Edited version of private advice

Authorisation Number: 1051781843991

Date of advice: 19 November 2020

Ruling

Subject: Commissioner's discretion subsection 109Y(2) of Division 7A

Question

Will the Commissioner exercise his discretion; under subsection 109Y(2) of Division 7A, of Part III of the ITAA 1936, to substitute the market value of Holdings' net assets, in calculating Holdings distributable surplus during income years where Holdings had unrealised profits?

Answer

No.

The Commissioner will not exercise his discretion under subsection 109Y(2) of the ITAA 1936 to substitute the value of Holdings' assets in calculating its distributable surplus during income years covered by the ruling period where Holdings had unrealised profits.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company Structure and Background

X (Holdings) is an Australian incorporated proprietary company.

Holdings is the head company of an Australian based economic group (X Group) which focusses on X.

The main Australian business is carried on by Holdings' wholly owned Australian subsidiary, X Pty Ltd (Pty Ltd).

Holdings has not elected to form a tax consolidated group with its Australian subsidiary entity.

The X Consolidated Group has expanded its business to the United States (US) and European markets through the establishment of X foreign subsidiary entities. X subsidiaries are US resident entities and X subsidiaries are Netherlands resident entities (collectively the Foreign Subsidiaries).

The X Accounting Consolidated Group's primary business is the manufacture and sale of X. Pty Ltd manufactures and sells the X to the Foreign Subsidiaries who operate in the major customer markets and on-sell the X.

The Foreign Subsidiaries are wholly owned by Holdings and were established to facilitate the sale and service of X.

Accounting losses

In every year since establishment, Holdings has made an accounting loss on a stand-alone basis as well as from a consolidated accounting group perspective.

At 30 June 20XX the X Consolidated Group accumulated loss is $XXX. Holding is also in a tax loss position as at 30 June 20XX.

It is expected that the X Consolidated Group will continue to generate losses for accounting and tax purposes in the 30 June 20XX income year.

Neither Holdings, as the parent entity, nor the broader X Consolidated Group will have any retained earnings at 30 June 20XX.

The Employee Share Plan

To incentivise Holdings' management and eligible employees, the company has developed an Employee Share Plan (ESP) with an associated Loan Plan (LP) which allows eligible employees to acquire a direct ownership stake in the business. The ESP has been in place since the first share issue in X.

As part of the ESP, eligible employees enter into a loan agreement with Holdings, and the loan provided is secured by the company against the shares issued to eligible employees on subscription. Shares are issued at full market value (i.e. not at a discount).

The ESP provides that employees are granted the shares and associated loan in their capacity as eligible employees rather than in their capacity as shareholders.

Loans provided under the LP may only be used for the purpose of subscribing to shares.

The loan is interest free until the repayment date of the loan and can be repaid through surrendering the Holdings ESP shares held.

Shares issued under the ESP are Class "N" shares which are entitled to dividends however carry no voting rights. Class "N" shares are not transferable.

At the discretion of the Board, a percentage of any dividends declared by the board on shares issued under the ESP may be used to reduce the repayable amount of the loan.

In the event an employee shareholder's employment with Holdings ceases, for any reason other than misconduct, the loan shall continue as if the shareholder were still employed but the employee will not be entitled to receive any future share offers.

In the case of misconduct, the shareholder loans will become immediately repayable on the date on which employment ceases and the company will buy back all of the shareholder's shares on the accelerated repayment date for an amount equal to the total of all repayable amounts. If the repayable amount is zero, the shares will be bought back by Holdings for $0.00.

Distributable Surplus in years where loans were made to shareholders

Based on the historical audited financial statements for the years ended 30 June 20XX through 30 June 20XX, the current draft of the 30 June 20XX Financial Information and the forecast 30 June 20XX numbers, the calculation of the distributable surplus of Holdings has been calculated as follows:

Holdings - Distributable Surplus

X

Forecast 30 June 20XX numbers for Holdings on a stand-alone basis are not prepared. For the purposes of calculating the above distributable surplus, the net loss for the period for Holdings for the 30 June 2021 year has been estimated to be $X and the net asset and distributable surplus figures have been calculated on that basis.

X Consolidated Group - Distributable Surplus

It is anticipated that the distributable surplus in respect to the 30 June 20XX year and 30 June 20XX year as outlined above for both Holdings as a standalone entity and the X Group should not significantly change once the financial information is finalised.

It is not anticipated there would be a prima facie distributable surplus.

Accounting records

X does not hold any accounting records that show different values to that contained in its Financial Statements prepared in accordance with accounting standards.

The above distributable surplus calculations are based on the Financial Statements.

There are various internal workpapers and journals which support the accounting values contained in the Financial Statements and trial balances.

The difference between the market value of Holdings (as reflected by the increased share price) and its net assets is representative of internally generated goodwill of its subsidiaries which carry on the trading activities of the company.

The Financial Statements do not recognise any amount of internally generated goodwill/intangibles as required under Accounting Standard AASB 138.

In accordance with AASB 127, Holdings' shares in subsidiaries are recorded at cost rather than at market value. Holdings does not revalue its shares in its subsidiaries in accordance with standard commercial practice and is not required to do so under the Australian Accounting Standards.

Representations to third parties

At no time during the ruling period did the X Group (consisting of X Holdings and its wholly owned subsidiaries) prepare for internal use or provide to any third party any information in respect of the value of the assets of the X Group that indicated a value that differed to the value recorded for the purposes of the X Group's Financial Statements.

The X Group has not prepared or provided financial reports or other documents that comment on or disclose the gross value of the X Group's assets or individual assets other than those that include the historical accounting values as disclosed in the X Group's financial statements from time to time.

Specifically, the X Group has not prepared or had prepared or provided at any time during the ruling period:

•         Any valuation or indication of value of the shares that Holdings holds in Pty Ltd or any of its other subsidiaries; or

•         Any valuation or indication of value in respect to the group's intangible assets including intellectual property, patents and designs or goodwill of any member of the group that differs to the values as disclosed in the X Group's financial statements previously provided.

Representations to shareholders

The value used for the shares in Holdings for ESP purposes was based on the most recent equity funding round in respect to which shares were most recently issued by X Holdings.

The equity funding round valuation drivers are based on margin, revenue growth, increased market brand and expansion of products/operations. However, whilst this supporting information is prepared by the company in relation to the proposed issues, the value is ultimately set by what the market will accept i.e. the valuation which is supported by the cornerstone investors.

Under no circumstances was the issue price determined by reference to the fair market value, for ESP shares based on the accounting carrying value of the assets of the X Group, any multiple or other amount based on recorded accounting carrying value or any amount based on or related to the value of the assets of the X Group.

Equity funding

Throughout the ruling period, Holdings has undertaken several equity funding rounds resulting in shares in Holdings being issued and subscription proceeds being received by Pty Ltd. In all cases, the share issue prices were based on the fair market value of the shares in Holdings as outlined above.

The existing shareholders of Holdings were generally offered the opportunity to subscribe for further shares with other parties also being offered shares at the same price where the existing shareholders did not fill the raise amount needed.

While formal external valuations were not obtained for all funding rounds, the share issue prices were always determined based on the fair market value of the shares in Holdings as outlined above.

Under no circumstances was the value of the Holdings shares determined based on the recorded accounting value of the assets of the X Group, any multiple to the accounting value or based on any amount which in any way related to the recorded accounting asset carrying amounts of the assets of the X Group.

Shareholder agreements

The X Holdings shareholders entered into the X Holdings Shareholders' Deed with effect from X 20XX. There are a number of clauses in the Shareholders' Deed that refer to the calculation of entry/exit price in certain circumstances including the transfer of shares to a third party, the issue of new securities and any future IPO/takeover.

In certain circumstances, if the parties to the transaction are unable to agree the cash sale price, there is a provision for determining the fair market value by reference to the average of five independent valuations, excluding the highest and the lowest of the valuations received.

There is no reference in the Shareholders' Deed to any value of the Holdings shares being determined based on the recorded accounting value of the assets of the X Group, any multiple to the accounting value or based on any amount which in any way related to the recorded accounting asset carrying amounts of the assets of the X Group.

Debt placements

Throughout the ruling period, the X Group has made Debt Placements, received shareholder loans and provided information to Creditors. In no circumstances was this information based on the accounting carrying value of the assets of the X Group, any multiple or other amount based on recorded accounting carrying value or any amount based on or related to the value of the assets of the X Group.

Specifically, in relation to X loan, the information provided to X that resulted in the waiver with respect to the 30 June 20XX X Covenant, comprised various trading status updates based on forecast financial information, in particular sales forecasts and cash flows forecasts.

However, no information was provided to X that indicated a value of the underlying assets including shares in subsidiary entities or intangible assets held.

External Borrowings

The X Group currently has external borrowings of USD$XXX with X.

The X Group does not have any other external borrowings and is not actively seeking any additional external financing in the short term.

No further special purpose financial statements were provided as part of the debt placement with Cigna Investments Inc.

An external valuation dated X/20XX was obtained and an Information Memorandum was produced and provided to potential investors in respect to a debt placement recently.

The information included in the Information Memorandum is presented on a consolidated basis and therefore does not include any values in relation to shares in other group entities.

Similarly, the value of the shares in Holdings as contained in the external valuation also does not include a valuation of its shares in subsidiary entities. Accordingly, X has not revalued its shares in its subsidiaries for the purpose of its accounts in accordance with standard commercial and accounting practice nor is X required to do so under the AASB.

The Information Memorandum was provided to potential investors in respect to X's recent debt placement. We note the overview of financial information (including Balance Sheet Overview on page 70) is consistent with the asset values in the 30 June 20XX general purpose financial statements.

Further, the projected values also do not include any internally generated goodwill of the group and, as they are presented on a consolidated basis, do not include any revaluation of shares in subsidiary entities. The intangibles value comprises capitalised development costs as opposed to any internally generated goodwill.

X also undertook an equity raise by way of private placement in X/20XX.

The overall value of the X group included in the Information Memorandum for the private placement is based on a valuation obtained in X/20XX and does not separately identify the value of its shares in subsidiary entities or internally generated goodwill. The Information Memorandum provided did not include an overview of Holding's Balance Sheet but only an overview of the 30 June 20XX Profit & Loss statement along with a two-year forecast.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 109D(1)

Income Tax Assessment Act 1936 Section 109NB

Income Tax Assessment Act 1936 subsection 109Y(2)

Income Tax Assessment Act 1997 Section 83A-20

Reasons for Decision

These reasons for decision accompany the Notice of private ruling for X Holdings Pty Ltd (the Taxpayer).

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question

Will the Commissioner exercise his discretion; under subsection 109Y(2) of Division 7A, of Part III of the ITAA 1936, to substitute the market value of Holdings' net assets, in calculating Holdings' distributable surplus during income years where Holdings had unrealised profits?

Summary

No.

The Commissioner will not exercise his discretion under subsection 109Y(2) of the ITAA 1936 to substitute the value of Holdings Pty Ltd's assets in calculating its distributable surplus during income years covered by the ruling period where Holdings had unrealised profits.

Detailed reasoning

Subsection 109D(1)

Under subsection 109D(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity at the end of one of the private company's years of income (the current year) if:

(a) the private company makes a loan to the entity during the current year; and

(b) the loan is not fully repaid by the end of the current year; and

(c) Subdivision D does not prevent the private company from being taken to pay

a dividend because of the loan at the end of the current year; and

(d) either:

(i)            the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or

(ii) a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time.

We note that where a loan under the LP to acquire ESS interests are provided to employees who are not existing shareholders (and it's reasonable to conclude the loan isn't made because they have been a shareholder or associate at some time), then subsection 109D(1) has no application to those loans. Accordingly, the analysis that follows is in respect of loans issued to existing shareholders (or those that have been a shareholder or an associate at some time).

Section 109NB

Under section 109NB of the ITAA 1936 a private company is not taken under section 109D to pay a dividend because of a loan made solely for the purpose of enabling the shareholder, or an associate of the shareholder, to acquire an ESS interest under an employee share scheme (within the meaning of the Income Tax Assessment Act 1997 (ITAA 1997)) to which:

(a) Subdivision 83A-B and subsections 83A-35(3) to (9) of that Act apply; or

(b) Subdivision 83A-C of that Act applies.

Subdivision 83A-B ITAA 1997 provides an immediate inclusion of discount in assessable income and section 83A-20 of the ITAA 1997 applies to an ESS interest if you acquire the interest under an employee share scheme at a discount.

Since the ESS interests issued by Holdings are not acquired under an ESS at a discount, but rather, they are issued at full market value, section 109NB of the ITAA 1936 is not relevant to Holdings' circumstances.

Section 109Y Distributable Surplus

Section 109Y allows for a reduction of the dividend to the extent it exceeds the distributable surplus for that year.

Distributable surplus is defined in section 109Y(2) of the ITAA 1936.

A private company's distributable surplus for its year of income is the amount worked out using the formula:

where:

net assets means the amount (if any), at the end of the company's year of income, by which the company's assets (according to the company's accounting records) exceed the sum of:

(a)  the present legal obligations of the company to persons other than the

company; and

(b) the following provisions (according to the company's accounting records):

(i) provisions for depreciation;

(ii) provisions for annual leave and long service leave;

(iii) provisions for amortisation of intellectual property and trademarks;

(iv) other provisions prescribed under regulations made for the purposes

of this subparagraph.

If the Commissioner considers that the company's accounting records significantly undervalue its assets or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate.

According to the company's accounting records

Paragraph 21 of TD 2009/5 states:

...'accounting records' include, but are not confined to, the company's books of account, financial statements and balance sheet. In the Commissioner's opinion, records of asset valuations (or costs of acquisition) would form part of the accounting records in the relevant sense provided that it was evident that they were adopted or relied.

It is necessary for the Commissioner to consider whether the company has correctly calculated its net assets based on all available accounting records (including, but not limited to, its Financial Statements).

We are advised that X does not hold any accounting records, as defined under common law that would show different values to that contained in its Financial Statements prepared in accordance with accounting standards.

Subsection 109Y(2) Commissioner's discretion

For the purpose of working out a private company's distributable surplus under subsection 109Y(2) of the Income Tax Assessment Act 1936, the Commissioner has a power to substitute an appropriate value for a company's assets. This is not limited by the omission to assign a value to a particular asset in the company's accounting records but must entail a comparison of the value assigned in the company's accounting records to the totality of the company's assets, to consider whether that value is substantially correct.

Taxation Determination (TD) 2009/5 at paragraph 4 states;

Where the company's accounting records understate the value of the company's assets because they are required to do so (for example where accounting standards require the value of internally generated goodwill to be omitted), the understatement is not itself an attempt to circumvent the operation of Division 7A. Subject to the qualification which follows, the Commissioner will not exercise his power under subsection 109Y(2) whenever accounting standards require the total value of assets to be understated; to do so would defeat the compliance simplification objective of the provision. However, where it is plain that the company, its shareholders and directors have acted, in making loans or other payments, in a way that treats the real and higher value of assets as their true value, that is, regardless of their value shown in the accounting records, and that the mischief against which Division 7A is directed is present, the Commissioner may, and generally will, substitute their true value.

Paragraph 23 of TD 2009/5 states:

The Commissioner therefore considers 'assets' to be a reference to all assets, not particular assets.14 Therefore, it is not necessary to consider what particular assets are recognised as such in the books, or even strictly the value of any particular asset,15 but rather what value is assigned to the totality of the company's assets in the company's accounting records. Of course, if the company's accounting records omit to recognise an asset it will usually16 follow that the value assigned to the company's assets will be less than the actual value of its assets.

Paragraph 28 of TD 2009/5 states:

...as a matter of practice, the Commissioner would not adjust the book value of assets shown in properly prepared accounts merely because the value of internally generated goodwill is omitted, and, more generally, would respect book values shown in proper accounts2 in the absence of matters pointing to an attempt to circumvent the Division.

Paragraph 31 of TD 2009/5 states;

The focus must be on whether it is necessary to exercise the discretion to tax what is in substance an informal distribution of earnings, not simply on whether asset values are understated.

As a starting premise, based on the facts available to us, the X Group's accounting records appear to understate the value of the its assets because they are required to do so, or are not specifically required to include a different value, under the AASB.

AASB 138 at paragraph 54 states;

No intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred.

Under AASB 127, X is not required to revalue the shares in Pty Ltd or the foreign subsidiary entities.

Based on the background facts provided, there does not appear to have been a deliberate understatement of the value of assets in the company's accounting records which have been prepared in accordance with the Australian Accounting Standards in effect at the date of their preparation. Accordingly, based on TD 2009/5, the understatement is not of itself an attempt to circumvent the operation of Division 7A.

It is therefore necessary to consider whether Holdings', its shareholders and directors have 'acted, in making loans or other payments, in a way that treats the real and higher value of assets as their true value, that is, regardless of their value shown in the accounting records, and that the mischief against which Division 7A is directed is present'.

Actions

As outlined in the background facts, we understand that at no time during the ruling period did the X Group prepare for internal use or provide to any third party any information in respect of the value of the assets of the X Group that indicated a value that differed to the value recorded for the purposes of the X Group's Financial Statements.

Further, the X Group has not prepared or provided financial reports or other documents that comment on or disclose the gross value of the X Group's assets or individual assets other than those that include the historical accounting values as disclosed in the x Group's financial statements from time to time.

This indicates that the X group has not acted in way that treats a different value as the true value of their assets.

Profit

Holdings is currently in an accounting loss position such that there are no "profits" in an accounting or commercial sense. Holdings expects that it will begin to make a current year profit in the 30 June 2022 financial year however this is not expected to exceed the historical accumulated accounting losses as at 30 June 2021 (i.e. Holdings will still be in an accumulated loss position).

Based on the facts available, whilst the market value of the shares in the company is greater than the contributed share capital, the unrealised gain arising from this does not appear to accessible to Holdings such that it would allow payment of dividends.

Motive & Purpose of Division 7A

Based on the facts provided to us, the ESP and associated LP does not appear to be an informal distribution of earnings; rather it is a management incentive plan which incentivises eligible employees to increase the market value of Holdings' shares and the overall business. Loans issued under an LP can only be utilised for the purpose of subscribing for shares in the company.

Paragraph 9.2 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No.3) 1998 states that:

The purpose of the amendments is to ensure that private companies will no longer be able to make tax free distributions of profits to shareholders (and their associates) in the form of payments or loans.

According to the Explanatory Memorandum of Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009, the purpose of the ESS legislation is to ensure that:

employees who take part in an employee share scheme are required to pay tax on any discount on the market value of a share or right they receive from their employer.

That is, the reason the rules were introduced was to ensure any discount on the market value does not escape the tax net. The mischief that the ESS rules seek to address does not appear to be present.

Conclusion

Based on the background facts outlined above and our analysis thereof, the Commissioner will not exercise his discretion under subsection 109Y(2) of the ITAA 1936 to substitute the value of Holdings assets in calculating its distributable surplus during income years covered by the ruling period where Holdings had unrealised profits.