Edited version of your written advice

Authorisation Number: 1051462667646

Date of advice: 18 December 2018

Ruling

Subject: Selective off market share buy-backs

Question 1

Will the Commissioner please confirm that Division 16K of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) will apply to the share buy-back transaction?

Answer

Yes

Question 2

Will the portion of the Purchase Price exceeding the $1 per share capital component, which is debited to Company’s retained earnings account, be a dividend for the purposes of section 159GZZZP of the ITAA 1936?

Answer: Yes

Question 3

Will the Dividend Component be a frankable distribution under section 202-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Unable to determine.

Question 4

Will the Commissioner conclude that section 177EA of the ITAA 1936 does not apply to the share buy-back scheme?

Answer:

Yes, but only to the extent that the dividend paid under the proposed share buy-back is frankable under section 202-40 of the ITAA 1997.

Question 5

Will the Commissioner conclude that section 204-30 of the Income Tax Assessment Act 1997 (ITAA 1997) will not apply to the share buy-back scheme?

Answer

Yes, but only to the extent that the dividend paid under the proposed share buy-back is frankable under section 202-40 of the ITAA 1997.

This ruling applies for the following period:

Year ending 30 June 20X2

The scheme commences on:

1 December 20X1

Relevant facts and circumstances

Background

The ABC School Pty Ltd (‘ABC Co’) is a private company and a resident of Australia for taxation purposes. There are currently two resident directors- Mr White and Ms White. There are 10,000 ordinary shares in ABC Co on issue with:

Aust Pty Ltd (Aust Co) owning 30% of ABC Co.

XYX Pty Ltd (XYZ) owning 10% of ABC Co.

Mr White owing 60% of ABC Co.

As mentioned above, Aust Co owns 30% in ABC Co but a cross share ownership currently exists in which ABC Co owns 20% of the ordinary shares in Aust Co.

The scheme

The key shareholder Mr White has been approached by a potential purchaser who wishes to purchase Mr White’s interests and those of his related parties interests in property holdings and share interests in:

● ABC Co

● Aust Co

● Other Co

In order to facilitate this sale, it is desirable to remove the cross share ownership between Aust Co and ABC Co. It is proposed that this will be achieved by ABC entering into an off-market selective share buy-back with Aust Co (the Participating Shareholder) in order for the Participating Shareholder’s 30% shareholding in ABC Co to be bought back by ABC Co and these shares to be subsequently cancelled.

The shareholders have agreed that the proposed off market share buy-back scheme as a means for the cross share ownership to be removed.

The participating shareholder has agreed to sell its entire holding of 3000 ordinary shares it has in ABC Co for the purchase price of $3,000,000 comprised of a $3000 capital component and a $2,997,000 dividend. To determine an appropriate dividend and capital split, the Average Capital per Share (ACPS) methodology will be utilised in accordance with paragraph 62 of PS LA 2007/9.

Pre share buy-back transaction

As at 30 June 2018, ABC has insufficient retained earnings to pay a $2,997,000 dividend to Aust Co in the proposed share buy-back. In addition there is also a shortfall in available franking credits available in order to fully frank the proposed dividend component of the share buy-back price.

Prior to the share buy-back transaction, it is expected that Aust Co and Other Co will pay a fully franked dividend to ABC Co which will raise its retained earnings and franking account balances to a level sufficient for ABC Co to enter the forthcoming selective share buy-back with Aust Co.

The selective off-market share buy-back

The Dividend will be debited to retained earnings account at the time of the share buy-back transaction is executed.

Immediately after the off market share buy-back transaction has been executed, it is expected that the ABC Co shares bought back from Aust Co will be cancelled and reduce the ordinary shares from 10,000 to 7,000. Consequently, the proportional interests in ABC Co ordinary shares held by the remaining shareholders will be:

Mr White 85.7%

XYZ Co 14.3%

Post SBB- settlement of related party loans.

After the share buy-back transaction has been executed, it is proposed that number of journal entries will be entered into between ABC Co, Aust Co and various shareholder loan accounts for the purposes of clearing these loan accounts in preparation for Mr White’s sale of his shares to a third party purchaser.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 16K

Income Tax Assessment Act 1936 section 159GZZZJ

Income Tax Assessment Act 1936 paragraph 159GZZZK(a)

Income Tax Assessment Act 1936 section 159GZZZN

Income Tax Assessment Act 1936 subsection 159GZZP(1)

Income Tax Assessment Act 1936 subsection 177A(1)

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 subsection 177EA(3)

Income Tax Assessment Act 1936 paragraph 177EA(3)(a)

Income Tax Assessment Act 1936 paragraph 177EA(3)(b)

Income Tax Assessment Act 1936 paragraph 177EA(3)(c)

Income Tax Assessment Act 1936 paragraph 177EA(3)(d)

Income Tax Assessment Act 1936 paragraph 177EA(3)(e)

Income Tax Assessment Act 1936 subsection 177EA(5)

Income Tax Assessment Act 1936 subsection 177EA(14)

Income Tax Assessment Act 1936 subsection 177EA(17)

Income Tax Assessment Act 1936 paragraph 177EA(17)(a)

Income Tax Assessment Act 1936 paragraph 177EA(17)(b)

Income Tax Assessment Act 1936 paragraph 177EA(17)(c)

Income Tax Assessment Act 1936 paragraph 177EA(17)(d)

Income Tax Assessment Act 1936 paragraph 177EA(17)(f)

Income Tax Assessment Act 1936 paragraph 177EA(17)(g)

Income Tax Assessment Act 1936 paragraph 177EA(17)(ga)

Income Tax Assessment Act 1936 paragraph 177EA(17)(i)

Income Tax Assessment Act 1936 paragraph 177EA(17)(j)

Income Tax Assessment Act 1997 section 202-5

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 section 203-5

Income Tax Assessment Act 1997 section 203-25

Income Tax Assessment Act 1997 section 204-30

Income Tax Assessment Act 1997 subsection 204-30(1)

Income Tax Assessment Act 1997 subsection 204-30(2)

Income Tax Assessment Act 1997 subsection 204-30(3)

Income Tax Assessment Act 1997 subsection 204-30(6)

Income Tax Assessment Act 1997 subsection 204-30(7)

Income Tax Assessment Act 1997 subsection 204-30(8)

Income Tax Assessment Act 1997 Division 207

Reasons for decision

Question 1 Will the Commissioner please confirm that Division 16K of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) will apply to the share buy-back transaction?

Summary:

As the company is buying shares in itself from the Participating shareholder and is cancelling them under an Agreement with the shareholders of the company, the purchase would constitute a buy-back and the buy-back is one to which Division 16K applies

Detailed Reasoning

Division 16K of the ITAA 1936 contains the rules for the tax treatment of share buy-backs and applies where a company buys a share in itself from a shareholder and cancels the share.

Under paragraph 159GZZZK(a) of the ITAA 1936, a buy-back involves a company purchasing shares in itself from a shareholder of the company. Where the shares are not listed on an official stock exchange, the buyback is an off-market buy-back under paragraph 159GZZZK(d) of the ITAA 1936.

As the company is buying shares in itself from the Participating shareholder and is cancelling them under an Agreement with the shareholders of the company, the purchase would constitute a buy-back and the buy-back is one to which Division 16K applies. As the shares are not listed on an official stock exchange, the buy-back is an off-market buy-back.

Under section 159GZZZN of the ITAA 1936, where a company buys back a share, the buy-back and any subsequent cancellation of the share is disregarded when determining whether an amount is included in the company’s assessable income, an amount is an allowable deduction to the company or in determining whether the company makes a capital gain or capital loss.

In accordance with section 159GZZZN of the ITAA 1936, the buy-back and the cancellation will be disregarded in determining the company’s assessable income, deductions, capital gains and capital losses.

Question 2 Will the portion of the Purchase Price exceeding the $1 per share capital component, which is debited to Company’s retained earnings account, be a dividend for the purposes of section 159GZZZP of the ITAA 1936?

Summary:

The Company is taken to have paid a dividend out of profits to each participating shareholder on the day of the buy-back equivalent to $999 per share under subsection 159GZZZP(1) of the ITAA 1936.

Detailed Reasoning

In an off-market share buy-back, the difference between the purchase price and any part of the purchase price in respect to the buy-back of a share debited amounts standing to the credit of the share capital account is taken to be a dividend paid out of profits by the company to the shareholder on the day the buy-back occurs under subsection 159GZZZP(1) of the ITAA 1936.

PS LA 2007/9 provides the acceptable methodologies to calculate the dividend/capital split. The Average Cost per Share (ACPS) method is the preferred method and requires a company’s ordinary issued capital to be divided by the number of shares on issue to give a reasonable of the capital component of a purchase price with any excess amount reflecting the dividend component.

The $1000 per share purchase price paid to Aust Co (or $3,000,000 when multiplied by 3000 shares that Aust Co owns in ABC Co), under the off-market share buy-back will exceed the amount that will be debited to the share capital account by $999 per share. The company used the ACPS method to reasonably estimate the dividend/capital split.

The $999 per share that Aust Co is expected to receive under the proposed share buy-back scheme as the sole participating shareholder will be taken to be a dividend paid out of profits by the Company on the day of the buy-back under subsection 159GZP(1) of the ITAA 1936.

Question 3 Will the Dividend Component be a frankable distribution under section 202-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The Dividend Component is a frankable distribution only to the extent the purchase price used in the proposed share buy-back does not exceed the market value of the ABC Co shares. The market value of the shares at the time of the proposed share buy-back is yet to be determined.

Detailed Reasoning

A distribution for the purposes of the Act is a dividend or something that is deemed to be a dividend under the Act as stated in section 960-120 of the ITAA 1997.

Under subsection 202-40(1) of the ITAA 1997, a distribution is a frankable distribution to the extent it is not un-frankable under section 202-45 of the ITAA 1997.

Section 202-45 of the ITAA 1997 provides a number of instances in which distributions are un-frankable distributions. Relevantly, subparagraph 202-45(h)(ii) of ITAA 1997 states that a deemed dividend by virtue of a section 45C determination is an un-frankable distribution.

The Dividend Component is a distribution for the purposes of the Act. The Commissioner has not considered whether sections 45A or 45B of the ITAA 1936 apply to the off-market share buy-back and, as such, has not made a section 45C determination. Therefore, the Dividend Component is a frankable distribution at this time.

However, should the Commissioner consider sections 45A and/or 45B of the ITAA 1936 at a later time and make a section 45C determination, the Dividend Component would be an un-frankable distribution in accordance with subparagraph 202-45(h)(ii) of the ITAA 1997.

Also paragraph 202-45(c) of the ITAA 1997 also provides that if the buy-back of a share by a company from one of its members is taken to be a dividend under 159GZZZP of the ITAA 1936, the amount of the purchase price that exceeds the market value of the shares at the time of the buy-back-price will be un-frankable.

The current market value of the shares at the time of the share buy-back cannot be determined at this stage as the share buy-back has not yet been executed yet and therefore the Commissioner is not in a position to determine the extent to which the dividend component of the share buy-back is frankable.

Question 4 Will the Commissioner conclude that section 177EA of the ITAA 1936 does not apply to the share buy-back scheme?

Summary

After consideration of the relevant circumstances, the Commissioner concludes that the provision of imputation benefits (but for any un-frankable portion under section 202-45(c)) to the Participating Shareholder was incidental to the off-market share buy-back. As the requisite purpose does not exist, section 177EA of the ITAA 1936 does not apply and no determination will be made under subsection 177EA(5) of the ITAA 1936.

Detailed reasoning

As mentioned above in Question 3, due to the fact that exact extent of the proposed dividend under the share buy-back is frankable under section 202-40 of the ITAA 1997, this question will address the treatment of imputation benefits taking into account that the Commissioner is not aware of the extent that the dividend proposed to the paid under the share buy-back is frankable under section 202-40 of the ITAA 1997.

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies to a wide range of schemes to obtain a tax advantage in relation to imputation benefits.

Subsection 177EA(3) of the ITAA 1936 states:

This section applies if:

(a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and

(c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d) except for this section, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

(e) 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 an imputation benefit.

Scheme for a disposition of member interests in a corporate tax entity

A scheme is defined in subsection 177A(1) of the ITAA 1936 as:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

Subsection 177EA(14) defines a ‘scheme for a disposition of membership interests’. A scheme for a disposition of membership interests would include an off-market share buy-back arrangement.

The Company is a corporate tax entity. As the off-market share buy-back of the Company’s shares constitutes a scheme for a disposition, paragraph 177EA(3)(a) of the ITAA 1936 is satisfied.

Frankable distribution has been paid to a person in respect of the membership interest

The Commissioner concluded in Question 3 that the Dividend Component paid to Aust Co under the share buy-back scheme is a frankable only if the purchase price of the shares in the proposed share buy-back does not exceed the market value of the shares in ABC Co.

As the market value of the shares is currently unavailable, the Commissioner is unable to determine the market value of shares in ABC Co at the time of the share buy-back and therefore cannot discount the possibility that some or all of the dividend component of the proposed share buy-back may be unfrankable under paragraph 202-45(c) of the ITAA 1997.

This is in addition to the requirement that a section 45C determination is not made at a later time if sections 45A and/or 45B of the ITAA 1936 are considered.

The distribution was a franked distribution

A distribution is a franked distribution if it is franked in accordance with section 202-5 of the ITAA 1997. Specifically, section 202-5 of the ITAA 1997 requires:

● the entity to be a franking entity and a resident at the time of the distribution

● the distribution to be a frankable distribution; and

● the entity to allocate franking credits to the distribution.

The Company proposes to pay a dividend component to Aust Co under the Share buy-back scheme. The Dividend Component will constitute a distribution. The Company is also a franking entity by virtue of being a corporate tax entity and will remain a resident at the time of the proposed distribution.

The Commissioner concluded at Question 3 that the Dividend Component will be a frankable distribution provided that:

● a section 45C determination is not made at a later time when sections 45A and/or 45B of the ITAA 1936 are considered. The Company allocated franking credits to the Dividend Component; and

● that the dividend is not an un-frankable distribution under paragraph 202-45(c) of the ITAA 1997.

The Dividend Component was a franked distribution and, as such, paragraph 177EA(3)(c) of the ITAA 1936 is satisfied.

As mentioned above, as the Commissioner if not in a position to consider the market value of the ABC Co shares being bought back from Aust Co, at the time of the share buy-back. Consequently, it cannot be currently determined the extent of the dividend proposed to be paid to Aust Co under the share buy-back transaction as being franked under section 202-5.

The relevant taxpayer would receive imputation benefits except for section 177EA

The only relevant taxpayer in this arrangement is Aust Co who is the only Participating Shareholder.

Situations in which a relevant taxpayer would directly receive an imputation benefit as a result of a distribution are detailed in subsection 204-30(6) of the ITAA 1997 and include:

● where a shareholder is entitled to the franking credit offset under Division 207 of the ITAA 1997 (paragraph 204-30(6)(a) of the ITAA 1997); and

● an amount of franking credit included in the assessable income of a trust provided that trust is not a corporate tax entity or a complying superannuation entity (paragraph 204-30(6)(b) and section 204-35 of the ITAA 1997).

To the extent that the requirement that the dividend paid is frankable under sections 202-40 and 202-45 of the ITAA 1997, the participating shareholder is expected to be entitled to the franking credit offset under Division 207 of the ITAA 1997. Consequently, the Participating Shareholder would receive an imputation benefit as a result of receiving the Dividend Component, but for the operation of section 177EA of the ITAA 1936.

On the basis of the assumption that the participating shareholder (Aust Co) is a corporate tax entity when the distribution was made, it is expected that Aust Co would receive an imputation benefit as an amount equal to the franking credit is included in its assessable income, but for the operation of section 177EA of the ITAA 1936.

As the relevant taxpayer (Aust Co) received an imputation benefit as a result of the distribution, paragraph 177EA(3)(d) of the ITAA 1936 would be satisfied.

There was a more than incidental purpose of enabling the relevant taxpayer to obtain an imputation benefit

Subsection 177EA(17) of the ITAA 1936 provides the relevant circumstances of a scheme that need to be considered in determining whether there was a more than incidental purpose of enabling a relevant taxpayer to obtain an imputation benefit.

The relevant circumstances listed in subsection 177EA(17) of the ITAA 1936 encompass a range of circumstances, which taken individually or collectively, could indicate the requisite purposes. Due to the diverse nature of the circumstances, some may or may not be present at any one time in relation to a particular scheme.

The relevant circumstances as they apply in this case are:

● the Participating Shareholder held the risks of loss and the opportunities for profit or gain the entire time they held shares in the Company. There is no evidence suggesting that anything was done to mitigate or alter the risks the Participating Shareholder was exposed to during the period they held shares in the Company (paragraph 177EA(17)(a) of the ITAA 1997)

● as the shareholders of the Company include residents who would also benefit from the franking credit offset, the Participating Shareholder would have derived a greater benefit from the franking credits attached to the Dividend Component than other shareholders who are not participating in the proposed share buy-back in the income year in which the distribution was made as per subsection 204-30(8) of the ITAA 1936 (paragraph 177EA(17)(b) of the ITAA 1997)

● if the off-market share buy-back had not occurred, the Company would have made franked distributions directly to the Company Shareholders in line with its existing dividend policy (paragraphs 177EA(17)(c) and (d) of the ITAA 1997)

● there is no consideration paid by the Participating Shareholder that represents the value of franking (paragraph 177EA(17)(f) of the ITAA 1997)

● there is no evidence to support a conclusion that a deduction is allowable or a capital loss is incurred in connection with the Dividend Component under the scheme (paragraph 177EA(17)(g) of the ITAA 1997)

● the Dividend Component is not sourced from unrealised or untaxed profits (paragraph 177EA(17)(ga) of the ITAA 1997)

● the Participating Shareholder held shares in the Company for an extended period of time (paragraph 177EA(17)(i) of the ITAA 1997)

● no steps undertaken as part of the off-market share buy-back suggest contrivance or artificiality, there is no disparity between the substance of the scheme and its form and there are no obvious timing advantages under the scheme (paragraph 177EA(17)(j) of the ITAA 1997); and

● the only entities whose financial position has changed under the off-market share buy-back is the Company who has less share capital and the Participating Shareholder whose financial position has changed due to the desire to exit the Company (paragraph 177EA(17)(j) of the ITAA 1997).

After consideration of the relevant circumstances, the Commissioner concludes that the provision of imputation benefits (if any) to the Participating Shareholder was incidental to the off-market share buy-back.

The Commissioner therefore concludes that the Company and the Participating Shareholder did not enter into the Arrangement for a more than incidental purpose of enabling the Participating Shareholder to obtain an imputation benefit.

The Commissioner will therefore not make a determination under subsection 177EA(5) of the ITAA 1997.

Question 5 Will the Commissioner conclude that section 204-30 of the Income Tax Assessment Act 1997 (ITAA 1997) will not apply to the share buy-back scheme?

Summary

As there was no streaming of distributions in such a way that favoured the Participating shareholder over other (non-participating) shareholders, the Commissioner concludes that section 204-30 of the ITAA 1997 would not apply and therefore no determination under subsection 204-30(3) of the ITAA 1997 will be made.

Detailed reasoning

Subdivision 204-D of the ITAA 1997 aims to prevent the streaming of imputation benefits to one member of a corporate tax entity in preference to another. Subsection 204-30(1) of the ITAA 1997 states:

This section empowers the Commissioner to make determinations if an entity streams one or more *distributions (or one or more distributions and the giving of other benefits), whether in a single *franking period or in a number of franking periods, in such a way that:

(a) an imputation benefit is, or apart from this section would be, received by a *member of the entity as a result of the distribution or distributions; and

(b) the member would *derive a *greater benefit from franking credits than another member of the entity; and

(c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

The member that derives the greater benefit from franking credits is the favoured member. The member that receives the lesser imputation benefits is the disadvantaged member.

A distribution is defined in subsection 960-120 of the ITAA 1997 as a dividend or something taken to be a dividend under the Act.

Where the above is present, the Commissioner can make a determination to either debit the franking account of the entity or that no imputation benefit is to arise in relation to the distribution made to the favoured member under subsection 204-30(3) of the ITAA 1997.

An imputation benefit is (relevantly) received as a result of a distribution where a member:

● is entitled to a tax offset under Division 207 of the ITAA 1997 (paragraph 204-30(6)(a) of the ITAA 1997); or

● includes an amount in assessable income as a result of the distribution by virtue of section 207-35 of the ITAA 1936 (paragraph 204-30(6)(b) of the ITAA 1997).

A favoured member receives a greater benefit from franking credits than another member pursuant to subsection 204-30(8) of the ITAA 1997 where, for example:

● the other member is a foreign resident (paragraph 204-30(8)(a) of the ITAA 1997); and

● the other member is not entitled to a tax offset under Division 207 because of the distribution (paragraph 204-30(8)(b) of the ITAA 1997).

However, subsection 204-30(7) of the ITAA 1997 states the above list should not be considered as exhaustive.

The term “streaming” is not defined in the Act. Streaming of distributions is roundly thought of as selectively directing the flow of franked distributions to those members who can most benefit from imputation benefits as stated in paragraph 3.28 of Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002.

Under the Share buy-back scheme, the Participating Shareholder if they meet the requirements of section 202-40 of the ITAA 1997 is expected to be provided with an imputation benefit as a result of the Dividend Component paid in relation to the buy-back of their shares. As the Participating Shareholder is a resident, they would have received a greater benefit from franking credits than other Company shareholders. The other shareholders did not receive any imputation benefits because they are expected to participate in the proposed share buy-back.

The Commissioner points to the fact that the Company shareholders who did not participate in the Scheme were resident entities and that the Company only has one class of share on issue.

What occurred under the Scheme would not constitute streaming of distributions to favoured shareholders. The imputation benefit (if any) expected to be provided to the Participating Shareholder would be merely incidental to the exit of this shareholder from the Company.

Subject to whether the distributions are frankable under section 202-40 of the ITAA 1997, the Commissioner concludes that section 204-30 of the ITAA 1997 would not apply and therefore no determination as provided under subsection 204-30(3) of the ITAA 1997 will be made.