Edited version of private advice

Authorisation Number: 1051580861524

Date of advice: 27 September 2019

Ruling

Subject: Capital return

Question 1

Will the proposed capital return by the Company constitute a distribution for the purposes of item 1 in the table in subsection 960-120(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

If the proposed capital return is a distribution, will the proposed capital return be a frankable distribution for the Company under section 202-40 of the ITAA 1997?

Answer

No.

Question 3

Will the Commissioner make a determination under subsection 45A(2) of Income Tax Assessment Act 1936 (ITAA 1936) that section 45C of the ITAA 1936 applies to the whole or any part of the proposed capital return such that the Company will be required to give a notice under section 45D of the ITAA 1936?

Answer

No.

Question 4

Will the Commissioner make a determination under subsection 45B(3) of ITAA 1936 that section 45C of the ITAA 1936 applies to the whole or any part of the proposed capital return such that the Company will be required to give a notice under section 45D of the ITAA 1936?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company is an Australian privately held company. All shareholders are Australian tax residents.

Management and employees of an existing business established the Company to acquire the existing business from its original owners. The acquisition of the existing business involved an establishment phase during which the Company established and customised client systems and the existing business' client base was transitioned to the Company.

Share capital and debt were raised to fund the establishment phase, including the issue of options to shareholders to subscribe in more shares, during a time when there was significant risk that the establishment phase and client transition might not be successfully completed and the prospects of the Company was difficult to determine.

After a number of years, and following significant delays in completing the establishment phase and client transition, the Company has moved into business as usual conditions and has generated cash flows beyond its original expectations.

The Company has used the cash flows generated from the business to pay down all major debt which originated from the establishment phase and has paid significant dividends to its shareholders. The Company is not currently pursuing business opportunities which would require further debt or share capital to be raised.

In the 20XX income year, the options were exercised raising $XX in share capital. The funds raised from the issue of capital have sat in the Company's bank account since its receipt and have not been deployed in the business. Management has concluded that the capital is surplus to the Company's operational requirements and intends to return the entire amount to shareholders as an 'equal reduction' under section 256B of the Corporations Act 2001 (proposed capital return).

The proposed capital return will be:

·         paid from the funds raised from the issue of shares from the exercise of options

·         wholly debited against the Company's share capital account, and

·         made on a pro rata basis in proportion to the number of shares held by shareholders, and on equal terms for all shareholders.

Management initially considered the proposed capital return a few months prior to the exercise date of the options, when it concluded, due to the strength of the Company's financial performance to date and based on cash flow forecasts conducted around the time, that a high percentage of the options would be exercised and would result in the Company raising and holding excess capital.

The Company has not disposed of any underlying assets of the business.

No amounts have been transferred that would result in the Company's share capital account becoming tainted under Division 197 of the ITAA 1997.

All parties to the proposed capital return are dealing with each other on arm's length terms.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 subsection 6(4)

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 45D

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 subsection 960-120(1)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

According to item 1 in the table in subsection 960-120(1) of the ITAA 1997, a 'distribution' by a company is defined as:

a dividend, or something that is taken to be a dividend, under this Act

The term 'dividend' is defined in subsection 6(1) of the ITAA 1936 to include any distribution (in the general sense rather than as defined in subsection 960-120(1) of the ITAA 1997) made by a company to any of its shareholders and any amount credited by a company to its shareholders. However, paragraph (d) of the definition of 'dividend' excludes a distribution that is debited against an amount standing to the credit of the share capital of the company.

'Share capital account' is defined in subsection 975-300(1) of the ITAA 1997 as an account which the company keeps its share capital, or any other account created after 1 July 1998 where the first amount credited to the account was an amount of share capital. Where a company's share capital account is tainted within the meaning of Division 197 of the ITAA 1997 it will not be a share capital account.

The operation of paragraph (d) is subject to subsection 6(4) of the ITAA 1936, which states that:

Paragraph (d) of the definition of dividend in subsection (1) does not apply if, under an arrangement:

(a) a person pays or credits any money or gives property to the company and the company credits its share capital account with the amount of the money or the value of the property; and

(b) the company pays or credits any money, or distributes property to another person, and debits its share capital account with the amount of the money or the value of the property so paid, credited or distributed.

According to the Explanatory Memorandum to Income Tax Assessment Act (No 4) 1967, subsection 6(4) of the ITAA 1936 was introduced to address "special arrangements" which "may be entered into for the purpose of exploiting the proposed exemption of distributions out of share premium accounts" where "a share premium account is created as part of a scheme for making a tax-free distribution of money or other property to shareholders".

Subsection 6(4) of the ITAA 1936 was subsequently substituted in its current form by Taxation Laws Amendment (Company Law Review) Act 1998 in light of the abolishment of the "share premium" concept under Corporations Law. According to paragraph 1.106 of the Explanatory Memorandum to Taxation Laws Amendment (Company Law Review) Act 1998, the substituted rule is intended to be an equivalent rule which will apply to the share capital account:

As a result of the Corporations Law changes that abolish the concept of share premiums and associated terms, the amendments introduce an equivalent rule to subsection 6(4) that applies to the share capital account. The rule will prevent companies entering into arrangements where a company raises share capital from certain shareholders and then makes a tax-preferred capital distribution to other shareholders.

The Commissioner has published a view that there is no 'purpose requirement' under subsection 6(4) of the ITAA 1936. Taxation Ruling TR 2012/1 states at paragraph 167:

There is no 'purpose requirement' under subsection 6(4) of the ITAA 1936 beyond the terms of the subsection. What the subsection requires is that in addition to an amount being paid to the company and credited to its share capital account, the amount is later paid or distributed by the company (being a debit to its share capital account) such as to another set of shareholders, with the payment to and by the company being common elements 'under an arrangement'. This is sufficient for subsection 6(4) to apply.

'Arrangement' for the purposes of subsection 6(4) of the ITAA 1936 is not defined and therefore takes its ordinary meaning in its context.

The term has not been ruled on judicially in the context of subsection 6(4) of the ITAA 1936, however it has been considered in the context of other provisions of the ITAA 1936, notably former subsection 44(2D) of the ITAA 1936 in the case Federal Commissioner of Taxation v. Lutovi Investments Pty. Ltd 78 ATC 4708. In this case, Gibbs and Mason JJ (with whom Murphy J agreed) stated that:

It is, however, necessary that an arrangement should be consensual, and that there should be some adoption of it. But in our view it is not essential that the parties are committed to it or are bound to support it. An arrangement may be informal as well as unenforceable and the parties may be free to withdraw from it or to act inconsistently with it, notwithstanding their adoption of it.

The proposed capital return is a distribution (in the general sense) by the Company to its shareholders which will be wholly debited against the Company's share capital account. Management has confirmed that the share capital account is not tainted. Therefore, the proposed capital return will be prima facie excluded from the definition of 'dividend' by virtue of paragraph (d) of the definition of dividend. This is subject to the qualification in subsection 6(4) of the ITAA 1936.

In this case, there is insufficient indication to suggest that an 'arrangement' exists for the purposes of subsection 6(4) of the ITAA 1936. Therefore, the exception under subsection 6(4) will not apply and the proposed capital return will not be a 'dividend' for the purposes of subsection 6(1) of the ITAA 1936.

As a result, no part of the proposed capital return will constitute a 'distribution' by the Company for the purposes of item 1 in the table in subsection 960-120(1) of the ITAA 1997.

Question 2

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

The term 'distribution' for the purposes of subsection 202-40(1) of the ITAA 1997 is defined in subsection 960-120(1) of the ITAA 1997.

According to subsection 202-45(e) of the ITAA 1997, a distribution that is sourced, directly or indirectly, from a company's share capital account is unfrankable.

As set out in response to Question 1, no part of the proposed capital return will constitute a 'distribution' for the purposes of item 1 in the table in subsection 960-120(1) of the ITAA 1997. The proposed capital return will also be wholly sourced from the Company's share capital account. Therefore, no part of the proposed capital return will be a frankable distribution for the Company.

Question 3

Section 45A of the ITAA 1936 applies where a company streams 'capital benefits' to shareholders (the advantaged shareholders) who derive a greater benefit from the receipt of share capital, and it is reasonable to assume that the other shareholders (the disadvantaged shareholders) have received or will receive dividends.

Although the Company will provide its shareholders with a 'capital benefit' (as defined in paragraph 45A(3)(b) of the ITAA 1936) via the proposed capital return, the capital benefit will be provided to all of the shareholders in direct proportion to their individual shareholding. The circumstances of the scheme do not indicate that there is a 'streaming' of capital benefits to advantaged shareholders and of dividends to disadvantaged shareholders.

Accordingly, 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 whole, or any part, of the proposed capital return.

As a result, the Commissioner will not be required to give a copy of a determination (with respect to section 45A of the ITAA 1936) to the Company under subsection 45D(1) of the ITAA 1936 and the Company will not be required to give a copy of such a notice to its shareholders under subsection 45D(1A).

Question 4

Section 45B of the ITAA 1936 is an anti-avoidance provision that allows the Commissioner to make a determination that section 45C of the ITAA 1936 applies to treat all or part of a return of a capital amount as an unfranked dividend if certain conditions are satisfied. Law Administration Practice Statement PS LA 2008/10 provides practical guidance on the application of section 45B to share capital reductions.

Section 45B of the ITAA 1936 applies where certain capital payments are made to shareholders in substitution for dividends. Specifically, the provision applies where:

·         there is a scheme under which a person is provided with a demerger benefit or a capital benefit by a company (paragraph 45B(2)(a))

·         under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with the demerger benefit or the capital benefit, obtains a tax benefit (paragraph 45B(2)(b)), and

·         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)).

Scheme

Subsection 45B(10) of the ITAA 1936 provides that 'scheme' for the purposes of section 45B has the meaning given in subsection 995-1(1) of the ITAA 1997. That definition is widely drawn and includes any arrangement, scheme, plan proposal, action, course of action or course of conduct, whether unilateral or otherwise.

The proposed capital return and the actions that will give rise, and give effect, to it will constitute a scheme for the purposes of section 45B of the ITAA 1936.

Capital benefit

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 provided to the person

·         there is a distribution to the person of share capital or share premium, or

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

The proposed capital return to the Company's shareholders will be debited to the Company's share capital account, hence the shareholders will be provided with a capital benefit under paragraph 45B(5)(b) of the ITAA 1936 in the form of a distribution of share capital.

Tax benefit

Subsection 45B(9) of the ITAA 1936 provides that a relevant taxpayer 'obtains a tax benefit', for the purposes of section 45B, 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:

·         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 an assessable dividend.

Under CGT event G1, the cost base of the shares would be reduced up to the amount of the capital return, that is, effectively tax would be deferred, and only to the extent that the capital return exceeds the cost base would a capital gain arise (section 104-135 of the ITAA 1997).

In contrast, a dividend would generally be included in the assessable income of the shareholders in the income year in which it is paid.

If the proposed capital return had instead been an assessable dividend, the shareholders would incur a greater tax liability and/or tax liabilities would be payable at an earlier time. Therefore, the shareholders will obtain a tax benefit, as defined in subsection 45B(9) of the ITAA 1936, from the proposed capital return.

Relevant circumstances

For the purposes of paragraph 45B(2)(c) of the ITAA 1936, the Commissioner is required to consider the relevant circumstances set out in subsection 45B(8) to determine whether any part of the scheme was entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit (the requisite purpose). The test of purpose is an objective one. The relevant circumstances are considered in turn below.

Attribution

Paragraph 45B(8)(a) of the ITAA 1936 requires consideration of the extent to which the capital benefit is attributable to capital or to unrealised or realised profits of the Company and its associates (within the meaning of section 318 of the ITAA 1936).

On balance, there is insufficient indication to suggest that the capital benefit is attributable to the profits of the Company. Relevant factors include:

·         The capital being returned will be paid from, and is equal to, the share capital raised from the issue of shares to shareholders from the exercise of options. The capital raised has sat in the Company's bank account since receipt and has not been deployed in the business.

·         The share capital raised from the exercise of options appears to genuinely be in excess of the Company's operating requirements.

o   The options were issued based on an estimate, at the time, of future capital requirements. The estimate was made in the early stages of the business where there was significant risk that the transition of the business to the Company would not be completed.

o   The options were exercised at a time when the Company had already completed the development of the client systems and moved into business as usual conditions, and had performed beyond expectations and generated robust cash flows, which meant that management had overestimated its capital requirements when the options were originally issued.

o   The Company has paid down all major debt which originated from the establishment phase.

o   The Company is not currently pursuing any opportunities to further establish or broaden the business which would require further capital raising.

·         The capital being returned is not attributable to profits from the realisation of assets by the Company.

Distribution culture

Paragraphs 45B(8)(b) of the ITAA 1936 requires consideration of the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the Company or associates.

There is insufficient indication to suggest that the proposed capital return is being paid in substitution of dividends to its shareholders.

Characteristics of shareholders

Paragraphs 45B(8)(c) to (f) of the ITAA 1936 require consideration of the following circumstances with respect to each shareholder:

·         whether the relevant shareholder has any capital losses that, apart from the scheme, would be unutilised at the end of the relevant year of income (paragraph 45B(8)(c)).

The Company is not aware of, and is unable to determine, whether its shareholders have capital losses.

·         whether some or all of the shares held by the shareholder in the Company were acquired or are taken to be pre-CGT (paragraph 45B(8)(d)).

The shares in the Company are not pre-CGT shares.

·         whether the shareholder is a non-resident (paragraph 45B(8)(e)).

All shareholders are Australian residents for tax purposes.

·         whether the cost base of the shareholder's shares in the Company are not substantially less than the value of the capital benefit (paragraph 45B(8)(f)).

The cost base of each shareholder's shares in the Company is expected to be significantly greater than the proposed capital return. This factor points towards a preference for a capital return over a dividend.

Overall, although this may incline towards the conclusion as to requisite purpose, these circumstances carry less weight in relation to this particular scheme than paragraph 45B(8)(a).

Nature of interest after the return of capital

Paragraph 45B(8)(h) of the ITAA 1936 requires consideration of whether the shareholder's shares in the Company after the proposed capital return will be the same as the interest would have been had an equivalent dividend been paid instead of the distribution of share capital. If the shareholders continue to own the same number of shares and retain the same proportional interest in the company, the outcome is consistent with that which would be achieved in the context of a dividend.

Immediately following the proposed capital return, the shareholders will each continue to own the same shares, in the same proportions, in the Company. Therefore, this circumstance moderately contributes towards a conclusion that the proposed capital return may be made in substitution for a dividend, but this carries less weight in relation to this particular scheme than paragraph 45B(8)(a) of the ITAA 1936.

Paragraphs 45B(8)(i)-(j)

Paragraph 45B(8)(i) of the ITAA 1936 is relevant for cases where a scheme involves the provision of ownership interests, or an increase in the value of ownership interests, and the later disposal of those interests. Paragraph 45B(8)(j) is about demergers. These circumstances are not relevant.

Part IVA matters

Paragraph 45B(8)(k) of the ITAA 1936 requires consideration of the matters referred to in subsection 177D(2) of the ITAA 1936. Although these factors appear in Part IVA, these factors are relevant in the context of section 45B to consider whether the scheme will be carried out for a more than incidental purpose of enabling the relevant taxpayer to 'obtain a tax benefit' (as defined in subsection 45B(9)) in consequence of the provision of a capital benefit.

These matters operate together to direct attention to the means by which the tax benefit has been obtained, and broadly include:

·         the manner in which the scheme was entered into or carried out

·         the form and substance of the scheme

·         the timing of the scheme

·         the financial, tax and non-tax effects of the scheme, and

·         the nature of any connection between the taxpayer and other parties to the scheme.

Many of the other relevant circumstances discussed above amplify or elaborate on the matters in subsection 177D(2) of the ITAA 1936 and to this extent there is some overlap.

The proposed capital return will enable the shareholders to obtain a tax benefit. However, an examination of the proposed capital return from a broad practical perspective by reference to the matters in subsection 177D(2) of the ITAA 1936, to identify its tax and non-tax objectives, does not suggest that the scheme will be carried out for the requisite purpose.

Overall

Having regard to the relevant circumstances of the proposed capital return, it does not appear that the scheme will be entered into or carried out for a more than incidental purpose of enabling the shareholders to obtain a tax benefit (within the meaning of subsection 45B(9) of the ITAA 1936).

Conclusion

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 whole, or any part, of the proposed capital return to the shareholders.

As a result, the Commissioner will not be required to give a copy of a determination (with respect to section 45B of the ITAA 1936) to the Company under subsection 45D(1) of the ITAA 1936 and the Company will not be required to give a copy of such a notice to its shareholders under subsection 45D(1A).