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Ruling

Subject: proposed share capital reduction

Question 1

Will the Commissioner make a determination under section 45C of the Income Tax Assessment Act 1936 (ITAA 1936), that either sections 45A or 45B of the ITAA 1936 apply, to treat some of the capital component of the payments to be made to shareholders of the company as unfrankable dividends under the proposed share capital reduction?

Answer

No

Question 2

Will the Commissioner make a determination that Part IVA of the ITAA 1936 applies to the proposed share capital reduction?

Answer

No

Question 3

Will Division 7A of the ITAA 1936 apply to deem any part of the share capital component of the proposed payments to be an unfrankable dividend?

Answer

No

Question 4

Will the component of the payment that is debited to the share capital account, based on the proposed apportionment, give rise to CGT Event G1 for the shareholders of the company at the time of payment?

Answer

Yes

Question 5

Will the component of the payment that is debited to the retained earnings account based on the proposed apportionment be a frankable distribution under subdivision 202-C of the ITAA 1997? Also, will the Commissioner accept that the component of the payment that is to be debited to the retained earnings is paid out of profits and is therefore a frankable distribution?

Answer

Yes

This ruling applies for the following period

Year ended 30 June 2013

The scheme commenced on

1 July 2012

Relevant facts and circumstances

The taxpayer is a private company.

It forms part of a family group with wholly owned subsidiaries.

Upon incorporation of the company, the trustees of a number of associated discretionary trusts each subscribed for 1 ordinary share for $1.

Some time after, the company issued a large number of additional shares to the trustees of the discretionary trusts for $1 for each share.

There have been no changes to the shareholdings in the company since that time.

When the additional share capital was introduced into the company, it was considered surplus capital of the family group that would be kept in the company, with the intention that it would be returned to the discretionary trusts when the family considered that the controllers of the shareholder trusts were sufficiently responsible to manage such funds. In the interim, it was retained as capital of the company for ease of accountability and management.

Now the controllers of the trustee shareholders have requested that the company make a return of a portion of that excess capital.

The directors of the company propose to return the capital in cash to the shareholder trusts, in proportion to their shareholdings.

The proposed return of capital will occur by way of an equal share capital reduction under section 256B of the Corporations Act 2001. There will be no cancellation of shares.

The capital share reduction applies only to ordinary shares held in the company and the terms of the reduction are the same for each holder of ordinary shares.

For the years 2007 to 2012, the company has only paid minimal, intermittent dividends, all of which were fully franked.

At the time of the proposed return of capital (during the 2013 income year), the company will adopt the dividend/capital 'slice approach'.

The proposed accounting entry will be:

DR Contributed equity

DR Retained earnings

CR Cash

Financial records were provided as part of the ruling application, along with the calculation of the relevant dividend and capital amounts.

The value of the Retained earnings/Net asset value prior to the proposed return of capital is not expected to vary materially from that provided in the application. Where the values vary from those set out in the Ruling, the calculation will vary accordingly, but the methodology used to apportion the capital/dividend split will remain the same.

Relevant legislative provisions

Section 45A of the ITAA 1936

Section 45B of the ITAA 1936

Section 45C of the ITAA 1936

Part IVA of the ITAA 1936

Section 177D of the ITAA 1936

Section 177EA of the ITAA 1936

Division 7A of the ITAA 1936

Section 109C of the ITAA 1936

Section 104-35 of the ITAA 1997

Subdivision 202-C of the ITAA 1997

Reasons for decision

Question 1

Under section 45C of the ITAA 1936, the Commissioner may make a determination under subsections 45A(2) or 45B(3) that the amount of a capital benefit be taken to be an unfranked dividend that is paid by the company to a shareholder.

Section 45A of the ITAA 1936 is an anti-avoidance provision that applies in circumstances where capital benefits are streamed to certain shareholders (the advantaged shareholders) who derive a greater benefit from the receipt of share capital and it is reasonable to assume that the other shareholders (the disadvantaged shareholders) have received or will receive dividends.

Although a 'capital benefit' (as defined in paragraph 45A(3)(b)) is provided to participating shareholders under the proposed share capital reduction, the circumstances of the arrangement indicate that there is no streaming of capital benefits to some shareholders and dividends to other shareholders. Accordingly, section 45A has no application to the arrangement.

The purpose of section 45B of the ITAA 1936 is to ensure that companies do not distribute what are effectively profits to shareholders as preferentially-taxed capital rather than dividends.

Subsection 45B(2) sets out the conditions under which the Commissioner may make a determination under subsection 45B(3) that section 45C applies to treat all or part of a distribution as an unfranked dividend. These conditions are that:

· there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a));

· under the scheme a taxpayer (the relevant taxpayer), who may or may not be the person provided with the capital benefit, obtains a tax benefit (paragraph 45B(2)(b)); and

· having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose, but not including an incidental purpose), of enabling the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(c).

Each of these conditions is considered below.

Scheme

A 'scheme' for the purposes of section 45B includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan or proposal.

The proposed return of capital by the company will constitute a scheme for the purposes of paragraph 45B(2)(a).

The phrase 'provided with a capital benefit' is defined in subsection 45B(5) and includes a distribution to a person of share capital. As the company will debit the proposed return of capital against its untainted share capital account, shareholders will, under the scheme, be provided with a capital benefit.

Tax benefit

A relevant taxpayer 'obtains a tax benefit', as defined in subsection 45B(9), if:

· an amount of tax payable; or

· any other amount payable under the ITAA 1936 or the ITAA 1997;

by the relevant taxpayer would, apart from the operation of section 45B, be less than the amount that:

· would have been payable; or

· would be payable at a later time than it would have been payable;

if the capital benefit had instead been an assessable dividend.

In the event that the distribution were a dividend rather than a capital benefit, it is likely that the amount of tax payable by shareholders would be greater than the amount payable in respect of the proposed return of capital payment (that payment being the capital benefit).

Ordinarily, a return of capital would be subject to the CGT provisions of the income tax law. Unless the amount of the distribution exceeds the cost base of the shares, there will only be a cost base reduction under CGT event G1 (section 104-135 of the ITAA 1997). It is only to the extent (if any) that the distribution exceeds the cost base of the shares that a capital gain arises. By contrast, a dividend would generally be included in the assessable income of a resident shareholder. Therefore, the shareholders will generally obtain a tax benefit from the scheme.

Relevant circumstances

Paragraph 45B(2)(c) of the ITAA 1936 requires the Commissioner to consider the 'relevant circumstances' of the scheme as set out in subsection 45B(8) of the ITAA 1936 to determine whether any part of the scheme is entered into for a purpose, other than an incidental purpose, of enabling the relevant taxpayer (that is, a shareholder in the company) to obtain a tax benefit.

The test of purpose is an objective one. The question is whether it would be concluded that a person who enters into or carries out the scheme or any part of the scheme does so for a more than incidental purpose of obtaining a tax benefit for the relevant taxpayer. The following points have been considered:

· The company does not have a history of making regular yearly dividend distributions to its shareholders. Overall, the pattern of dividends made by the company does not suggest that the proposed return of capital will be made in substitution for dividends.

· The shareholders are all resident trust estates, none of the taxpayers have a capital loss that would otherwise be carried forward, and none of the ownership interests were acquired prior to 20 September 1985.

· After the return of capital, the shareholders will have the same proportionate interest in the company. CGT event G1 should happen equally for all shareholders and the (combined) cost base of shares in the company will be reduced by $9m.

· By applying the slice approach, the shareholders will receive their proportionate share of fully franked dividends in addition to the return of capital. Had the taxpayers sought to apply the average capital per share approach, there would be no dividend component to the proposed payment. The applicant considers that the slice approach more accurately reflects the economic substance of the transaction given the existence of substantial retained earnings.

The company has demonstrated that the scheme seeks to return an amount of capital that had been issued by the company, which has always been considered excess to requirements, and which was always intended to be returned to the shareholders. The practical implications of the scheme for the company and its shareholders are consistent with it being, in form and substance, a return of capital.

Therefore, having regard to the relevant circumstances it cannot be concluded that the scheme is to be entered into or carried out for a more than incidental purpose of enabling shareholders to obtain a tax benefit.

Therefore, as the Commissioner considers that neither sections 45A or 45B of the ITAA 1936 apply to the arrangement, he will not make a determination pursuant to section 45C of the ITAA 1936.

Question 2

The matters for consideration in the application of Part IVA of the ITAA 1936 are similar to those matters considered in the application of section 45B of the ITAA 1936, except that for Part IVA to apply to a scheme, it must have been entered into for the dominant purpose of obtaining a tax benefit.

For the same reasons as discussed in question 1 above, the Commissioner will not seek to apply Part IVA of the ITAA 1936.

Question 3

Section 109C of Division 7A of the ITAA 1936 provides that:

A private company is taken to pay a dividend to an entity at the end of the private company's year of income if the private company pays an amount to the entity during the year and either:

(a) the payment is made when the entity is a shareholder in the private company or an associate of such a shareholder; or

(b) a reasonable person would conclude (having regard to all the circumstances) that the payment is made because the entity has been such a shareholder or associate at some time.

Subsection 109L(2) of the ITAA 1936 provides that if another section excludes a payment from assessable income, then Division 7A will not apply. Amounts that are debited to a company's share capital account are excluded from the definition of a dividend pursuant to subsection 6(1) of the ITAA 1936.

Division 7A will not apply to deem any part of the proposed payments that are debited against the company's share capital account to be an unfrankable dividend.

Question 4

Under section 104-135 of the ITAA 1997, CGT event G1 happens if:

(a) a company makes a payment to you in respect of a share you own in the company; and

(b) some or all of the payment is not a dividend, or an amount that is taken to be a dividend; and

(c) the payment is not included in your assessable income.

As these three requirements are satisfied, CGT event G1 will happen when the payment for the share capital reduction is made.

The shareholders will make a capital gain if the return of capital is more than the cost base of the share they hold (subsection 104-135(3) of the ITAA 1997). If they make a capital gain, the share's cost base is reduced to nil.

If the return of capital is equal to or less than the cost base of the shares at the time of the payment, the cost base and reduced cost base of the shares will be reduced by the amount of the payment (subsection 104-135(4) of the ITAA 1997).

The shareholders cannot make a capital loss from this CGT event.

Question 5

Subdivision 202-C of the ITAA 1997 provides that a distribution is a frankable distribution to the extent that it is not unfrankable under section 202-45. The object of the subdivision is to ensure that only distributions equivalent to realised taxed profits can be franked.

None of the exceptions in section 202-45 of the ITAA 1997 are applicable in this instance to the component that will be debited to the retained earnings account.

The company is making a dividend payment from retained earnings. The balance of this account shows that there have been sufficient profits to make this payment out of profits, and the balance of the franking account shows that there should be a sufficient balance to enable the dividend to be fully franked at the time it is paid.

The amount of the payment which is debited to the retained earnings account will be a frankable distribution.