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Ruling

Subject: Share capital tainting

Question 1

In relation to the 'non-exercised options', do the journal entries recording the granting of the share options to employees by Company A or subsequent lapsing of these options result in the share capital account of Company A being tainted pursuant to section 197-50 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

In relation to the 'exercised options', do the journal entries recording the granting of the share options to employees by Company A and the subsequent issue of shares by Company A as a result of the exercise of these options result in the share capital account of Company A being tainted pursuant to section 197-50 of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2008

The scheme commences on:

1 July 2003

Relevant facts and circumstances

Company A is an Australian tax resident company and was the head company of a tax consolidated group. Company B was also a member of the tax consolidated group.

In the relevant income years, the employees of Company B provided services to other members of the Company A tax consolidated group.

The franking account of the Company A tax consolidated group as at a X had a balance of nil, and Company A had never paid any dividends to its shareholders.

Company B performed all the banking on behalf of Company A, which resulted in the existence of a current account at call loan between Company A and Company B.

The shareholder register of Company A on X included individual shareholders.

Employee share scheme

Company A provided employees within the Company A Group the opportunity to participate in an employee share scheme, the Employee Equity Plan (EEP). Under the scheme, employees of Company B received options to acquire shares in Company A as part of their remuneration for the services they provided to Company B.

Under the EEP there were both options that vested in employees but were not exercised (non-exercised options) and options that vested in employees and were exercised (exercised options).

Non-exercised options consisted of options where employees were required to pay amounts on exercise (EEP options). These options were not exercised and were allowed to lapse.

Exercised options were exercised to acquire shares in Company A and included:

· options with no exercise price (Zero Exercise Price Options, or ZEP options), and

· options where employees were required to pay amounts on exercise (Long Term Incentive Options, or LTI options).

Option terms

LTI options

LTI options required the holder of the option to pay an exercise price on exercise of the options. Broadly, vesting conditions for LTI options were based on performance of Company A relative to the target EBITDA in the half-yearly budget as well as approval by the Board for the relevant 6 month period.

The LTI options vested early due to a change of control clause included within the LTI Option terms and conditions and were exercised in X.

ZEP options

ZEP options did not require the payment of an exercise price, thus if an option holder became entitled to shares when the qualification condition was fulfilled, the holder paid nothing for the shares issued on exercise of the options.

The ZEP options vested early, due to a clause included within the terms and conditions, and were exercised in X.

Transactions

Under the EEP, Company B procured Company A to grant certain employees of Company B options to acquire shares in Company A. Company B agreed to pay Company A an amount equal to the value of the option granted.

Non-exercised options

The following journal entries were made by Company A and Company B on each of the dates that non-exercised options were granted to the employees:

Company B

Dr Option expense (P/L)

Cr Intercompany loan (liability)

Company A

Dr Intercompany loan (asset)

Cr Option reserve (equity)

These options were allowed to expire. As a result, the following journals were posted to reverse the expense in June 2009:

Company B

Dr Intercompany loan (liability)

Cr Retained earnings (P/L)

Company A

Dr Option reserve (equity)

Cr Intercompany loan (asset)

There were no entries against the share capital account of Company A in relation to these EEP options.

Exercised options

The following journal entries were made by Company A and Company B when the ZEP and LTI options were granted to the employees of Company B:

Company B

Dr Option expense (P/L)

Cr Intercompany loan (liability)

Company A

Dr Intercompany loan (asset)

Cr Option reserve (equity)

These options were subsequently exercised by employees in X. On exercise of the LTI options, an amount was paid to Company B by the employees for the exercise of those options. Company B recorded this cash receipt as a loan owing to Company A. This amount was then recorded by Company A as an addition to the issued capital of Company A.

Company B and Company A posted the following journals on exercise of the options which occurred on in X:

To account for amounts received from employees on exercise of LTI options:

Company B

Dr Cash

Cr Intercompany loan (liability)

Company A

Dr Intercompany loan (asset)

Cr Share capital (equity)

To account for the exercise of ZEP options and LTI options:

Company A

Dr Option reserve (equity)

Cr Share capital (equity)

The share capital account represents an account that the company keeps of its share capital and the applicant has advised that it was not already a tainted share capital account as defined in section 197-50 of the ITAA 1997 at the time of the above journal entries.

Relevant legislative provisions

Income Tax Assessment Act 1997 197-5

Income Tax Assessment Act 1997 197-25

Income Tax Assessment Act 1997 197-45

Income Tax Assessment Act 1997 197-50

Income Tax Assessment Act 1997 197-55

Income Tax Assessment Act 1997 197-60

Income Tax Assessment Act 1997 975-300

Income Tax Assessment Act 1997 995-1

Reasons for decision

Question 1

Share Capital Accounts

Section 995-1 of the ITAA 1997 defines a company's 'share capital account' to have the meaning given in section 975-300 of the ITAA 1997 which defines it 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': subsection 975-300(1) of the ITAA 1997. If there is more than one account covered by that provision, the accounts are taken to be a single account (subsection 975-300(2) of the ITAA 1997).

'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.

His Honour also considered the meaning of the term 'issued share capital', at 166 to mean where:

…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 [2009] FCAFC 62 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.

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.

Tainted Share Capital Accounts

Section 197-5 of the ITAA 1997 provides that:

(1) 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.

(2) The other provisions of the Subdivision may stop this Division from applying to some or all of the transferred amount. If those other provisions stop this Division from applying to only some of the transferred amount, this Division (other than this Subdivision) applies to the balance of the transferred amount as if only that balance of the amount had been transferred to the company's *share capital account.

The purpose of Division 197 of the ITAA 1997 is to prevent profit being distributed as share capital as explained in paragraph 4.4 of the Explanatory Memorandum to the Taxation Laws Amendment (2006 Measures No 3) Bill 2006 (the EM):

…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 of the ITAA 1997 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.

It is stated in the private ruling application that Company A made the following accounting journal entry at the points in time the options were granted to the employees of Company B for the value of the options granted:

Dr Intercompany loan (asset)

Cr Option reserve (equity)

As the options were subsequently allowed to expire, the following entries were made to reverse the expense:

Dr Option reserve (equity)

Cr Intercompany loan (asset)

In this instance, the amounts were credited to an option reserve account (which is not considered to meet the requirements of section 975-300(1) of the ITAA 1997 and as such is not a share capital account) and subsequently reversed out. There were no amounts credited to a share capital account of Company A, and therefore no amounts were transferred to a share capital account for the purposes of section 197-5 of the ITAA 1997.

As there was no transfer to a share capital account, the journal entries recording the granting of the share options and subsequent lapsing of those options do not result in the share capital account of Company A being tainted in the context of Division 197 of the ITAA 1997.

Question 2

As detailed above in the reasoning for the answer to Question 1, as there was no transfer to a share capital account when the 'exercised options' were granted, the journal entries recording the granting of these share options do not result in the share capital account of Company A being tainted.

Division 197 of the ITAA 1997 treatment of exercise price

The exercised options include both LTI options, and ZEP options. In exercising the LTI options, employees paid an amount to Company B whereas ZEP options did not require an amount to be paid to exercise the options.

The employees of Company B paid the amount in X upon exercise of LTI options. At this time, Company B debited its cash account and credited its Intercompany loan account, while Company A debited its Intercompany loan account and credited its share capital account.

This amount represents consideration, or part of the consideration from employees of Company B for the issue of shares in Company A. The amount was paid by the employees to Company B, which recorded the amount as a loan owing to Company A. The amount is owing to Company A as consideration for the issue of shares, and therefore is share capital of Company A. The amount is identifiable as share capital of Company A from when the liability is incurred by Company B until it is credited to Company A's share capital account. Section 197-10 of the ITAA 1997 provides that Division 197 of the ITAA 1997 does not apply to an amount that could, at all times, be identified as share capital. Therefore Division 197 of the ITAA 1997 does not apply to the amount.

Division 197 of the ITAA 1997 treatment of option premium

As the options were exercised by employees of Company B for shares in Company A, both Company B and Company A recorded journal entries to reflect the transactions. The following journal entries were made by Company B and Company A when the options were originally granted:

Company B

Dr Option expense (P/L)

Cr Intercompany loan (liability)

Company A

Dr Intercompany loan (asset)

Cr Option reserve (equity)

These options were subsequently exercised by employees in X and the following journal entries recorded by Company A representing the amount of the value of ZEP options and LTI Options:

Dr Option reserve (equity)

Cr Share capital (equity)

At the time of the credit to the Company A share capital account and debit to the option reserve account, there is a transfer of an amount to the share capital account within the meaning of subsection 197-5(1) of the ITAA 1997. As such, Division 197 of the ITAA 1997 would apply to the transferred amount such that the share capital account becomes tainted, unless an exception applies.

'Option premium reserve' exception

Section 197-25 of the ITAA 1997 provides that Division 197 of the ITAA 1997 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.

While the legislation does not explain or define what an option premium is, 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 and states 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.

The context of the term as used in the EM is considered by ATO ID 2009/87 to be consistent with the dictionary definition of 'option'; 'premium' and 'option premium' which encompasses '…the dollar amount paid to the seller for an option' (Oxford Dictionary of Australian Investment Terms, 6th ed, Oxford University Press, Melbourne 2003).

Further, ATO ID 2009/87 provides that option premiums are amounts provided by employees as consideration for the contractual right to acquire shares and the amounts of option premiums provided should equal the value of the services provided by employees.

The option reserve account held by Company A may be viewed as an option premium reserve account. The 'option premiums' are amounts provided as consideration for the contractual right (ie the options) to acquire shares in the company. In the current circumstances, the amount of 'option premium' provided should be equal to the value of the services provided by the employees.

In this case, the services provided by the employees were provided to Company B and the value of those services, which were paid for by way of the issue of options, was transferred (but not actually paid) to Company A.

The applicant has contended that the payment by way of intercompany loans from Company B to Company A is an 'option premium'. The loan to Company B by Company A was to credit Company A (in the form of the asset of the unpaid liability of Company B) with the value of the services provided by the Company B employees in return for the options issued under the EEP.

The value of the services provided by the employees represents consideration for the options, and although the amount was transferred to Company A by way of an intercompany loan from Company B, the amount credited to the option reserve of Company A was an 'option premium' received in consideration for the issue of the options.

Section 197-25 of the ITAA 1997 does not require that the option be provided to the same person that pays the premium, and therefore the fact that Company B provided the consideration and the options were provided to its employees does not affect the conclusion that the consideration represents an option premium.

The private ruling application states that the option reserve of Company A is used to record the value of the options granted under the EEP and the transfer from the option reserve to the share capital account occurs when the employees exercise their option to acquire shares in the company (paragraph 197-25(b) of the ITAA 1997).

Further, the loan from Company B to Company A (for the value of services provided by the employees to Company B) represents premiums in respect of those options, for the purposes of paragraph 197-25(a) and paragraph 197-25(c) of the ITAA 1997.

The option reserve account of Company A would therefore satisfy paragraphs (a), (b) and (c) of section 197-25 of the ITAA 1997, and its option reserve account would constitute an option premium reserve for the purposes of paragraph 197-25 of the ITAA 1997.

Therefore the amounts transferred to the Company A share capital account under the EEP during the relevant income year are, by virtue of section 197-25 of the ITAA 1997, excluded from the operation of Division 197 of the ITAA 1997.

Accordingly, in relation to the 'exercised options', the journal entries recording the granting of share options to employees by Company A and the subsequent issue of shares by Company A as a result of the exercise of these options does not result in the share capital account of Company A being tainted pursuant to section 197-50 of the ITAA 1997.