareholder decides to apply a dividend they have derived to subscribe for additional equity, the shareholder's right to subscribe arises from the derivation of the dividend and the decision of the shareholder to apply it in that way. The right may have value (such as because the dividend may be able to be subscribed for equity worth more than the amount of the dividend). However, Taxation Determination TD 2000/3 expresses the Commissioner's view that the shares subscribed for are not issued in relation to the original shares. The right to subscribe is itself in relation to the dividend, rather than in relation to the original shares on which the dividend is derived. The McNeil decision does not alter the view of the Commissioner expressed in TD 2000/3.
Rights in relation to equity in another entity
Valuable rights an equity holder gets in relation to equity in another entity are not income by reason of McNeil. Depending on the circumstances, they may involve a derivation of income for other reasons.
Where a company provides its shareholders with rights to subscribe for equity in another entity for less than the market value of the equity, or with rights to sell back equity in another entity for more than the market value of the equity, the special issues on which McNeil focused may not arise at all, or may do so only in a minor way. Where the value of such rights is income, this is likely to be for more general reasons.
Suppose the entity in relation to which the company provides rights is not owned by, or the subject of any equity investment by, the company. Then the valuable rights are no different to any other valuable thing provided by a company to its shareholders. They aren't a re-expression of the profit-yielding structure represented by their shareholdings. If the company is to provide the rights, it must first secure them, and will ordinarily do so only for value.
Suppose that the entity in relation to which the company provides rights is owned by, or the subject of equity investment by, the company. Shareholders have no direct interests in the assets of the company of which they are shareholders; the valuable rights are not a re-expression of the profit-yielding structure represented by their shareholdings. The company's interest in the entity may be such that it can secure the rights other than for value, or for less than full value.
In either case, where the company secures the rights and provides them to its shareholders, the value of those rights is likely to be income from the shares, and will commonly be a dividend for the purposes of the income tax law.
Where an equity holder gets valuable rights because they are an equity holder but not from and not in relation to the entity in which they hold equity, those rights are not a dividend or in the nature of a dividend. This situation arose in Allina Pty Ltd v Commissioner of Taxation (1991) 21 ATR 1320; 91 ATC 4195. There, rights obtained by an equity holder from a different entity and held on capital account were found to have a deemed market value cost base for CGT purposes, so that no material gain arose when the rights were sold. The exception in item 4, Table, subsection 112-20(3) now means that such rights would not have a deemed market value consideration in similar circumstances to those in Allina.
The rights may be income in some cases, but where this is so it is not by reason of McNeil.
Rights in relation to convertible interests
The principles enunciated in McNeil's case are not easily applied to convertible interests. Whether the value of any right arising in respect of a convertible interest in a company or trust and given by the company or trust to its shareholders or unit holders is income will depend on the application of general principles to the particular circumstances. Rights to holders of convertible interests are not made non-assessable non-exempt income under the recent legislative amendments.
Implications on current Public Rulings & Determinations
There are four Class Rulings to which McNeil is relevant, and none of these requires adjustment. There are no other Public Rulings or Determinations for which McNeil has implications.
Implications on Law Administration Practice Statements
There are no Law Administration Practice Statements for which McNeil has implications.
Commissioner of Taxation (NSW) v Stevenson
(1937) 59 CLR 80
Thornett v Federal Commissioner of Taxation
(1938) 59 CLR 787
Federal Commissioner of Taxation v Blakely
(1951) 82 CLR 388
Federal Commissioner of Taxation v Uther
(1965) 112 CLR 630
Federal Commissioner of Taxation v Slater Holdings Ltd
(1984) 156 CLR 447
84 ATC 4883
15 ATR 1299
Ord Forrest Pty Ltd v Federal Commissioner of Taxation
(1974) 130 CLR 124
74 ATC 4034
4 ATR 230
Federal Commissioner of Taxation v Miranda
(1976) 11 ALR 85
(1976) 76 ATC 4180
(1976) 6 ATR 367
Inland Revenue Commissioners v Blott
 2 AC 171
Federal Commissioner of Taxation v Dixon
(1952) 86 CLR 540
Reseck v Federal Commissioner of Taxation
(1975) 133 CLR 45
75 ATC 4213
5 ATR 538
Commissioner of Taxation v Montgomery
 HCA 34
(1999) 99 ATC 4749
(1999) 198 CLR 639
(1999) 73 ALJR 1160
(1999) 42 ATR 475
(1999) 164 ALR 435
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