Edited version of private advice

Authorisation Number: 1012649103140

Ruling

Subject: Share Restructure - Division 7A - Capital gains tax

Question 1

For Company A, will there be a capital loss in the 2013-14 financial year in relation to the original shares in Company B?

Answer

No

Question 2

Will the transfer of shares from Company A to its shareholders and their SMSFs be treated as a dividend to its shareholders and their associates and assessable under section 44 of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 3

For capital gains tax (CGT) purposes, does the market value substitution rule apply to determine the capital gain or loss made by Company A and to determine the first element of the cost base or reduced cost base for the recipients in relation to the replacement shares?

Answer

Yes

This ruling applies for the following period(s)

Year ended 30 June 2014

The scheme commences on

1 July 2013

Relevant facts and circumstances

Company A is a proprietary company. Several years ago Company A acquired shares in Company B for a total arm's length value of $x. The shares were not held as trading stock.

Company B recently became a listed public company. In order to facilitate its public listing, it implemented a capital restructuring. As a result of the restructure, eligible shareholders were entitled to have their original shares substituted with replacement shares.

Company A was allocated a number of replacement shares at a notional price. The new shares were subject to escrow restrictions, preventing sale for just over 12 months of the public listing.

The shareholders of Company B could choose to have some or all of their allotted shares allocated to their nominees; provided the nominee satisfied one or more specified criteria. Company A (in its capacity as a shareholder of Company B) nominated its own shareholders and their SMSFs to receive all of its allotted shares.

Company B transferred the shares to the nominees of Company A. Company A does not own any of the replacement shares. No consideration was received by Company A in exchange for the shares.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 6(1)

Income Tax Assessment Act 1936 Section 44

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Section 109C

Income Tax Assessment Act 1936 Section 109L

Income Tax Assessment Act 1936 Section 109Y

Income Tax Assessment Act 1936 Section 109ZD

Income Tax Assessment Act 1936 Section 318

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 110-25(2)

Income Tax Assessment Act 1997 Subsection 110-55(2)

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Paragraph 112-20(1)(a)

Income Tax Assessment Act 1997 Section 124-240

Reasons for decision

Summary

The issuing of new shares in substitution of the original shares would not involve ownership of the shareholdings ending and is not considered a disposal of shares. There is no capital gain or loss in relation to the original shares as there is no CGT event.

The taxation of payments or transfers of property to shareholders or associates of shareholders primarily arise from the operation of section 44 of the ITAA 1936 and Division 7A of the ITAA 1936. For the purposes of Division 7A, the meaning of 'payment' includes transfers of property for less than the amount that would have been paid in an arm's length dealing. Company A has nominated its shareholders, and the SMSFs of its shareholders to receive its substituted shares for no consideration. For Company A, the consequences are that it is treated as having paid ordinary dividends to its shareholders under section 44, or deemed dividends to associates of shareholders under Division 7A.

For CGT purposes there is a change of ownership in the assets (i.e. the shares) when they are transferred to the shareholders or their associates. The transfer of the shares is an off market transfer. The relevant CGT event is A1. The nomination of the shareholders is not considered to be a D1 CGT event. In situations such as this, the market value substitution rules apply to determine the capital gain or loss made by Company A, and to determine the first element of the cost base and reduced cost base for the recipients of the replacement shares.

Detailed reasoning

Company A was the owner of shares in Company B. When Company B re-structured their shares, Company A was entitled to have their original shareholding substituted with new shares. No further consideration was received. The share re-structure by Company B and the issuing of new certificates to Company A (and the other Company B shareholders) would not be considered to be a CGT event. The issuing of new shares in substitution of the original shares would not involve ownership of the shareholdings ending under section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997); and would not be considered a disposal of shares under section 104-10 of the ITAA 1997. Section 124-240 of the ITAA 1997 dealing with the exchange of shares in the same company would allow shareholders in Company B to choose a replacement asset rollover.

In this case however, Company A nominated that the substitute shares to which they were entitled be issued to its shareholders and their SMSFs. The nomination by Company A would not be considered to be a D1 CGT event. The nomination does not create contractual rights in the Company A shareholders and their SMSFs, and would not be sufficient to enable them to compel performance by Company B.

When the shares were transferred to the Company A shareholders and their SMSFs there was a change of ownership in the shares. Shares are intangible assets that are capable of ownership. The shares in Company B are a CGT asset, and the transfer of their ownership (by way of a gift from Company A) is a disposal of a CGT asset which is an A1 CGT event.

Tax consequences

It is considered that the taxation of payments or transfers of property to shareholders or associates of shareholders primarily arise from the operation of section 44 of the ITAA 1936 and Division 7A of the ITAA 1936. See for example TR 2013/D6: matrimonial property proceedings and payments of money or transfers of property by a private company to a shareholder (or their associate). The following part of the discussion is based on paragraphs 51 to 75.

Shares transferred to shareholders

A payment of money or transfer of property to a shareholder out of the profits of a private company is an assessable dividend under section 44 of the ITAA 1936.

Section 44 relevantly provides:

The assessable income of a shareholder in a company (whether the company is a resident or a non-resident) includes:

(a)  if the shareholder is a resident:

(i)  dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source.

The word 'dividend' is defined in subsection 6(1) of the ITAA 1936 to include:

(a)  any distribution made by a company to any of its shareholders, whether in money or other property.

The meaning of 'distribution' in context has been judicially considered and held:

1.  to at least involve a dealing out or bestowal (Commissioner of Taxation v. Black (1990) 25 FCR 274 at 281; (1990) 21 ATR 701 at 707; 90 ATC 4699 at 4705);

2.  to encompass a very broad range of applications of company property and money to shareholders while the company is a going concern (Commissioner of Taxes (Victoria) v. Nicholas (1938) 59 CLR 230 at 238; (1938) 1 AITR 266 at 268-9; (1938) 4 ATD 484 at 486 per Latham CJ);

3.  to undoubtedly be of wide import and concerned with the manner in which the shareholder receives the benefit of the dividend, emphasising that, in whatever manner the dividend reaches the shareholder it is to be regarded as assessable income (Commissioner of Taxation (New South Wales) v. Stevenson (1937) 59 CLR 80 at 108.);

4.  that the legal form of the transaction and the capacity in which the benefit is conferred on the shareholder will be relevant factors (Davis Investments Pty Ltd v. Commissioner of Stamp Duties (New South Wales) (1958) 100 CLR 392);

5.  to not require the existence of the conditions necessary to declare a lawful dividend under the Corporations Act 2001 (MacFarlane v. Federal Commissioner of Taxation (1986) 13 FCR 356; 86 ATC 4477; (1986) 17 ATR 808).

The High Court in Federal Commissioner of Taxation v. Slater Holdings Ltd (No. 2) ((1984) 156 CLR 447; (1984) 15 ATR 1299; (1984) 84 ATC 4883) confirmed that it is the fact that a payment to a shareholder is sourced in the profits of a company (as opposed to whether that payment has the character of income in the hands of the shareholder) that is decisive of whether that payment is a dividend for the purposes of section 44 of the ITAA 1936. In that case, Gibbs CJ said:

In FC of T v. Uther, Kitto J., in his dissenting judgment at pp. 638-640, advanced a criticism of the judgment of Fullagar J., which, with all respect, I find compelling. Fullagar J. was right in saying that the distribution made to the shareholders in F.C. of T. v. Blakely was a capital receipt according to general principles, but he gave insufficient weight to the change that had been effected to the law by defining ``dividend'' so as to include a distribution made by a company to any of its shareholders. As Kitto J. pointed out at p. 639, the effect of the amendments to the law, first made by the Income Tax Assessment Act 1934 and repeated when the Act was passed in 1936, was to make shareholders in a company which is a going concern assessable to tax on a principle fundamentally different from that of the previous legislation. Kitto J. continued:

'The criterion for the inclusion of a shareholder's receipts from the company is no longer the 'dividend' character of the receipts, that is to say their income character when considered from the shareholder's point of view; it is the profit character - from the company's point of view - of the source from which distributions should be made.' (At CLR 457, At ATR 1304, At ATC 4887).

In terms of whether a distribution has been paid out of profits, the Commissioner has previously explained in paragraphs 15 and 16 of Taxation Ruling TR 2003/8: Income tax : distributions of property by companies to shareholders - amount to be included as an assessable dividend.

In deciding whether, as a question of fact, a distribution has been made out of profits derived by the company in cases where the distribution is not formally acknowledged as such, a substantive approach should be adopted. There does not need to be a formal debiting of an account of profit of the company. So long as the market value of the company assets exceeds the total amount (as shown in its books of account) of its liabilities and share capital what remains is profits. If the distribution is not debited to share capital the distribution is one of profits.

Such an approach was adopted by the NSW Supreme Court in Masterman v. FCT 85 ATC 4015. In reaching its decision that the payment to shareholders in that case was a payment out of profits derived by the company, the court noted (at page 4030) that the company was solvent and that there was no evidence that the relevant payment was out of non-profit sources, and that 'common sense would require that the company be kept solvent and that only surplus amounts not putting that requirement at risk be paid out'.

It follows for tax purposes that it does not matter whether a dividend is intended or predicated upon any particular process. Rather, a factual enquiry is required as to whether there is a distribution to a shareholder and whether it is made out of profits.

Shares in Company B, that were the property of Company A, were transferred to shareholders of Company A. As a result the shareholders will have been paid a dividend as defined, out of profits, which is assessable under section 44 of the ITAA 1936. As section 44 applies; Division 7A will not also apply (section 109L).

Shares transferred to SMSFs

Under Division 7A (specifically, under paragraph 109C(1)(a) of the ITAA 1936), where a private company makes a payment or transfers property to an entity that is a shareholder or an associate of a shareholder of that company, the private company is taken to have paid a dividend to the shareholder or associate. In the current case some shares have been transferred to the trustees of the SMSFs of shareholders.

Section 109ZD of the ITAA 1936 states that 'associate' has the meaning given by section 318 of the ITAA 1936. An 'associate' of a natural person (other than in the capacity of trustee) includes a trustee of a trust under which there is a benefit to the individual (paragraph 318(1)(d)). The shareholders in Company A are individuals. Accordingly the trustee of the individual's SMSF is the trustee of a trust under which there is a benefit to the individual, and therefore is an associate of the shareholder.

Subsection 109C(3) defines a payment to mean:

(a) a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and

(b) a credit of an amount to the extent that it is:

(i)  to the entity; or

(ii)  on behalf of the entity; or

(iii)  for the benefit of the entity; and

(c)  a transfer of property to the entity.

'Property' is not defined for the purposes of Division 7A of the ITAA 1936 (distributions to entities connected with a private company) but the term can be used to describe 'every type of right, (that is, a claim recognised by law), interest or thing which is legally capable of ownership and which has a value'; (Butterworths Australian Legal Dictionary, 1998, 2nd edn. Nygh, P and Butt, P). As discussed above the shares are considered to be property.

Pursuant to subsection 109C(4) of the ITAA 1936, the amount of a payment consisting of a transfer of property is the amount that would have been paid for the transfer by the private company and the shareholder or their associate if they had been dealing at arm's length, less any consideration given by the shareholder or their associate for the transfer.

Subdivision D of Division 7A of the ITAA 1936 sets out rules about payments and loans that are not treated as dividends. However, the exclusions in Subdivision D do not prevent the private company from being taken to pay a dividend to the taxpayer in this case.

As the private company has transferred property to the taxpayer, who is an associate of the shareholder, the payment is taken to be a dividend under subsection 109C(1) of the ITAA 1936.

Under subsection 109C(2) of the ITAA 1936, the dividend is taken to equal the amount paid, subject to section 109Y of the ITAA 1936. Section 109Y limits the total amount of dividends taken to have been paid by the private company under Division 7A to the company's distributable surplus as at the end of the year of income.

The transfer of the shares to the SMSF is assessable as a dividend under section 44 of the ITAA 1936, by virtue of section 109C of the ITAA 1936.

CGT issues

Notwithstanding the operation of section 44 and Division 7A in this case, the CGT provisions must also be considered. You make a capital gain or capital loss if and only if a CGT event happens (section 102-20 of the ITAA 1997). Section 104-10 of the ITAA 1997 specifies that CGT event A1 happens if you dispose of a CGT asset. You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of the law.

The nomination by Company A of its shareholders and their SMSFs resulted in an off market transfer of the ownership of the Company A shareholding in Company B. Therefore, Company A will make a capital gain or loss as CGT event A1 will occur when the ownership is transferred (section 104-10 of the ITAA 1997).

Capital proceeds is the term used to describe what you receive or are entitled to receive as a result of a CGT event happening (section 116-20 of the ITAA 1997). There are special rules for calculating the capital proceeds if you dispose of an asset by way of a non-arm's length transaction (section 116-30 of the ITAA 1997). In determining whether parties deal at arm's length, consideration must be given to any connection between the parties and any other relevant circumstances.

In the current case, because there is a definite connection between Company A and its shareholders and their associates, it is deemed that the parties are not dealing at arm's length and the market value substitution rule applies (section 116-30 of the ITAA 1997). In applying this rule, although Company A will not receive any money for the transfer of the shares, for the purposes of calculating its capital gain or loss, the capital proceeds are deemed to be the market value of the shares at the time of the transfer of ownership.

Subsequently the acquirers of the shares are deemed to have received them at market value. The general rules for working out the cost base and reduced cost base of a CGT asset are in Division 110 of the ITAA 1997. They may be modified by the rules in Subdivision 112-A of the ITAA 1997 (and, in some cases, by other rules in the Income Tax Assessment Acts).

Under the general rules, the first element of the cost base and reduced cost base of a CGT asset is the total of the money paid, or required to be paid, to acquire the asset. It also includes the market value of any property given, or required to be given, for the asset: subsections 110-25(2) and 110-55(2) of the ITAA 1997.

In the current case, no consideration was paid. Paragraph 112-20(1)(a) of the ITAA 1997 provides that, if you did not incur any expenditure to acquire a CGT asset from another entity, the first element of the cost base and reduced cost base of the asset is its market value.