Edited version of private advice

Authorisation Number: 1051945404161

Date of advice: 22 March 2022

Ruling

Subject: Share capital reduction

Question 1

Will any part of the cancellation payments to their shareholders under the selective share capital reductions that is debited to the respective company's share capital account constitute a dividend as defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) and for the purposes of subsection 44(1) of the ITAA 1936?

Answer

No

Question 2

Will the dividend component of the cancellation payments under the selective share capital reductions, being the balance of the cancellation payment that is not debited to share capital account, constitute a dividend pursuant to subsection 44(1) of the ITAA 1936 that is a frankable distribution for the purposes of subsection 202-40(1) of the ITAA 1997?

Answer

Yes

Question 3

Will the Commissioner make a determination under paragraph 204-30(3)(a) of the ITAA 1997 and/or under paragraph 204-30(3)(c) of the ITAA 1997 in relation to the share capital reductions?

Answer

No

Question 4

Will the Commissioner make a determination under paragraph 177EA(5)(a) of the ITAA 1936 in relation to the share capital reductions?

Answer

No

Question 5

Will the Commissioner make a determination under subsection 45A(2) or subsection 45B(3) of the ITAA 36 that section 45C of the ITAA 36 applies in relation to the share capital reductions?

Answer

No

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company A and the other companies are Australian incorporated companies, together referred to as the 'Group'.

Individual A is the xxxx, xxxx, xxxx and xxxx of each company.

A selective share capital reduction has been undertaken in relation to each Group company.

Pursuant to the share capital reductions, the minority shareholders and a Trust (collectively, the 'participating shareholders') were paid an amount for the cancellation of their shares in each of the companies (cancellation payment).

The share capital reductions were implemented in line with each company's constitution and the relevant provisions of the Corporations Act 2001.

Relevantly, the participating shareholders have held their shares in Company A for a number of years and have not contributed any further capital in the period since their initial share capital subscription and the present share capital reductions.

The purpose of the share capital reductions are threefold:

a)            to facilitate a complete exit from the business of participating shareholders;

b)            to provide the minority shareholders with a means of generating liquidity from their long-standing investment; and

c)            to consolidate ownership under the Individual and facilitate subsequent investment by key personnel.

The share capital reductions were selected as the preferred transaction structure to facilitate the exit of participating shareholders as it guaranteed the exit of all minority shareholders, subject to the required special resolution being passed.

Immediately after completion of the share capital reductions, Individual A was the sole remaining shareholder in the Group companies. Following completion of the share capital reduction, Individual A will sell their shares in the Group companies to The Holding Company, which will become the holding company for the Group.

The cancellation payments for the Group company shares affected by the selective share capital reductions represent market value consideration - being the market value of the shares at the time of the transaction.

For income tax purposes the cancellation payments will be split into a capital component and a dividend component. The capital component will be accounted for by debiting the share capital and the dividend component will be sourced from and accounted for by debiting retained earnings

The capital component of the cancellation payment is calculated based on the 'average capital per share' ('ACPS') method, by dividing the number of shares on issue of each company by the issued capital in each company. The dividend component is the difference between the cancellation payment and the capital component for each company's shares.

Company A had the necessary franking account balance to frank dividends that resulted from its capital reduction.

The equity account for Company A at the time of the capital reduction was as provided.

The Group companies do not have any carry forward income tax or capital gains tax losses.

The Trust is an Australian resident discretionary trust that does not have any carry forward income tax or capital gains tax losses, nor do any entities which are eligible to benefit from the distribution of capital gains from the Trust.

The Trust has nominal cost base in its shareholdings in Group companies.

The Group companies share capital accounts are not tainted for the purposes of Division 197 of the ITAA 1997.

The minority shareholders are Australian tax resident individuals.

The companies do not have any carry forward income tax or capital gains tax losses.

The Member Register of the Group companies before and after the capital reduction scheme have been provided.

Reasons for decision

Question 1

Summary

A dividend for the purposes of subsection 44(1) of the ITAA 1936 does not include distributions sourced from the company's share capital account. (paragraphs (a) and (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936).

Detailed reasoning

A dividend includes any distribution made by a company to any of its shareholders, whether in money or other property, and any amount credited by a company to any of its shareholders as shareholders.

Relevantly, subsection 44(1) of the ITAA 1936 provides that the assessable income of a shareholder of a company (whether resident or non-resident) includes:

•                    if the shareholder is a resident, dividends paid to the shareholder by the company out of profits derived by it from any source; or

•                    if the shareholder is a non-resident, dividends paid to the shareholder by the company to the extent to which they are paid out of profits derived by it from sources in Australia.

A dividend does not include moneys paid or credited, or property distributed, by a company to shareholders where the amount of the money or the value of the property is debited against an amount standing to the credit of the company's share capital account (subsection 6(1) of the ITAA 1936).

Taxation Ruling TR 2003/8 Income tax: distributions of property by companies to shareholders - amount to be included as an assessable dividend, in explaining when dividends are paid or taken to be paid out of profits, confirms that a distribution that is sourced from the company's share capital account does not fall within the ambit of subsection 44(1) of the ITAA 1936:

13. In most cases a company which distributes property to its shareholders and debits part of the value of that property to its share capital account would debit the remaining part to another account or reserve. Where that account or reserve does not represent share capital, it would, for subsection 44(1) purposes, represent profits derived by the company so that the amount debited to it would be included in the shareholder's assessable income under that subsection.

Consequently, any part of the cancellation payments to participant shareholders under the selective share capital reductions that is debited to the respective company's share capital account does not constitute a dividend as defined in subsection 6(1) and for the purposes of subsection 44(1) of the ITAA 1936.

As the share capital accounts of the companies are not tainted within the meaning of Division 197 of the ITAA 1997, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 applies. Accordingly, the capital component of the cancellation payments will not constitute a dividend.

Question 2

Summary

The portion of the cancellation payment exceeding the share capital component, which is debited to a company's retained earnings account, is a dividend (paragraphs (a) and (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936). The dividend component is a frankable distribution pursuant to section 202-40 of the ITAA 1997 - it is not an unfrankable dividend under section 202-45 of the ITAA 1997.

Detailed reasoning

As explained above, an amount paid out of retained earnings constitutes a dividend as defined in subsection 6(1) of the ITAA 1936 and for the purposes of subsection 44(1) of the ITAA 1936.

That is, a distribution will be a dividend for tax purposes to the extent that it is not debited to share capital account (paragraphs (a) and (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936). Consequently, the part of a distribution, being the balance of the cancellation payment under the selective share capital reduction that is not debited to the share capital account constitutes a dividend.

In this case, only one of the companies' share purchase price under the selective share capital reductions exceeded the amount that was debited to that company's share capital account (Company A). The company used the ACPS method to reasonably estimate the dividend/capital split.

The amount that exceeded the amount that was debited to the share capital account per share which is debited to Company A's retained earnings account, is a dividend.

A 'frankable distribution' means a distribution under section 202-40 of the ITAA 1997 that is not an unfrankable distribution under section 202-45 of the ITAA 1997

Section 202-45 of the ITAA 1997 sets out the instances in which distributions are unfrankable distributions.

Relevantly,

•                    under paragraphs 202-45(e) of the ITAA 1997, a distribution that is sourced, directly or indirectly, from a company's share capital account; and

•                    under subparagraph 202-45(h)(ii) of the ITAA 1997, because a determination has been made by the Commissioner under section 45C of the ITAA 1936 affects the distribution.

These exceptions do not apply in this instance as:

•                    The franking is limited to the distribution (being the dividend component) that is sourced from that company's retained earnings.

•                    The Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 or subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole, or any part, of the capital component of the cancellation payment the company's shareholders received (as discussed below).

As a result, the entire dividend component is a frankable distribution (in this case, with respect to that company's cancellation payments).

Question 3

Summary

The Commissioner will not make a determination under paragraph 204-30(3)(a) of the ITAA 1997 that a specified franking debit arises in the franking account of Company A in respect of the whole or part of the dividend component (i.e. the component of the cancellation payment sourced from the company's retained earnings) or that under paragraph 204-30(3)(c) of the ITAA 1997 no imputation benefit is to arise in respect of the dividend to those shareholders who derive a greater benefit.

Detailed reasoning

Section 204-30 of the ITAA 1997 gives the Commissioner the power to make a determination when distributions and other benefits are streamed. Subsection 204-30(1) of the ITAA 1997 states:

204-30 (1) This section empowers the Commissioner to make determinations if an entity streams one or more *distributions (or one or more distributions and the giving of other benefits), whether in a single *franking period or in a number of franking periods, in such a way that:

(a) an *imputation benefit is, or apart from this section would be, received by a *member of the entity as a result of the distribution or distributions; and

(b) the member would *derive a *greater benefit from franking credits than another member of the entity; and

(c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

The member that derives the greater benefit from franking credits is the favoured member. The member that receives the lesser imputation benefits is the disadvantaged member.

Pursuant to subsection 204-30(3) of the ITAA 1997, where the elements in paragraphs (a) to (c) are satisfied:

The Commissioner may make one or more of these determinations:

(a) that a specified *franking debit arises in the *franking account of the entity, for a specified *distribution or other benefit to a disadvantaged member;

(b) that a specified *exempting debit arises in the *exempting account of the entity, for a specified *distribution or other benefit to a disadvantaged member;

(c) that no *imputation benefit is to arise in respect of a distribution that is made to a favoured member and specified in the determination.

...

The dividend component of the cancellation payment will be a 'distribution' within the meaning given by section 960-120 of the ITAA 1997. In this case only Company A will make a distribution so described.

Relevant to this case, an imputation benefit is received as a result of a distribution under subparagraphs 204-30(6)(a); 204-30(6)(b) or 204-30(6)(c) of the ITAA 1997 if:

•         a member is entitled to a tax offset under Division 207 of the ITAA 1997; or

•         an amount would he included in the member's assessable income as a result of the distribution because of the operation of section 207-35 of the ITAA 1997

•         a franking credit would arise in the franking account of the member as a result of the distribution.

Each participating Company A shareholder will receive an imputation benefit as a result of the Company A distribution.

Relevantly, subsection 204-30(8) of the ITAA 1997 provides that:

A member of an entity *derives a greater benefit from franking credits than another member of the entity if any of the following circumstances exist in relation to the other member in the income year in which the distribution giving rise to the benefit is made, and not in relation to the first member:

(a) the other member is a foreign resident;

(b) the other members would not be entitled to any tax offset under Division 207 because of the distribution;

(c) the amount of the income tax that, apart from this Division, would be payable by the other members because of the distribution is less than the tax offset to which the other member would be entitled;

(d) the other member is a corporate tax entity at the time the distribution is made, but no franking credit arises for the entity as a result of the distribution;

(e) the other member is a corporate tax entity at the time the distribution is made, but cannot use franking credits received on the distribution to frank distributions to its own members because:

(i) it is not a franking entity; or

(ii) it is unable to make frankable distributions;

(f) the other member is an *exempting entity.

The term 'streaming' is not defined in the Act. Streaming of distributions is broadly explained in paragraph 3.28 of Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 as selectively directing the flow of franked distributions to those members who can most benefit from imputation benefits.

Under Company A's selective share capital reduction, the participating shareholders were provided with an imputation benefit as a result of the dividend component paid in relation to the reduction of their shares. The participating shareholders will receive equivalent dividends for each share.

As participating shareholders are residents, they have received a greater benefit from franking credits than Individual A as Individual A did not receive any imputation benefits because they were not a participant in the share capital reduction. However, what occurred under the selective share capital reduction does not constitute streaming of distributions to favoured shareholders. Further, the imputation benefit (if any) provided to the participating shareholders would be merely incidental to the exit of these shareholders from Company A.

Consequently, section 204-30 of the ITAA 1997 would not apply in these circumstances and therefore no determination as provided under subsection 204-30(3) of the ITAA 1997 will be made.

Question 4

Summary

The Commissioner will not exercise his discretion to make a determination pursuant to paragraph 177EA(5)(a) of the ITAA 1936 that a franking debit arises in the company's franking account in respect of the whole or part of the franked dividend component of the cancellation payments.

Detailed Reasoning

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies to a wide range of schemes designed to obtain imputation benefits. In essence, it applies to schemes for the disposition of shares or an interest in shares, where a franked distribution is paid or payable in respect of the shares or an interest in shares.

This would include a selective share capital reduction with a franked dividend component.

Subsection 177EA(3) provides that section 177EA applies if:

(a)          there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and

(b)          either:

(i)            a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii)           a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of membership interests, as the case may be; and

(c)          the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d)          except for this section, a person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

(e)          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 the relevant taxpayer to obtain an imputation benefit.

Where section 177EA of the ITAA 1936 applies, the Commissioner has the discretion to make a determination to debit a company's franking account pursuant to paragraph 177EA(5)(a) of the ITAA 1936.

The conditions of paragraphs 177EA(3)(a) to 177EA(3)(d) of the ITAA 1936 are satisfied in respect of the selective share capital reduction. Accordingly, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that on the part of the company (i.e. Company A), its shareholders or any other relevant party, there was more than a merely incidental purpose of conferring an imputation benefit under the scheme. In respect of the selective share capital reduction, the relevant taxpayers are the participating shareholders and the scheme comprises the circumstances surrounding the selective share capital reduction.

In arriving at a conclusion the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed in subsection 177EA(17) of the ITAA 1936 encompass a range of circumstances which, taken individually or collectively, could indicate the requisite purpose.

The selective share capital reductions are being carried out to allow participating shareholders to exit their investment. Based on the information provided, the Commissioner's consideration of all of the relevant circumstances of the scheme would not, on balance, lead to a conclusion that the purpose of enabling participating shareholders to obtain imputation benefits is more than incidental.

As a result, and having regard to the relevant circumstances of the scheme, the five conditions in 177EA(3) of the ITAA 1936 have not been satisfied and section 177EA of the ITAA 1936 will not apply to any fully franked distribution (with reference to the dividend component of the cancellation payment) under the proposed transaction.

Where section 177EA of the ITAA 1936 does not apply, the Commissioner does not have discretion to make a determination to debit a corporate tax entity's franking account pursuant to paragraph 177EA(5)(a) of the ITAA 1936.

Therefore, in this case, the Commissioner will not be empowered to use his discretion in such a way as to debit the company's (ie Company A's) franking account pursuant to paragraph 177EA(5)(a) of the ITAA 1936.

Question 5

Summary

The Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 or subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole, or any part, of the capital component of the cancellation payments.

Detailed reasoning

Sections 45A and 45B of the ITAA 1936 are two anti-avoidance provisions which, if they apply, allow the Commissioner to make a determination that section 45C of the ITAA 1936 applies. The effect of such a determination is that all or part of the capital component received under the selective share capital reduction would be treated as an unfranked dividend.

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

Although the distribution of share capital per share is the 'provision of a capital benefit' to participating shareholders under the share reduction, the circumstances of the reduction indicate that there is no streaming of capital benefits to some shareholders and dividends to other shareholders.

Accordingly, section 45A of the ITAA 1936 does not apply to the selective share capital reductions.

The Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies to treat all or part of the distribution of share capital per share as an unfranked dividend paid by the company (ie Company A).

Section 45B of the ITAA 1936 applies where certain capital payments are paid to shareholders in substitution for dividends. In broad terms, section 45B of the ITAA 1936 applies where:

•                    there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a) of the ITAA 1936)

•                    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) of the ITAA 1936) 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 the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(a) of the ITAA 1936).

The conditions of paragraphs 45B(2)(a) and (b) of the ITAA 1936 were met in respect of the selective share capital reduction.

However, having regard to the 'relevant circumstances' of the selective share capital reduction/reductions, the Commissioner considers that the scheme consisting of the selective share capital reductions and share cancellations was not entered into or carried out for a more than an incidental purpose of enabling the shareholders who participated in the share capital reduction to obtain a tax benefit. Some of the key factors are:

•                    the capital component (a distribution of share capital) per share accords with the average capital per share methodology: the capital distribution is attributable to the share capital and retained earnings on a proportionate basis to take into account the Individual's interest in the share capital account; and

•                    it cannot be said that, in these circumstances, the capital benefit was provided for the purposes of shareholders obtaining a tax benefit by way of applying capital losses against any capital gain from CGT Event C2 happening upon the cancellation of shares under the selective share capital reduction.

Accordingly, section 45B of the ITAA 1936 does not apply to the selective share capital reductions.

The Commissioner will not make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies to treat all or part of the distribution of share capital per share as an unfranked dividend paid by the company (ie Company A).