Edited version of your written advice

Authorisation Number: 1013094113106

Date of advice: 22 September 2016

Ruling

Subject: Share capital reduction

Question 1

Will CGT event G1 happen when the Company makes the Payment to the Taxpayer under the proposed share capital reduction?

Answer

Yes

Question 2

Is any part of the Payment under the proposed share capital reduction a dividend, as defined in section 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936), and for the purposes of section 44 of the ITAA 1936?

Answer

No

Question 3

Will the Commissioner make a determination under section 45C of the ITAA 1936 that section 45A of the ITAA 1936 will apply to treat some of the Payment to be made to the Taxpayer as an unfrankable dividend under the proposed share capital reduction?

Answer

No

Question 4

Will the Commissioner make a determination under section 45C of the ITAA 1936 that section 45B of the ITAA 1936 will apply to treat some of the Payment to be made to the Taxpayer as an unfrankable dividend under the proposed share capital reduction?

Answer

No

Question 5

Will Division 7A of the ITAA 1936 apply to deem any part of the Payment under the proposed share capital reduction to be a dividend under section 109C of the ITAA 1936?

Answer

No

Question 6

To the extent that a capital gain arises to the Taxpayer from CGT event G1, will it be a 'discount capital gain' under Division 115 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods:

Income year ended 30 June 20XX

Income year ended 30 June 20XX

The scheme commenced:

During the income year ended 30 June 20XX

Relevant facts and circumstances

1. The Company is a privately owned company with four shareholders (including the Taxpayer). All of the shareholders in the Company are Australian residents.

2. Shortly after its incorporation, the Company raised additional share capital, through the issue of new shares, to fund its operations.

3. The business carried on by the Company has grown significantly and has performed strongly since the business was commenced. The business now generates significant business income and profits. A significant proportion of these profits have been paid to the Company's shareholders as dividends.

4. The directors of the Company have determined that a portion of its share capital is surplus to its requirements as its operations can now be funded by recurrent business income. As a consequence, it is inefficient for the Company's balance sheet to carry more share capital than it requires as the excess cannot be put to a productive use for its shareholders.

5. Under the specified scheme, the Company proposes to undertake a share capital reduction by way of an equal share reduction under section 256B of the Corporations Act 2001. There will be no cancellation of shares.

6. The proposed share capital reduction will be made to all shareholders equally and on the same terms and will result in a payment of approximately $X in respect of each ordinary share (the Payment).

7. The whole of the Payment will be debited to an amount standing to the credit of the share capital account of the Company. No part of the Payment will be debited to an account recording the Company's retained earnings or profits.

8. The Company's share capital account, or equivalent account, is not tainted within the meaning of Division 197 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1),

Income Tax Assessment Act 1936 section 44,

Income Tax Assessment Act 1936 section 45A,

Income Tax Assessment Act 1936 section 45B,

Income Tax Assessment Act 1936 section 45C,

Income Tax Assessment Act 1936 section 47,

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 1997 section 104-135,

Income Tax Assessment Act 1997 Division 115,

Income Tax Assessment Act 1997 section 115-5,

Income Tax Assessment Act 1997 section 115-10,

Income Tax Assessment Act 1997 section 115-15,

Income Tax Assessment Act 1997 section 115-20,

Income Tax Assessment Act 1997 section 115-25,

Income Tax Assessment Act 1997 section 115-40,

Income Tax Assessment Act 1997 section 197-50, and

Income Tax Assessment Act 1997 section 975-300.

Reasons for decision

Question 1

Summary

1. Capital Gains Tax (CGT) event G1 under section 104-135 of the ITAA 1997 will happen when the Company makes the Payment to the Taxpayer under the proposed share capital reduction.

Detailed reasoning

2. Section 104-135 of the ITAA 1997 contains the rules dealing with CGT event G1. CGT event G1 happens if:

(a) a company makes a payment to a taxpayer in respect of a share the taxpayer owns in the company (except for CGT event A1 or C2 happening in relation to the share); and

(b) some or all of the payment is not a dividend, or an amount that is a distribution by a liquidator which is taken to be a dividend under section 47 of the ITAA 1936; and

(c) the payment is not included in the taxpayer's assessable income.

3. CGT event G1 will happen when the Company makes the Payment to the Taxpayer in respect of a share that they own in The Company at the Record Date and continue to own at the time of that payment (section 104-135 of the ITAA 1997). In this regard, it is noted that the Payment will not occur as a result of a disposal or cancellation of shares, nor will the payment be a dividend or deemed dividend under section 47 of the ITAA 1936.

4. The Taxpayer will make a capital gain if the Payment is more than the cost base of the Taxpayer's share in the Company. The amount of the capital gain will be equal to the excess (subsection 104-135(3) of the ITAA 1997).

5. If the Taxpayer makes a capital gain when CGT event G1 happens, the cost base and reduced cost base of the share in the Company will be reduced to nil. The Taxpayer cannot make a capital loss from CGT event G1 happening (note 1 to subsection 104-135(3) of the ITAA 1997).

6. If the Payment is equal to or less than the cost base of the share in the Company at the time of the payment, the cost base and reduced cost base of the share will be reduced (but not below nil) by the amount of the payment (subsection 104-135(4) of the ITAA 1997).

Question 2

Summary

7. The Payment will not be a dividend as defined in subsection 6(1) of the ITAA 1936 and for the purposes of section 44 of the ITAA 1936.

Detailed reasoning

8. Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined in subsection 6(1) of the ITAA 1936, paid to the shareholders out of profits derived by the company from any source (if the shareholder is a resident of Australia) and from an Australian source (if the shareholder is a non-resident of Australia).

9. The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders. However, paragraph (d) specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the company.

10. The term 'share capital account' is defined in subsection 975-300(1) of the ITAA 1997 as an account which the company keeps of its share capital, or any other account created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital. Subsection 975-300(2) of the ITAA 1997 further explains that if a company has more than one share capital account, the accounts are taken for the purposes of the ITAA 1997 to be a single account.

11. Subsection 975-300(3) of the ITAA 1997 states that an account is not a share capital account, except for certain limited purposes, if it is tainted. Section 197-50 of the ITAA 1997 states that a share capital account is tainted if an amount to which Division 197 of the ITAA 1997 applies is transferred to the account and the account is not already tainted.

12. The Payment will be debited entirely against an amount standing to the credit of the Company's share capital account. As the share capital account of the Company is not tainted within the meaning of Division 197 of the ITAA 1997, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 will apply. Accordingly, the Payment will not be a dividend as defined in subsection 6(1) of the ITAA 1936 and for the purposes of section 44 of the ITAA 1936.

Question 3

Summary

13. The Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the Payment made to the Taxpayer under the proposed share capital reduction.

Detailed reasoning

14. Section 45A of the ITAA 1936 applies where capital benefits are streamed to some shareholders (the Advantaged Shareholders), who would derive a greater benefit from the receipt of capital than other shareholders (the Disadvantaged Shareholders) and these Disadvantaged Shareholders receive, or are likely to receive, dividends.

15. A reference to the 'provision of a capital benefit to a shareholder in a company' is defined in paragraph 45A(3)(b) of the ITAA 1936 to include the distribution to the shareholder of share capital. The Company will provide its shareholders with a 'capital benefit' as defined in paragraph 45A(3)(b) of the ITAA 1936. The capital benefit will be provided to all shareholders and in direct proportion to the number of shares held. Consequently no shareholder will be advantaged over other shareholders.

16. Therefore, section 45A of the ITAA 1936 will not apply to the Payment. Accordingly, the Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole, or a part, of the Payment made to the Taxpayer under the proposed share capital reduction.

Question 4

Summary

17. The Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the Payment made to the Taxpayer under the proposed share capital reduction.

Detailed reasoning

18. Section 45B of the ITAA 1936 applies where certain capital payments, including a payment arising from a share capital reduction, are paid to shareholders in substitution for dividends. It allows the Commissioner to make a determination that section 45C of the ITAA 1936 applies to a capital benefit. Specifically, the provision applies where:

• there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a) of the ITAA 1936);

• 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) of the ITAA 1936); and

• having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, entered into the scheme or carried out the scheme or any part of the scheme for a purpose, other than an incidental purpose, of enabling the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(c) of the ITAA 1936).

19. Each of these conditions is considered below.

Scheme

20. A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided in subsection 177A(1) of Part IVA of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise undertaking, scheme, plan or proposal. The Company's proposed share capital reduction would be captured within this broad definition.

21. The phrase 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936. It states that a person is provided with a capital benefit if:

• an ownership interest in a company is issued to the person;

• there is a distribution to the person of share capital; or

• the company does something in relation to an ownership interest that has the effect of increasing the value of the ownership interest (which may or may not be the same interest) held by that person.

22. As the payments made under the proposed share capital reduction will be debited to the Company's share capital account, the Company will provide shareholders with a capital benefit under paragraph 45B(5)(b) of the ITAA 1936 in the form of a distribution of share capital.

Tax benefit

23. A relevant taxpayer 'obtains a tax benefit' as defined in subsection 45B(9) of the ITAA 1936 if:

• the amount of tax payable; or

• any other amount payable under the ITAA 1936 or the ITAA 1997,

would, apart from the operation of section 45B of the ITAA 1936, be less than the amount that:

• would have been payable; or

• be payable at a later time than it would have been payable,

if the capital benefit had instead been a dividend.

24. Ordinarily, a distribution of share 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, a shareholder in the Company will obtain a tax benefit from the proposed share capital reduction.

Relevant circumstances

25. 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. A consideration of these circumstances determines whether any part of the scheme will be entered into for a purpose, other than an incidental purpose, of enabling the relevant taxpayer (a Company shareholder) to obtain a tax benefit. Each of the circumstances must be considered in order to determine whether or not, individually or collectively, they reveal the existence of the requisite purpose.

26. 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 does so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit. The purpose does not have to be the most influential or prevailing purpose, but it must be more than an incidental purpose.

27. The relevant circumstances contained in subsection 45B(8) of the ITAA 1936 cover the circumstances of the company and the tax profile of the shareholders. In this instance, because the proposed share capital reduction will be made to all the Company's shareholders, regardless of their individual circumstances, paragraphs 45B(8)(c) to 45B(8)(h) of the ITAA 1936 do not incline for or against the requisite purpose. The circumstances covered by paragraphs 45B(8)(i) and 45B(8)(j) of the ITAA 1936, pertaining to the provision of ownership interests and demergers respectively are not relevant. The relevant matters are therefore those covered by the circumstances described in paragraphs 45B(8)(a), 45B(8)(b) and 45B(8)(k) of the ITAA 1936, which are considered in detail below.

Paragraph 45B(8)(a) of the ITAA 1936 - Appropriate capital and profit allocation

28. Paragraph 45B(8)(a) of the ITAA 1936 refers to the extent to which the capital benefit is attributable to capital and profits (realised and unrealised) of the company or an associate (within the meaning of section 318 of the ITAA 1936) of the company.

29. Paragraph 1.35 of the Explanatory Memorandum to Taxation Laws Amendment (Company Law Review) Bill 1998 provides the following guidance on the expected operation of this test:

…if a company makes a profit from a transaction, for example the disposal of business assets, and then returns capital to shareholders equal to the amount of the profit, that would suggest that the distribution of capital is a substituted dividend. On the other hand, if a company disposed of a substantial part of its business at a profit and distributed an amount of share capital which could reasonably be regarded as the share capital invested in that part of the business, the distribution of capital would not be seen as a substituted dividend because no amount would be attributable to profits.

30. In this case, the directors of the Company have determined that the share capital amount is surplus to its requirements as its operations can now be funded by recurrent business income. The Company therefore proposes to return the amount of share capital by way of an equal distribution to its shareholders.

31. No part of the proposed capital return is attributable to profits, realised or unrealised, of the Company. Further, the Company proposes to continue its policy of annual dividend payments as a means of distributing profits to shareholders.

32. Therefore, this factor does not incline towards the requisite purpose.

Paragraph 45B(8)(b) of the ITAA 1936 - Pattern of distributions

33. Paragraph 45B(8)(b) of the ITAA 1936 directs attention to the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or an associate (within the meaning in section 318 of the ITAA 1936) of the company. The inference here is that an interruption to the normal pattern of profit distribution and its replacement with a capital return would suggest dividend substitution.

34. The Company has a history of paying dividends, representing a substantial proportion of its annual profits, to its ordinary shareholders.

35. In the Commissioner's view, the proposed share capital reduction is not an interruption to the normal profit distribution pattern, but rather a mechanism to return contributed capital to shareholders which is considered excess to its requirements.

36. This factor does not incline towards the requisite purpose.

Paragraph 45B(8)(k) of the ITAA 1936 - Part IVA matters

37. This circumstance requires regard to be had to any of the matters referred to in paragraphs 177D(2)(a) to 177D(2)(h) of the ITAA 1936.

38. The incorporation of the Part IVA factors into section 45B of the ITAA 1936 does not introduce a different (dominant) purpose test into section 45B of the ITAA 1936. The matters are applied in the context of the 'more than incidental purpose test' in section 45B of the ITAA 1936.

39. The eight matters in subsection 177D(2) of the ITAA 1936 are matters by reference to which a scheme is able to be examined from a practical perspective in order to identify and compare its tax and non-tax objectives. The matters include the manner in which the scheme is carried out, its form and substance, and its financial and other implications for the persons involved.

40. The Company has demonstrated that the scheme, being a proposed share capital reduction, seeks to legitimately return an amount of excess share capital to its shareholders. The return will release capital which the Company has stated is excess to its current needs. In this case, the practical implications of the scheme are consistent with it being, in form and substance, a share capital reduction. It is therefore considered that none of the matters in subsection 177D(2) of the ITAA 1997 incline towards the requisite purpose.

Conclusion

41. Having regard to the relevant circumstances of the scheme, as set out in subsection 45B(8) of the ITAA 1936, it is considered that the proposed share capital reduction is not being undertaken for a more than incidental purpose of obtaining a tax benefit.

42. Accordingly, the Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the Payment made to the Taxpayer under the proposed share capital reduction.

Question 5

Summary

43. Division 7A of the ITAA 1936 will not apply to deem any part of the Payment made under the proposed share capital reduction to be a dividend under section 109C of the ITAA 1936.

Detailed reasoning

44. Subsection 109C(1) of the ITAA 1936 provides that a private company is taken to pay a dividend to an entity if the private company pays an amount to the entity during the income year and:

• the entity is a shareholder or associate of a shareholder in the company at the time of the payment, or

• a reasonable person would conclude that the payment was made because the entity has been a shareholder or associate at some time.

45. Subsection 109L(2) of the ITAA 1936 however relevantly provides that a private company is taken not to have paid a dividend under section 109C of the ITAA 1936 where another provision of the Act has the effect of the payment not being included in the entity's assessable income.

46. With this in mind, subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined in subsection 6(1) of the ITAA 1936, paid to the shareholders out of profits derived by the company from any source (if the shareholder is a resident of Australia) and from an Australian source (if the shareholder is a non-resident of Australia).

47. The term 'dividend', is defined in subsection 6(1) of the ITAA 1936, and includes any distribution made by a company to any of its shareholders. However, paragraph (d) of subsection 6(1) of the ITAA 1936 specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the company.

48. As the Payment will be debited entirely against an amount standing to the credit of the Company's share capital account, this Payment will be excluded from being assessable income as a dividend due to the operation of paragraph (d) of subsection 6(1) of the ITAA 1936. As a consequence, it will also not be an assessable dividend of the Taxpayer under Division 7A of the ITAA 1936 due to the operation of subsection 109L(2) of the ITAA 1936.

Question 6

Summary

49. To the extent that a capital gain arises to the Taxpayer from CGT event G1 happening under the proposed share capital reduction, it will be a 'discount capital gain' under Division 115 of the ITAA 1997.

Detailed reasoning

50. A discount capital gain is a capital gain that meets the requirements of sections 115-10, 115-15, 115-20 and 115-25 of the ITAA 1997.

51. These provisions specifically require that to qualify as a discount capital gain:

(a) The capital gain must be made by an individual, trust, complying superannuation fund or a life insurance company (in respect of particular assets)- section 115-10 of the ITAA 1997;

(b) The capital gain must result from a CGT event happening after 11.45am (by legal time in the Australian Capital Territory) on 21 September1999- section 115-15 of the ITAA 1997;

(c) The capital gain must have been calculated without reference to indexation at any time;- section 115-20 of the ITAA 1997; and

(d) The capital gain must result from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least 12 months before the CGT event- section 115-25 of the ITAA 1997.

52. In the current circumstances, these conditions will be satisfied as the Taxpayer, a trust will make a capital gain, calculated without reference to indexation, when CGT event G1 happens at the time the Payment is made by the Company to the Taxpayer under the proposed share capital reduction. The relevant CGT assets (the shares in the Company) were also acquired by the Taxpayer at least 12 months before the CGT event. This capital gain will therefore be a discount capital gain.

53. It is also noted that a capital gain made by the Taxpayer in these circumstances will not be precluded from being a discount capital gain by any of the following specific provisions because:

• the capital gain will not arise from a CGT event which is excluded under subsection 115-25(3) of the ITAA 1997; and

• the circumstances described in section 115-40 of the ITAA 1997 (capital gain resulting from agreement made within a year of acquisition) and section 115-45 of the ITAA 1997 (capital gain from equity in an entity with newly acquired assets) will not be present.