Edited version of your written advice

Authorisation Number: 1051203511663

Date of advice: 22 March 2017

Ruling

Subject: Tax treatment of liquidator distributions

Question 1

Will the proceeds from the sale of Land by Company X be a deemed dividend under section 47 of the Income Tax Assessment Act 1936 (ITAA 1936) when the sale proceeds are distributed to the shareholders of Company X in the course of winding up the company?

Answer

No

Question 2

Will section 45B of the ITAA 1936 apply to a capital payment made in respect of the shares sourced from the pre-CGT profit reserve or realised pre-CGT profit reserve?

Answer

No

Question 3

Will Part IVA of the ITAA 1936 apply to a capital payment made from the pre-CGT profit reserve or realised pre-CGT profit reserve?

Answer

No

This ruling applies for the following period

Income year ended 30 June 2017

Income year ended 30 June 2018

The scheme commenced on

1 July 2016

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Sometime before 20 September 1985, Company X acquired land.

Company X used the Land in operating a farming business either by the Company or as lessor of the land to a related entity.

Under subsection 149-30(1) of the Income Tax Assessment Act 1997 (ITAA 1997), the Land stopped being a pre-CGT asset at the earliest time when the majority underlying interests in the Land were not held by the ultimate owners who held the majority underlying interest in the asset immediately before 20 September 1985.

In accordance with Section 149-35 of the ITAA 1997 the first element of the cost base of the Land is the market value at the time referred to in subsection 149-30(1).

Company X obtained a valuation of the Land. The valuation was signed off by registered members of the Australian Property Institute.

The difference between the historical cost price for the acquisition of the Land and the market value under valuation was allocated in the accounts of Company X to a "pre-CGT Reserve".

There were two prior disposals of part of the land. The first was a partial sale of the land. The second occurred at a later time. A portion of the gain was treated as a disposal of a post CGT asset by reason of the operation of Division 149 of the ITAA 1997 and included in the assessable income of Company X.

There was a further sale of the remaining Land. Company X executed a Contract for the sale of the remaining Land. The Contract indicated that the sale was of a farming business and GST going concern.

At the time of settlement, there was no development undertaken on the land. No capital works, no registered plan of subdivision obtained as a precursor to a sale of individual smaller blocks of land. The Land was sold "as is" with a farming business or going concern.

The Directors, with the consent of the Shareholders of Company X, intend to wind up Company X. Consequently, a Liquidator will be appointed as part of a member's voluntary wind up.

The total pre CGT reserve after the sale of the Land will be distributed to the Shareholders by the Liquidator.

The Shareholders wish to wind up Company X and realise their investment. Company X has no substantial assets other than cash or debtors. The Shareholders do not wish to conduct any further business venture in Company X.

Under the Voluntary Wind Up process a Liquidator will be appointed who will collect and call in the assets and distribute the amounts to the Shareholders.

Assumptions

Since 19 September 1985, the shareholding of Company X changed on several occasions, and an analysis undertaken of the shareholding indicated that the majority underlying interest in the land for the purposes of Section 149-15 of the ITAA 1997 changed.

Company X sustained trading losses from farming, and capital losses from the sale of the Land. Further, Company X also incurred capital losses from the sale of post-CGT improvements to the Land. As a consequence of trading and other issues, as well as the effect of the second, third, fourth and fifth elements of the cost base of the land that arose after the change in majority underlying interest, no capital gain was realised when the sale of the remaining Land was completed.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 44

Income Tax Assessment Act 1936 Section 45B

Income Tax Assessment Act 1936 Section 47

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 Section 177A

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Division 149

Income Tax Assessment Act 1997 Division 149-15

Income Tax Assessment Act 1997 Section 149-30

Income Tax Assessment Act 1997 Section 149-35

Reasons for decision

Question 1

Summary

The proceeds from the sale of Land by Company X will not be a deemed dividend under section 47 of the ITAA 1936 when the sale proceeds are distributed to the shareholders of Company X in the course of winding up the company.

Detailed reasoning

Liquidator distributions from the capital reserve account sourced from assets acquired prior to 20 September 1985 are, in some circumstances, not taxable as either a deemed dividend under section 47 of the ITAA 1936, or a net capital gain under section 104-25 of the ITAA 1997. If the assets were acquired prior to 20 September 1985 and a capital gain is disregarded, then these assets maintain the tax-free status of the distribution from the capital profits reserve account.

Archer Bros Pty Ltd (In Vol Liq) v. FCT (1953) 90 CLR 140; 27 ALJ 353; 10 ATD 192 (Archers Case) discusses distributions. In a joint judgement, the Full High Court of Australia in Archers Case observed by way of obiter dicta:

By a proper system of bookkeeping the liquidator, in the same way as the accountant of a private company which is a going concern, could so keep his accounts that…distributions could be made wholly and exclusively out of…particular profits…or income…'

Taxation Ruling TR 95/10 discusses the significance of the “Archer Brothers principle” in the context of liquidation distributions:

The observations in Archers Case have given rise to what is known as the Archer Brothers principle. The principle is that if a liquidator appropriates a particular fund of profit or income in making a distribution, that appropriation ordinarily determines the character of the distributed amount for the purposes of the Income Tax Assessment Act. Generally, a liquidator may rely on the Archer Brothers principle, except where a specific provision produces a different result.

Archers Case refers to 'profits' or 'income'. However, if a liquidator ostensibly distributes an amount representing capital actually contributed by shareholders, we accept that the distribution is treated as a non-dividend return of capital.

Provided the liquidator is able to identify the source from which a particular distribution is made, we will accept a liquidators nominated appropriation. For example, identifying pre-CGT non-assessable profits separately to post-CGT capital gains.

If a liquidator can identify the source of funds distributed, then those funds retain the character of the source. So, a pre-CGT gain on disposal of land would remain pre-CGT when it was distributed and would therefore be tax free to the shareholders.

Section 47 of the ITAA 1997 specifically deems certain amounts to be dividends paid to the Shareholders out of the profits derived by the Company.

Specifically, subsection 47(1) of the ITAA 1936 provides that:

Distributions to shareholders of a company by a liquidator in the course of winding-up the company, to the extent to which they represent income derived by the company (whether before or during liquidation) other than income which has been properly applied to replace a loss of paid-up share capital, shall, for the purposes of this Act, be deemed to be dividends paid to the shareholders by the company out of profits derived by it.

The use of the term "income" in the context of subsection 47(1) of the ITAA 1997 has been interpreted in Gibb v FCT (1966) 118 CLR 628 as meaning income according to ordinary concepts rather than "assessable income". Hence, amounts that are deemed to be assessable income but are not of an income or revenue character are not considered, for the purposes of subsection 47(1) to be "income".

As the Land was the principal asset of Company X since its acquisition pre 1985, it is considered that the gain made on the disposal of the land was not income according to ordinary concepts. There is no suggestion that the land was ventured into a profit making undertaking or scheme. There was no development on the land. It was land that was leased or used in a farming business. It was the profit yielding subject as that term was used in the Sun Newspapers Ltd v FCT (1938) 61 CLR 337 decision per Dixon J. It was of an enduring character.

Subsection 47(1A) of the ITAA 1997 includes in the reference in subsection 47(1) to income derived by a Company a reference to an amount included in the Company's assessable income or a net capital gain that would be included in the Company's assessable income if the required net capital gain is worked out in accordance with the method statement contained in paragraph 47(1A)(b) of the ITAA 1997.

The effect of subsection 47(1A) of the ITAA 1997 is that it only includes in income the net capital gains that are included in assessable income (without indexation) under Part 3-3 of the ITAA 1997. Capital gains that are disregarded or otherwise not within the concept of a net capital gain included in the assessable income of the Company are also not within the meaning of the word "income".

In the case of a pre-CGT asset held by a Company at a time when the majority underlying ownership changes, subsection 149-30(1) of the ITAA 1997 specifies that the pre-CGT asset stops being a pre-CGT asset at the earliest time when the majority underlying interests in the asset were not held by the ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985.

Subsection 149-30(1A) of the ITAA 1997 treats the asset as having been acquired at that earliest time within subsection 149-30(1). Under section 149-35 of the ITAA 1997, the first element of the cost base of the asset is the market value at the time referred to in subsection 149-30(1) (i.e. the earliest time the majority underlying ownership ceased).

On the basis that the gain made on the disposal of the land was not income, then subsection 47(1A) only includes as "income" within subsection 47(1), an amount of a net capital gain that will be included in the Company's assessable income for year of income. The net capital gain that would be included is the difference between the capital proceeds and the cost base of the land.

The first element of that cost base as specified in section 149-35 of the ITAA 1997 is the market value of the property at the time the majority underlying interest changed. In this case it is assumed that the majority underlying interest changed. Hence, the difference between the selling price under the Contract (less the market value of the land sold at the time of the change of majority underlying ownership) is the amount that is included in "income" by reason of the extension of that concept made under subsection 47(1A) of the ITAA 1997.

It is also assumed that Company X sustained trading losses from farming, and capital losses from the sale of the Land. Further, that Company X also incurred capital losses from the sale of post-CGT improvements to the Land. As a consequence of these losses, there is no capital gain that will be included as income within subsection 47(1A) of the ITAA 1997 by reason of the respective losses Company X sustained as well as the effect of the second, third, fourth and fifth elements of the cost base of the land that arose after the change in majority underlying interest.

It is therefore considered that the proceeds from the sale of Land by Company X will not be a deemed dividend under section 47 of the ITAA 1936 when the sale proceeds are distributed to the shareholders of Company X in the course of winding up the company.

With regard to the pre-CGT profit reserve in the accounts of Company X, at the time the pre-CGT profit reserve was created, the profit had not been realised. It was created as a result of the operation of Division 149 of the ITAA 1997. Once the property was sold, the pre-CGT profit as reflected in that reserve was realised.

There is no aspect of the reserve that relates to anything other than a pre-CGT profit. Therefore, it is considered that if the Liquidator appropriated the pre-CGT profit reserve that was created at the time Division 149 of the ITAA 1997 applied, the principle in Archers Case will apply to the reserve and it ought not to be treated as income for the purposes of Section 47(1) of the ITAA 1997.

The Applicant has advised that it is proposed to reverse the pre-CGT profit reserve and create a "realised pre-CGT profit reserve". The amounts will be the same and will reflect the same thing. The only distinction is that the profit within the "realised pre-CGT profit reserve" will represent a realised profit. It is considered that this accounting treatment would also be consistent with the decision in Archers Case and with the guidance provided in Taxation Determination TD 95/10.

Further, regardless of whether a realised pre-CGT profit reserve or a pre-CGT profit reserve is used to record the sale of the Pastoral Land, it is considered that any payment by a Liquidator in the future would be treated as a capital payment that will not result in a capital gain for the reasons outlined above.

Question 2

Summary

Section 45B of the ITAA 1936 will not apply to a capital payment made in respect of the shares sourced from the pre-CGT profit reserve or realised pre-CGT profit reserve.

Detailed reasoning

Subsection 45B(2) of the ITAA 1936 applies if:

(a) there is a scheme under which a person is provided with a capital benefit by a Company; and

(b) 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; and

(c) having regard to the relevant circumstance 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 a taxpayer (the relevant taxpayer) to obtain a tax benefit.

Subsection 45B(5) of the ITAA 1936 defines being provided with a capital benefit as a reference to any of the following:

(a) the provision of ownership interests in a company to the person;

(b) the distribution to the person of share capital or share premium;

(c) something that is done in relation to an ownership interest that has the effect of increasing the value of an ownership interest.

Subsection 45B(8) of the ITAA 1936 outlines the relevant circumstances of the scheme as including:

(a) the extent to which the capital benefit is attributed to capital or the extent to which the capital benefit is attributable to profits (realised and unrealised of the company or an associate;

(b) the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or by an associate of the company;

(c) whether the relevant taxpayer has capital losses that, apart from the scheme, would be unutilised at the end of the relevant income year;

(d) whether some or all of the ownership interests in the company or an associate of the company held by the relevant Taxpayer were acquired or taken to have been acquired by the relevant taxpayer before 20 September 1985;

(e) whether the relevant Taxpayer is a non-resident;

(f) whether the cost base of the relevant ownership interest is not substantially less than the value of the applicable capital benefit;

(g) Repealed;

(h) if the scheme involved the distribution of share capital or share premium — whether the interests held by the relevant taxpayer after the distribution is the same as the interest that would have been if the equivalent dividend had been paid instead of the distribution of share capital or share premium;

(i) if the schemes involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests:

(i) The period for which the ownership interests are held by the holder of the interests;

(ii) When the arrangement for the disposal of the ownership interests was entered into;

(k) any of the matters referred to in subsection 177D(2).

The intent of section 45B of the ITAA 1936 is to ensure relevant amounts are treated as dividends for taxation purposes if:

(a) components of a demerger allocation as between capital and profit do not reflect the circumstance of a demerger; or

(b) certain payments, allocations and distributions are made in substitution for dividends.

Paragraphs 30-33 of Practice Statement Law Administration PSLA 2008/10 states:

In essence, the second object of section 45B is concerned with ensuring that companies do not distribute what are effectively profits to shareholders as preferentially-taxed capital rather than dividends. The substituted dividend rule of section 45B requires the Commissioner to identify and weigh all of the relevant circumstances surrounding the provision of a 'capital benefit' to the relevant taxpayer in order to determine whether the object of delivering a tax preferred receipt to the shareholders constitutes more than an incidental purpose of the scheme.

Section 45B does not premise that a dividend would have been paid if share capital had not been distributed, unlike Part IVA which operates on the basis of reasonable expectation of the alternative. Rather, the reference in section 45B to dividend substitution is a reference to distributions being more readily attributable to the company's profits than its share capital.

As noted at paragraph 59 PS LA2005/21, section 45B is concerned not only with capital benefits provided in substitution for an ordinary dividend but also the substitution of capital benefits for extraordinary dividends.

In the context of the above comments, section 45B of the ITAA 1936 is focussed on return of capital benefits when the Company continues operating rather than on liquidation.

In this case, the purpose of liquidating Company X is so that the shareholders may realise their investment and continue on individually, rather than conduct another business venture. The subject of the business venture being the Land was sold. There is no longer any need for Company X. The Shareholders determined that Company X ought to be wound up and the net proceeds within Company X be distributed to the shareholders as such.

It is not considered that there is a dominant purpose or an incidental purpose that a capital payment is being made to a shareholder under a scheme in substitution for a dividend. Nor is there a dominant purpose or incidental purpose of providing a tax benefit.

It is considered that the comments made in Mills v Commissioner of Taxation [2012] HCA 51 are equally relevant to the application of section 45B of the ITAA 1936. To facilitate the winding up of a company, the shareholders are given a capital benefit that arises by the Liquidator appropriating, inter alia, the pre CGT capital profits reserve as part of the process of distribution the net assets of the company. The provision of the capital benefit is incidental to the process of liquidating the company. It is not the streaming of a capital benefit arising where the provision of that benefit is incidental some other purpose.

Therefore, section 45B of the ITAA 1936 will not apply to a capital payment made in respect of the shares sourced from the pre-CGT profit reserve or "realised pre-CGT profit reserve".

Question 3

Summary

Part IVA of the ITAA 1936 will not apply to a capital payment made from the pre-CGT profit reserve or realised pre-CGT profit reserve.

Detailed reasoning

The main elements of Part IVA of the ITAA 1936 contained in section 177D are that there is a scheme that was entered into for a purpose of enabling a taxpayer to obtain a tax benefit. The relevant importance of "purpose" is that the purpose must be the dominant or most influential purpose of obtaining a tax benefit as part of the scheme (subsection 177A(5) of the ITAA 1936).

In this case, the scheme involves the decision to liquidate Company X instead of choosing to pay the pre-CGT profit out as a dividend prior to liquidation.

The issue is whether the decision to liquidate had a dominant purpose of enabling a taxpayer to obtain a tax benefit. The reason for the liquidation is the desire of the shareholders to realise their investment. Further, the shareholders have no intention of conducting another business venture in Company X. The primary asset of Company X was sold. The proceeds now need to be paid to the shareholders and Company X wound up.

In this case, the liquidation of Company X results in the payment of a capital amount to shareholders that are sourced form a pre-CGT profit reserve or a realised pre-CGT profit reserve. It is not considered that any of the anti-avoidance provisions apply to the decision to liquidate the company.

Therefore, Part IVA of the ITAA 1936 will not apply to a capital payment made from the pre-CGT profit reserve or realised pre-CGT profit reserve.