31 st August Hon Chris Pearce MP Parliamentary Secretary to the Treasurer of the Commonwealth Parliament House Canberra ACT 2600.

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1 Level 2 95 Pitt Street Sydney, NSW 2000 Telephone Facsimile tia@taxinstitute.com.au Website ABN st August 2006 Hon Chris Pearce MP Parliamentary Secretary to the Treasurer of the Commonwealth Parliament House Canberra ACT 2600 Dear Mr Pearce Corporations Act 2001 Redemption of redeemable preference shares The Taxation Institute of Australia ( Taxation Institute ) is concerned that section 254K of the Corporations Act 2001 ( CA ), which requires the redemption of redeemable preference shares ( RPS ) out of profits or the proceeds of a new issues of shares made for the purpose of the redemption, renders the redemption of these shares impracticable and also potentially subjects any redemption to anomalous and inequitable tax treatment. To address these problems, the Taxation Institute believes that there is a pressing need to amend the procedure for the redemption of RPS in section 254K of the CA. The redemption of the subscription amount for RPS should be permitted to be returned directly out of share capital rather than out of profits. This will simply ensure that the original subscriber gets the subscribed sum back without inequitable tax consequences. A summary of the basis for the our recommendation follows: Under the CA a company is permitted (subject to certain criteria) to redeem RPS, but only out of profits or the proceeds of a new issues of shares made for the purpose of the redemption (section 254K of the CA). Ever since the 1998 reforms to the CA, redeeming RPS out of the proceeds of a new issue is likely to be practicable only if the RPS have been issued on the basis that they were convertible into ordinary shares in the issuing company. Otherwise, redemption out of the proceeds of a new issue of shares will generally be impracticable. Because of the interaction between the CA and relevant provisions of the Income Tax Assessment Act 1936 ( ITAA 1936 ) and the Income Tax Assessment Act 1997 ( ITAA 1997 ) redemption of RPS out of profits will expose the company to franking debits and also often to untainting tax, being in effect a double detriment merely for following a procedure currently mandated by the Australian Securities and Investment Commission ( ASIC ) in their Practice Note 68. It is anomalous and unfair that a procedure prescribed by the CA should expose the company to disadvantageous treatment.

2 When RPS are issued, the company s share capital increases by the subscription amount. On redemption of RPS out of profits, by way of return of the subscription amount, the current procedure under the CA reduces the company s profit by the amount of the proceeds of redemption and leaves the share capital unchanged. It is submitted that the current procedure in the CA for redemption of RPS ought to be amended. We recommended that the CA should permit the subscription amount for RPS to be returned on redemption directly out of share capital rather than out of profits. This would be consistent both with the purpose of the 1998 reforms (which was to simplify and streamline procedures for returning share capital to shareholders, subject to appropriate protection for creditors), and with the effects of the pre 1998 rules concerning capital redemption reserves, share capital accounts and share premium accounts in relation to RPS. The amendment could be done by amending section 254K(b) of the CA to read : (b) as to an amount not exceeding the amount subscribed for the relevant share, out of share capital, and as to any amount payable on the redemption out of profits or out of the proceeds of a new issue of shares made for the purpose of the redemption. It would also in theory be possible to deem a return of the subscription amount on redemption of RPS, for tax purposes only, to be a return of share capital, in which case, it would be necessary also for the company to maintain a hypothetical share capital account purely for tax purposes, which would mirror the real share capital account except for entries reflecting the deeming referred to above. The disadvantages of this, in added complexity and artificiality of the tax system, are obvious. The Taxation Institute believes that an amendment of the company law as referred to above is the only practicable solution. In making a case for the above recommendation, in the Appendix to our submission you will find more detailed technical analysis and commentary supporting our recommendation that looks at the company law and tax positions before the 1998 company law reforms, the company law and tax positions after these 1998 reforms, as well as a range of issues occasioned by the redemption of RPS that we believe are addressed by our proposed amendment to section 254K. Should you require clarification of any of the matters contained in this submission, please do not hesitate to contact in the first instance Dr Michael Dirkis, Senior Tax Counsel of the Taxation Institute on (02) Yours faithfully Andrew Mills President cc. Commissioner of Taxation, M D Ascenzo cc. Mr Geoff Miller, General Manager, Corporations and Financial Services Division, Treasury cc. Phil Lindsay, Senior Advisory to Minister for Revenue and Assistant Treasurer 2

3 APPENDIX A Submission by the Taxation Institute of Australia in respect of Corporations Act 2001 Redemption of redeemable preference shares A. The company law position before the 1998 reforms 1. The requirement that redeemable preference shares ( RPS ) be redeemed only out of profits or the proceeds of a fresh issue of shares used to be contained in former section 192(3)(b) of the Corporations Law ( CL ). That section applied only to a return of paid-up capital on redemption of RPS. At that time, RPS (like other shares) were issued at a par value with any amount subscribed on issue above that par value being treated as share premium, not share capital. A premium on redemption of RPS could be paid either from profits or from share premium account (former section 192(4) of the CL). As a practical consequence, RPS were frequently issued at a very small par value and a very large premium, so that section 192(3)(b) applied only to a very small proportion of the proceeds of redemption. 2. In effect, therefore, the vast bulk of the money subscribed for RPS could be returned by a simple debit to the share premium account. In practice the vast bulk of funds paid on redemption of RPS was funded by a direct debit to the share premium account. The requirements concerning out of profits or fresh issue applied only to a very small part of the amount paid on redemption. Those requirements operated as follows. 3. On a redemption of RPS funded from the proceeds of a fresh issue of shares ( share funded redemption ), the amount subscribed for the fresh issue was credited to the share capital account, and share capital account was debited with the amount of paid-up capital returned on redemption, that is the par value ( returned capital ). 4. On a redemption funded from profits ( profit funded redemption ), the then law required the relevant profits (that is, an amount equal to the returned capital) to be credited to a capital redemption reserve former section 192(5) of the CL. The then law required two debits, each equal to the amount of returned capital. One debit was to the share capital (in respect of the amount actually returned to the shareholder) and the other to profits. The net assets of the company were, however, reduced only by an amount equal to the returned capital. The two debits were offset by one crediting to the capital redemption reserve, which was effectively a repository of an amount formerly treated simply as profits. The capital redemption reserve was required for company law purposes to be treated in a manner fairly similar to paid up capital. As noted above, this was generally all done only for a small nominal amount. 5. From a corporate perspective, the share premium rules thus facilitated redemption of RPS, since: a) as long as the terms of issue were in conventional form, the vast bulk of the proceeds of redemption could be paid directly out of the share premium account; and b) redemption could therefore occur even if there were only a small amount of profits, or failing that if, for example, the RPS holder were willing to subscribe the comparatively nominal amount of share capital for a fresh issue in order to facilitate payment of the returned capital (with the vast bulk of redemption proceeds being paid from share premium). 3

4 B. The tax position before the 1998 reforms 1. From a taxation perspective, payment of the redemption premium out of the share premium account did not, prima facie, constitute a dividend, by virtue of former paragraph (d) in the definition of dividends in section 6(1) of the Income Tax Assessment Act 1936 ( ITAA 1936 ). Generally speaking, section 6(4) of the ITAA 1936 was not applied so as to deem a dividend to arise where all that was occurring was that a premium paid on subscription was returned on redemption. In most cases section 6(4) would not have applied even on the most literal interpretation, since there would be no arrangement for another person (ie someone other than the subscriber for the RPS) to receive a relevant distribution out of the share premium account. 2. Repayment of returned capital on redemption was also generally not treated as a dividend, under former paragraph (e) of the definition of dividend in section 6(1) of the ITAA That is, presumably, because the returned capital was simply debited against share capital (being, effectively, the share capital that had been subscribed for the RPS). If an amount were paid to shareholders out of a capital redemption reserve, that amount should have been taxed as a dividend, since it was not debited against share capital, and was ultimately sourced out of profits (refer section 44 of the ITAA 1936). 3. The rules relating to capital redemption reserve and share premium account had the effect that the mere return on redemption of monies which had originally been subscribed on issue did not have to give rise to a dividend. Those rules, and the share premium rules, also had the effect that the redemption did not involve tainting of the share capital account under former sections 160ARDR to 160ARDT of the ITAA It may be noted that prior to the 1998 reforms, a return of share capital or share premium on any shares other than RPS generally required Court approval, among other things. The method of redemption of RPS was meant to, and in practice did, create a more flexible means of raising and returning equity capital. C. The Company law position after the 1998 reforms 1. The 1998 reforms abolished par value for shares, the whole concept of share premium, and the creation of a capital redemption reserve on a profit funded redemption of RPS. 2. The abolition of par value and the concept of share premium means that the entire subscription price of RPS is now treated as share capital. 3. That has had the effect that share funded redemptions have, in most case, become impracticable. Instead of being able to fund the vast bulk of the proceeds of redemption from share premium account, and needing to obtain only a small amount of new share capital from a fresh issue, a company making a share funded redemption would have to obtain the entire amount of the proceeds of redemption by way of subscription for a fresh issue. 4. Therefore, at the time of issue of RPS, unless they are convertible at the option of the issuer, it will usually be impracticable for a company to expect to be able to redeem the RPS by a share funded redemption. 5. Neither in section 254K of the Corporations Act 2001 ( CA ), or elsewhere in companies legislation, is there a prescription of the effect of a profit funded redemption on the redeeming company s share capital account and other 4

5 accounts. ASIC has stated in Practice Note PN 68 ( PN 68 ) at paragraph 101 as follows: Where all or part of the redemption is met out of profits, s245k(b) requires an additional entry in the nature of a transfer from retained profits in order to preserve the capital of the company and protect creditors. The entries required would be as follows (assuming the redemption is satisfied by cash): DR profit and loss appropriation CR share capital (equity) DR share capital redeemable preference shares (liability) CR cash. 6. Transitional rules permitted grandfathering of share premium for then existing RPS. The new rules apply even to those shares in respect of the actual share capital component, meaning that PN 68 still applies in part to them. D. Tax Position after the 1998 reforms 1. The definition of dividend in section 6(1) of the ITAA 1936 expressly excludes:- (e) moneys paid or credited by a company for the redemption or cancellation of a redeemable preference share if: (i) (ii) (iii) the company gives the holder a notice; and the notice specifies the amount paid-up on the share ; and the amount is debited to the company s share capital account; except to the extent that the amount of those moneys. is greater than the amount specified in the notice 2. Former Section 6D of the ITAA 1936 provided that an account that is tainted for the purposes of Division 7B of Part IIIA [of that Act] is not a share capital account (except for certain specific purposes). 3. Division 7B of Part IIIA of the ITAA 1936 has been repealed, but corresponding rules have been reintroduced in Division 197 of the Income Tax Assessment Act 1997 ( ITAA 1997 ). 4. In very broad terms: (a) (b) (c) a share capital account is tainted if the company transfers an amount to its share capital account from another of its accounts (subject to exceptions not relevant here) section and (1) ITAA 1997; there is automatically a franking debit broadly as if the transferred amount were a dividend section (1) ITAA 1997 (but note that no shareholders benefit from any corresponding credit); a company can untaint its share capital account by making an election under sections (2) and ITAA 1997 which has the effect: (i) (ii) of giving rise to a franking debit in some circumstances section ; and in some cases of giving rise to untainting tax which dos not give rise to franking credits (sections (2) and ). 5. The effect of the franking debits and untainting taxes are, in effect, to impose the highest possible tax liability (net of the franking debits) that could have arisen had a dividend been paid from the transferred amount, rather than transferring it to the share capital account. The effect is substantially punitive because: 5

6 (i) (ii) (iii) the tax and franking debits may well exceed the tax that the shareholders would actually have paid; it may be imposed earlier than any actual distributions on the shares from the relevant amounts; and an actual distribution of dividends would reduce the value of the shares thus reducing a potential capital gain (or revenue profit) on sale of the shares the tainted money is not actually distributed by the company, so tainting procedure could lead to double tax compared with an actual dividend payment. 6. It is accepted, though, that if profits could be turned into share capital, then the general effect of dividend rules and CG Event G1 might be that tax could be deferred or in part avoided completely, and therefore that tainting rules or something similar may be regarded as necessary in these circumstances. 7. The difficulty in relation to RPS is that: (a) (b) the CA and ASIC PN 68 require that a profit funded redemption of RPS involve a transfer of profits into the share capital account, this creating tainting by what should be a simple return of the amount originally subscribed for the RPS; and share funded redemptions will usually be impracticable for the reasons referred to above. E. Would an alternative view of the CA help? 1. An alternative would be that a redemption out of profits could be effected simply by debiting retained profits and crediting cash, and not affecting the share capital at all. This is not mandated by ASIC s PN 68, and it is understood that it does not accord with accounting treatment. This submission will not discuss this in detail since the alternative is not satisfactory (see 2 below), and accordingly even if this were possible reform would be needed. 2. This would not solve the problem, because the direct return of profits would be taxed as a dividend even though it is in economic substance a return of the account subscribed. Presumably the tax law will not be amended to preclude profits being taxed as dividends in these circumstances, because that would enable a company to effectively convert profits into share capital, just by issuing and redeeming RPS (even if that was done with no tax avoidance motive). F. Do the debt/equity rules help? Not in their current form. Amounts subscribed for RPS are still, under the CA, credited to share capital account, even if the RPS is classified as a debt interest for tax purposes. Therefore, even if the RPS is a debt interest, share tainting will still arise if PN 68 is followed as described above, and there is still the problem of profits either being taxed at an inappropriate time or being tax free (see E above). G. The problem cannot be alleviated satisfactorily, otherwise than permitting redemption by direct debit to share capital. 1. Re-introducing a share premium account is presumably impractical. In any case that would not preclude some tainting on a profit funded redemption, to the extent that the par value redemption still required profits to be credited to share capital account (PN 68) or otherwise involved the problems referred to in E above. 6

7 2. Re-introducing a capital redemption reserve concept is also presumably impractical. 3. The tax laws could be amended to deem a return of the subscription price on a profit funded redemption of RPS to be a return of the share capital rather than a payment of profits. Presumably, though the Government would wish that, when the relevant amount of share capital was actually distributed, it would be treated as a dividend. Otherwise, a company could issue RPS (increasing its share capital) and then do a profit funded redemption for the subscription price, with presumably no tax consequences to the holder, thus turning profits into share capital in tax free fashion. However, provisions purporting to treat the ultimate return of that share capital as a dividend would add complexity and artificiality to the tax system. (Note that the non share equity account already required by the debt/equity regime has no application to RPS and could not practically be made to do so.) Whenever the tax laws mandate an artificial difference between tax and reality there is the danger of mistakes by the innocent, evasion by the unscrupulous, compliance costs for taxpayers and increased work for ATO auditors. Presumably also the Government would wish that, in avoidance cases, an ostensible payment out of the real CA share capital account could be treated as being from the deemed profits for tax purposes. Possibly existing section 45B would be adequate for this purpose, but the uncertainties of application of that section have been well documented and an amendment which increases the occasions for it s potential application is not prima facie a desirable one. H. Are the streamlined return of share capital or share buyback provisions in the CA adequate for this purpose? The return of capital provisions permit capital to be returned on any share, including by way of cancellation of the share, subject to some constraints which can (or at least should) be assessed only at the time of the proposed return. Similar constraints and processes apply in general to the share buyback provisions under the CA. In practice, RPS often do end up being bought back in order to resolve the problems referred to in this submission. These provisions do not really solve the problem, though, for example because it is often desired to issue RPS which in some circumstances are redeemable at the option of the holder. It is obviously impractical for the company to commit to buy back, redeem or cancel in those circumstances if it will be unable to buy back, redeem or cancel except in the circumstances set out in those provisions. In fact a share buy back agreement could freeze the RPS under section 257H of the CA and is thus impracticable for this purpose. It may be noted that if the holder has the option to require redemption the RPS are highly likely to be classified as liabilities for accounting, and there seems no reason why restrictions on payment of that liability are any more necessary for creditor protection than in respect of any other liability. I. What are the consequences of amending the CA to permit redemption by direct debit to share capital? 1. This would permit a redemption to be done in a manner which reflects reality- ie in the simple case where the original subscriber simply gets the subscribed sum back, there should be no tax consequences at all, and the company s level of profits (and of share capital) after the redemption should reflect its true financial position. 2. Company, and investors, could be confident at the time RPS were issued that (subject to normal solvency and similar concerns) it should be practicable for them to be redeemed when they were intended to be redeemed. 7

8 3. From a tax perspective, as long as the CA continued to require redemption amounts exceeding the subscription price to be paid out of profits or out of proceeds of a fresh issue the amendment set out in paragraph A7 above ought not to create any problems. 4. This would permit the return of the subscribed amount even if the company had no profits (nor proceeds from a fresh issue). That raises the issue of whether there needs to be any extra protection for creditors. It is submitted that it does not, since: (a) (b) (c) until 1998 the vast bulk of redemption proceeds could be (and almost invariably were) paid by direct debit to share premium account, so the amendment set out in A7 simply restores, for all practical purposes, the old position; these days if the holder has a right of redemption the RPS are generally treated in the accounts as a liability, in which case a creditor is in no worse position as regards disclosure than in respect of any other liability, while if the holder has no right of redemption the directors will have all their normal duties to creditors before voluntarily making a decision to pay out money on redemption of the RPS- see for example section 588G and the note to section 254K in the CA; An ASIC Company Extract discloses details of the class of shares on issue by a company (as disclosed to ASIC). The mere existence of RPS should therefore put a creditor who searches the ASIC records on notice as to the possibility of redemption, whereas a creditor who does not search (or at least ask the company) will presumably not be making decisions about dealing with the company that depend on the existence or otherwise of RPS. 5. In order to take advantage of the new amendment it would be necessary for the company to keep records of how much was subscribed for each RPS, but a company is expected to do so anyway for tax purposes given paragraph (e) of the tax definition of dividend. J. Accounting Treatment of RPS 1. If the CA were amended as proposed in this submission, then, on a profit funded redemption of RPS for an amount equivalent to the subscription price for the RPS, the redeeming company s share capital would be reduced by that amount, rather than its profits being reduced by that amount as under the current system. On the basis described below, it is not envisaged that the proposed amendments to the CA would otherwise significantly affect the accounting treatment of RPS. 2. ASIC stated in its PN 68, at paragraph 99, that: Redeemable preference shares would normally be classified as a liability in accordance with accounting standard AASB1033 Presentation and Disclosure of Financial Instruments. 3. ASB has now been superseded by AASB132, issued in July This submission does not contain statistical details on how many RPS are defined as financial liabilities under AASB132, but it is submitted that many RPS are calculated as financial liabilities under AASB132, rather than as an equity instrument. 4. This submission cannot make definitive assertions as to how AASB132 applies in specific cases. It is understood, though, that classification of RPS as a financial liability or as an equity instrument is unlikely to be affected by whether a profit 8

9 funded redemption is debited directly against share capital rather than requiring a debit against retained profits. 5. Accordingly, although this submission does not comment definitively on the relevant accounting issues, it is not envisaged that the amendments to CA proposed by this submission would significantly affect the accounting classification of RPS. K. Conclusion 1. It is submitted that the current procedure in the CA for redemption of RPS ought to be amended. Currently, the law renders the redemption of these shares impracticable and subjects the redemption to anomalous and inequitable tax treatment. The end result is that the redemption of RPS no longer reflects business reality. 2. We recommended that the CA should permit the subscription amount for RPS to be returned on redemption directly out of share capital rather than out of profits. 3. This amendment this would be consistent both with the purpose of the 1998 reforms (which was to simplify and streamline procedures for returning share capital to shareholders, subject to appropriate protection for creditors), and with the effects of the pre 1998 rules concerning capital redemption reserves, share capital accounts and share premium accounts in relation to RPS. 9