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Ruling

Subject: Share Capital Tainting

Question 1

Is the Share-based Payments Reserve part of the "share capital account" of XYZ Co 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 XYZ Co's share capital account, is there a "transfer" of an amount or amounts to XYZ Co's share capital account from another account within the meaning of subsection 197-5(1) of the ITAA 1997?

Answer

Yes

Question 3

Are amounts credited to the Share-based Payments Reserve "option premiums" that are excluded from the operation of the share capital tainting rules pursuant to section 197-25 of the ITAA 1997?

Answer

Yes

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

XYZ Co established an option plan for its executives and employees (Employee Share Option Plans).

In order to receive shares, participants must satisfy certain vesting and pre-determined criteria outlined in plan rules. The plan rules specify that options will also be subject to a service-based vesting condition. The options will vest in various tranches.

On the basis that the vesting criteria have been satisfied, following payment of the exercise price, participants will be entitled to shares in XYZ Co.

XYZ Co is required to recognise an expense for share-based payments, based on the fair value of the options granted. A debit is made to its Share-based Payments Expense (profit and loss account) and a corresponding credit is made to its Share-base Payments Reserve.

The amounts credited to the Share-based Payments Reserve records only the options under the Employee Share Option Plans and nothing else. The amounts credited to the Share-based Payments Reserve represent the fair value of the services rendered by the employee, which constitutes consideration for the issue of shares.

Options lapse when an employee ceases employment with XYZ Co and options that they hold have not vested as the service based vesting condition has not been satisfied. When this occurs the Share-based Payments Expense that has been recognised and the corresponding balance that has been recognised in the Share-based Payments Reserve is reversed.

During various income years, a certain amount was reclassified from XYZ Co's Share-based Payments Reserve to its Share Capital Account. The reclassification (i.e. balance reclassified from Share-based Payments Reserve to Share Capital Account) only happens upon the exercise of options.

This ruling applies for the following period<s>:

1 July 2006 to 30 June 2007

1 July 2007 to 30 June 2008

1 July 2008 to 30 June 2009

1 July 2009 to 30 June 2010

1 July 2010 to 30 June 2011

The scheme commences on:

The income year ended 30 June 2007

Reasons for Decision

Question 1

Is the Share-based Payments Reserve part of the "share capital account" of XYZ Co within the meaning of section 975-300 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

No.

The Share-based Payments Reserve does not form part of the "share capital account" of XYZ Co within the meaning of section 975-300 of the ITAA 1997.

Detailed reasoning

Section 975-300(1) of the ITAA 1997 defines a company's share capital account as "an account that the company keeps of its share capital " or "any other account [where]… the first amount credited to the account was an amount of share capital". If there is more than one account covered by that provision, the accounts are taken to be a single account (section 975-300(2)). It therefore follows that there can be no transfer for the purposes of Division 197 of the ITAA 1997 between accounts that are taken to be part of the one share capital account.

'Share Capital' is not defined in either of the Income Tax Assessments Acts for the purposes of Division 197 of the ITAA 1997. 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 (Archibald) 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 (emphasis added)

The above statement was referred to and approved by Gillard j in Re The Swan Brewery Co Ltd (1976) 3 ACLR 164 (Swan Brewery). His Honour said, at 166:

But when one talks about share capital, in my view, it means capital raised by the company from the issue of shares.

The meaning of the term 'issued share capital', was considered by Gillard J in Swan Brewery at ACLR 166:

…when one uses the words 'issued share capital', then it seems to me that this expression means money or money's worth derived from the issue by directors of shares in order to raise capital.

These statements were endorsed and applied by 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. As Perram J said at FCAFC paragraphs 90 to 93:

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.

The amounts credited to the Share-Based Payments reserve are not part of the 'share capital account' of XYZ Co as they are amounts that represent the fair value of the options of the Employee Share Option Schemes in anticipation of the future issue of shares.

Question 2

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

Summary

At the time of a credit to XYZ Co's share capital account, there is a "transfer" of amounts to XYZ Co'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 Share-based Payments Expense (profit and loss account) and represented the fair value of options granted to employees to acquire shares under the Employee Share Option Plans. They are amounts that do not represent the consideration for the issue of shares, but are amounts of profit that are credited to the XYZ Co's Share Capital Account.

Therefore, at the time of a credit to the XYZ Co's share capital account, there is a "transfer" of an amount to its share capital account within the meaning of subsection 197-5(1) of the ITAA 1997.

Question 3

Are amounts credited to the Share-based Payments Reserve "option premiums" that are excluded from the operation of the share capital tainting rules pursuant to section 197-25 of the ITAA 1997?

Summary

The amounts credited to the Share-based Payments Reserve are "option premiums" that are excluded from the operation of the share capital 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 ID 2009/87 states 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.

Employee Share Option Plans

The Share-based Payments Reserve of XYZ Co may be viewed as an option premium reserve account by another name. Option premiums are amounts provided by employees as consideration for the contractual right to acquire shares in the company. The amounts of option premiums provided should also equal to the value of the services provided by the employee.

Therefore the amounts credited to the Share-based Payments Reserve are "option premiums" that are excluded from the operation of the share capital tainting rules pursuant to section 197-25 of the ITAA 1997.

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?

Summary

Any transfers associated with these transactions, could not 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 of the ITAA 1997 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." The amount that is transferred to the share capital account therefore needs to first 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.

As explained in answering Question 1 above, the amount in the Share-based Payments Reserve does not constitute 'share capital'. Consequently, the transferred amounts from XYZ Co's Share-based Payments Reserve to its Share Capital Account 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.