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Subject: Injection of Capital

Question

Is the equity capital received by Headco from its shareholders in the specified period considered an injection of capital for the purpose of paragraph 707-325(4)(a) of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following period(s):

1 July 2012 to 30 June 2016

The scheme commences on:

1 July 2011

Relevant facts and circumstances

Headco was incorporated in Australia with nominal share capital. Subsequent to its incorporation, Headco issued shares to establish its particular ownership structure and became the head company of an income tax consolidated group (the consolidated group). The consolidated group was established as a vehicle for the acquisition of Company D (the Acquisition).

The consolidated group did not commence trading activities prior to the Acquisition. Its activities were limited to:

The raising of equity capital by issuing shares to its shareholder companies;

Making the offer to acquire, and acquiring, shares in Company D

Appointing advisers in respect to the Acquisition and paying adviser fees;

Shortly before the formation of the consolidated group, Headco, its shareholders and certain other relevant parties entered into an agreement (the Agreement) which set out the obligation of the shareholders to subscribe for shares in Headco to allow the Acquisition to be funded.

The purpose of the Headco shares issues was to establish the capital structure of the consolidated group so that the group had the funds required to acquire shares in Company D and pay related acquisition costs. The amount of equity subscribed for was equal to the cost of the Acquisition. Headco periodically issued shares to its shareholders prior to completion of the Acquisition.

It would not have been efficient from a commercial perspective for the shareholders to provide Headco with equity funding on the date the Agreement was signed because Headco did not require equity funds until the purchase of Company D shares needed to be settled.

The consolidated group successfully acquired all the shares in Company D. As a result of Company D joining the consolidated group, the application of the tax consolidation rules entitled Headco to deductions which will result in tax losses to the consolidated group.

The consolidated group is seriously contemplating joining another Australian income tax consolidated group.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 707-A

Income Tax Assessment Act 1997 Subdivision 707-C

Income Tax Assessment Act 1997 section 707-325

Income Tax Assessment Act 1997 subsection 707-325(1)

Income Tax Assessment Act 1997 subsection 707-325(2)

Income Tax Assessment Act 1997 subsection 707-325(3)

Income Tax Assessment Act 1997 subsection 707-325(4)

Income Tax Assessment Act 1997 paragraph 707-325(4)(a)

Corporations Act 2001 section 119

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise specified.

Summary

The equity capital is not an injection of capital for the purposes of paragraph 707-325(4)(a) as it is an initial share issue. Pursuant to Taxation Ruling TR 2004/9, an initial share issue is not considered to be an injection of capital for the purposes of that paragraph.

Detailed reasoning

Subdivision 707-C provides a legislative framework for the utilisation of losses that are transferred to the head company of a consolidated group under Subdivision 707-A. An entity is required to work out its modified market value at the time it becomes a member of a consolidated group for the purpose of calculating the available fraction for a bundle of losses the entity transfers to the head company under Subdivision 707-A.

The basic rule for working out the modified market value of an entity that becomes a member of a consolidated group at a particular time is in subsection 707-325(1). It provides that the modified market value of the entity is the market value of the entity at that time based on certain assumptions.

Subsection 707-325(2) provides that if:

· there are one or more events described in subsection 707-325(4) of the ITAA 1997;

· that occurred in the four years before the time an entity becomes a member of a consolidated group; and

· the modified market value of the entity calculated under subsection 707-325(1) exceeds what it would have been if none of those events occurred,

· then the modified market value worked out under subsection 707-325(1) is reduced by the amount worked out under subsection 707-325(3).

Subsection 707-325(4) describes the events that are referred to in subsection 707-325(2). Relevantly in this case, paragraph 707-325(4)(a) identifies one event as an injection of capital into the entity or an associate of the entity.

The expression 'injection of capital' is not defined for the purposes of paragraph 707-325(4)(a). Accordingly, it takes its ordinary meaning consistent with the purpose of the relevant provisions.

Taxation Ruling TR 2004/9 Income tax: consolidation: what is meant by 'injection of capital' in section 707-325 of the Income Tax Assessment Act 1997? provides the Commissioner's interpretation of the expression 'injection of capital' as it is used in Subdivision 707-C. Paragraph 9 of TR 2004/29 states that, for the purposes of paragraph 707-325(4)(a), the expression 'injection of capital' covers transactions and acts with all the inter-related characteristics listed at that paragraph. The most common form of an injection of capital is by way of the issue of shares for consideration (refer paragraph 13 of TR 2004/9).

The purpose of the transaction or act is not a factor that determines the application of the integrity rule or adjusting event. Therefore, the purpose of the share issues by Headco is not determinative in relation to the application of the integrity rule in subsection 707-325(2) (refer paragraph 10 of TR 2004/9).

The share issues by Headco to its shareholder companies during the specified period display all of the characteristics of an injection of capital as listed in paragraph 9 of TR 2004/9. The issues enhanced the net asset position of Headco and affected its capital structure. They introduced wealth from outside, rather than from the entity's own resources. They were not related to earnings or profits made by Headco from its activities and operations, and were not a transaction on profit account.

However, an initial share issue is not considered to be an injection of capital for the purposes of paragraph 707-325(4)(a) because an initial share issue is part of the process of the formation of the entity (paragraph 17 of TR 2004/9). Accordingly, the share issues by Headco in the specified period will not be considered an injection of capital if they are an initial share issue.

Paragraph 18 of TR 2004/9 explains what is an initial share issue for the purposes of the ruling. Relevantly, it states:

18. For the purposes of this ruling, an initial share issue is an equity raising made at or around the time of the formation of the company or before the company commenced any operating or trading activity and its only activity to date (if any) related directly to the raising of initial finance. ...

Adopting the principle in paragraph 18 of TR 2004/9, the share issues by Headco in the specified period will be an initial share issue if either of the following is the case:

The share issues are an equity raising made at or around the time of the formation of Headco; or

The share issues are an equity raising made before Headco commenced any operating or trading activity and its only activity to date (if any) related directly to the raising of initial finance.

Equity raising made at or around the time of the formation of the company

Section 119 of the Corporations Act 2001 states (in part):

A company comes into existence as a body corporate at the beginning of the day on which it is registered.

In accordance with the Corporations Act 2001, Headco came into existence at the beginning of the day on which it was registered with ASIC.

The phrase 'at or around the time of the formation of the company' comprises two compound expressions; 'at or around' and 'the time of the formation of the company. Neither the compound expressions nor their components are defined in TR 2004/9 and accordingly take their ordinary meaning in English usage in the context in which they are used. The compound expressions are not considered to be expressions that have already acquired a special meaning.

In ascertaining the ordinary meaning of an expression or term, recourse can be had to the use of dictionaries. The use of a standard dictionary is not mandatory for finding the meaning of a term nor is there any one dictionary that is to be taken as authoritative (refer paragraph 63 of TR 2004/9).

The Macquarie Dictionary does not define the meaning of the compound expressions 'at or around' or 'the time of formation of the company' but does define their components.

In the absence of finding a special meaning, it is open to examine what is actually meant by the words in the expressions so used in TR 2004/9. Reference to their respective dictionary meanings may lead to a better understanding of what is a reasonable conclusion as to the meaning of the expressions.

Grammatically, the word 'at' is a particle specifying a point occupied as in, for example, time, and hence used in phrases expressing relative position. An event that happens 'at' the time of formation of a company can thus refer to an event that happens in close proximity to that time.

The ordinary meanings of the word 'around', in the sense relevant to its use in the expression 'around the time of' in TR 2004/9, are 'somewhere about or near' or 'approximately; near in time'. An equity raising can thus be reasonably characterised as made around the time of formation of a company if it is made somewhere near in time to the formation of the company or at approximately the time of the formation of the company.

Example 1 at paragraph 98 of TR 2004/9 deals with paid up capital received as consideration for share issues made after a company incorporation. In that example, the share issues occur 'at or around the time of formation of the company' and are not a capital injection as the consideration goes to the formation of the company.

The ordinary meanings of the noun 'time' include 'the period in which an action is completed', 'a particular period considered as distinct from other periods' and 'the period necessary for or occupied by something'.

The ordinary meanings of the word 'formation', in the sense relevant to its use in the expression 'time of the formation of the company' in TR 2004/9, are 'the act or process of forming' and 'the manner in which a thing is formed; formal structure or arrangement'. It is a noun associated with the verb 'form' which, relevantly, has the ordinary meanings 'to take or assume form' and 'to take a particular form or arrangement'.

These definitions suggest an equity raising can reasonably be characterised as going to the formation of a company if it is part of a process (rather than merely a single act), undertaken over a necessary period, of forming the company.

An Australian company legally comes into existence on the day it is registered with ASIC. However, the formation of the company is not completed without its initial capital structure being set up to enable the company to start operating. This is consistent with the view set out in TR 2004/9 that the process of the formation of a company includes initial capitalisation.

The capital raising made by Headco from its shareholder companies in the specified period was to set up the capital structure of Headco and the consolidated group. The activities undertaken by the consolidated group during the period were limited to those establishing the group's capital structure (equity) and preliminary or preparatory activities to put the consolidated group in the position to undertake, after the Acquisition, operating or trading activities. Without the Acquisition, Headco and the consolidated group would not have been established and the equity raising by Headco would not have been made.

In the context of the use of the phrase 'the time of formation of the company' at paragraph 17 of TR 2004/9 and on the particular facts of this case, it is considered reasonable to accept that 'the time of the formation' of Headco includes the time over which it undertook the particular activities, steps and transactions to establish its initial capital structure preparatory to any business operations, being the time preliminary to the time at which, in a practical sense, it undertook operating or trading activity. Accordingly, the time of formation of Headco is not restricted to the date on which the company was registered with ASIC.

Having regard to the ordinary meaning of the expression 'at or around', it is apt to describe the equity raising made by Headco in the specified period as made around the time of the formation of Headco.

Accordingly, the equity raising made by Headco in that period is an initial share issue for the purposes of TR 2004/9. It follows that, subject to a consideration of the matters at paragraph 19 of TR 2004/9, the equity capital is not considered to be an injection of capital for the purposes of paragraph 707-325(4)(a).

Paragraph 19 of TR 2004/9 states:

19. An initial share issue will be treated as an injection of capital if it forms part of a wider arrangement in respect of which, as a whole, it would be reasonable to form the view that the arrangement is an injection of capital. Arrangements that have been structured in a contrived manner to appear to be initial share issues will also not be treated as initial share issues for the purposes of this ruling. Each case will be considered according to its own facts.

Accordingly, the initial share issue by Headco in the specified period will be treated as an injection of capital if either of the following is the case:

It forms part of a wider arrangement in respect of which, as a whole, it would be reasonable to form the view that the arrangement is an injection of capital.

It is an arrangement that has been structured in a contrived manner to appear to be initial share issue.

On the particular facts of this case, while the initial share issue might be said to be part of a commercial arrangement that included the Acquisition, on the whole it is not considered reasonable on that basis to form the view that the arrangement is an injection of capital.

In general terms, a business arrangement is contrived if it is not driven by commercial considerations. In the context of TR 2004/19, a share issue would be said to be structured in a contrived manner if it was undertaken by way of a device or a scheme the purpose and effect of which is to present, in an artificial or non-genuine manner, the appearance of an initial share issue. On the particular facts of this case, the initial share issue was not undertaken by transactions that were circuitous or artificial; it had a sensible commercial reality and was an unsurprising choice of form with no special features which might indicate contrivance. The difference in time between the incorporation of Headco and the initial share issue reflected the capital structure needed to allow funds to flow as they were required by Headco. Accordingly, the initial share issue can reasonably be characterised as an ordinary commercial transaction and is not characterised as structured in a contrived manner to appear to be an initial share issue.

Brimaud v Boston Securities

The private ruling application refers to Brimaud v Boston Securities Entertainment Investments Pty Ltd [1998] FCA 1104 (Brimaud case) in support of the view that the equity capital raised by Headco in the specified period was initial capitalisation of Headco. We consider that the Brimaud case does not set a precedent for the purpose of applying section 707-325 because:

· the Brimaud case is not a case concerning the application of income tax law;

· the case did not consider the concept of 'initial capitalisation' in the context of section 707-325; and

· Emmett J referred to all the share issues by Cinema Plus Pty Ltd prior to the initial public offer (IPO) under the heading 'Initial Capitalisation of Cinema Plus' as background information in order to determine the amount of damages that Mr Brimaud may be entitled to. His Honour did not consider the concept of 'injection of capital' in the context of income tax law or conclude that shares issued by Cinema Plus Pty Ltd in the period 8 July 1994 to 21 March 1996 were the initial capitalisation of the company.