Edited version of private advice

Authorisation Number: 1051924801966

Date of advice: 8 December 2021

Ruling

Subject: Proposed return of capital

Question 1

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

Answer

No.

Question 2

Will Company A be required to give a notice to its shareholder Company B under section 45D of the ITAA 1936 on the basis that the Commissioner has made a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole, or a part of, the proposed capital distribution by Company A?

Answer

No.

Question 3

Will the Commissioner make a further determination under section 45C of the ITAA 1936 that the whole or part of the return of capital by Company A of US$X was paid under a scheme for a purpose of avoiding franking debits arsing in relation to the distribution from the company?

Answer

See reasons for Question 2.

This ruling applies for the following period:

Year ending 31 December 20XX

The scheme commences on:

1 January 20XX

Relevant facts and circumstances

Structure of the XXXXX in Australia

Company A is an Australian proprietary company.

Company A has only ordinary shares on issue and all ordinary shares rank equally for dividend and capital distributions.

Company A is an indirect wholly-owned subsidiary of Parent Company (Company B), a mining company based in X.

The capital distribution will be a partial return of capital on each share on issue, and no shares will be cancelled.

The dividend distribution will be fully franked and have a franking percentage of 100%.

Company A has disposed of its assets and no longer has any operational activities in Australia other than to act as a holding company for its overseas subsidiaries.

Given the completion of the asset divestments in 20XX, maintaining capital in Australia is inconsistent with the Global Group's corporate strategy of reducing its presence in Australia'

There are surplus funds in the form of receivables held by the Group that have built up over the years.

Due to the ongoing reduction of the Global Group's presence in Australia following the divestment of various assets, there has been a release of capital that is excess to the current working capital needs of the Global Group in Australia.

In recognition of the fact that Company A has retained profits and any distribution by Company A to its shareholder relating to the divestment of various assets will comprise both a capital and a profit component, the distributions have been split into their respective capital and profit components by applying the 'slice approach', where X% of the distribution will be paid as a return of capital and Y% as a dividend.

The proposed distribution will be used to fund the Global Group's global operations and/or to fund dividend distributions to Parent Company, depending upon the funding needs of the Global Group.

As at XX December 20XX, Company A (and its direct and indirect subsidiaries) had fully paid ordinary shares on issue, with share capital totalling to $X.

As at XX December 20XX, the share capital account of Company A is not tainted, nor has the share capital account of Company A been tainted at any time.

The proposed capital distribution by Company A of US$X will be debited against the amount standing to the credit of Company A's untainted share capital account of $X.

The shares in Company A are not 'indirect Australian real property interests' as defined in section 855-25 of the Income Tax Assessment Act 1997.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6(1)

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 104-135

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 section 855-25

Income Tax Assessment Act 1997 section 975-300

Reasons for decision

Question 1

Summary

The proposed return of capital by Company A will not constitute a dividend as defined by subsection 6(1) of the ITAA 1936.

All references are to the Income Tax Assessment Act 1936 unless otherwise stated.

Detailed reasoning

Subsection 44(1) includes in shareholder's assessable income any dividends as defined by subsection 6(1), paid to a shareholder out of profits derived by the company from any source (if a resident of Australia for tax purposes) and from an Australian source (if non-resident).

'Share capital account' is defined in section 975-300 of the Income Tax Assessment Act 1997 (ITAA 1997) as an account in which the company keeps its share capital, or any other amount created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital.

The capital distribution by Company A to their shareholder will be debited against an amount standing to the credit of Company A's untainted share capital account. Subsection 6(4) will not apply in this case.

Therefore, paragraph 6(1)(d) will be satisfied when the return of US$X is debited against the amount standing to the credit of the share capital account of Company A.

Question 2

Summary

Company A is not required to give a notice under section 45D because the Commissioner will not make a determination under subsection 45B(3) that section 45C applies to whole or part of the return of capital.

Detailed reasoning

Section 45B is a specific anti-avoidance provision. The section is designed to prevent companies from effectively distributing company profits as preferentially taxed capital rather than taxable dividends.

Subsection 45B(2) sets out the conditions under which the Commissioner will make a determination under subsection 45B(3) that section 45C applies. These conditions are:

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

•         under the scheme a person (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

•         having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, entered into or carried out the scheme or any part of the scheme for a purpose (other than an incidental purpose) of enabling the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(c)).

The capital component of the distribution of US$X constitutes a scheme for the purposes of paragraph 45B(2)(a) because the return of capital will provide the shareholders with a capital benefit.

Under the scheme, Company B will receive a distribution of share capital as a result of the proposed return of capital, which constitutes a capital benefit under paragraph 45B(5)(b).

Generally, a return of capital would be subject to the CGT provisions of the income tax law. Unless the amount of the distribution exceeds the cost base of the shares, there will only be a cost base reduction under CGT event G1 (section 104-135 of the ITAA 1997). It is only to the extent (if any) that the distribution exceeds the cost base of the shares that a capital gain arises. By contrast, a dividend would generally be included in the assessable income of a resident shareholder.

In the present case, the return of capital by Company A to Company B is not subject to Australian income tax. However, if the amount were paid as a dividend by Company A, it would be subject to a 5% Australian dividend withholding tax.

It follows that the amount of tax payable by Company B on the return of capital may be less than the amount that would have been payable if the return of capital was instead a dividend, providing a tax benefit as defined in subsection 45B(9). Therefore, paragraph 45B(2)(b) will be satisfied in respect of Company A's return of capital.

As the criteria within paragraphs 45B(2)(a) and (b) are satisfied, the application of section 45B turns on whether, having regard to the relevant circumstances of the scheme, it may be concluded objectively that a more than incidental purpose of one of the persons who entered into or carried out the scheme was to enable a taxpayer to obtain a tax benefit (paragraph 45B(2)(c)).

A person (or persons) can be found objectively to have two or more purposes, none of which is merely incidental. In such a case, all that is necessary for section 45B to apply is that one of those purposes is a more than incidental purpose of obtaining a tax benefit (either as a demerger benefit or a capital benefit).

Subsection 45B(8) lists the relevant circumstances of the scheme which the Commissioner must have regard to when determining whether or not the requisite purpose exists. The list of circumstances is not exhaustive and the Commissioner may have regard to other circumstances which he regards as relevant.

Paragraph 45B(8)(a): the extent to which the capital benefit is attributable to capital or profit

Paragraph 45B(8)(a) refers to the extent to which the capital benefit is attributable to capital and profits (realised and unrealised) of the company or of an associate (within the meaning of section 318) of the company. The implication of this inquiry at paragraph 45B(8)(a) is that despite the distribution taking the form of share capital it can be ascribed in fact to either the company's share capital or the profits of the company or its associates.

Where the capital benefit is attributable to profits, it would ordinarily lead to the conclusion that the persons, or one of the persons, who entered into or carried out the scheme did so for the purpose of enabling a taxpayer to obtain a tax benefit. This is because a provision of a capital benefit attributable to profits is, in effect, distributing profits. It would thus be made in substitution for a dividend and secures the associated tax deferral advantages for the shareholder.

Where capital distribution is attributable to the disposal of assets of a business, a reasonable approach should be taken to determine the extent to which share capital was invested in the disposed assets and is available for distribution to shareholders. In circumstances where it may be appropriate to allocate capital across the enterprise, this may be done based on the compilation of assets as between capital and profit, and at the market value of the assets (slice approach). The capital distribution should be attributed on a proportionate basis.

In these circumstances, the Commissioner accepts that the proposed return of capital will be surplus to Company A's need of it, in accordance with Parent Company's corporate strategy to reduce its presence in Australia. The Commissioner accepts that this reduced presence in Australia also results in capital that is excess to the current working capital needs of the Global Group in Australia. The Commissioner also accepts that the Australian Group will remain in Australia because the Australian entities act as holding companies.

This factor points against there being more than an incidental purpose of gaining a tax benefit.

Paragraph 45B(8)(b): pattern of distributions

Paragraph 45B(8)(b) requires consideration of 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 company.

An interruption of the normal pattern of profit distribution and its replacement with a distribution of capital may suggest dividend substitution. The fact that a company may not have made any distributions previously, whether of profit or share capital, does not point away from the requisite purpose. However, in considering this factor, regard must be given to the company's distribution culture and other relevant commercial exigencies that impact on the company's ability to make distributions, whether of dividends or capital, in evaluating this relevant circumstance.

Aside from one instance in which Company A paid a dividend distribution totalling $USX to its shareholders on XX December 20XX, Company A does not otherwise have a history of paying dividends to its shareholders.

The same applies to the return of capital totalling US$X that Company A paid to its shareholders on XX December 20XX. Other than this payment, no capital has been released from any of the divestments in Company A's subgroup between 20XX and 20XY for distribution to its shareholders.

Given there is no relevant pattern of distribution of dividends, this factor points away from the requisite purpose in paragraph 45B(2)(b).

Paragraph 45B(8)(c): capital losses

Paragraph 45B(8)(c) requires consideration of whether the relevant taxpayers have capital losses that, apart from the scheme, would be unutilised.

Where shareholders have capital losses that can be applied against the capital benefit this would suggest that the capital benefit was provided for the purpose of securing a tax benefit.

The shares in Company A are not 'indirect Australian real property interests' as defined in section 855-25 of the ITAA 1997 on the basis that Company A holds no taxable Australian property.

Accordingly, the return of capital is exempt from Australian income tax on the basis that it will be made to non-resident shareholders on shares that are not taxable Australian property.

This circumstance is not indicative of the requisite purpose and no conclusion is drawn in relation to this circumstance.

Paragraph 45B(8)(d): pre-CGT ownership interests

Paragraph 45B(8)(d) requires consideration of whether some or all of the ownership interests in the company held by the relevant taxpayer were acquired, or are taken to have been acquired, before 20 September 1985.

None of the ownership interests in Company A or its associate subsidiaries were acquired by Parent Company before 20 September 1985. This factor points away from the requisite purpose in paragraph 45B(8)(d).

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

Paragraph 45B(8)(e): residency of owners of the head entity

Paragraph 45B(8)(e) requires consideration of whether the relevant shareholders are non-residents.

The implication of non-residency would normally point towards a tax preference for a distribution of capital rather than profits because a distribution of capital to a non-resident shareholder would not be assessable to that shareholder. Non-residents are normally taxed on dividends at the rate of 5% but they are not exposed to capital gains on disposal of the shares unless those shares are 'indirect Australian real property interests' under section 855-25 of the ITAA 1997.

In the present case, Company B is a non-resident of Australia for income tax purposes, therefore it is not exposed to capital gains on disposal of shares given that the shares of Company A are not indirect Australian real property interests as defined in section 855-25 of the ITAA 1997. However, if the amount was paid as a dividend by Company A, it would be subject to a 5% dividend withholding tax.

Company A has significant equity invested in it by their shareholder together with sufficient retained profits. It is clear from the final divestment of assets in 2019 that the Company A no longer requires the amount of capital to be retained.

The dividend being paid is franked. Paragraph 128(3)(ga) provides that there is no liability for withholding tax on the franked part of a dividend.

This circumstance is indicative as to purpose, but no conclusion is drawn in relation to this circumstance.

Paragraph 45B(8)(f): cost base of ownership interests

For the purposes of paragraph 45B(8)(f), 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 return of capital is exempt from Australian income tax given that it will be made to a non-resident shareholder on shares which are not an indirect Australian real property interest.

The proposed capital distribution will be a partial return of capital and the cost base which Company B will have in its shares in Company A will not be substantially less than the value of the proposed capital distribution.

On balance, this circumstance does not indicate a purpose of obtaining a tax benefit.

Paragraph 45B(8)(h): nature of interest after return of capital

Paragraph 45B(8)(h) of the ITAA 1936 requires consideration of whether the interests held by the relevant taxpayers after the distribution of share capital are the same as they would have been if an equivalent dividend had been paid. It questions whether the return of capital performs the same function as a distribution of dividends.

An equal share capital reduction under which no shares are cancelled (often called a pro-rata return of capital) does not affect a shareholder's substantive interests, either individually or inter se and thus the interests remain the same as if a dividend had been paid instead. From the shareholders' perspective a reduction of capital without a cancellation of shares is not dissimilar economically to a special dividend, in that cash is distributed to them while they retain the share with all of its rights intact.

In the case of Company A, the proposed payment of the return of capital has no effect on Company B's shareholder interest in Company A. Therefore, the return of capital is not dissimilar from the payment of a dividend.

This factor does incline towards the requisite purpose.

Paragraph 45B(8)(i): if the scheme involves later disposal of ownership interests

Paragraph 45B(8)(i) applies if the scheme involves the provision of ownership interests or an increase in the value of ownership interests, and there is a later disposal of those interests.

This circumstance is not relevant as the scheme does not involve a subsequent disposal of the ordinary shares in Company A.

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

Paragraph 45B(8)(k): the Part IVA matters

Paragraph 45B(8)(k) requires regard to be had to any of the matters referred to in paragraphs 177D(2).

The paragraph 177D(2)(a) to (h) matters operate together to direct attention to the means by which the tax benefit has been obtained.

Having regard to the matters raised in paragraphs 177D(2)(a) to 177D(2)(h) does 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.

The return of share capital to Company B will not be a dividend as defined in subsection 6(1).

The Commissioner will not make a determination under section 45C because subsection 45B(3) will not apply to any part of the return of share capital to Company B. Accordingly, Company A will not be required to give notice to Company B under section 45D.

Question 3

Application of section 45C

Summary

No, based on the reasons provided in Question 2.