Edited version of private advice

Authorisation Number: 1052328738818

Date of advice: 14 November 2024

Ruling

Subject: Return of capital - off-market share buy-back

Question 1

Will the Commissioner make a determination under subsection 45B(3) of the Income Tax Assessment Act 1936 (ITAA 1936) that subsections 45C(1), (2) and (4) of the ITAA 1936 will apply to Company A's proposed share buy-back, so that all or part of the capital benefit (being the amount debited to the share capital account) is taken to be an unfranked dividend that is paid by Company A to Company B out of profits of Company A?

Answer

No.

Question 2

As part of the share buy-back purchase price is taken to be a dividend under section 159GZZZP of the ITAA 1936 (being the difference between the total purchase price and that part of the purchase price that is debited to Company A's share capital account), does paragraph 202-45(c) of the Income Tax Assessment Act 1997 (ITAA 1997) apply to treat that part of the dividend that is attributable to the excess of the purchase price over market value as unfrankable?

Answer

No.

This ruling applies for the following period:

1 July 2024 to 30 June 2025

The scheme commences on:

1 July 2024

Relevant facts and circumstances

Company A's tax-related information

1.    Company A is an Australian resident for income tax purposes and is not a member of an Australian income tax consolidated group.

2.    Company A does not own any real property situated in Australia and currently leases its business premises under an operating lease.

3.    Company B holds its shares in Company A on 'capital account' for Australian income tax purposes and these shares were acquired on or after 20 September 1985.

4.    Company A's share capital account is not, and has not been, tainted for the purposes of Division 197 of the ITAA 1997.

5.    Company A and Company B do not have any carried forward revenue tax losses or net capital losses for Australian income tax purposes.

6.    Company A's current franking account balance as of 30 September 2024 is $X.

Company A's share and capital structure

7.    Company A is not listed on the Australian stock exchange or any other recognised stock exchange.

8.    All shares in Company A are ordinary shares and are legally and beneficially held by Company B as the sole shareholder. Company B is incorporated in, and is a tax resident of, XXXX.

9.    Company A has never declared or paid dividends to its shareholders.

10.  Company A has previously undertaken a capital return to a shareholder without cancelling any shares. Company A has not undertaken any further capital returns since.

11.  Based on Company A's financial statements as of 30 June 2024:

a.    Company B held X ordinary shares in Company A with a total face value of $A, which was also the share capital balance of Company A at that time. The face value per share equated to $Z and this is the CGT cost base of each share.

b.    Company A had a retained earnings balance in accordance with Australian Accounting Standards of $XX at that time.

The Proposed Scheme

12.  Company A proposes to repatriate $B of cash by undertaking an off-market share buy-back via a share cancellation (the Proposed Scheme).

13.  The Proposed Scheme will be in the form of an equal access buy-back, rather than a selective buy-back.

14.  The relevant Company A shares will be bought back for $C per share.

15.  In addition:

a.    The total market value of Company A as of 30 June 2024 was $XXX.

b.    The number of shares being bought back is D.

c.     The capital component ($YYY) calculated under the 'average capital per share' (ACPS) method, calculated as ($A/X) multiplied by ($B/$C), will be debited to Company A's share capital account (which had a credit balance above $YYY as of 30 June 2024).

d.    The dividend component ($ZZZ) calculated under the ACPS method, calculated as $B minus the capital component, will be franked to the maximum extent possible.

16.  The accounting journal entries for the buy-back will not include any transfers (including of profits), either directly or indirectly, to company A's share capital account, in particular the existing share capital account for ordinary shares.

17.  Rather, the buy-back consideration will be fully funded from cash to be received from debtors. Such cash was loaned to Company B on arm's length terms in March 2024 and as such, rather than settle the intercompany balance by requiring Company B to return the cash to Company A, the buy-back consideration would be offset against the receivable balance on Company A's books. No other assets will be liquidated and there will be no debt or equity financing to fund the buy-back transaction.

Commercial rationale for the Proposed Scheme

18.  The commercial purpose for the share buy-back is to enable Company A to return excess capital to its shareholder (Company B) and achieve a more efficient and optimal capital structure with a lower cost of capital.

19.  Company A's excess capital reserves are due to its history as Company X:

a.    Following a corporate restructure, Company X is now trading as Company A.

b.    Since the restructure, Company A has reduced its various operating activities in Australia, as it has transitioned from a full-service manufacturer to a limited risk distributor. Company A no longer carries out manufacturing activities in Australia and as such, its activities are largely limited to 'box and ship' activities.

20.  As a result of its changed business services, Company A now requires much less capital to fund its activities. It also requires a smaller employee base in Australia given that its distributed products are mainly manufactured outside Australia.

Assumptions

The Commissioner provides this Ruling based on the market valuation of Company A as at the valuation date (i.e. 30 June 2024).

The Ruling is made on the basis that there is no material change in the market valuation of Company A between the valuation date and the share buy-back transaction date.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 45C

Income Tax Assessment Act 1936 section 159GZZZK

Income Tax Assessment Act 1936 section 159GZZZM

Income Tax Assessment Act 1936 section 159GZZZP

Income Tax Assessment Act 1997 section 202-45

Reasons for decision

Question 1

Will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that subsections 45C(1), (2) and (4) of the ITAA 1936 will apply to Company A's proposed share buy-back, so that all or part of the capital benefit (being the amount debited to the share capital account) is taken to be an unfranked dividend that is paid by Company A to Company B out of profits of Company A?

Summary

The Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that subsections 45C(1), (2) and (4) of the ITAA 1936 will apply to Company A's proposed share buy-back.

Detailed Reasoning

On-market vs. off-market share buy-back

1.    For the purposes of Division 16K of the ITAA 1936, section 159GZZZK provides that a share buy-back is:

(a)  an on-market purchase if the share is listed on a stock exchange and the purchase is made in the ordinary course of business of that stock exchange, and

(b)  an off-market purchase in all other circumstances.

2.    Given Company A is not listed on a recognised stock exchange, the proposed share buy-back will constitute an off-market buy-back.

Purchase price and consideration for the buy-back

3.    Under section 159GZZZM of the ITAA 1936, the purchase price paid by the company to the shareholder in respect of a buy-back is the amount of money and/or the market value of any property the shareholder receives as consideration for the buy-back.

4.    In the case of an off-market buy-back, section 159GZZZP further provides that the difference between:

(a)  the purchase price, and

(b)  the part of the purchase price in respect of the buy-back which is debited against the company's share capital account,

is taken to be a dividend paid by the company to the shareholder out of the profits of the company on the day the buy-back occurs.

5.    Therefore, the buy-back consideration for Company A's proposed buy-back will be characterised as:

(a)  capital proceeds to the extent that the buy-back consideration is debited against Company A's share capital account (the Capital Component), and

(b)  a dividend to the extent that the balance of the buy-back consideration exceeds the amount debited against Company A's share capital account (the Dividend Component).

6.    In the absence of exceptional circumstances, the Commissioner's preferred approach for determining the split between the Capital Component and Dividend Component of the buy-back consideration is the ACPS method (Practice Statement Law Administration PS LA 2007/9 Share buy-backs (PS LA 2007/9), paragraphs 62 & 69).

Application of ACPS method

7.    The key characteristics of Company A's proposed share buy-back include:

(a)  ordinary issued capital: $A,

(b)  total buy-back consideration: $B,

(c)   buy-back price per share: $C

(calculated as Company A's total market value of $XXX divided by X ordinary shares on issue), and

(d)  number of shares being bought back: D

(calculated as $B divided by $C).

8.    In applying the ACPS method, the split of the buy-back consideration between the Capital Component and Dividend Component would be as follows:

Table 1: In applying the ACPS method, the split of the buy-back consideration between the Capital Component and Dividend Component would be as follows:

Does section 45B apply to the proposed buy-back?

Section 45B

9.    Section 45B of the ITAA 1936 applies if:

(a)  there is a scheme under which a person is provided with a capital benefit by a company,

(b)  under the scheme, a taxpayer (the relevant taxpayer) obtains a tax benefit, and

(c)   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 a taxpayer (the relevant taxpayer) to obtain a tax benefit.

10.  The purpose of section 45B of the ITAA 1936 is to ensure that relevant amounts are treated as dividends for taxation purposes if, amongst other things, certain payments, allocations, and distributions are made in substitution for dividends.

11.  Whilst paragraph 62 of PS LA 2007/9 provides that the ACPS method gives rise to a strong presumption that section 45B should not apply to the proposed buy-back, this presumption can be overridden if there is strong evidence of a 'more than incidental' purpose of conferring a tax benefit.

12.  If section 45B of the ITAA 1936 is found to apply, the Commissioner is empowered under subsection 45B(3) to make a determination that section 45C of the ITAA 1936 applies to the whole or a part of the capital benefit. The effect of section 45C is that the amount of the capital benefit, or part of it, is taken for the purposes of the ITAA 1936 to be an unfranked dividend paid to the shareholder by the company out of profits. Thus, the capital benefit, or part of it, becomes fully assessable income of the shareholder.

Does section 45B apply to Company A?

13.  Company A's proposed share buy-back constitutes a 'scheme' within the broad definition given by subsection 995(1) of the ITAA 1997. As share capital will be distributed by Company A, Company B will also be provided with a capital benefit for the purposes of paragraph 45B(5)(b) of the ITAA 1936. Therefore, paragraph 45B(2)(a) of the ITAA 1936 will be satisfied.

14.  For the purposes of subsection 45B(8), the 'relevant taxpayer' is Company B. Under the proposed scheme, Company B will receive a tax benefit as defined in subsection 45B(9), as the amount of tax payable from the treatment of a return of capital distribution would, apart from the operation of 45B, be less than the amount that would be payable if the distribution had instead been a dividend. Therefore, paragraph 45B(2)(b) of the ITAA 1936 will be satisfied.

15.  Therefore, in determining whether section 45B applies, the key question is whether the proposed share buy-back will be made for 'more than an incidental' purpose of conferring a tax benefit to Company B in satisfaction of paragraph 45B(2)(c) (the Purpose Test).

The Purpose Test

16.  PS LA 2007/9 provides guidance on the principles relevant to the Purpose Test as it applies to share buy-backs.

17.  Paragraph 100 of PS LA 2007/9 provides that to apply section 45B of the ITAA 1936 to a share buy-back, objective evidence is required of a substantial tax purpose of substituting share capital for a part of the purchase price which would otherwise be a dividend.

18.  In making this assessment, paragraphs 105 to 107 of PS LA 2007/9 outline the following general principles:

(a)  the purpose of any one of the persons who entered into or carried out the scheme or any part of the scheme is sufficient to attract the operation of section 45B. Relevant persons would include the company, its directors and managers, and its shareholders.

(b)  a more than incidental purpose includes the 'main or substantial purpose' but does not need to be the 'most influential or prevailing purpose' and will not include a purpose which occurs 'fortuitously or in subordinate conjunction with one of the main or substantial purposes...or merely follows that purpose as a natural incident.[1]

(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.

(d)  the presence of the requisite 'more than incidental' purpose is to be inferred objectively from the circumstances of the arrangement.

19.  To facilitate the test and reveal the requisite purpose, a non-exhaustive list of 'relevant circumstances' is outlined in subsection 45B(8) of the ITAA 1936. Paragraph 107 of PS LA 2007/9 provides that the Commissioner should consider all the circumstances outlined in subsection 45B(8) and determine whether they are in favour of, against or are neutral as to the conclusion of a purpose of enabling the relevant taxpayer to obtain a tax benefit.

20.  Each relevant circumstance listed in subsection 45B(8) of the ITAA 1936 is discussed in further detail below. Despite not applying directly to share buy-backs, PS LA 2008/10 Application of section 45B of the Income Tax Assessment Act 1936 to share capital reductions (PS LA 2008/10) provides useful guidance on the relevant factors to consider when applying these circumstances.

(a) the extent to which the capital benefit is attributable to capital or to profits (realised and unrealised) of the company

21.  Despite a 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. A distribution of share capital that is attributable to profits is, in effect, distributing profits, and is thus being made in substitution for a dividend such that it secures associated tax advantages for the shareholder.

22.  PS LA 2008/10 provides that a capital distribution that is attributable to share capital should reflect circumstances which show that the share capital distributed is genuinely surplus to the company's need of it and that it is not merely a cash distribution debited against share capital on the basis of shareholder tax preference. For example, a release of the capital from a disposal of part of the business structure, some other business structural change, or in some circumstances its replacement with debt capital where it is shown to be more profitable to shareholders.

23.  In the present case, Company A's current share capital was largely accumulated when the company operated as Company X and carried on a broader spectrum of activities than it currently does. Company A's capital requirements have changed over time and its share capital is excess to its current and future business needs.

24.  Therefore, this circumstance weighs against section 45B applying to the proposed share buy-back.

(b) the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company

25.  An interruption to the normal pattern of profit distribution and its replacement with a distribution of capital may suggest dividend substitution.

26.  In the present case, the proposed share buy-back would be Company A's second capital reduction. Furthermore, Company A has never declared a dividend.

27.  Given there is no observable pattern of distributing dividends or returns of capital by Company A, this circumstance is neither in favour nor against section 45B applying to the proposed share buy-back.

(c) whether the relevant taxpayer has capital losses that, apart from the scheme, would be unutilised at the end of the relevant year of income

28.  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.

29.  The ordinary shares in Company A held by Company B (the relevant taxpayer) are not taxable Australian property (TAP) and Company B does not have any carry forward capital losses.

30.  Accordingly, this circumstance neither weighs for or against section 45B applying.

(d) 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, by the relevant taxpayer before 20 September 1985

31.  Where taxpayers receive a capital distribution in respect of a pre-CGT asset, there would ordinarily be no CGT implications for the shareholders, and this could influence the company's decision to return capital to shareholders.

32.  Given the shares held by Company B in Company A were acquired after 20 September 1985, this circumstance weighs against section 45B applying.

(e) whether the relevant taxpayer is a non-resident

33.  Non-resident taxpayers are normally taxed on dividends at the rate of 15%, but they are not exposed to capital gains on the disposal of shares unless those shares are 'indirect Australian real property interests' as defined in section 855-25 of the ITAA 1997. The implication of non-residency is that it would normally point towards a tax preference for a distribution of capital over profit.

34.  Given Company B is a non-resident, this circumstance weighs in favour of section 45B applying on the basis that the tax treatment of a capital benefit to a non-resident taxpayer is more favourable than a dividend distribution.

(f) whether the cost base of the relevant ownership interest is not substantially less than the value of the applicable capital benefit

35.  Where the cost base of the ownership interest is similar or greater in value than the capital benefit provided, the capital distribution will not expose the relevant taxpayer to a capital gain under CGT event G1 or C2 where the provision of the capital benefit involves the subsequent cancellation of a share. This could point towards a tax preference for capital over profit.

36.  Given the ordinary shares in Company A held by Company B are not TAP as discussed above, this circumstance neither weighs for or against section 45B applying.

(h) whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital

37.  This circumstance examines the effect of the capital reduction on the substance of the shareholder's interest in the company directly and relative to other shareholders.

38.  On the basis that Company B is the sole shareholder in Company A, the substance of Company B's interest will remain unchanged as a result of the proposed buy-back.

39.  Therefore, this circumstance may point in favour of section 45B applying to the proposed share buy-back.

(i) if the scheme involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests:

(i)            the period for which the ownership interests are held by the holder of the interests; and

(ii)           when the arrangement for the disposal of the ownership interests was entered into.

40.  It is a question of fact whether the scheme involves the later disposal of ownership interests or not.

41.  Company B will be receiving cash as consideration for the proposed buy-back (notwithstanding the possible offset of the buy-back consideration against a prior loan from Company A to Company B).

42.  Given Company B will not be required to acquire further ownership interests in Company A with the consideration received, this circumstance weighs against section 45B applying.

(k) any of the matters referred to in subsection 177D(2)

43.  The matters in paragraph 177D(2)(b) which are relied on to determine purpose under Part IVA of the ITAA 1936 are included by virtue of this paragraph. The Part IVA matters are to be given equal attention with the other matters in subsection 45B(8).

Table 2: The matters in paragraph 177D(2)(b) which are relied on to determine purpose under Part IVA of the ITAA 1936 are included by virtue of this paragraph. The Part IVA matters are to be given equal attention with the other matters in subsection 45B(8).

44.  On balance, none of the factors above collectively outweigh the strong presumption against section 45B applying, due to the ACPS method being used to determine the capital/dividend split.

Conclusion: Applicability of section 45B to the proposed buy-back

45.  Following a consideration of the relevant circumstances of the proposed share buy-back listed in subsection 45B(8), the Commissioner is satisfied that the Proposed Scheme will not be entered into for a 'more than incidental' purpose of conferring a tax benefit to Company B for the purposes of paragraph 45B(2)(c).

46.  Therefore, the Commissioner will not make a determination under subsection 45B(3) that section 45C applies to the whole or a part of the capital benefit.

Question 2

As part of the share buy-back purchase price is taken to be a dividend under section 159GZZZP of the ITAA 1936 (being the difference between the total purchase price and that part of the purchase price that is debited to Company A's share capital account), does paragraph 202-45(c) of the ITAA 1997 apply to treat that part of the dividend that is attributable to the excess of the purchase price over market value as unfrankable?

Summary

Paragraph 202-45(c) of the ITAA 1997 will not apply to treat part of the dividend as unfrankable, because the purchase price of the shares will not exceed their market value.

Detailed Reasoning

47.  Under section 202-45 of the ITAA 1997, an unfrankable distribution includes:

(c)   where the purchase price on the buy-back of a *share by a *company from one of its *members is taken to be a dividend under section 159GZZZP of the Income Tax Assessment Act 1936 - so much of that purchase price as exceeds what would be the market value (as normally understood) of the share at the time of the buy-back if the buy-back did not take place and were never proposed to take place.

48.  Paragraph 202-45(c) covers a situation where part of the purchase price of a share is taken to be a dividend and the price exceeds the market value of the share.

49.  In the present case, part of the buy-back purchase price is taken to be a dividend under section 159GZZZP of the ITAA 1936, equal to the difference between the total purchase price and that part of the purchase price that is debited to Company A's share capital account ($ZZZ).

50.  Based on the market valuation, and that this ruling is made on the basis that there is no material change in the valuation of Company A between the date of the market valuation to the date of the buy-back, the Commissioner is satisfied that the market value of the shares as at the buy-back date is equal to what the market value of the shares would be at the time of the buy-back if the buy-back did not take place and was never proposed to take place.

51.  Therefore, given the purchase price of the buy-back will not exceed what would be the market value at the time of the buy-back, paragraph 202-45(c) will not apply to treat any part of the dividend as unfrankable.

[1] The Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998, at paragraphs 1.31 and 1.32.