Edited version of private ruling

Authorisation Number: 1011739640426

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Ruling

Subject: Share Capital Account Tainting

Question 1

Are amounts debited to the Share-based Payments Reserve part of the 'share capital account' of the company (the Applicant) within the meaning of section 975-300 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No

Question 2

At the time of a credit to the Applicant's share capital account, is there a 'transfer' of an amount or amounts to the Applicant's share capital account from another account within the meaning of subsection 197-5(1) of the ITAA 1997?

Answer: Yes

Question 3(a)

Are amounts credited under the Option Plan to the Applicant's Share-based Payments Reserve 'option premiums' that are excluded from the operation of the share capital account tainting rules pursuant to section 197-25 of the ITAA 1997?

Answer: Yes

Question 3(b)

Are amounts credited under the Share Acquisition Plan (SAP) to the Applicant's Share-based Payments Reserve 'option premiums' that are excluded from the operation of the share capital account tainting rules pursuant to section 197-25 of the ITAA 1997?

Answer: No

Question 4

If there were transfers associated with these transactions, were those transfers in respect of amounts that, at all times, could be identified as 'share capital' pursuant to section 197-10 of the ITAA 1997?

Answer: No

Relevant facts and circumstances

The Applicant is a resident Australian public company.

The Applicant operates a number of employee share schemes for its employees. The two plans of relevance to this Application are the Option Plan and the SAP.

Option Plan

Options granted under the Option Plan carry no dividend or voting rights and are granted to eligible employees. No consideration is payable by employees for the grant of the options, other than services provided by employees. An eligible employee may only exercise the option if they are entitled to do so in accordance with the terms and condition of the Option Plan.

Entitlements to the options are vested as soon as they become exercisable.

The fair value of the options is measured at grant date and recognised as an expense over the period during which the employee becomes unconditionally entitled to the options and the following journal entry is recorded accordingly:

Dr/Share-based Payments Expense (P&L)

Cr/Share-based Payments Reserve (Equity)

Upon the exercise of the options, the amounts received from employees in respect of the exercise price of the options are debited to the Receivable / Cash account and credited to the Share Capital Account. Simultaneously, to recognise the reclassification of the fair value of the options upon exercise, the Applicant debited its Share-based Payments Reserve and credited its Share Capital Account.

Where options lapse or are not exercised the options' value is not reclassified to share capital.

It is this final journal entry (i.e. the debiting of the Share-based Payments Reserve and crediting of the Share Capital Account) which is the subject of this Ruling.

Amounts of the Option Plan share option value were reclassified from the Applicant's Share-based Payments Reserve to its Share Capital Account after 30 June 2006.

SAP

The SAP Plan Rules (the Plan Rules) provide that:

· the acquisition of shares under the SAP will be exclusively and fully funded by a loan (the Share Plan Loan) advance by the Applicant to the Participant;

· the Share Plan Loan is applied by the Applicant directly towards payment of the subscription price of the shares to be acquired.

· the Share Plan Loan shall be made to a Participant on a limited recourse basis, in that the Applicant will not be entitled to require a Participant to repay the Share Plan Loan other than in accordance with, and to the extent provided by, other relevant rules of the Plan Rules, and will not be entitled to have recourse to any assets of the Participant other than the shares held by the Participant;

· a Participant has legal and beneficial ownership of the shares issued to him or her, but any disposal of those shares is to be restricted in accordance with the Plan Rules;

· until such time as the Share Plan Loan is repaid in full, the Applicant will retain all dividends payable to a Participant in respect of the shares acquired by that Participant utilising the proceeds of the Share Plan Loan, and those dividends shall be applied in reduction of the Share Plan Loan;

· until the Share Plan Loan is repaid in full:

o the Applicant shall have a lien over all of the shares held by that Participant to which the Share Plan Loan relates and the Applicant is entitled to sell those shares in accordance with the Plan Rules;

o a Holding will be placed on all shares issued to the Participant under the SAP to which the Share Plan Loan relates, and for so long as a Holding Lock remains in place, the Participant is effectively prevented from having the shares to which the Share Plan Loan relates transferred to another person; and

o the Participant may not, other than set out in the Plan Rules, Encumber those shares;

· if, prior to the repayment of the Share Plan Loan in accordance with the Plan Rules a Participant;

(a) ceases to be employed by the Applicant for any reason;

(b) dies or is totally or permanently disabled; or

(c) becomes bankrupt;

the Participant may elect, by serving written notice on the Applicant within six months of such event occurring, one of the following two alternatives. If such a notice is not served within six months of the event occurring, the Participant is taken to have elected Alternative 1.

Alternative 1 is to have the Applicant sell so many of the shares on the ASX or other similar exchange as may be required to discharge the amount of the Share Plan Loan and apply the net proceeds of sale (after deduction of all reasonable expenses, including an administration fee, having regard to increases in administration costs, and brokerage) in repayment of the Share Plan Loan. The Applicant must release its lien over any shares or other assets held by the Participant after discharge of the relevant Share Plan Loan, and refund any surplus from such proceeds of sale to the Participant.

Alternative 2 is to repay the Share Plan Loan and have the shares fully vested in the Participant's name;

· notwithstanding any other Rule, a Participant may elect to repay the Share Plan Loan in full and have the relevant shares fully vested in their name at any time while a loan balance exists, and prior to termination of employment; and

· a Participant is not liable for any balance of the Share Plan Loan remaining due after the Applicant has sold the Participant's shares and applied the proceeds of sale.

When the shares are issued to the Participant, the following two journal entries are posted.

Dr/Loan Account (Equity)

Cr/Share Capital Account (Equity)

Dr/Share-based Payments Expense (P&L)

Cr/Share-based Payments Reserve (Equity)

The first entry recognises the fair value of the issued share which is funded by the Share Plan Loan. The second entry recognises the "option" in the loan arrangement, being the Participant's ability to repay the Share Plan Loan in full and have the relevant shares fully vested in their name, free of any Holding Lock or lien on and over the shares.

The value of this embedded "option" is determined by the Applicant based upon the Black-Scholes valuation model.

Upon repayment of the Share Plan Loan, the following journal entries are recorded to reflect this repayment by the Participant and to reclassify the embedded "option" from Share-based Payment Reserve to Share Capital.

Dr/Cash (Asset)

Cr/Loan Account (Equity)

Dr/Share-based Payments Reserve (Equity)

Cr/Share Capital Account (Equity)

It is this final journal entry (i.e. the debiting of the Share-based Payments Reserve and crediting of the Share capital Account) which is the subject of this Ruling.

The Share-based Payments Reserve is the only reserve account maintained by the Applicant.

Only those amounts credited to the Applicant's Share Capital Account from 30 June 2006 are relevant to the potential application of Division 197 of the ITAA 1997.

Reasons for decision

Question 1

Summary

The amounts debited to the Share-based Payments Reserve are not part of the 'share capital account' of the Applicant within the meaning of section 975-300 of the ITAA 1997.

Detailed reasoning

'Share capital account' for the purposes of Division 197 of the ITAA 1997 is defined in subsection 975-300(1) as:

(a) an account that the company keeps of its share capital; or

(b) any other account (whether or not called a share capital account) that satisfies the following conditions:

(i.) the account was created on or after 1 July 1998;

(ii.) the first amount credited to the account was an amount of share capital.

The share capital account represents a liability owed to the shareholders by the company and appears with other liability accounts on the liabilities side of a balance sheet in traditional accounting: it is not to be confused with an asset account. The accounts to which Division 197 of the ITAA 1997 refers are not asset accounts. A 'negative' asset account, however, is a liability account and vice versa.

'Share capital' is not defined for the purposes of Division 197. It is therefore necessary to consider the ordinary meaning of the term 'share capital'.

The concept of share capital was considered in the High Court case of Archibald Howie Proprietary Ltd & Ors v. Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 where Williams J stated, at 157:

A company obtains capital by the issue of its shares....The amount payable may be satisfied by the payment of money or by some other proper consideration. But all shares must be paid for in full by money or money's worth. When the person to whom the shares are allotted pays or assumes the liability to pay for the shares in money or money's worth, full consideration in money or money's worth moves from him to the company for all the rights which he acquires under the memorandum and articles of association.

The Full Court of the Federal Court in St George Bank Ltd v. Federal Commissioner of Taxation (2009) 176 FCR 424; [2009] FCAFC 62; 2009 ATC 20-103; (2009) 73 ATR 148 considered share capital as follows, per Perram J at paragraph 90:

…If the subscription consideration is money then the company obtains money; if it is land, it obtains land; if the share is not fully paid then the company acquires a right to call upon the unpaid portion. The 'capital' of the company is the money or money's worth derived by the company from the issue of shares: Re The Swan Brewery Co Ltd (1976) 3 ACLR 164 at 166 per Gillard J.

As stated above, in respect of the Option Plan, upon exercise of the options in order to recognise the reclassification of the fair value of the options upon exercise, the Applicant debited its Share-based Payments Reserve and credited its Share Capital Account. Similarly, under the SAP, upon repayment of the Share Plan Loan, the Applicant also debited its Share-based Payments Reserve and credited its Share Capital Account.

In respect of the Option Plan, the amounts entered in the reserve account represent the fair value of the option, not the consideration received for the issue of shares.

Likewise, in respect of the SAP the amounts entered in the reserve account do not represent consideration received for the issue of shares, rather the amounts represent the value of the embedded "option" in the Share Plan Loan. That is, the additional amount of services recognised by the Applicant's entries in its Share-based Payments Reserve does not constitute payment for the shares, but rather, payment for the limited recourse facility on the loan.

Consequently, amounts debited to the Share-based Payments Reserve are not part of the 'share capital account' of the Applicant.

Question 2

Summary

At the time of a credit to the Applicant's Share Capital Account, there is a 'transfer' of an amount to the Applicant's Share Capital Account from another account within the meaning of subsection 197-5(1) of the ITAA 1997.

Detailed reasoning

Division 197 of the ITAA 1997 provides for a company's share capital account to become 'tainted' if an amount is transferred to the share capital account from another account.

Subsection 197-5(1) of the ITAA 1997 provides:

Subject to subsection (2), this Division applies to an amount (the transferred amount) that is transferred to a company's *share capital account from another of the company's accounts, if the company was an Australian resident immediately before the time of the transfer. [subsection (2) is not relevant for present purposes]

The purpose of Division 197 is to prevent profit being distributed as share capital. This is consistent with the purpose of the share capital tainting rules explained in paragraph 4.4 of the Explanatory Memorandum to the Taxation Laws Amendment (2006 Measures No 3) Bill 2006 (the EM) which states:

… The share capital tainting rules are integrity rules designed to prevent a company from disguising a distribution of profits as a tax-preferred capital distribution by transferring profits into its share capital account and subsequently making distributions from that account.

The purpose of Division 197 is therefore to prevent the transfer of profit to share capital, and subsequently prevent the tax preferred distribution of capital out of what is actually profit.

In the present case, the amounts in the Share-based Payments Reserve are amounts that were originally debited to the profit and loss account and represented the fair value of option that the employees had under the Option Plan to acquire shares and the "option" the employees had under the SAP in respect of the Share Plan Loan. They are amounts that do not represent the consideration for the issue of shares, but are amounts of profit that are credited to the Applicant's Share Capital Account.

Therefore, to the extent that amounts were credited to the Applicant's Share Capital Account from 30 June 2006, at the time of the credit there is a 'transfer' of that amount to the Applicant's Share Capital Account within the meaning of subsection 197-5(1) of the ITAA 1997.

Question 3(a)

Summary

Amounts credited under the Option Plan to the Applicant's Share-based Payments Reserve are 'option premiums' that are excluded from the operation of the share capital account tainting rules pursuant to section 197-25 of the ITAA 1997.

Detailed reasoning

Section 197-25 of the ITAA 1997 provides that Division 197 does not apply to the transferred amounts if:

(a) it is transferred from an option premium reserve of the company; and

(b) the transfer is because of the exercise of options to acquire shares in the company; and

(c) premiums in respect of those options were credited to the option premium reserve.

Additionally, ATO Interpretative Decision ATOID 2009/87 provides that:

The legislation does not explain or define what option premiums are.

In ascertaining what amounts are included in 'premiums in respect of those options', paragraph 4.19 of the Explanatory Memorandum (EM) accompanying the Taxation Laws Amendment (2006 Measures No. 3) Bill 2006 highlights the intended meaning of option premiums by providing that:

A company's share capital account does not become tainted if an amount is transferred from an option premium reserve to its share capital where the amount transferred represents option premiums that were received by the company in consideration for the issue of the options that have been exercised.

A share-based payments reserve may be viewed as an option premium reserve account by another name. The Share-based Payments Reserve of the Applicant is used only to record the fair value of the option on grant of the options under the Option Pan (and the value of the "option" embedded in the Share Plan Loan at grant under the SAP). Consequently, the Applicant's Share-based Payments Reserve constitutes an option premium reserve for the purposes of paragraph 197-25(a) of the ITAA 1997.

The transfer from this 'option premium reserve' to the Applicant's Share Capital Account happens when participants exercise their option under the Option Plan to acquire shares in the Applicant (paragraph 197-25(b) of the ITAA 1997). Additionally, the services provided by the employees to the Applicant represent premiums in respect of those options, for the purposes of paragraph 197-25(c) of the ITAA 1997, as the fair value of the option recognised at grant time represents consideration provided by employees for the contractual right to acquire shares in the Applicant.

As such, the transferred amounts under the Option Plan are, by virtue of section 197-25 of the ITAA 1997, excluded from the operation of Division 197 of the ITAA 1997.

Question 3(b)

Summary

Amounts credited under the SAP to the Applicant's Share-based Payments Reserve are not 'option premiums' that are excluded from the operation of the share capital account tainting rules pursuant to section 197-25 of the ITAA 1997.

Detailed reasoning

Based on the explanation in respect of section 197-25 of the ITAA 1997 as outlined above at Question 3(a), paragraphs 197-25(a) and 197-25(c) of the ITAA 1997 are satisfied in respect of the SAP, however paragraph 197-25(b) of the ITAA 1997 is not.

As stated above, paragraph 197-25(b) of the ITAA 1997 requires that the transfer is because of the exercise of options to acquire shares in the company.

In respect of the "option" embedded in the Share Plan Loan, the transfer to the Applicant's Share Capital Account following repayment of the Share Plan Loan is not a consequence of the exercise of an option to acquire shares in the Applicant, as the shares have already been acquired by a Participant prior to any option being exercised. Rather, it is a consequence of the exercise of an option to repay the loan and deal with the shares free of any encumbrances. Under the Plan Rules, the shares are already legally and beneficially owned by the participants prior to the embedded "option" being exercised and therefore an exercise of the "option" would only result in the Applicant removing the Holding Lock and lien on and over the shares.

The fact that the arrangement is accounted for as an option to acquire shares does not affect the legal form of the arrangement. The Participant pays full value for the share, using the Share Plan Loan. Therefore (as stated above) the additional amount of services recognised by the Applicant's entries in its Share-based Payments Reserve does not constitute payment for the shares, but rather, payment for the limited recourse facility of the loan.

While the Applicant's accounting treatment of the Share Plan Loan is equivalent to the accounting treatment of an option to acquire shares, paragraph 197-25(b) of the ITAA 1997 requires that the transfer is because of the actual exercise of an option to acquire shares in a company, and not merely as a result of accounting for an arrangement (with a different legal form) as an option.

As such, section 197-25 of the ITAA 1997 does not apply to exclude the amounts credited to the Applicant's share capital account after 30 June 2006 in respect of the SAP after 30 June 2006 from the operation of Division 197 of the ITAA 1997.

Question 4

Summary

No transfers associated with these transactions, could at all times, be identified as 'share capital' pursuant to section 197-10 of the ITAA 1997.

Detailed reasoning

Section 197-10 of the ITAA 1997 provides that Division 197 does not apply "to the transferred amount if it could, at all times before the transfer, be identified in the books of the company as an amount of share capital." This means that the amount that is transferred to the share capital account needs to be identified.

Whether the transferred amount was identifiable in the books of the account as share capital is to be assessed at the time the transfer occurs, rather than the time at which shares were issued.

In respect of both the Option Plan and the SAP, before the relevant amounts were transferred, they were in the Share-Based Payments Reserve of the Applicant. As explained in answering Question 1 above, the amounts in the Applicant's Share-based Payments Reserve do not constitute 'share capital'. Consequently, the transferred amounts could not at all times be identified as 'share capital'. As such, the exclusion in section 197-10 of the ITAA 1997 does not apply.