Edited version of private advice

Authorisation Number: 1052173948317

Date of advice: 7 December 2023

Ruling

Subject: Share buy-back

Question 1

Is the transaction a share buy-back under Division 16K of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes.

Question 2

Is the appropriate capital and dividend component based on the market value of the shares had they been sold to a third party?

Answer

No.

This private ruling applies for the following period:

Year ended 30 June 2022

The scheme commenced on:

1 July 2021

Relevant facts and circumstances

Company A is the trustee for the Trust.

Individual A is a beneficiary of the Trust.

Individual A was a contractor and then an employee of Company B.

Company C owned 100% of the shares in Company B.

At all material times Company B operated a business. Company B also derived income from some other activities.

In 20YY, the Trust purchased X ordinary class shares which equated to Y% of interest in Company B from Company C.

The purchase price paid by the Trust was $Z. As part of the agreement between the Trust and Company B, prior to the sale of the shares to the Trust, all of Company B's retained earnings were declared as dividends to the then existing owner, Company C.\

The Trust has been entitled to dividends from profits from the time they became a shareholder, in accordance with the dividend policy in the Shareholder Agreement.\

In 20YY, Individual A was appointed as director of Company B at the same time as the Trust purchased the shares.

Individual B is also a director of Company B and Company C continued to have an X% ownership in Company B.

Throughout Individual A's time as director, it was advised there was an intention to take a period of leave.

In 20YY, Individual A advised Individual B that they wished to take leave.

Individual A initially sought Individual B's agreement to return as a director of the company but this was not permitted.

Individual B indicated that they wanted individual A to resign as a director and employee. This request was agreed to.

This required that as per clause Y of the Shareholders Agreement the Trust would be required to dispose of its shares in Company B.

Individual B sought to obtain valuations of the Trust's shares in Company B in order to set a disposal price.

This valuation was to be based upon the termination value of the franchise.

Initially, the disposal price of the shares was $Y.

In addition it was proposed a dividend of $X would be paid to the Trust, in respect of the company's profits from the years up to and including 20YY, based on the company's dividend policy.

Clause X of the shareholders agreement provided that Company B would engage in a selective buyback of the Trust's shares unless Company B wished to procure another party to purchase the shares.

From the initial discussions, Individual A was under the impression that Individual B had agreed that the Trust would sell its shares to Company C.

In 20YY, Individual A signed a share buy-back agreement between Company B and the Trust.

Company B's lawyers informed ASIC that the transaction was a share buy-back for the purposes of the Corporations Act 2001.

The following documentation was provided:

•         Minutes of a meeting of the directors of Company B where the selective buy-back received approval

•         Selective Buy Back Explanatory Statements

•         Resolution of shareholder of the company (signed but undated)

•         Share transfer (signed but undated)

•         Resolution of a sole director of the company

Balance sheet as at 30 June 20YY showed:

Issued and paid up capital X

Retained profits Y

Balance sheet as at 31 December 20YY showed:

Fully paid shares X

Retained earnings Y

Dividends paid Z

Relevant legislative provisions

Income Tax Assessment Act 1936 section 159GZZK

Income Tax Assessment Act 1936 paragraph 159GZZZK(c)

Income Tax Assessment Act 1936 paragraph 159GZZZK(d)

Income Tax Assessment Act 1936 paragraph 159GZZZM(a)

Income Tax Assessment Act 1936 section 159GZZZP

Reasons for decision

Question 1 and 2

Section 159GZZK of the ITAA 1936 provides that for tax purposes a share buy-back occurs where a company buys a share in itself from a shareholder in the company.

Paragraph 159GZZZK(c) of the ITAA 1936 provides that an on-market purchase will arise if:

(i)   the share is listed for quotation in the official list of a stock exchange in Australia or elsewhere; and

(ii)   the buy-back is made in the ordinary course of trading on that stock exchange.

As AGA's shares are not listed for quotation on the official list of a stock exchange in Australia or elsewhere, the buy-back cannot be 'made in the ordinary course of trading on that stock exchange.' Therefore, in accordance with paragraph 159GZZZK(d) of the ITAA 1936, the buy-back arrangement entered into between you and AGA is an off-market purchase in accordance with section 159GZZZK of the ITAA 1936.

Relevantly, pursuant to paragraph 159GZZZM(a) of the ITAA 1936, the purchase price in respect of shares the company acquires through the buy-back is the amount of money the participating shareholder received or are entitled to receive as a result of or in respect of the buy-back.

Section 159GZZZP relevantly provides:

(1) For the purposes of this Act, but subject to subsection (1A), where a buy-back of a share or non-share equity interest by a company is an off-market purchase, the difference between:

(a)   the purchase price; and

(b)   the part (if any) of the purchase price in respect of the buy-back of the share or non-share equity interest which is debited against amounts standing to the credit of:

(i)    the company's share capital account if it is a share that is bought back; or

(ii)    the company's share capital account or non-share capital account if it is a non-share equity interest that is bought back;

is taken to be a dividend paid by the company:

(c)   to the seller as a shareholder in the company; and

(d)   out of profits derived by the company; and

(e)   on the day the buy-back occurs.

(2) The remainder of the purchase price is taken not to be a dividend for the purposes of this Act.

For the purposes of section 159GZZZP of the ITAA 1936, Practice Statement PSLA 2007/9 states that the Commissioner's preferred methodology for determining the 'split' between the return of capital and dividend paid to participating shareholders in an off-market share buy-back is the average capital per share (ACPS) method unless companies can demonstrate exceptional circumstances for the use of an alternative method (paragraph 12 and 69 of Practice Statement Law Administration PS LA 2007/9).

PSLA 2007/9 states the following:

59. An essential aspect of any off-market share buy-back is the 'split' between the return of capital and dividend paid to participating shareholders. Section 159GZZZP of the ITAA 1936 prescribes that:

•        'capital' is debited against the company's share capital account, and

•        the balance of the purchase price is a dividend.

The 'split' is nominated by the company. However, the ATO will have regard to the various anti-avoidance and integrity rules in the provision of written advice to the company.

60. For example, a 'split' that has too low a capital component will both stream dividends and artificially increase capital losses to vendor shareholders. Conversely, a capital component that is too high will provide or stream capital benefits at the expense of dividends. Neither of these outcomes is desirable.

61. The ATO considers that there are a number of acceptable methodologies for ascertaining the capital/dividend split, although not all have equal applicability in every case. The following discussion is designed to provide guidance to tax officers in deciding whether to accept the dividend/capital split proposed or to apply one of the various anti-avoidance provisions of the ITAA 1936. All of these methodologies have been accepted by the ATO in cases involving share buy-backs. The question becomes which is the most appropriate methodology in each case.

Methodologies

Average capital per share

62. One method used to determine the 'split' is for the company to work out its average capital per share (ACPS). This is obtained by dividing a company's ordinary issued capital by the number of shares on issue. The amount so derived is a reasonable estimate of any capital component of the split. The balance of any buy-back price would be a dividend. This method does overcome the dilution issue discussed at paragraph 63 of this practice statement. Another clear advantage is that ACPS gives rise to a strong presumption that sections 45A and 45B of the ITAA 1936 would not apply to the buy-back. Tax officers should examine recent financial year data as well as projected movements in the average. Evidence of recent capital injections just before a share buy-back may attract the anti-avoidance provisions. ACPS should, prima facie, be applied to determine the capital component in an off-market share buy-back. The other methods discussed below may have particular relevance or application in specific instances only.

Share capital/retained earnings ratio (Slice Approach)

63. Another acceptable method of determining the capital/dividend split, in an established company, is to calculate the ratio of share capital to retained earnings on a company's most recent balance sheet. It is sometimes referred to as the 'Slice Approach'. This ratio should then be reflected in any capital/dividend split proposed. This method seems to more accurately reflect splits in established companies as newer companies do not have a history of retained earnings. However, companies that conduct successive off-market share buy-back may contribute to significant dilution of share capital over time if they continue to use this method. This may require an examination for possible breaches of section 45B of the ITAA 1936. For this reason, it is preferable to use the ACPS method.

64. There may be particular circumstances where the use of the 'Slice Approach' is appropriate. For instance, a decision by a taxpayer company to sell-off a particular business and return that capital to shareholders is a case in point. Should the proceeds from that sale be comprised of both capital and profits, and the company proposed a distribution reflective of that capital/profits split, the ATO would probably consider that split more appropriate than ACPS. Any distribution should be capital and dividend proportionately to the interest of the shareholder in them.

65. There may be other instances where a 'Slice Approach' would be acceptable to the ATO. Tax officers should fully and critically examine the commercial rationale behind a buy-back proposal for these reasons.

Embedded value

66. The concept of 'embedded value' is an actuarial calculation reflecting the amount of value (usually for CGT purposes) per share in a demutualised entity. Former mutual companies that become companies limited by shares have used this method to attribute values to shares issued to former policy holders or members.

67. It is acceptable for a recently demutualised company to have a capital/dividend split that approximates the embedded value/retained earnings ratio. It will become less acceptable, to the ATO, over time to use this method.

68. It is similarly acceptable for a recently established listed company (without a history of retained earnings) to adopt such a method in setting its split. For example, a company 'spun-off' from an existing listed entity may propose the issue price as a capital amount. Once again, this amount (and method) loses its relevance over time.

Preferred ATO methodology

69. Tax officers should apply ACPS for share buy-backs unless companies can demonstrate exceptional circumstances for the use of an alternative methodology.

Question 1

Application to your circumstances

In this case, all of the documentation provided to evidence the transaction demonstrate a share buy-back occurred. The requirements under Corporations Law, including the explanatory statement, have been provided and signed by the relevant parties. We consider the arrangements is a share buy-back per Division 16K of the ITAA 1936.

Question 2

Application to the circumstances

In this case, the Trust held X fully paid ordinary shares in the company. As a result of the buy-back transaction, the Trust received total consideration of $Y. The company's sole remaining shareholder became Company B following the transaction.

The Trust has proposed to divert from the ACPS methodology described above and instead allocate the market value of the shares, had they been sold to a third party in an arm's length transaction, as the capital component of the consideration received.

We do not consider this approach would accurately assess the value of the arrangement. An assessment of market value is by nature not comparable to a buy-back transaction. It is inherent that the market value methodology requires the X fully paid shares be owned by an entity and not be cancelled by the issuing company. It is factually inconsistent with the arrangement. The projected outcome in the application of this methodology would produce a situation that Company C would not have become the sole shareholder of Company B or have rights to all of the future income stream. This will be inconsistent with the factual outcome of the arrangement. Therefore, we do not consider the proposed alternate methodology to be an accurate reflection of the value of the buy-back arrangement.

Based on the information provided, including the financial statements for both before and after the buy-back, we consider all but $Y of the payment has been paid from Company B's retained earnings as franked dividend. The Commissioner considers that the proposed use of market value for the capital component will distort the application of the franking credits to the appropriate shareholders.

We do not consider the appropriate capital component should be based on the market value of the shares had they been sold to a third party. In this case the arrangement was entered into between two parties at arms' length under normal commercial settings for transactions commonly found in divestment. The transaction was not conducted under exceptional circumstances and therefore the ACPS methodology should be applied to the buy-back transaction.