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Edited version of your written advice
Authorisation Number: 1051463598873
Date of advice: 05 December 2018
Ruling
Subject: Capital gains disregarded when calculating a deemed dividend under section 47 of the ITAA 1936
Question
If in the course of winding up a company the liquidator makes a distribution to its shareholders, the portion of the distribution attributed to a capital gain disregarded by the company during the year of income, will also be disregarded by the shareholders under section 47 of the ITAA 1936.
Answer
Yes
This ruling applies for the following period
Year ending 30 June 2019
Relevant facts and circumstances
Company A intends to sell all the shares (the Sale) that it owns in Company B. These shares were acquired before 19 September 1985 and the Sale will result in a Capital Gains Tax (CGT) event A1 capital gain that is disregarded under subsection 104-10(5) of the Income Tax Assessment Act 1997 (ITAA 1997).
After the Sale, Company A will be liquidated pursuant to section 495 of the Corporations Act 2001.
The profits from the Sale will be placed in a pre-CGT profits reserve.
The liquidator will make distributions from the capital profits reserve to the shareholders of Company A in the course of its winding up.
Assumption
The capital gain, calculated under CGT event K6 as per section 104-230 of the ITAA 1997, will be undertaken by Company A after a valuation of the assets of Company B is obtained.
Relevant legislative provisions
Income Tax Assessment Act 1997 subsection 104-10(5)
Income Tax Assessment Act 1997 section 104-230
Income Tax Assessment Act 1936 section 47
Income Tax Assessment Act 1936 subsection 47(1)
Income Tax Assessment Act 1936 subsection 47(1A)
Corporations Act 2001 section 495
Reasons for decision
Subsection 47(1) of the ITAA 1936 deems certain amounts distributed to shareholders by a liquidator in the course of winding up a company to be a dividend, where the amounts distributed by the liquidator 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.
Subsection 47(1A) of the ITAA 1936 determines that income referred to in subsection 47(1) includes:
(a) an amount (except a net capital gain) included in the company's assessable income for a year of income; or
(b) a net capital gain that would be included in the company's assessable income for a year of income if the ITAA 1997 required a net capital gain to be worked out as follows:
Step 1: Work out each capital gain (except a capital gain that is disregarded) that the company made during that year of income without indexation.
Step 2: Total the capital gains worked out under step 1. The result is the net capital gain for that year of income.
Therefore, a capital gain disregarded under subsection 104-10(5) of the ITAA 1997 will not be included in the deemed dividend distributed to shareholders in the course of the winding up of a company.
However, in order for the non-taxable gains to retain their character when distributed to the shareholders, upon winding up of the company, it must be clear that it is from a non-taxable source.
The Arthur Brothers principle resulted from observations made by the Full High Court of Australia in Archer Bros Pty Ltd (In Vol Liq) v. FCT (1952-53) 90 CLR 140 at 155; 10 ATD 192 at 201. The principle is that if a liquidator appropriates (or 'sources') a particular fund of profit or income in making a distribution (or part of a distribution), that appropriation ordinarily determines the character of the distributed amount for the purposes of section 47 and other provisions of the ITAA 1936.
Taxation Determination TD 95/10 Income tax: what is the significance of the archer Brothers Principle in the context of liquidation distributions? (TD 95/10) states at paragraph 4 that the principle applies if the company accounts have been kept so that a liquidator can clearly identify a specific profit or fund in making a distribution and it is clear from either the accounts or statements of distribution that the liquidator has appropriated the specific profit or fund in making the distribution.
In the case of Company A the profits from the Sale will be placed in a pre-CGT profits reserve. The liquidator will make distributions from the capital profits reserve to the shareholders of Company A in the course of its winding up.
Therefore the source of the distribution will be clearly identifiable as from a non-taxable source of the company and will accordingly not be taxable in the hands of the shareholders to whom it is distributed.