Edited version of private ruling

Authorisation Number: 1011818405601

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Ruling

Subject: Share capital tainting

Question 1

As at the date specified in the ruling request, does the taxpayer have a tainted share capital account by virtue of the accounting treatment adopted for equity based remuneration under certain employee share schemes in accordance with Australian Accounting Standard AASB2 Share-based Payment (AASB2) resulting in a transfer of an amount to which Division 197 of the Income Tax Assessment Act 1997 (ITAA 1997) applies to its share capital account?

Answer

No.

This ruling applies for the following period:

n Income tax year ended 30 June 2006

n Income tax year ended 30 June 2007

n Income tax year ended 30 June 2008

n Income tax year ended 30 June 2009

n Income tax year ended 30 June 2010

n Income tax year ended 30 June 2011

The scheme commences on:

1 July 2005

Relevant facts and circumstances

The taxpayer is a public company incorporated in Australia and listed on the Australian Stock Exchange.

The taxpayer seeks to confirm that the accounting treatment adopted for the grant and vesting (or lapse/forfeiture) of shares and rights/options to acquire shares under certain of its employee share schemes has not resulted in the tainting of the taxpayer's share capital account under Division 197 of the ITAA 1997.

The numbers shown in the accounting entries below are illustrative only.

Employee Share Schemes

The taxpayer operates or has operated 6 separate employee share schemes (collectively referred to as the ESS) as detailed below.

The following employee equity participation plans were previously offered:

Equity Participation Plan A

The Equity Participation Plan A (EPPA) allowed participants to acquire shares in the taxpayer through salary sacrifice. Participants had to acquire a minimum of $1000 in shares and no more than 50% of remuneration could be acquired under the EPPA each year. Shares were acquired in quarterly instalments and allocated based on the average share price at the time of allocation.

Equity Participation Plan B

The Equity Participation Plan B (EPPB) allowed participants to receive an interest free loan to acquire shares in the taxpayer. The loans matured five years after commencement or upon cessation of employment and were repaid by way of instalments through salary deductions or on cessation of employment. All loans held had matured well prior to the ruling application date.

The following incentive equity plans were previously offered:

Incentive Equity Plan A

The Incentive Equity Plan A (IEPA) allowed participants to obtain a loan from a share plan administration company to purchase shares in the taxpayer. The dividends received from the shares acquired were applied towards paying interest on the outstanding loan balance, a cash payment to cover the personal income tax liability associated with the dividend and loan principal repayments. The loans had to be repaid on the cessation of employment.

Medium Term Incentive Equity Plan B

The Medium Term Incentive Equity Plan (MTIEPB) allowed participants who achieved sustained performance over a two year period to receive restricted shares which were subject to a two year service condition during which time the shares could not be traded. The recipient retained full entitlement to both dividends and voting rights. Any shares provided to employees under the MTIEPB were acquired by the taxpayer in the name of the employee in an on-market transaction.

The following incentive equity plans are currently offered:

Short Term Incentive Equity Plan C

The Short Term Incentive Equity Plan C (STIEPC) allows participants who achieve group, divisional and individual performance goals over a relevant 12 month period to be rewarded in cash or other benefits. Senior managers are required to take a specified percentage of their STIEPC as restricted shares.

Shares awarded as part of the STIEPC are awarded under the Deferred Plan (DP) which has been used to:

· Allow employees to acquire shares through voluntary sacrifice of any STIEPC award (this ceased to be offered in a recent year) (voluntarily acquired); and

· Require senior employees to take a specified percentage of their STIEPC award as restricted shares which are subject to forfeiture if the participant terminates their employment within a specified period.(mandatorily acquired). The shares may not be traded while restricted, but holders have voting and dividend rights.

The taxpayer has made it a policy after 25 May 2006 (the date of application for the tainting rules under Division 197 of the ITAA 1997 being 26 May 2006) that all shares under the STIEPC are purchased on-market in the name of the relevant employee. However, some time after 26 May 2006 a number of shares were mistakenly issued rather than purchased on-market in relation to the STIEPC. This included a number (A) of shares which were voluntarily acquired by employees on a sacrifice of their STIEPC award and a number (B) of shares which were mandatorily acquired by senior employees as a specified percentage of their STIEPC award.

Long Term Incentive Equity Plan D

The Long Term Incentive Equity Plan D (LTIEPD) allows participants who contribute to long-term shareholder value creation with the opportunity to acquire shares, subject to meeting market based performance hurdles and service conditions. Any shares provided to employees under the LTIEPD after 25 May 2006 are acquired by the taxpayer in the name of the employee in an on-market transaction.

Equity accounts operated as part of the ESS and AASB2

The taxpayer operates 4 equity accounts in relation to the ESS for the purposes of reporting that is consistent with the Australian Accounting Standard AASB2 Share-based Payment (AASB2).

Equity Account A

The Equity Account A account (EAA) is a debit equity account created on shortly before 26 May 2006. It records share awards made under the STIEPC and under the MTIEPB. The account has a debit running balance which records the cost of shares purchased on-market and granted to employees of the taxpayer. The amounts debited to the account reflect the cost of purchasing shares on-market and are subsequently expensed through the profit and loss account. The account should always have a debit or nil balance.

The first amount credited to the account was the expensing to profit and loss of amounts previously debited to the account on the purchase of shares:

Equity Account B

The Equity Account B account (EAB) a credit equity account created in contemplation of and prior to the taxpayer's July 2005 transition to AIFRS. The account deals with the arrangements where share rights and/or share options are granted to employees subject to both taxpayer performance-based and employee service-based forfeiture conditions. The balance of the account increases whilst rights and options remain on foot to reflect the amounts expensed through the profit and loss in accordance with AASB2. The relevant balance of the account is swept, on the rights or options vesting or lapsing, to the Equity Account C account.

The EAB may also increase with the corresponding debit entry being made to the redundancy provision account where the redundancy provision has been created in relation to executives holding LTIEPD awards.

The first amount credited to the account was required on the taxpayer's transition to the Australian International Financial Reporting Standards (AIFRS) to recognise the amortisation of the estimated value of shares potentially to be provided in the future to employees granted share rights and options prior to the taxpayer's July 2005 transition to AIFRS.

Equity Account C

The Equity Account C account (EAC) records amounts related to the lapse of rights or options which are swept to it from the EAB. The account was created when the taxpayer adopted AASB2 and it became active with the first transaction shortly before 25 May 2006.

The EAC also records amounts related to the vesting of rights or options which are swept to it from the EAB. On the rights or options being exercised the taxpayer purchases shares on-market which then reduces the balance of the account.

The EAC also records consideration received from employees upon the exercise of vested options granted pursuant to an ESS arrangement. The balance of the account is reduced around the same time when shares are purchased on-market to provide to the relevant employee.

The first amount credited to the account arose shortly before 25 May 2006.

The journal entry was a reallocation to correct the following journal incorrectly posted, on the vesting of rights and options, to the Issued Capital account shortly before 25 May 2006.

The correct journal entry should have been:

Equity Account D

The Equity Account D account (EAD) is a debit equity account which records loan amounts related to the former IEPA. The IEPA involved executives being granted a loan from a share plan administration company.

The taxpayer contends that the EAD was in existence prior to 25 May 2006. The taxpayer considers that the account was likely created around the time they adopted AASB2, being July 2005. The credit entries to the account after 25 May 2006 involved a corresponding debit entry to an asset account such as cash, resulting in a reduction in the debit balance of the account. These entries related to the repayment of some or all of the loan either by dividends or proceeds on the sale of shares by participants in IEPA.

The taxpayer considers that although they cannot confirm the first credit entry to the account without accessing an old accounting system it is likely it was of a similar nature to entries which have occurred after 25 May 2006.

While the EAD should always have been run through the share plan administration company, some of the EAD entries were incorrectly recorded within the accounts of the taxpayer rather than the accounts of the share plan administration company. The outstanding balance of any entries to the account posted through the taxpayer was subsequently transferred to the share plan administration company.

Liability accounts operated as part of the ESS and AASB2

The taxpayer operates 1 liability account in relation to the ESS for the purposes of reporting that is consistent with AASB2.

Liability Account A

The Liability Account A account (LAA) is a liability account that records potential STIEPC awards that accrue during a performance year and which are satisfied by the purchase of shares voluntarily acquired by an employee as part of their STIEPC. In accordance with AASB2 the value of the shares relates to the performance of the employee during the year preceding acquisition of the shares and does not therefore need to be amortised as a remuneration expense over future periods.

The accounting entry used to record a potential STIEPC award accrued during a performance year (e.g. 1 July 2005 to 30 June 2006) is:

The accounting entry used to record a provision of that part of the STIEPC award satisfied by the purchase of shares in the taxpayer in an on-market transaction is:

The accounting entry used and which recorded the incorrect issue of shares sometime after 25 May 2006 was:

Reasons for decision

The first thing to consider is whether or not any of the equity accounts involved in recording the accounting treatment adopted for the ESS answer the description of being share capital accounts for the purposes of section 975-300 of the ITAA 1997.

If none of the accounts involved in recording the accounting treatment adopted for the ESS are share capital accounts then there can be no possibility of transfers between them tainting the share capital account for the purposes of Division 197 of the ITAA 1997.

Definition of share capital account

The definition of a share capital account is contained within the ITAA 1997:

975-300(1)

A company's share capital account is:

(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.

975-300(2)

If a company has more than one account covered by subsection (1), the accounts are taken, for the purposes of this Act, to be a single account.

A share capital account is therefore an account which the company keeps of its share capital or an account created after 1 July 1998 where the first amount credited to the account was an amount of share capital.

No definition of share capital is provided within the ITAA 1997. The Explanatory Memorandum which accompanied the introduction of the Tax Laws Amendment (2006 Measures No. 3) Bill 2006 provides at page 23 that the ordinary meaning of share capital '…includes amounts received by a company in consideration for the issue of shares.'

In a general sense share capital is recognised as being the total amount contributed or promised to be contributed to a corporation by members in money or money's worth.

The prior definition of a share capital account was identical in form but was contained within the now repealed sub-section 6D(1) of the Income Tax Assessment Act 1936 (ITAA 1936). That definition was introduced in the Taxation Laws Amendment Act (No. 7) 1999 and repealed by the Tax Laws Amendment (2006 Measures No. 3) Act 2006.

Equity Account A

The EAA was established shortly before 26 May 2006. The account is a debit equity account and has a debit running balance which records the cost of shares purchased on-market and granted to employees of the taxpayer. The amounts debited to the account are eventually expensed through the profit and loss account.

Is the EAA a share capital account because it is kept by the company as an account of share capital?

The taxpayer does not consider the EAA to be an account it keeps of share capital. The taxpayer considers that the account records the cost of shares purchased on-market and granted to employees.

The EAA is not a share capital account for the purposes of paragraph 975-300(1)(a) of the ITAA 1997.

Is the EAA a share capital account because it was created after 1 July 1998 and the first amount credited was an amount of share capital?

The EAA was created shortly before 26 May 2006 and therefore satisfies the requirement that it be created after 1 July 1998 for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

The first amount credited to the account was the expensing to profit and loss of amounts previously debited to the account on the purchase of shares:

The first amount credited to the account was not an amount of share capital but represented the expensing of an amount previously debited for the purchase of shares in an on-market transaction in the name of eligible employees.

The EAA is therefore also not a share capital account for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

Accordingly, the EAA is not a share capital account as it does not satisfy the definition of a share capital account in sub-section 975-300(1) of the ITAA 1997.

Equity Account B

The EAB was created in contemplation of and prior to the taxpayer's July 2005 transition to AIFRS. The account is a credit equity account which records the fair value of rights/options potentially owed to employees as representing consideration for services provided by employees to acquire the rights/options. The account accordingly reflects the amounts expensed over time through the profit and loss in accordance with AASB2.

Is the EAB a share capital account because it is kept by the company as an account of share capital?

The taxpayer does not consider the EAB to be an account that it keeps of share capital but rather an account which reflects the amounts to be expensed through the profit and loss in accordance with AASB2. The Commissioner agrees with this view.

The EAB is not a share capital account for the purposes of paragraph 975-300(1)(a) of the ITAA 1997.

Is the EAB a share capital account because it was created after 1 July 1998 and the first amount credited was an amount of share capital?

The EAB was created in contemplation of and prior to the taxpayer's July 2005 transition to AIFRS and satisfies the requirement that it be created after 1 July 1998 for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

The first amount credited to the account was required on the taxpayer's transition to the AIFRS to recognise the amortisation of the estimated value of shares potentially to be provided in the future to employees granted share rights prior to the taxpayer's July 2005 transition to AIFRS .

The first amount credited to the account, as a representation of the amortisation of the estimated value of shares potentially to be provided in the future to employees, was too remote to the issue of shares and cannot be considered an amount of share capital.

The EAB is therefore also not a share capital account for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

Accordingly, the EAB is not a share capital account as it does not satisfy the definition of a share capital account in sub-section 975-300(1) of the ITAA 1997

Equity Account D

The EAD was established at an undetermined point in time and is a debit equity account which records amounts related to the granting of loans to executives through a share plan administration company.

Is the EAD a share capital account because it is kept by the company as an account of share capital?

The taxpayer does not consider the EAD to be an account that it keeps of share capital but rather an account which records loan arrangements where loans have been granted to executives for the acquisition of shares.

The amounts recording loans which have been granted to executives for the acquisition of shares are not share capital of the company.

The EAD is not a share capital account for the purposes of paragraph 975-300(1)(a) of the ITAA 1997.

Is the EAD a share capital account because it was created after 1 July 1998 and the first amount credited was an amount of share capital?

The taxpayer contends that the EAD was in existence well before 25 May 2006. The taxpayer considers that the account was likely created around the time they adopted AASB2, being July 2005. If that is correct then the account satisfies the requirement that it be created after 1 July 1998 for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

The taxpayer submits that credit entries to the account after 25 May 2006 have always involved a corresponding debit entry to an asset account, such as cash. The entries made related to the repayment of the loans by participants in the relevant ESS.

The taxpayer considers that although they cannot confirm the first credit entry to the account without accessing an old accounting system it is likely it was of a similar nature to entries which have occurred after 25 May 2006.

The conclusion of the taxpayer seems reasonable given the purpose served by the account and the broader explanation provided in relation to the IEPA.

It is doubtful that the first credit entry was an amount of share capital given the explanation provided and the accounting entries which can be identified as having been made in relation to the EAD after 25 May 2006.

The Commissioner is satisfied that the EAD is therefore also not a share capital account for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

Accordingly, the EAD is not a share capital account as it does not satisfy the definition of a share capital account in sub-section 975-300(1) of the ITAA 1997

Equity Account C

The EAC records three different types of transactions. The first is that it records amounts which are swept to it from the EAB upon the vesting of rights or options issued under the LTIEPD. The second is that it records amounts which are swept to it from the EAB upon the lapse of rights or options issued under the LTIEPD. The third is that it records consideration received from employees upon the exercise of vested options to acquire shares on-market in the taxpayer.

Is the EAC a share capital account because it is kept by the company as an account of share capital?

The taxpayer does not consider the EAC to be an account of share capital.

The transactions described above are in accordance with the AASB2. The transactions do not reflect treatment of the account as an account of share capital.

The EAC is not a share capital account for the purposes of paragraph 975-300(1)(a) of the ITAA 1997.

Is the EAC a share capital account because it was created after 1 July 1998 and the first amount credited was an amount of share capital?

The EAC was likely created around the time the taxpayer adopted AASB 2, being July 2005. The EAC became active when the first transaction occurred shortly before 25 May 2006. The EAC satisfies the requirement that it be created after 1 July 1998 for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

The first amount credited to the account arose shortly before 25 May 2006.

The Issued Capital account is an account of share capital which records consideration provided for the issue of shares. The Issued Capital account therefore satisfies the definition of a share capital account in sub-section 975-300(1) of the ITAA 1997.

As the Issued Capital account is an account of share capital a concern exists that the transfer of A$300 from it to the EAC could have involved the transfer of an amount of share capital. If an amount of share capital was the first amount credited to the EAC then it may be a share capital account as it would then satisfy paragraph 975-300(1)(b) of the ITAA 1997. It is therefore necessary to identify whether the transfer of A$300 was a transfer of an amount of share capital.

The taxpayer correctly identified that the Explanatory Memorandum which accompanied the Taxation Laws Amendment (2006 Measures No. 3) Bill 2006 provides at 4.12 that an amount is transferred when it is moved from one account to another with the effect that the balance of the first account is reduced whilst the balance of the second account is increased by the same amount.

The transfer of A$300 between the Issued Capital account and EAC involved a transfer of the type anticipated by Division 197 of the ITAA 1997. That is because the transfer effectively resulted in the decrease of one equity account and the increase of another equity account.

The transfer was to correct an incorrect accounting entry made shortly before 25 May 2006:

The taxpayer submits that the cumulative effect of the accounting entries reflects what the correct transfer and accounting entry should have been:

Treatment of the A$300 amount first credited to the EAC

The taxpayer submits that the amount of A$300 did not become share capital as a result of inadvertently passing through the Issued Capital account.

A share capital amount should be identifiable within the books of a company and should be relatable to an increase, reduction or alteration of rights in the shares in a corporation. The taxpayer submits that the amount of A$300 when in the EAB reflected nothing more than the amounts to be expensed through the profit and loss in relation to arrangements where share rights and/or share options are granted to employees in accordance with AASB2. As outlined above, an amount such as that is too remote from the actual issue of shares to be considered an amount of share capital. The amount of A$300 transferred between the EAB, Issued Capital account and EAC did not involve the transfer of an amount of share capital.

The EAC is therefore also not a share capital account for the purposes of paragraph 975-300(1)(b) of the ITAA 1997.

The EAC is not a share capital account as it does not satisfy the definition of a share capital account in sub-section 975-300(1) of the ITAA 1997.

As none of the equity accounts involved in recording the accounting treatment adopted for the ESS are share capital accounts there can be no possibility of transfers between them having tainted the share capital account for the purposes of Division 197 of the ITAA 1997.

Liability Account A

The LAA is a liability account that records potential STIEPC awards that accrue during a performance year and which are satisfied by the purchase of shares which have been voluntarily or mandatorily acquired by employees as part of their annual STIEPC. In accordance with AASB2 the value of the shares relates to the performance of the employee during the year preceding acquisition of the shares and does not need to be amortised as a remuneration expense over future periods.

The LAA does not satisfy paragraphs 975-300(1)(a) or 975-300(1)(b) of the ITAA 1997. The LAA is therefore not a share capital account as it does not satisfy the definition of a share capital account in sub-section 975-300(1) of the ITAA 1997.

As the LAA is not a share capital account there can be no possibility of any transfers between it and other accounts involved in recording the accounting treatment adopted for the ESS having tainted the share capital account for the purposes of Division 197 of the ITAA 1997.

Treatment of the transfer of an amount from the LAA liability account to the Share Capital account

Some time after 25 May 2006 a number of shares were mistakenly issued rather than purchased on market in relation to the STIEPC. This included a number of (A) shares which were voluntarily acquired by employees on a sacrifice of their STIEPC award and a number of (B) shares which were mandatorily acquired by senior employees as a specified percentage of their STIEPC award.

The incorrect issue of shares was recorded in company accounts as follows:

It is necessary to consider whether the transfer of this amount from the LAA to the Share Capital account could have caused the share capital account to become tainted for the purposes of Division 197 of the ITAA 1997.

Section 197-5 of the Income Tax (Transitional Provisions) Act 1997 (ITTPA 1997) provides that the share capital tainting provisions only apply to transfers that occur after the introduction day. Section 197-1 of the ITTPA 1997 defines the introduction day as being the day that the Bill for the Act which added the Division that contains the share capital tainting provisions was introduced into the Parliament. The share capital tainting provisions were introduced into Parliament in the Tax Laws Amendment (2006 Measures No 3) Bill 2006 on 25 May 2006.

A transfer occurred as the movement of the amount from one account to the other decreased the LAA and increased the Share Capital account by the same amount. As the transfer was made some time after 25 May 2006 it was a transfer that could therefore enliven Division 197 of the ITAA 1997.

The Explanatory Memorandum which accompanied the Taxation Laws Amendment (2006 Measures No. 3) Bill 2006 provides that the share capital tainting provisions were introduced as integrity rules directed toward preventing a company from transferring profits into its share capital account and subsequently making distributions from that account thereby effectively disguising a distribution of profits as a tax-preferred capital distribution. This is important, as it is necessary to interpret the share capital tainting provisions in the context of the overall object of the legislation and the mischief they were intended to overcome.

The amounts in the LAA represent the accrued value from previous periods of employees STIEPC awards. Those amounts can be taken in the form of cash or other benefits (including shares). It is not possible to identify which amounts will or will not be used to purchase shares. Amounts such as these would generally be too remote from the actual issue of shares to be considered share capital.

The transfer some time after 25 May 2006 of an amount from the LAA to the Share Capital account formed the consideration or part of the consideration received by the company from employees for the actual issue of the number of shares in the company. The amount formed part of the share capital of the company at that time and is not an amount to which it is considered Division 197 of the ITAA 1997 would apply.

As none of the equity accounts involved in recording the accounting treatment adopted for the ESS are share capital accounts then there can be no possibility of transfers between them tainting the share capital account for the purposes of Division 197 of the ITAA 1997. As there have been no transfers from any of these equity accounts to the Issued Capital account after 25 May 2006 there cannot be a tainting of the taxpayer's share capital by virtue of any such transfer. In addition, transfer of the amount from the LAA to the Share Capital account some time after 25 May 2006 is not considered to be, in the particular circumstances, a transfer that would attract the operation of Division 197 of the ITAA 1997.

Accordingly, as at the date specified in the ruling request, the taxpayer does not have a tainted share capital account by virtue of the accounting treatment adopted for equity based remuneration under certain employee share schemes in accordance with AASB2 as they have not resulted in a transfer to its share capital account of an amount to which Division 197 of the ITAA 1997 applies.