Edited version of private advice

Authorisation Number: 1012623799751

Ruling

Subject: Share Capital Tainting and Intercompany Debt Forgiveness

Question 1

Does a credit to the Equity Reserve account of Company X cause Company X's share capital account to become tainted under subsection 197-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will any franking debit arise in the franking account of Company Y in accordance with section 197-45 of the ITAA 1997 as a result of any debt forgiveness?

Answer

No.

Relevant facts and circumstances

Background

Company Y is the head company of an Australian income tax consolidated group.

Company X is a subsidiary member of the consolidated group.

Company Y made a substantial loan to Company X to fund Company X's trading operations. Company X owes an outstanding amount to Company Y.

Company X will be unable to repay the loan for some time.

Company Y will forgive the outstanding loan owed by Company X.

The loan is legal form debt and does not constitute redeemable preference shares. Company X recognises the loan as a debt liability in its financial accounts.

Company X will not issue any shares to Company Y in respect of the debt forgiveness.

All the issued shares held in Company X are fully paid. No amounts forgiven will be applied to offset any unpaid amounts for partly paid shares.

The share capital accounts of Company Y and Company X respectively are not currently tainted.

Company X will record the forgiveness as a credit to an equity reserve in its Statement of financial position. The decrease in liabilities will not be reflected in retained earnings.

International Accounting Standard ('IAS') 1.79(b) requires an entity to disclose 'a description of the nature and purpose of each reserve within equity'. Therefore the equity reserve used by Company X to record contributions from owners will be labelled as 'Equity Reserve Account'. The description of the nature and purpose of the reserve in accordance with International Accounting Standard ('IAS') 1.79(b) that will be disclosed in the financial statements of Company X is as follows:

'The reserve account represents intercompany debts forgiven recognised directly within equity'.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 197

Income Tax Assessment Act 1997 Section 197-1

Income Tax Assessment Act 1997 Subsection 197-5(1)

Income Tax Assessment Act 1997 Section 975-300

Income Tax Assessment Act 1997 Subsection 975-300(1)

Income Tax Assessment Act 1997 Subsection 975-300(2)

Income Tax Assessment Act 1997 Subdivision 709-A

Income Tax Assessment Act 1997 Section 709-50

Income Tax Assessment Act 1997 Section 709-65

Income Tax Assessment Act 1997 Subsection 709-75(1)

Income Tax Assessment Act 1997 Subsection 709-75(2)

Income Tax Assessment Act 1997 Subsection 709-75(3)

Reasons for decision

All legislative references are to provisions of the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

The Explanation is provided on the basis that the loan forgiven does not constitute non-share equity interests for Australian income tax purposes.

Question 1

Does a credit to the Equity Reserve account of Company X cause Company X's share capital account to become tainted under subsection 197-5(1)?

Detailed reasoning

Relevant legislation

Division 197

Pursuant to section 197-1, Division 197:

(a) applies to certain amounts transferred to a company's share capital account (see Subdivision 197-A); and

(b) provides for a franking debit to arise if such an amount is transferred to the share capital account (see Subdivision 197-B); and

(c) provides for the tainting of the share capital account if such an amount is transferred, for how the account may be untainted, and for consequences that flow from untainting the account (see Subdivision 197-C).

Section 975-300

Subsection 975-300(1) states that 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.

Subsection 975-300(2) states that if a company has more than one account covered by subsection 975-300(1), the accounts are taken, for the purposes of the Act, to be a single account.

Meaning of share capital

The term 'share capital' is not defined in the Act. In this regard, the Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 3) Bill 2006 states:

4.10 The concept of share capital is not defined in the ITAA 1997. Under its ordinary meaning, share capital includes amounts received by a company in consideration for the issue of shares.

Based on this, share capital comprises amounts received by a company as consideration for the issue of shares.

The concept of share capital is also examined in paragraphs 32, 34 and 50 of Taxation Ruling TR 2010/1 Income tax: retail premiums paid to shareholders where share entitlements are not taken up or are not available which state:

…

32. It is the Commissioner's view for the purposes of the income tax law that all amounts paid in consideration for the issue of shares by a company are share capital of the company (which should be credited to the company's share capital account).

…

34. The ITAA 1936 and the ITAA 1997 use the concept of share capital without a statutory definition of the term (though share capital account has long been defined for income tax purposes, currently in section 975 300 of the ITAA 1997). The Corporations Act 2001 includes Chapter 2H Shares and Chapter 2J Transactions affecting share capital but also without a statutory definition of the term. The ordinary meaning of share capital applies. This meaning is supported by case law, which has also been reflected in discussions in legal text books and Explanatory Memoranda.

…

50. The amounts proffered in subscription for the issue of shares are share capital of the company and are properly credited by the company to its share capital account.

For the purposes of these Reasons, it is unnecessary to consider the jurisprudence on share capital.

Meaning of share capital account

In Commissioner of Taxation v Consolidated Media Holdings Ltd [2012] HCA 55, the High Court of Australia examined what constitutes a 'share capital account' for the purposes of the share buy-back provisions in Division 16K of Part III of the Income Tax Assessment Act 1936 (ITAA 1936). The High Court held that the purchase price for the share buy-back was debited against the share capital account of Crown Limited ('Crown') for the purposes of section 159GZZZP of the ITAA 1936, although Crown established a separate general ledger account called 'Share Buy-Back Reserve Account' to record the buy-back. In addition, Crown's audited financial statements for the year ended 30 June 2002 showed a reduction in Crown's 'Contributed Equity' account (which corresponded with the balance shown in the 'Shareholders Equity Account').

The Court held at paragraph 42 that the meaning of 'share capital account' in section 6D of the ITAA 1936 was not to be construed narrowly:

…

42. An aspect of legislative history that is of greater utility in the construction and application of ss 6D and 159GZZZP(1) of the ITAA 1936 is the contemporaneous commencement on 1 July 1998 of Pt 2M.2 of Ch 2M of the Corporations Law. Section 6D must be read in light of that Part's replacement of the previous notions of a company having "accounts" and "accounting records" with the broader and more functional notion of a company having "financial statements" and "financial records". The reference in s 6D(1)(a) to "an account which the company keeps of its share capital" (emphasis added) cannot in that light be confined, in the manner suggested by the Full Court, to the account "to which the paid up capital of the company was originally credited" or to "one in which a company ordinarily keeps its share capital on contribution" (emphasis added). Much less can it be confined, as PBL argued in the appeal, to an account which the company kept of its share capital on 1 July 1998.

Their Honours stated at paragraphs 44:

…

44. In a context in which the relevant record-keeping obligation of a company under Pt 2M.2 of Ch 2M of the Corporations Law was to keep written financial records that correctly recorded and explained its transactions and financial position and performance and that would enable true and fair financial statements to be prepared and audited, it was sufficient for an account to answer the description in s 6D(1)(a) of "an account which the company keeps of its share capital" (emphasis added) that the account, whether debited or credited with one or more amounts, be either a record of a transaction into which the company had entered in relation to its share capital, or a record of the financial position of the company in relation to its share capital.

Application to Company X

Equity Reserve account

Company X will establish a new Equity Reserve account in order to record the whole amount forgiven in its financial statements. The amounts credited in the Equity Reserve account do not represent consideration received for the issue of shares. The account will be separate from the other equity accounts of Company X, and in particular separate from the share capital account and the retained earnings / accumulated losses account. Further, no part of the debt forgiveness will be credited to, nor will increase, the existing share capital account of Company X. The whole amount of the forgiveness will be credited to the Equity Reserve account.

No new shares will be issued by Company X in respect of the debt forgiveness. The transaction will not increase, nor be recorded as a credit in, the share capital account of Company X as the transaction will not involve an issue of new shares, or a discharge of any obligation to pay the subscription price of previously issued shares.

The amounts in the Equity Reserve account will not constitute share capital for the purposes of the Corporations Act 2001 as the amounts do not represent funds contributed by members as consideration for the issue of shares.

In Commissioner of Taxation v Consolidated Media Holdings Ltd [2012] HCA 55, the High Court of Australia stated that it was sufficient for an account to be a share capital account under section 6D of the ITAA 1936 if that account was an account that was either a record of a transaction into which the company had entered in relation to its share capital, or a record of the financial position of the company in relation to its share capital.

The Equity Reserve account will not be an account which records a transaction that Company X will enter in relation to its share capital. The account will also not be a record of the financial position of Company X in relation to its share capital. The Equity Reserve account will record a reduction in the debt liabilities of Company X.

As the Equity Reserve account will not record a credit to the share capital account, the Commissioner accepts that the account does not constitute a share capital account for Australian income tax purposes.

Share Capital Tainting

As the Equity Reserve account will not constitute a share capital account, a credit entry to the account will not cause Company X's share capital account to become tainted under subsection 197-5(1).

Question 2

Will any franking debit arise in the franking account of Company Y in accordance with section 197-45 as a result of any debt forgiveness?

Relevant legislation

Subdivision 709-A

Subdivision 709-A deals with franking accounts for tax consolidated groups. Section 709-50 sets out that:

Only the head company of a consolidated group has an operating franking account. The subsidiary members' franking accounts do not operate while they are subsidiary members. Debits or credits that would otherwise arise in subsidiary members' franking accounts arise instead in the head company's franking account.

Section 709-65 states that the:

… franking account of an entity that is a subsidiary member of a consolidated group does not operate during the period:


(a)  beginning just after the entity becomes a subsidiary member of the group; and
(b)  ending when the entity ceases to be a subsidiary member of the group.

However, section 709-75 operates if a debit would arise in the franking account of a subsidiary member of a consolidated group at a time (the debiting time) apart from section 709-65. The debit instead arises in the franking account of the head company of the group at the debiting time. The amount of the debit is the same as the amount of the debit that would arise in the franking account of the subsidiary member.

Therefore, if a franking debit would arise to a subsidiary member's franking account pursuant to section 197-45 (apart from section 709-65), then the debit arises in the franking account of the head company pursuant to section 709-75.

Application of law to Company Y's circumstances

In the circumstances of Company Y, the franking account of Company X does not operate while Company X is a member of the consolidated group. Any debits that would otherwise arise in the franking account of Company X would arise instead in the franking account of Company Y.

As no amount would form part of (and therefore would not be transferred to) the share capital account of Company X for the purposes of subsection 197-5(1), there would be no amount to which Division 197 would apply. Therefore, section 197-45 will not apply, and no franking debit will arise in the franking account of Company Y