Edited version of private ruling

Authorisation Number: 1011730644993

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Ruling

Subject: Return of capital

Issue 1

Question

Will the Commissioner seek to make a determination under subsection 45C(3) of the Income Tax assessment Act 1936 (ITAA 1936) to debit the class C franking account of A Co in relation to the proposed reduction of capital?

Answer

No

Issue 2

Question

Will interest expenditure incurred on borrowed funds to facilitate the return of capital be deductible under section 8-1 of the Income tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period

Year ending 31 December 2010

Year ending 31 December 2011

Year ending 31 December 2012

Year ending 31 December 2013

Year ending 31 December 2014

Year ending 31 December 2015

The scheme commences on:

1 January 2010

Relevant facts and circumstances

A Co is an Australian resident public company listed on the Australian Securities Exchange (ASX)

A Co is the parent entity of a group of entities that operate various businesses.

Details of the return of capital

A Co received shareholder approval at its Annual General Meeting (AGM) for a capital management program of up to $X. However, it is proposed that capital management strategy will be undertaken by way of a pro-rata return of capital of $Y

The return of capital will be undertaken in accordance with section 256B of the Corporation Act 2001. This means that the return of capital will only be made to those ordinary shareholders that hold shares in A Co as at the Record Date. Return of capital will be undertaken without buying back or cancelling any shares.

The entirety of the proposed share capital reduction is to be debited to the share capital account of A Co. A Co's share capital account has not and will not be tainted for the purposes of Division 197 of the ITAA 1997.

Funding the return of capital

The proposed return of capital will be funded using cash, proceeds from a proposed assets sale and borrowings.

Borrowings

A wholly owned subsidiary Sub Co1 of A Co has a debt facility with external lenders. Sub Co1 will borrow $Z from the loan facility and return the amount as capital to Sub Co 2 which will in turn, return the amount as capital to A Co. A Co will use the monies towards funding the proposed return of capital to shareholders.

The capital was originally used by the company to acquire wholly owned subsidiaries or to fund company's working capital needs. The funding will not be used to finance payments to shareholders in respect of share capital that arose out of the issue of bonus shares.

Franking Account Balance

The amount of franking credits that A Co had available as at 31 December 2009 was nil. It is not expected that this will change in the 31 December 2010 income year.

Non-share equity account

A Co does not have a non-share equity account.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 Subsection 45((3)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Subsection 8-1(2).

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

Reasons for decision

Issue 1

Question

Will the Commissioner seek to make a determination under subsection 45C(3) of the Income Tax assessment Act 1936 (ITAA 1936) to debit the class C franking account of A Co in relation to the proposed reduction of capital?

Summary

No.

Detailed reasoning

No. The Commissioner will not make a further written determination pursuant to subsection 45C(3) of the ITAA 1936, and will not debit the class C franking account of the company in respect of a capital benefit received under the arrangement.

Issue 2

Question

Summary

Yes. The interest on funds borrowed by Sub Co 1 to fund the return of capital by A Co will be deductible under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 is the general provision that deals with deductibility of expenditure.

The requirement for deductibility under section 8-1 is that the expenditure is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income. This is subject to exclusions in subsection 8-1(2) of the ITAA 1997 that provide that expenditure that is capital, private or domestic in nature or incurred in relation to gaining or producing exempt income is not deductible.

The Commissioner's view on interest deductibility is expressed in Taxation Ruling TR 95/25. At paragraph 3 of TR 95/25, the Commissioner indicates that the following is relevant to determining whether an interest expense is deductible for purposes of the section 8-1 of the ITAA 1997.

The interest expense must have a sufficient connection with the operations or activities that more directly gain taxpayer's assessable income and not be of capital, private or domestic nature. To establish this connection character of the interest expense must be determined by looking at all relevant circumstances in which the expense is incurred (paragraph 3(a) of TR 95/25).

This character is generally established by looking at objective circumstances of the use to which the borrower puts the borrowed money. All circumstances are relevant, including the character of the taxpayer business, the objective purpose of the borrowing, the nature of transaction etc. In some instances, taxpayer's subjective purpose of making the borrowing may be relevant (paragraph 3(b) of TR 95/25).

Tracing of the borrowed money to establish purpose for which the money will be used may be helpful in determining the connection between the income producing activity and the interest expense (paragraph 3(c) of TR 95/25). However, a rigid tracing will not be necessary or appropriate where the funds borrowed are used to replace the withdrawn funds people had previously invested in the business (paragraph 3(d) of TR 95/25).

The Commissioner considers that when deciding whether companies can claim deductions for interest expenses incurred in relation to borrowings used to repay share capital or pay a dividend, regard must be given to the commercial context in which the company borrowed the relevant funds. For example, there will usually be a need for a business to maintain a pool of circulating capital from which to meet the expenses of that business. In these circumstances, the deductibility of the interest expense cannot be determined by considering only the immediate reason for making a payment and ignoring the overall purpose with which the liability was incurred: see Dixon J in Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113 at 118 (paragraph 12 of TR 95/25).

Accordingly, the interest on a borrowing by a company may be deductible where the borrowing is used to fund:

· a repayment of share capital to the shareholders (including bonus shares out of realised profits), and

· the payment of a declared dividend to the shareholders (out of the unappropriated profits account of the company),

in circumstances where the funds repaid were employed as capital or working capital in the business carried on by the company for the purpose of deriving assessable income (subject to apportionment where exempt income is also derived from the business activities).

When the liability to pay dividend or repayment of capital reduces the amount to the credit of the unappropriated profits account and the reduction is replaced in the company's account by the loan there will usually be a nexus between the interest expense and the carrying on of a business for the purposes of deriving assessable income (paragraphs 13 to 15 of TR 95/25).

However, interest is not deductible if the borrowing finances:

· payments to shareholders in reduction or extinguishment of share capital such as bonus shares paid up out of an unrealised asset revaluation reserve, or in reduction of unrealised profit reserves such as from the recognition of internally generated goodwill; and

· payment of dividends out of unrealised profit reserves (paragraph 16 of the TR 95/25).

The purpose of the borrowings and the use of borrowed funds

Following from the above, whether the interest on funds borrowed by the subsidiary (or the companies from its consolidated group) is deductible under section 8-1 of the ITAA 1936 will depend on the character of the interest as established through the examination of the purpose of the borrowing and the use to which the borrowed funds are put. To determine this all the circumstances, including the commercial context in which the borrowing is made, must be considered.

Relevant circumstances are as follows. A Co does not have any reserves in their accounts that reflect unrealised profits and has accumulated net losses. It has market capitalisation of approximately $C.

Further, A Co has stated that the funds will not be borrowed on basis of this market capitalisation. The funds will instead be borrowed in respect of the future cash-flows and will be repaid from these cash flows.

A Co will use the funds borrowed to finance a return of capital, which effects the replacement of equity with debt. The equity was originally used by A Co to acquire wholly owned subsidiaries or to fund company's working capital needs. The value of A Co's share capital account as at the 31 December 2010 was $B. A Co will debit the return of capital of up to $Z, partially funded by the borrowed funds, against this share capital account.

A Co stated that the borrowed funds will not be used to finance payments to shareholders in respect of share capital that arose out of the issue of bonus shares nor will it be used to fund payments that represent a distribution of unrealised profits reserves, as the corporate group does not have any. Accordingly, the borrowings will not be used to fund a payment of dividends out of unrealised profit reserves for purposes of paragraph 16 of TR 95/25.

Further, the Commissioner accepts that the outgoing of interest in these circumstances is not an outgoing of capital or of a private or domestic nature and has not been incurred in gaining or producing exempt income and not subject to the exclusion in subsection 8-1(2) of the ITAA 1997.

In light of the reasons stated above, company's interest on the borrowings will be deductible under section 8-1 of the ITAA 1997.