Edited version of private advice

Authorisation Number: 1052206109217

Date of advice: 7 February 2024

Ruling

Subject:Early stage innovation company

Issue one

Determining the income tax liability of A:

Question 1

For the purposes of determining A Pty Ltd (A)'s income tax liability does the single entity rule in subsection 701-1 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to ignore the liquidation of B Pty Ltd (B)?

Answer

Yes.

Issue two

For the purposes of determining the income tax liability of the A shareholders:

Question 2

Does CGT event C2, in section 104-25 of the ITAA 1997, happen at the time when the shares in B and A are cancelled by the respective liquidators?

Answer

Yes.

Question 3

Is the capital gain or loss that arises as a result of the in-specie distribution of the C Ltd (C) and D Pty Ltd (D) shares by the liquidator of B disregarded in accordance with subsection 360-50(3) and subsection 360-50(4) of the ITAA 1997?

Answer

Yes.

Question 4

To the extent that the B liquidator's in-specie distribution of the C and D shares results in a CGT amount that is disregarded in accordance with subsection 360-50(4) of the ITAA 1997, will that amount be deemed to be income by subsection 47(1) of the ITAA 1936?

Answer

No.

Question 5

To the extent that the A liquidator's in-specie distribution of the C and D shares to the A shareholders represents an amount that is the CGT gain amount disregarded by B in accordance with subsection 360-50(4) of the ITAA 1997, will that amount be deemed to be income by subsection 47(1) of the ITAA 1936?

Answer

No.

Question 6

Is the capital gain that is derived by A when CGT event C2 happens when A's shares are cancelled as a result of the liquidation and the in-specie distribution of C and D shares to the A shareholders 'income derived' by A for the purposes of subsection 47(1A) of the ITAA 1997?

Answer

Yes.

Question 7

Will the first element of the cost base and reduced cost base of the C and D shares acquired by the A shareholders as a result of the A liquidator's in-specie distribution of those shares be in accordance with paragraph 110-25(2)(b) of the ITAA 1997?

Answer

Yes.

Question 8

Will the market value of the C and D shares that A shareholders receive when their shares in A are cancelled by the A liquidator and CGT event C2, in section 104-25 of the ITAA 1997 happens, be included in the capital proceeds, as defined in section 116-20 of the ITAA 1997, for that event?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 202x

The scheme commences on:

1 July 202x

Relevant facts and circumstances

B is an Australian private company.

A is the head entity of a tax consolidated group.

B has 2 fully paid $1 ordinary shares on issue, both shares are owned by A.

B has ownership of investments in C and D shares and no other investments.

B holds the C and D shares on capital account.

C was an early stage innovation company (ESIC) under Division 360 of the ITAA 1997 at the time it issued shares to B.

D was an ESIC under Division 360 of the ITAA 1997 at the time it issued shares to B.

C is listed on the Australian Stock Exchange (ASX).

D intends to list on the ASX.

Neither B, nor its members are affiliates of C or D or their directors.

B is not excluded under section 360-20 of the ITAA 1997 from qualifying for the tax offset for investing in early stage innovation companies provided under 360-15 of the ITAA 1997.

Pursuant to section 360-50 of the of the ITAA 1997, B is entitled to the modified capital gains tax (CGT) treatment for early stage investors in relation to the shares it holds in C and D.

The shares held in C and D were not issued under an employee share scheme.

C and D have provided B with relevant information including confirmation that they meet the criteria of the ESIC tests under subsection 360-40(1) of the ITAA 1997 for the relevant years.

B is entitled to the tax offset pursuant to section 360-15 of the ITAA 1997.

The shareholders of A wish to hold their respective proportionate interest in C and D directly.

Prior to the tenth anniversary of the issue of shares in C and D, the following scheme will be implemented:

•         B will enter into voluntary liquidation;

•         The liquidators of B will make an in-specie distribution of the C and D shares to A;

•         The amount representing the liquidator's distribution in the voluntary liquidation of B will be credited to a capital account reserve of A.

•         A then will enter into voluntary liquidation;

•         The liquidator of A will make an in-specie distribution of the C and D shares to the shareholders of A.

•         The market value of shares in C and D will be greater than the cost base of the shares held in A at the time of the liquidation distribution.

Reasons for decision

Question 1 deals with the income tax liability of A as a result of the transaction.

Summary

The single entity rule in section 701-1 of the ITAA 1997 applies and the liquidation of B is ignored for the purposes of calculating A's income tax liability.

Detailed reasoning

The single entity rule in section 701-1 of the ITAA 1997 provides that entities that are subsidiary members of a consolidated group are taken to be parts of the head company of the group for core purposes. Those core purposes are working out the head company's and the entities' liability for income tax or their loss of a particular sort for a relevant income year.

The Commissioner has set out the tax implications of liquidating companies within a consolidated group in TD 2007/D5 Income tax: consolidation: does the single entity rule in section 701-1 of the Income Tax Assessment Act 1997 apply in determining whether distributions by the liquidator of a head company represent 'income derived' by the head company for the purposes of section 47 of the Income Tax Assessment Act 1936? (TD 2007/D5).

Paragraph 1 of TD 2007/D5 states that it is the Commissioner's view that:

The single entity rule in section 701-1 of the ITAA 1997 applies only for the head company core purposes and entity core purposes described in that section. For other purposes of the income tax law, such as the application of section 47 of the ITAA 1936 to determine the income tax liability of a shareholder of a head company, the single entity rule does not apply.

A is the head entity of the consolidated group. For the purpose of working out A's income tax liability, the single entity rule (SER) applies and distributions from the liquidation of B are ignored or not recognised.

Issue two

Questions 2 to 8

Questions 2 to 8 deal with the income tax liability of the shareholders of A as a result of the transactions

Summary

Section 47 of the ITAA 1936 is only concerned with determining what is assessable as a dividend amount distributed to the shareholders of A. Division 116 of Part 3-1 of the ITAA 1997 will apply to determine the amount of capital proceeds that the shareholders of A will receive from the cancellation of their shares. This would be so even if the shares of C and D were disposed of prior to the liquidation of A. The full amount of the final distribution made by the liquidator of A would be included in the capital proceeds for the ending of the shareholder's shares in A for the purposes of determining the capital gains or capital losses made on the happening of CGT event C2. Subsection 118-20(1), when read with subsection 118-20(1A) of the ITAA 1997, reduces the proportion of the capital gain that is assessable as a dividend so that no part of the final liquidator's distribution is taxed both as a dividend and as a capital gain.

Detailed reasoning

Single entity rule:

In accordance with the Commissioner's ruling in TD 2007/D5, the SER in section 701-1 of the ITAA 1997 does not apply for the purpose of determining the income tax liability of a shareholder of a head company of a consolidated group where section 47 of the ITAA 1936 has application. Consequently, the application of section 47 of the ITAA 1936 will need to be considered when calculating As shareholders' income tax liability when B is liquidated.

Ordinary income:

Section 6-5 of the ITAA 1997 provides that assessable income includes income according to ordinary concepts. Whether a receipt is income depends upon its quality in the hands of the recipient: Scott v Federal Commissioner of Taxation [1966] HCA 48;(1966)117 CLR 514; (1966) 14 ATD 286.

Dividends:

Section 44 of the ITAA 1936 includes in assessable income any dividends paid to a shareholder by a company out of profits and any non-share dividends paid to a shareholder by a company. The term dividends' is defined in subsection 6(1) of the ITAA 1936 to include any distribution made by a company to any of its shareholders, whether in money or other property, or an amount credited by a company to any of its shareholders as shareholders, except to the extent that it represents an amount paid out of the company's share capital account.

Distributions by liquidators:

At common law, a distribution to a shareholder by a liquidator is capital, not income, in the hands of the shareholder since it is a realisation of the shareholder's interest in the company: FC of T (NSW) v Stevenson (1937) 4 ATD 415; (1937) 59 CLR 80; FC of T v Blakely (1951) 9 ATD 239 at 245, 247; (1951) 82 CLR 388 at 402, 407; FC of T v Brewing Investments Ltd [2000] FCA 920 per Hill J at 18-19.

However, section 47 of the ITAA 1936 deems certain liquidator distribution amounts to be dividends paid to the shareholders out of the profits derived by the company and assessable under subsection 44(1) of the ITAA 1936.

Subsection 47(1) of the ITAA 1936 provides that:

Distributions to shareholders of a company by a liquidator in the course of winding-up the company, to the extent to which they represent income derived by the company (whether before or during liquidation) other than income which has been properly applied to replace a loss of paid-up share capital, shall, for the purposes of this Act, be deemed to be dividends paid to the shareholders by the company out of profits derived by it.

The meaning of 'income derived by the company' in subsection 47(1) of the ITAA 1936 is income according to ordinary concepts.

Subsection 47(1A) of the ITAA 1936, extends the meaning of 'income derived by the company' in subsection (1) to include:

(a) an amount (except a net capital gain) included in the company's assessable income for a year of income; or

(b) a net capital gain that would be included in the company's assessable income for a year of income if the ITAA 1997 required a net capital gain to be worked out as follows:

Method statement

Step 1. Work out each capital gain (except a capital gain that is disregarded) that the company made during that year of income.

Step 2. Total the capital gain or gains worked out under Step 1. The result is the net capital gain for the year of income.

The effect of section 47 of the ITAA 1936 is to treat certain distributions by a liquidator to be dividends paid out of profits when they otherwise would have been treated as a capital distribution.

Subsection 47(1A) of the ITAA 1936 operates to only include in income the net capital gains that are included in assessable income (without indexation) under Part 3-3 of the ITAA 1997. Capital gains that are disregarded or otherwise not within the concept of a net capital gain included in the assessable income of the company are also not within the meaning of the word 'income'.

Where a shareholder receives a distribution that relates to capital that is disregarded, section 47 of the ITAA 1936 would not deem the distribution to be a dividend, as no part of the distribution would represent income derived by the company.

Archer Bros Pty Ltd (In Vol Liq) v. FCT (1953) 90 CLR 140; 27 ALJ 353; 10 ATD 192 discusses liquidator's distributions. Taxation Determination TD 95/10 Income tax: what is the significance of the Archer Brothers principle in the context of liquidation distributions? discusses the significance of the "Archer Brothers principle" in the context of liquidation distributions:

1.    In a joint judgment, the Full High Court of Australia in Archer Bros Pty Ltd (In Vol Liq) v. FCT (1952-53) 90 CLR 140 at 155; 10 ATD 192 at 201 observed by way of obiter dicta:

'By a proper system of bookkeeping the liquidator, in the same way as the accountant of a private company which is a going concern, could so keep his accounts that...distributions could be made wholly and exclusively out of...particular profits...or income...'

2. These observations have given rise to what is known as the Archer Brothers principle. The principle is that if a liquidator appropriates (or 'sources') a particular fund of profit or income in making a distribution (or part of a distribution), that appropriation ordinarily determines the character of the distributed amount for the purposes of section 47 and other provisions of the Income Tax Assessment Act 1936 (the Act). Generally, we accept that a liquidator may rely on the Archer Brothers principle, except where a specific provision in the Act produces a different result (e.g., the rules in section 160ZLA that specify the order in which different types of funds are distributed).

3. The judicial dicta quoted above refer only to the selection of particular 'profits' or 'income'. However, if a liquidator ostensibly distributes an amount representing capital actually contributed by shareholders, we accept that the distribution is treated as a non-dividend return of capital even if the funds used to return the amount could be traced to a receipt of income or profit. We do not consider that the decision in Glenville Pastoral Co Pty Ltd (In Liq) v. FCT (1963) 109 CLR 199 is authority for a contrary result.

Tax incentives for early stage investors - modified CGT treatment:

A CGT asset is defined in subsection 108-5(1) of the ITAA 1997 as any kind of property or a legal or equitable right that is not property. Shares in a company are CGT assets: Note 1 to section 108-5 of the ITAA 1997.

Subsection 360-50(1) of the ITAA 1997 provides that shares that give rise to an entitlement to a tax offset under Subdivision 360-A of the ITAA 1997 for an investor are also required to apply the modified CGT treatment in section 360-50 of the ITAA 1997. The shares are treated as being held on capital account as per subsection 360-50(2) of the ITAA 1997. As B is entitled to the tax offset, it satisfies paragraph 360-50(1) and (2) of the ITAA 1997.

The specific modified CGT treatment arising for these shares will depend on when the investor entity deals with the shares (and the relevant CGT event happens); and whether the investor entity realises a capital gain or a capital loss from that event as described in paragraphs 360-50(3)(a) and (b), 360-50(4)(a) and (b) and subsection 360-50(5) of the ITAA 1997.

Where an investor has continuously held a qualifying share for between 12 months and less than ten years, that investor may disregard a capital gain arising from the share pursuant to subsection 360-50(4) of the ITAA 1997. However, it must disregard any capital loss as persubsections 360-50(3).

Capital gains under CGT event C2 under a liquidation

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

•                being redeemed or cancelled; or

•                being released, discharged or satisfied; or

•                expiring; or

•                being abandoned, surrendered or forfeited; or

....

The time of the event is when you enter into the contract that results in the asset ending or, if there is no contract, when the asset ends: subsection 104-25(2) of the ITAA 1997.

A taxpayer will make a capital gain if the capital proceeds from the ending are more than the asset's cost base or a capital loss if those capital proceeds are less than the asset's reduced cost base: subsection 104-25(3) of the ITAA 1997.

Broadly, capital proceeds include the money and market value of property you receive (or are entitled to receive) when an event happens: section 116-20 of the ITAA 1997.

Taxation Determination TD 2001/27 Income tax: capital gains: how do Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 ('ITAA 1997') treat: (a) a final liquidation distribution, including where all or part of it is deemed by subsection 47(1) of the Income Tax Assessment Act 1936 ('ITAA 1936') to be a dividend; and (b) an interim liquidation distribution to the extent it is not deemed to be a dividend by subsection 47(1)? (TD 2001/27) considers how Parts 3-1 and 3-3 of the ITAA 1997 treat interim and final liquidation distributions.

In respect to final liquidation distributions, paragraph 1 of TD 2001/27 states that:

The full amount of a final distribution made by a liquidator on the winding-up of a company constitutes capital proceeds from the ending of the shareholder's shares in the company for the purposes of capital gains or capital losses made on the happening of CGT event C2 (about cancellation, surrender and similar endings) in section 104-25 of the ITAA 1997. After the winding-up of a company, CGT event C2 happens to the shares when the company ceases to exist in accordance with the Corporations Act 2001 (see Taxation Determination TD 2000/7 paragraphs 3 and 4).

Paragraph 3 of TD 2001/27 states that even if all or part of the liquidator's distribution constitutes a dividend under subsection 47(1) of the ITAA 1936, it does not alter the position that the full amount is the capital proceeds for CGT event C2 in section 104-25 of the ITAA 1997 happening to the shares.

Paragraph 4 of TD 2001/27 explains that:

the apportionment rule in subsection 116-40(2) of the ITAA 1997 does not apply. The capital proceeds for the ending of the shares are not limited to the portion of the distribution that is not assessable under subsection 44(1) of the ITAA 1997.

Subsection 118-20(1), when read with subsection 118-20(1A) of the ITAA 1997, ensures that no part of the final liquidator's distribution is taxed both as a dividend and as a capital gain by reducing the capital gain the shareholder makes from CGT Event C2 by the amount of the dividend included in their assessable income.

Application to your circumstances:

In this case, upon the transfer or disposal of the shares in C and D by B to its shareholder A, CGT event A1 happens (subsection 104-10(1) of the ITAA 1997) for B at that time.

However, as B was entitled to a tax offset under Subdivision 360-A of the ITAA 1997, the capital gain on the transfer of the shares in C and D from B will be disregarded in accordance with subsections 360-50(4) of the ITAA 1997.

Consequently, to the extent that the liquidator's distribution for B includes the amount so disregarded in accordance with section 360-50 of the ITAA 1997, none of this amount will be included for the calculation under subsection 47(1A) of the ITAA 1936 and will not result in assessable income under subsection 47(1) of the ITAA 1936 for the purposes of section 44 of the ITAA 1936.

As the capital gain is disregarded, and applying the Archer Brothers principle, these assets maintain the tax-free status of the distribution from the capital account. That is, provided the liquidator can identify the source from which a distribution is made, the Commissioner accepts a liquidator's nominated appropriation and those funds retain the character of the source. So, a disregarded capital gain on the disposal of shares would remain capital.

Under the scheme, A acquires the shares in C and D shares at the time of the liquidation of B. For CGT purposes A must determine the cost base of these CGT assets. Under the general cost base and reduced cost base rules covered under subsections 110-25(2) and 110-55(2) of the ITAA 1997, the first element of the cost base and reduced cost base of an asset is the sum of the amount paid (or required to be paid) and the market value of property given (or required to be given) in respect of acquiring it. The first element of cost base or reduced cost base of the shares in C and D acquired by A is the acquisition consideration; that is the market value of property given by A to acquire the assets. The market value of property given is worked out as at the time of acquisition of the shares (paragraph 110-25(2)(b)). Hence, as A is required to give property (i.e. the shares in B) for the C and D shares, paragraph 110-25(2) of the ITAA 1997 will apply and the cost base or reduced cost base will be the market value of those shares in B at the time A acquires the C and D shares, apportioned appropriately to each share.

When A is liquidated, any increase in value of the shares in C and D while held by A is taken into account by section 47 of the ITAA 1936.

As mentioned above, subsection 47(1A) of the ITAA 1936 includes in a company's income, for the purposes of a liquidator's distribution, a net capital gain as worked out in accordance with the method statement contained in paragraph 47(1A)(b) of the ITAA 1936. Accordingly, any net capital gain calculated as a result of the disposal of the shares in C and D by A will be included as income derived by A and be a deemed dividend for the shareholders of A pursuant to subsection 47(1) of the ITAA 1936 for the purposes of section 44 of the ITAA 1936.

There will be a capital gain in relation to the shares in C and D shares held by A if the capital proceeds from the disposal are more than the asset's cost base, and a capital loss if the capital proceeds are less than the reduced cost base (section 104-10 of the ITAA 1997).

Under the scheme, A will dispose of the shares in C and D at the time of CGT event A1 happening to those shares. Under subsection 116-20(1) of the ITAA 1997 the capital proceeds from a CGT event are the money and the market value of any other property received or are entitled to receive in respect of the CGT event.

The capital proceeds from A's disposal of the shares in C and D will be the market value of the shares in A, appropriately apportioned to each share.

This amount will be a deemed dividend under section 47 of the ITAA 1936 and be included in the A shareholder's assessable income under section 44 of the ITAA 1936.

To the extent that the liquidator's distribution for A includes the amount disregarded by B in accordance with section 360-50 of the ITAA 1997, none of this disregarded amount will be included for the calculation under subsection 47(1A) of the ITAA 1936 and will not result in assessable income for the shareholders of A under subsection 47(1) of the ITAA 1936 for the purposes of section 44 of the ITAA 1936.

When the liquidator of A cancels their shareholders' shares, CGT event C2, in paragraph 104-25(1)(a) of the ITAA 1997, happens in relation to those shares. The capital proceeds of that CGT event, pursuant to subsection 116-20(1) of the ITAA 1997, is the total of the money received (or entitled to be received) and the market value of property received (or entitled to be received) in respect of the event happening. For the cancellation of their shares, the shareholders of A will receive the amount of the liquidator's distribution which includes the market value of the shares in C and D at the time of A's liquidation.

Based on the facts provided, this amount will be greater than the cost base of the shareholder's shares in A.

Section 118-20 of the ITAA 1997 ensures that no part of the final liquidator's distribution is taxed both as a dividend and as a capital gain. This is achieved by reducing the proportion of the capital gain that is assessable as a dividend. When the A shareholders are calculating the capital gain or loss attributable to the shares they held in A, if there is a capital gain it will be reduced by the amount of any part of the liquidator's distribution deemed to be a dividend under section 47 of the ITAA 1936.

Consequently, the shareholders in A will need to determine the amount of capital gain to include in their assessable income in the year the shares in A are cancelled and include any deemed dividend under section 47 of the ITAA 1936.

The cost base of the shares in C and D, when they are distributed to the shareholders of A is the market value of those shares at the time they are transferred by A (see 110-25(2)(b) of the ITAA 1997).