Edited version of your written advice

Authorisation Number: 1051474648980

Date of advice: 18 January 2019

Ruling

Subject: Return of capital

Question 1

Will the proposed return of capital by Company A constitute a dividend as defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

Question 2

Will the Commissioner make a determination under subsection 45B(3) of the Income Tax Assessment Act 1936 (ITAA 1936) that section 45C of the ITAA 1936 applies to the whole, or any part of the return of share capital by Company A?

Answer

No

This ruling applies for the following period:

1 January 2019 to 31 December 2019

The scheme commences on:

1 January 2019

Relevant facts and circumstances

1. Company A is an Australian Proprietary Company incorporated in 2015.

2. Company A is the head company of an Australian tax consolidated group with one wholly owned subsidiary member (Subsidiary 1).

3. Company A also has two 80% owned Australian subsidiary companies in its economic group (referred to as Subsidiary 2 and Subsidiary 3 in this Ruling).

4. Company A adopted a substituted accounting period and its income year ends on 31 December.

5. Company A is 100% owned by Company B, a non-resident company incorporated and headquartered overseas.

6. Company B did not have any Australian carry forward capital losses.

7. Company A proposes a return of capital to Company B.

8. Company A intends to reorganise the current structure such that the all the subsidiary members will have the same parent entity in which Company B and other shareholder will share the equity interests.

9. Company B proposed to introduce the Minority Shareholders of Subsidiary 2 and Subsidiary 3 into Company A in exchange of their interest in the Subsidiary 2 and Subsidiary 3.

10. After the proposed restructure, Company A will own 100% interest in both Subsidiary 2 and Subsidiary 3.

11. Company A’s share capital account (as defined in section 975-300 of the ITAA 1997), or equivalent account, is not tainted within the meaning of Division 197 of the ITAA 1997.

12. Company A proposed to return $ x million of the capital to Company B, the whole amount of capital return will be debited against the Company A’s share capital account.

13. The journal entries to record the respective steps of the capital return will be as follows:

14. The return of capital will not impact Company A’s total shares on issue.

15. The return of the capital will be funded by an interest bearing loan from Company B.

16. Company A is wholly owned by Company B, and Company A’s issued share capital is made up of xx million ordinary shares of $1.

17. Company A is wholly equity funded without any external debts at present.

18. Company A has not paid any dividends since incorporation.

19. Company A has been in a loss position since incorporation, and it does not expect to make any profit for the current financial year ended 31 December 2018.

20. Company A has a franking account balance of nil.

21. At the time the capital return is implemented, Company A will not have any material current year profits or unrealised gains, which could be the source for the capital return.

Relevant legislative provisions

Income Tax Assessment Act 1936 (ITAA 1936) Subsection 6(1)

ITAA 1936 section 45A

ITAA 1936 section 45B

ITAA 1936 Section 45C

Income Tax Assessment Act 1997 (ITAA 1997) section 104-25

ITAA 1997 section 104-135

ITAA 1997 Division 197

ITAA 1997 section 197-50

ITAA 1997 section 975-300

ITAA 1997 995-1(1)

Reasons for decision

Question 1

Summary

The return of capital by Company A will not be a dividend as defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936).

Detailed reasoning

Subsection 44(1) of the ITAA 1936 includes in a shareholder’s assessable income any dividends as defined in subsection 6(1), paid to the shareholder 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).

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 the definition of ‘dividend’ excludes a distribution from the meaning of ‘dividend’ if the amount of the distribution is debited against an amount standing to the credit of the company’s share capital account.

The term ‘share capital account’ is defined in section 975-300 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(3) of the ITAA 1997 provides that an account is generally taken not to be a share capital account 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.

Company A’s share capital consists solely of ordinary shares. The return of share capital will be debited against Company A’s share capital account. Company A has confirmed that its share capital account is not tainted within the meaning of Division 197 of the ITAA 1997.

As such, paragraph (d) of the definition of dividend in subsection 6(1) of ITAA 1936 applies and the distribution of share capital is not a dividend as defined in subsection 6(1) of ITAA 1936.

Question 2

Summary

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 whole, or any part of the return of share capital by Company A to Company B.

Detailed reasoning

Section 45B applies where certain capital payments are made to shareholders in substitution for dividends. In broad terms, subsection 45B(2) applies where:

a) there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a)); 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 (paragraph 45B(2)(b)); and

c) 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 a taxpayer (the relevant taxpayer) to obtain a tax benefit (paragraph 45B(2)(c)).

Each condition is considered below.

Scheme

For paragraph 45B(2)(a) of the ITAA 1936 to be satisfied, a taxpayer must be provided with a capital benefit by a company under a scheme. A scheme for the purposes of section 45B has the meaning given by subsection 995-1(1) of the ITAA 1997 (see subsection 45B(10) of the ITAA 1936). A scheme is broadly defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a) any arrangement; or

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

The phrase ‘provided with a capital benefit’ is defined in subsection 45B(5) of the ITAA 1936. Relevantly, it includes the provision of ownership interests in a company to a person, and the distribution to a person of share capital (see paragraphs 45B(5)(a) and (b) of the ITAA 1936).

As Company A’s return of capital to Company B will be debited to Company A’s share capital account, this capital return arrangement will provide Company B with a capital benefit. Therefore, paragraph 45B(2)(a) of the ITAA 1936 will be satisfied in respect of Company A’s return of capital to its shareholders.

Tax Benefit

For paragraph 45B(2)(b) of the ITAA 1936 to be satisfied, a taxpayer must obtain a tax benefit. Pursuant to subsection 45B(9) of the ITAA 1936, a ‘tax benefit’ will be obtained if the amount of tax payable by the relevant taxpayer would, apart from this section, be less than the amount that would have been payable if the capital benefit had been a dividend. Generally, where there is a distribution of share capital, a tax benefit will arise as a shareholder or the relevant taxpayer will pay less tax on the distribution than they would have if the amount had instead been a ‘dividend’.

The return of capital to be distributed by Company A will not be assessable to its shareholder Company B because the payment would be excluded from the definition of ‘dividend’ in subsection 6(1) of the ITAA 1936. For this reason, the shareholders will obtain a tax benefit as defined in subsection 45B(9) of the ITAA 1936. Therefore, paragraph 45B(2)(b) of the ITAA 1936 will be satisfied in respect of Company A’s return of capital to its shareholders.

Relevant circumstances

Paragraph 45B(2)(c) of the ITAA 1936 sets out an objective purpose test, having regard to the relevant circumstances of the scheme under which a tax benefit is provided. Paragraph 45B(2)(c) of the ITAA 1936 requires the Commissioner to objectively consider the ‘relevant circumstances of the scheme’ pursuant to subsection 45B(8) of the ITAA 1936 as to whether any part of the scheme would be entered into for a purpose, other than an incidental purpose, of enabling a taxpayer to obtain a ‘tax benefit’. The test is not satisfied if the purpose (of obtaining a tax benefit) is only incidental, notwithstanding this, the purpose does not have to be the dominant purpose of the scheme. That is, the test is satisfied so long as the purpose of obtaining a tax benefit is not incidental.

In the application of the purpose test consideration is given to the relevant circumstances of the scheme as set out in paragraphs 45B(8)(a) to (k) of the ITAA 1936. However, the list of relevant circumstances in subsection 45B(8) is not exhaustive and regard may be had to other circumstances on the basis of their relevance.

For the purposes of this specific ruling, the relevant circumstances of Company A and the tax profile of its shareholder Company B are addressed below.

(a) Extent to which the capital benefit is attributable to profits of the company

Paragraph 45B(8)(a) of the ITAA 1936 refers to the extent to which the capital benefit is attributable to capital or profits (realised and unrealised) of the company or an associate (within the meaning of section 318 of the ITAA 1936) of the company. Whether the return of capital is attributable to profit is essentially concerned with determining whether there is a discernible connection between the amount distributed as share capital and the share capital and profits that are available for distribution.

Law Administration Practice Statement PS LA 2008/10 Application of section 45B of the Income Tax Assessment Act 1936 to share capital reductions (PS LA 2008/10) states that a distribution of profit would normally be expected to be a relatively ordinary business occurrence, whereas a distribution of capital would be a relatively extraordinary one. Paragraph 68 of PS LA 2008/10 states:

68 … A decision to reduce capital would generally be expected to coincide with and be influenced by some other commercial circumstance. For example, a release of the capital from a disposal of part of the business structure, some other business structural change, or in some circumstances its replacement with debt capital where it is shown to be more profitable for shareholders…

In the present case, the decision to reduce capital coincided with and was influenced by the commercial consideration of Company A to restructure so that all the subsidiary members will have the same parent entity, which will promote cooperation, improve efficiency and align the economic interest of all the shareholders.

Further, Company A has neither retained earnings nor any franking credits. Company A has been in a loss position since incorporated in December 2015, and does not expect to make any profit for the financial year ended 31 December 2018 and will not have any material current year profits or unrealised gains, which could be the source for the capital return. As such, the proposed return of capital will not been distributed from Company A’s retained profits, given that Company A does not have retained profits to fund the return of capital.

At present, Company A is wholly equity funded from Company B without any external debts. Company B intends to replace part of its equity contribution with an interest-bearing loan - Company B and Company A will enter into a long-term borrowing agreement in which Company B will agree to lend interest bearing loan of $ x million to Company A. The proposed return of capital will be funded by the interest bearing loan from Company B indicating that the distribution is not funded by the business’s operational profit.

As a result, the proposed return of capital will not be in substitution for a distribution of profits. This circumstance tends towards the capital return being a genuine return of capital to shareholders as a result of rebalancing the company’s funding structure, and not to any realised or unrealised profits.

(b) Pattern of distributions

Paragraph 45B(8)(b) of the ITAA 1936 refers to the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or by an associate (within the meaning in section 318 of the ITAA 1936) of the company. The Commissioner has explained in paragraph 77 of PSLA 2008/10 that a pattern of making capital distributions (with the capital performing the function of dividends) may point towards the company engaging in dividend substitution.

Company A has not paid any dividends since incorporation in 2015, and Company A has a franking account balance of nil as at 31 December 2017. The absence of a pattern of distributions does not indicate that the return of capital is in substitution for a dividend. Further, the funds for the return of capital will be sourced by the interest bearing loan from Company B.

No conclusion is drawn in relation to this circumstance.

(c) Capital losses

Paragraph 45B(8)(c) of the ITAA 1936 refers to whether shareholders have capital losses, that, apart from the scheme, would be carried forward to a later year of income.

Company B is a non-resident company and did not have any Australian carry forward capital losses, which may be available to recoup against any capital gain arising on the return of capital. Therefore, it would have less incentive for Company A to substitute a dividend for return on capital, which will be governed by the relevant CGT provision.

This circumstance is not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(d) Pre-CGT ownership interests

Paragraph 45B(8)(d) of the ITAA 1936 refers to whether any of the ownerships interests in the company or an associate of the company were held by the shareholders before 20 September 1985.

Company A was incorporated in December 2015; therefore, Company B’s ownership interest in Company A is not a pre-CGT asset.

This circumstance is not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(e) Residency of the owners of Company A

Paragraph 45B(8)(e) of the ITAA 1936 directs attention to whether the relevant taxpayer is a non-resident.

The implication of non-residency is that it would normally point towards a tax preference for a distribution of capital rather than of profits because a distribution of capital to a non-resident shareholder would not be assessable to that shareholder.

Company B is a non-resident of Australia for income tax purposes. There is no immediate direct tax benefit to Company B from receiving the return of share capital rather than a dividend. Therefore, this circumstance is not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(f) Cost base of the ownership interests – whether the cost base is not substantially less than the capital benefit

For the purposes of paragraph 45B(8)(f) of the ITAA 1936, if the cost base of the relevant ownership interest is substantially less than the return of capital, this circumstance may be indicative of purpose.

The cost base of the relevant ownership interest is substantially more than the capital return. Therefore, this circumstance is not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(h) Whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital or share premium.

Following the return of capital from Company A, the number of shares held by Company B in Company A and its 100% ownership will not alter as a result of the capital return. This circumstance is therefore not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(i) If the scheme involves the provision of ownership interest and the later disposal of those interest, or an increase in the value of ownership interest and the later disposal of those interest.

The proposed return of the capital does not involve the provision of any ownership interest to Company B or its associated entity. This circumstance is therefore not indicative as to purpose and no conclusion is drawn in relation to this circumstance.

(k) Any matters referred to in s 177D(2) of the ITAA 1936

Paragraph 45B(8)(k) also includes any matters referred to in subsection 177D(2) of the ITAA 1936 to be a relevant circumstance of the scheme. The matters provided in subsection 177D(2) are:

(a) the manner in which the scheme was entered into or carried out;

(b) the form and substance of the scheme;

(c) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

(d) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

(e) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

(f) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

(g) any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out;

(h) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f).

On balance it is considered that the matters raised in paragraphs 177D(2)(a) to 177D(2)(h) of the ITAA 1936 do not lead to a conclusion that a purpose, other than an incidental purpose, of obtaining a tax benefit exists in relation to the entering of the scheme.

Conclusion

Company A has provided factors supporting commercial objectives for the return of share capital and distribution to its shareholder Company B.

These are considered against the factors that would incline towards the conclusion that the scheme is being implemented for a more than incidental purpose for the relevant taxpayer to obtain a tax benefit.

Notwithstanding that paragraphs 45B(2)(a) and 45B(2)(b) of the ITAA 1936 are satisfied, having regard to the relevant circumstances of the scheme as stipulated within subsection 45B(8) of the ITAA 1936, it cannot be concluded that the scheme will be implemented for a more than incidental purpose of enabling the relevant person to obtain a tax benefit for the purposes of paragraph 45B(2)(c) of the ITAA 1936.

Therefore, the return of share capital to Company B will not be a dividend as defined in subsection 6(1) of the ITAA 1936.

The Commissioner will not make a determination under section 45C of the ITAA 1936 because subsection 45B(3) of the ITAA 1936 will not apply to any part of the return of share capital to Company B.