TAX IN AN UNCERTAIN ECONOMY Managing Capital Structure

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1 NSW Division 7 November 2008 Swissotel, Sydney TAX IN AN UNCERTAIN ECONOMY Written by/presented by: Andrew Foster Goldman Sachs JBWere Simon Jenner ATIA Ernst & Young Andrew Foster and Simon Jenner 2008 Disclaimer: The material and opinions in this paper are those of the author and not those of the Taxation Institute of Australia. The Taxation Institute of Australia did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 The views in this paper are those of the authors and do not necessarily reflect those of Goldman Sachs JBWere and/or Ernst & Young. Any omissions or errors are those of the authors. Andrew Foster and Simon Jenner 2008 Disclaimer: The material and opinions in this paper are those of the author and not those of the Taxation Institute of Australia. The Taxation Institute of Australia did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

3 CONTENTS 1. Introduction Distributions from companies to shareholders Capital reductions Tax treatment of shareholder Tax treatment of company Special dividends Off-market share buy-backs Components of the buy-back price Buy-back price and disposal proceeds Franking of dividend component Franking credit anti-avoidance rules Maximum buy-back price discount Other matters Current status On-market share buy-backs Tax treatment of shareholder Tax treatment of company Capital raisings Effectively Non-Contingent Obligation ATO Discussion Paper Overview of debt/equity rules Equity interest Debt interest Effectively Non-Contingent Obligation Issuer s option to convert - Taxation Ruling TR 2008/ Dollar value convertible notes Draft Taxation Determination TD 2007/D Section 177EA of the ITAA TD 2007/D16 subject matter General comments Specific comments Current status Stapled security arrangement Draft Taxation Determination TD 2008/D Andrew Foster and Simon Jenner

4 3.4.1 Current status Buying-Back Debt Conclusions Andrew Foster and Simon Jenner

5 1. INTRODUCTION The purpose of this paper is to provide an overview of some of the recent trends displayed by companies in managing their capital structure. This paper provides very high level comments in relation to those trends. The paper also provides detailed discussion of the income tax issues surrounding capital structure management techniques. This paper contains two sections as follows: 1. Current issues regarding capital management techniques involving distributions from companies to shareholders. 2. Recent ATO public comments and guidance regarding issues surrounding particular forms of capital raisings. In particular, the discussion in this paper is focussed on the following key public guidance and developments that has emerged in recent times: A Practice Statement from the Commissioner of Taxation ( the Commissioner ) in respect of the application of section 45B of the Income Tax Assessment Act 1936 ( ITAA 1936 ) to share capital reductions, PS LA 2008/10. A Practice Statement from the Commissioner in respect of the application of various income tax laws to on-market and off-market share buy-backs, PS LA 2007/9. An Australian Taxation Office ( ATO ) draft discussion paper concerning the definition of effectively non-contingent obligation and Draft Taxation Determination TD 2008/D14. Taxation Ruling TR 2008/3 in relation to the debt test and convertible notes with an issuer s option to convert. Draft Taxation Determination TD 2007/D16 in relation to the potential application of section 177EA of the ITAA 1936 to dollar value convertible notes. Draft Taxation Determination TD 2008/D6 in relation to the application of the traditional securities provisions to a stapled security arrangement. The discussion in this paper is set out so as to link the key developments referred to above with the area of capital management to which they are most directly related. Accordingly: A discussion of the key outcomes from PS LA 2008/10 is presented in the context of a discussion of the income tax issues surrounding capital returns and capital reductions. A discussion of the key outcomes from PS LA 2007/9 is presented in the context of discussing the income tax issues surrounding share buy-backs, particularly off-market share buy-backs. A discussion of the debt/equity rules in the context of hybrid capital raisings. This discussion notes key issues arising from Taxation Ruling TR 2008/3, Draft Taxation Determination TD 2008/D14, Draft Taxation Determination TD 2007/D16 and Draft Taxation Determination TD 2008/D6. This paper also contains a discussion in relation to the income tax implications to be considered if a company were to buy-back its own debt trading on a secondary market. This paper assumes that readers have a working knowledge of the relevant provisions surrounding capital structure management techniques. However, a brief overview of the relevant rules is provided as appropriate to set the context within which the issues are then discussed. This paper does not contain an exhaustive list of income tax issues surrounding capital structure management techniques. The information in this paper is necessarily of a general and summary nature only and is subject to change. This paper is current as at 31 October Andrew Foster and Simon Jenner

6 The summary of income tax matters in this paper is based on judicial and administrative interpretations of the ITAA 1936, the Income Tax Assessment Act 1997 ( ITAA 1997 ), and accompanying explanatory memoranda and has regard to proposed changes to the extent relevant. However, the ultimate interpretation of the tax laws rests with the courts. The law, and the way that the ATO administers the law, may change over time. This paper is not a substitute for your own detailed research and professional advice. A detailed analysis of relevant issues must be undertaken prior to undertaking a particular transaction having regard to the particular facts and circumstances of each case. 2. DISTRIBUTIONS FROM COMPANIES TO SHAREHOLDERS During 2006 and 2007, companies and investors were strongly focussed on balance sheet efficiency. This included optimising weighted average cost of capital ( WACC ), avoiding lazy balance sheets and remaining competitive with private equity. As a result, a significant dollar value of share buy-backs was announced. In 2008, there has been a shift in focus. The primary focus is around debt re-finance risk. That is, the cost of debt re-finance and the implications for the company under the associated debt covenants. Consequently, there is a stronger focus on debt metrics. The gearing levels of Australian companies have been trending down since Gearing levels have risen slightly in 2008 as EBITDA estimates have reduced. Capital management activity grew in value up to 2007 but 2008 has since seen a sharp slow down. This suggests that companies are not taking advantage of lower equities prices to undertake buy-backs. Current income tax issues surrounding the following forms of capital structure management techniques are discussed in this paper: Capital reductions; Special dividends; Off-market share buy-backs; and On-market share buy-backs. The discussion is set out below. 2.1 Capital reductions A company cannot return share capital to shareholders before a winding up unless it complies with the requirements of the Corporations Act 2001 ( the Corporations Act ). The Corporations Act permits companies to undertake equal or selective share capital reductions, (so long as particular processes are followed). 1 Share capital reductions may or may not involve a cancellation of shares. This paper is focussed on share capital reductions in relation to ordinary shares. The paper does not discuss issues related specifically to, for example, redeemable preference shares. Share capital reductions may be equal or selective. An equal share capital reduction relates only to ordinary shares. It applies in the same proportion to the number of ordinary shares held (that is, it is prorata). The terms of the share capital reduction must be the same for each ordinary shareholder. If the capital reduction does not meet these requirements, it will be treated as a selective reduction for the purposes of the Corporations Act Tax treatment of shareholder The key income tax issues for shareholders participating in a capital reduction are: 1 Section 256B of the Corporations Act Andrew Foster and Simon Jenner

7 Will the amount received be assessable as a dividend in the hands of the shareholder (either as a dividend as defined or as a deemed dividend)? 2 Will the capital reduction give rise to a capital gain in the hands of the shareholder? These issues are discussed below Dividend under subsection 6(1) ITAA 1936 definition Subsection 6(1) ITAA 1936 defines a dividend (subject to certain exclusions) to include the following: a) any distribution made by a company to any of its shareholders, whether in money or other property. A capital reduction will typically be a distribution of money to shareholders. Therefore, this element of the definition will be satisfied. Paragraph (d) of the definition of dividend contained in section 6(1) ITAA 1936, excludes the following distributions from the definition: d) moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company. Typically, a company will account for a capital reduction by debiting the amount of the capital returned against the amount standing to the credit of the share capital account of the company. However, this simple accounting treatment does not mean that the exclusion contained in paragraph (d) is necessarily satisfied. There are two further tests that need to be satisfied. The first test is that the account to which the company debits the proceeds of the capital return must be a share capital account as defined. The meaning of share capital account is contained in section of the ITAA Subsection (3) of the ITAA 1997 provides that if a company s share capital account is tainted, that account is taken not to be a share capital account for the purposes of the Act (other than for certain specific exclusions). The definition of when a company s share capital account is tainted is set out in subsections (1) and (2) of the ITAA Subsection (1) provides that a company s share capital account becomes tainted when an amount to which Division 197 of the ITAA 1997 applies is transferred to the account if at the time of the transfer the account has not already been tainted. Subsection (2) provides that the share capital account remains tainted until the company chooses to untaint the account. 4 Division 197 applies to an amount that is transferred to a company s share capital account from another of the company s accounts, if the company was an Australian resident immediately before the time of 2 Pursuant to section 44 of the ITAA Subsection (1) provides, broadly, that an account the company keeps of its share capital is a share capital account for these purposes. Subsection (2) provides that if a company has more than one account covered by subsection (1), the accounts are taken for the purposes of the Act to be a single account. 4 A company chooses to untaint a share capital account by making a choice in the approved from and giving it to the Commissioner in accordance with section of the ITAA The choice to untaint a share capital account will give rise to a liability to untainting tax (section of the ITAA 1997). Untainting tax is due and payable at the end of 21 days after the end of the franking period in which the choice to untaint was made (section of the ITAA 1997). A choice to untaint a share capital account may also give rise to further franking debits (section ). This is in addition to the franking debit that can arise as a result of the transfer that caused the tainting of the share capital account in the first place (section of the ITAA 1997). Andrew Foster and Simon Jenner

8 transfer. 5 Certain exclusions are set out in relation to particular amounts that, if transferred to a share capital account, do not result in that share capital account being tainted (for example, debt/equity swaps). 6 Therefore, a distribution from a tainted share capital account will be a dividend as defined in subsection 6(1) of the ITAA 1936 and would be included in the assessable income of the shareholder in receipt of it pursuant to section 44 of the ITAA A distribution by a company from a tainted share capital account is an unfrankable distribution. 7 Accordingly, it will be important for a company to establish that its share capital account is not tainted before it implements a capital reduction. The second test is whether an exclusion from the operation of paragraph (d) of the definition of dividend is satisfied. Subsection 6(4) ITAA 1936 provides that the exclusion in paragraph (d) of the definition of dividend in subsection 6(1) will not apply where, under an arrangement : a) a person pays or credits any money or gives property to the company and the company credits its share capital account with the amount of the money or the value of the property; and b) the company pays or credits any money, or distributes property to another person, and debits its share capital account with the amount of the money or the value of property so paid, credited or distributed. This provision will need to be considered if the capital reduction is proposed to be undertaken in connection with any proposed crediting of the share capital account such as, for example, a preference share issue used to fund a capital return on ordinary shares. It is outside the scope of this paper to consider the other negative aspect of paragraph (d) of the definition of dividend, namely in respect of redeemable preference shares Deemed dividend There are two key sections pursuant to which the Commissioner may deem a capital reduction paid to a shareholder to be a dividend. These sections are section 45A and section 45B of the ITAA Section 45A of the ITAA 1936 Section 45A ITAA 1936 applies 9 if: a company streams the provision of capital benefits and the payment of dividends to its shareholders; this is done in such a way that the capital benefits are received by shareholders (the advantaged shareholders) who would in the year of income the capital benefits are provided, 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. Each of these elements is discussed further below. 5 Subsection 197-5(1) of the ITAA Subsection 197-5(2) of the ITAA See sections , , , , , and of the ITAA Paragraph (e) and paragraph (3)(ba) of the ITAA These provisions (as well as certain subsections of section 44 of the ITAA 1936) apply to a non-share equity interest in the same way as they apply to a share; to an equity holder in the same way as they apply to a shareholder; and to a non-share dividend in the same way as they apply to a dividend. Refer to subsection 43B(1) of the ITAA The section of this paper which discusses capital raisings provides further information in relation to the concepts of non-share equity interest and non-share dividend. 9 Refer to subsection 45A(1) of the ITAA Andrew Foster and Simon Jenner

9 Capital benefit The meaning of the provision of capital benefits is any of the following 10 : Greater benefit a) the provision to the shareholder of shares in the company. This is not usually the case in relation to a typical capital reduction. b) the distribution to the shareholder of share capital or share premium. It is usually the case that a company is distributing part of the balance standing to the credit of its share capital account to its shareholders when effecting a capital reduction. c) something that is done in relation to a share that has the effect of increasing the value of a share (which may or may not be the same share) held by the shareholder. This will depend on the particular facts. In order for the Commissioner to be able to make a determination under subsection 45A(2) ITAA 1936, it must be the case that the company streams the provision of capital benefits and the payment of dividends to shareholders in such a way that: the capital benefits are, or apart from this section would be, received by shareholders (the advantaged shareholders) who would, in the year of income the capital benefits are provided, derive a greater benefit from the capital benefits than other shareholders. The circumstances in which a shareholder would in a year of income, derive a greater benefit from capital benefits than another shareholder include, but are not limited to, any of the circumstances set out in subsection 45A(4), which exist in relation to the first shareholder but not the second. As a general proposition, section 45A is more likely to have potential application in the case of a selective capital reduction rather than an equal or pro-rata capital reduction. This is because under an equal or prorata capital reduction, all shareholders are being provided with the same capital benefit. If the Commissioner forms a view that section 45A applies, the Commissioner can make a determination that section 45C applies in relation to the whole, or a part of the capital benefits. 11 If the Commissioner makes a determination under subsection 45A(2), the amount of the capital benefit, or the part of the capital benefit, is taken to be an unfranked dividend that is paid by the company to the shareholder at the time that the shareholder is provided with the capital benefit. 12 The dividend is taken to have been paid out of profits of the company. 13 The combination of the provisions in subsections 45C(1) and 45C(2) effectively means that the deemed dividend will be included in the assessable income of the shareholder pursuant to section 44 of the ITAA Section 45B of the ITAA 1936 Section 45B of the ITAA 1936 was introduced to ensure that certain amounts paid to shareholders are treated as dividends where the payments, allocations or distributions are made in substitution for dividends. In particular, section 45B applies where: there is a scheme under which a person is provided with a capital benefit by a company; under the scheme, a taxpayer obtains a tax benefit; and 10 Refer to subsection 45A(3) of the ITAA Subsection 45A(2) of the ITAA Subsection 45C(1) of the ITAA Subsection 45C(2) of the ITAA 1936 Andrew Foster and Simon Jenner

10 having regard to the relevant circumstances of the scheme, it would be concluded that the scheme was entered into or carried out for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit. The ATO issued a Practice Statement PS LA 2008/10 in relation to the application of section 45B of the ITAA 1936 to share capital reductions on 15 May The stated purpose of PS LA 2008/10 is to provide instruction and practical guidance to tax officers on the application of section 45B of the ITAA 1936 to a share capital reduction by a company, including a non-share distribution to the extent to which it is a non-share capital return. The Practice Statement does not apply in relation to share buy-backs. 14 Scheme For the purposes of section 45B, scheme takes the meaning in section 177A of the ITAA 1936 as follows: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct. Given the wide definition of scheme, a capital reduction is likely to constitute a scheme for the purposes of section 45B in most, if not all, circumstances. Capital benefit Under the scheme, a person must be provided with a capital benefit. The term provided with a capital benefit is defined by subsection 45B(5) as a reference to any of the following: (a) the provision of ownership interests in a company; (b) the distribution to the person of share capital or share premium; (c) something that is done in relation to an ownership interest that has the effect of increasing the value of an ownership interest (which may or may not be the same interest) that is held by the person. The definition of provided with a capital benefit in subsection 45B(5) is broadly similar to that contained in section 45A of the ITAA As discussed in relation to section 45A, it is normally the case that a company is distributing part of its share capital to its shareholders when effecting a capital reduction, such that paragraph (b) of the definition would be satisfied. Tax benefit Subsection 45B(9) of the ITAA 1936 provides that a relevant taxpayer obtains a tax benefit where an amount of tax payable (or other amount payable under the ITAA 1936) by the relevant taxpayer would, apart from section 45B, be less than the amount that would have been payable, or would be payable at a later time than it would have been payable, if the capital benefit had been a dividend. In applying this definition to the circumstances of most typical capital reductions, it is likely (although not certain) that a tax benefit would arise for these purposes. By way of example, if the shareholders hold the shares in the company on capital account, a tax benefit may arise where the return of capital simply reduces the capital gains tax cost base of each share (refer discussion below) and does not result in an immediate capital gain. If a dividend were to be paid instead, it is reasonable to assume some shareholders would have had a higher tax liability (even after taking into account the effect of any franking credit offset). 14 Paragraph 11 of PS LA 2008/10 Andrew Foster and Simon Jenner

11 Where a shareholder would not make a capital gain as a result of a capital return, that shareholder would almost certainly obtain a tax benefit from a capital reduction. Purpose The final condition for section 45B of the ITAA 1936 to apply is that, having regard to the relevant circumstances of the scheme, it would be concluded that a person entered into the scheme or any part of the scheme for a purpose of enabling a taxpayer to obtain a tax benefit. The purpose need not be the dominant purpose but it must be more than an incidental purpose. In this sense, a more than incidental purpose includes the main or substantial purpose, but does not need to be the most influential or prevailing purpose. It will not include circumstances where it occurs fortuitously or in subordinate conjunction with one of the main or substantial purposes or merely follows that purpose as a natural incident. 15 Purpose is to be assessed on an objective basis. 16 In determining the purpose of a person who entered into a scheme, it is necessary to have regard to the relevant circumstances as listed in subsection 45B(8). The relevant circumstances are set out below. Also set out are some observations from PS LA 2008/10 in respect of each relevant circumstance. These observations are particularly instructive as they provide guidance as to what the Commissioner may be expected to examine in assessing whether section 45B might apply to a particular share capital reduction. a) The extent to which the capital benefit is attributable to profits of the company or of an associate of the company. In respect of this circumstance, the following observations from PS LA 2008/10 are noteworthy: A decision to reduce capital would generally be expected to coincide with and be influenced by some other commercial circumstance. 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 for shareholders. However, the fact that a capital distribution may have been funded from debt does not preclude it from being attributable to profits. 17 Profit for these purposes includes realised and unrealised profits of the company or an associate. Profits of subsidiaries are therefore relevant. 18 An unrealised gain, whether or not it is of a permanent character and whether or not it meets the technical requirements for distribution under the Corporations Act, constitutes relevant profits for these purposes. 19 The mere existence of profits will not automatically trigger the application of section 45B; rather, the availability of profits is but one matter to be considered. 20 If the capital distribution arises as a result of the disposal of assets of the business, a reasonable approach should be taken in determining the extent to which share capital was invested in the disposed assets. In some instances, the capital may be traced directly to the asset and in others it may be a matter of inferring its allocation on a reasonable basis. For example, it may be appropriate to allocate capital across the enterprise as a whole, based on the market value of assets (a slice approach ). 21 If the occasion for the share capital reduction is to increase the company s gearing (debt/equity) ratio, it will affect both profits and share capital, each being components of equity. This means that an increase in the gearing ratio can be achieved just as effectively by returning profits as reducing share capital. Generally, in the absence of other relevant factors, PS LA 2008/10 states that tax officers should regard the capital 15 The Explanatory Memorandum (House of Representatives) to Taxation Laws Amendment (Company Law Review) Bill 1998, at paragraphs 1.31 and 1.32, as cited at paragraph 54 of PS LA 2008/ The ATO notes this at paragraph 52 of PS LA 2008/ Paragraph 68 of PS LA 2008/10 18 Paragraph 69 of PS LA 2008/10 19 Paragraph 70 of PS LA 2008/10, see also MacFarlane v FCT (1986) 86 ATC 4477, FCT v Sun Alliance Investments Pty Ltd (in Liq) [2005] HCA 70, as cited in the Practice Statement. 20 Paragraph 72 of PS LA 2008/10 21 Paragraph 73 of PS LA 2008/10 Andrew Foster and Simon Jenner

12 distribution as being attributable to share capital and retained earnings on a proportionate basis. 22 b) The pattern of distributions of dividends, bonus shares and returns of capital by the company. In respect of this circumstance, the following observations from PS LA 2008/10 are noteworthy: The inference is that an interruption to the normal pattern of profit distribution and its replacement with a distribution of capital may suggest dividend substitution. 23 Maintaining an ordinary dividend return does not mean that a distribution of share capital could not still be undertaken in place of an extraordinary distribution of profit. 24 The fact that a company may not have made distributions previously, whether of profit or share capital, does not point away from the requisite purpose. 25 A company may have a history of retaining excess profits when profits are higher so as to be able to distribute dividends when profits are lower. PS LA 2008/10 notes that if, objectively speaking, this is done to maintain consistent dividend payouts or to counter downturns in the business cycle, these are factors which should be taken into account by tax officers. It may be that those factors would incline against the requisite purpose. 26 c) Whether the relevant taxpayer has capital losses that, apart from the capital return, would be carried forward to a later year of income. 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. 27 d) Whether some or all of the shares held in the company by the relevant taxpayer were acquired, or are taken to have been acquired, by the relevant taxpayer before 20 September Where taxpayers receive a capital benefit in respect of a pre-cgt asset there would be no CGT implications for the shareholders and this could influence the company s decision to return capital to shareholders. 28 e) Whether the relevant taxpayer is a non-resident. Due to the rules in Division 855 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. 29 f) Whether the capital gains tax cost base of the taxpayer's shares is not substantially less than the value of the applicable capital benefit. 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. This could point towards a preference for capital over profit. 30 g) Repealed. 22 Paragraph 74 of PS LA 2008/10 there is no guidance given as to how the proportionate basis is to be calculated. However, it could be assumed it would involve the relevant percentage of share capital plus retained earnings being treated as attributable to share capital/retained earnings. 23 Paragraph 77 of PS LA 2008/10 24 Paragraph 78 of PS LA 2008/10 25 Paragraph 78 of PS LA 2008/10 26 Paragraph 80 of PS LA 2008/10 27 Paragraph 85 of PS LA 2008/10 28 Paragraph 86 of PS LA 2008/10 29 Paragraph 87 of PS LA 2008/10 30 Paragraph 88 of PS LA 2008/10 Andrew Foster and Simon Jenner

13 h) If the scheme involves the distribution of share capital 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. This proceeds from the premise that when a dividend is paid, the shareholder s interest remains unchanged and that a distribution of capital made in similar circumstances (for example, a pro rata return of capital) may be performing the same function as a dividend and be made in substitution for it. 31 The same applies to an equal share capital reduction because the shareholders interests remain proportionately unchanged. 32 Depending on the facts, a selective capital reduction may point away from the capital reduction being made in substitution for a dividend. 33 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, the period for which the ownership interests are held by the holder of the interests and when the arrangement for the disposal of the ownership interests was entered into. This circumstance recognises that the proceeds on disposal of such ownership interests may provide the equivalent of a cash dividend in a more tax-effective form. 34 In relation to a share capital reduction, an example where this circumstance could be relevant is if the cash received from the capital reduction is compulsorily subscribed by shareholders in return for further ownership interests which are then subsequently disposed. 35 j) Applies only to a demerger. k) Any of the matters referred to in the relevant factual consideration of Part IVA the general anti-avoidance provisions. The manner in which the scheme was entered into or carried out. The form and substance of the scheme. The time at which the scheme was entered into and the length of the period during which the scheme was carried out. The result in relation to the operation of this Act that, but for this Part would be achieved by the scheme. Any change in financial position for the relevant taxpayer that has resulted, will result, or may reasonably result, from the scheme. Any change in the financial position of any person who has, or has had, any connection (whether business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme. Any other consequence for the relevant taxpayer, or for any person referred to above, of the scheme having been entered into or carried out. The nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to above. 31 Paragraph 92 of PS LA 2008/10 32 Paragraph 94 of PS LA 2008/10 33 Paragraph 95 of PS LA 2008/10, but the Practice Statement notes that section 45A may be relevant. 34 Paragraph 96 of PS LA 2008/10 35 Paragraph 97 of PS LA 2008/10 Andrew Foster and Simon Jenner

14 In relation to the matters in paragraph 45B(8)(k), paragraph 102 of PS LA 2008/10 comments as follows: 102. One of the chief indicators against the application of section 45B will be the non-tax objects or effects of the return of capital scheme. The eight matters in paragraph 177D(b) constitute the essential facts and circumstances of a scheme, including the outcomes for the parties to the scheme, by reference to which the tax and non-tax objects of the scheme are able to be revealed and contrasted from an objective point of view. It is also worth noting the following general observations of the ATO emerging from the Practice Statement: Section 45B is not a profits first rule. It is a sanction against schemes to provide shareholders with capital benefits which were entered into or carried out for a significant purpose of enabling the shareholder to benefit from receiving preferentially taxed capital rather than profit. 36 (In this regard, the use by the ATO of the word significant to describe the purpose is interesting given that the section has a threshold of more than incidental.) If a company can choose to distribute either capital or profits, other than the tax preference of shareholders, there should be compelling, objective and commercial reasons why a company would choose the difficulty of distributing share capital (difficulty in the sense of the Corporations Act requirements, including the requirement to obtain shareholder approval) over the relative simplicity of distributing profits. 37 In relation to the circumstances listed in paragraphs 45B(8)(c) to (g), to the extent the shareholders tax characteristics are known, they should be considered thoroughly to discern whether they incline for or against a conclusion as to requisite purpose. Because the relevant purpose is to be determined objectively, the relevant taxpayers tax characteristics would not be excluded from being relevant just because the company (or the relevant person who carried out the scheme) was subjectively unaware of them. 38 In other words, it is not necessarily a defence for a listed public company (for example) to say that it does not know the tax characteristics of its shareholders. Another tax consequence resulting from share and non-share capital reductions is that the company can preserve franking credits by distributing share capital rather than paying a dividend. If the company has scarce franking credits, this would be significant and could suggest that the company has distributed capital and not profits on the basis of the shareholders tax preference. 39 If the Commissioner forms a view that section 45B applies, the Commissioner can make a determination that section 45C applies in relation to the whole, or a part of the capital benefits. 40 If the Commissioner makes a determination under subsection 45B(3), the amount of the capital benefit, or the part of the capital benefit, is taken to be an unfranked dividend that is paid by the company to the shareholder at the time that the shareholder is provided with the capital benefit. 41 The dividend is taken to have been paid out of profits of the company. 42 The combination of the provisions in subsections 45C(1) and 45C(2) effectively means that the deemed dividend will be included in the assessable income of the shareholder pursuant to section 44 of the ITAA In addition, the Commissioner can also make a further determination under subsection 45C(3). This determination is relevant to the tax position of the company making the distribution and is discussed below at Paragraph 33 of PS LA 2008/10 37 Paragraph 38 of PS LA 2008/10 38 Paragraph 84 of PS LA 2008/10 39 Paragraph 115 of PS LA 2008/10 40 Subsection 45A(2) of the ITAA Subsection 45C(1) of the ITAA Subsection 45C(2) of the ITAA 1936 Andrew Foster and Simon Jenner

15 Capital Gains Tax The discussion below assumes that a shareholder receiving a capital return holds the share on which the return is paid on capital account and not on revenue account. If the share capital reduction does not involve the cancellation of shares, then the share capital reduction will not involve a disposal of the shares for CGT purposes. Instead, the share capital reduction will mean that CGT event G1 happens. 43 Where CGT event G1 happens, a shareholder will make a capital gain if the non-assessable part of the payment received is more than the share s cost base. If the shareholder makes a capital gain, the share s cost base and reduced cost base are reduced to nil. If the nonassessable part of the payment received is not more than the share s cost base, that cost base and its reduced cost base are reduced by the amount of the non-assessable part. A shareholder cannot make a capital loss under CGT event G1. 44 If a share capital reduction does involve the cancellation of the shares by the company, the cancellation is a cancellation or ending of the shares, which means that CGT event C2 happens. 45 A capital gain will arise if the amount of the capital proceeds received on the ending is more than the share s cost base. A capital loss will arise if the capital proceeds received on the ending is less than the share s reduced cost base. 46 Whether a capital gain arises as a result of CGT event G1 or CGT event C2, where the share has been held for at least 12 months before the CGT event, the CGT discount rules may apply if the shareholder is one of the prescribed types of entity. 47 A non-resident shareholder should refer to the rules in Division 855 of the ITAA 1997 to determine if any such capital gain or loss is disregarded Non-share capital reduction In order to effect a non-share capital reduction in respect of a non-share equity interest, the distribution is debited against the company s non-share capital account. Such a distribution is not a non-share dividend (pursuant to subsection (2) of the ITAA 1997) and is therefore not assessable to the holder under section 44 of the ITAA If the non-share capital return is made for the surrender, cancellation or redemption of the non-share equity interest, and the interest is a traditional security (see discussion later in this paper), any gain or loss should be assessable under section 26BB of the ITAA 1936 and any loss may be deductible under section 70B of the ITAA CGT event C2 is also relevant. Section of the ITAA 1997 will prevent any double taxation of a gain. Subdivision 110-B of the 1997 Act will prevent any deductible loss amount from also being recognised in the reduced cost base relevant to any capital loss calculation. If a non-share capital return is made without cancellation of the interest, CGT event G1 cannot apply. This is because CGT event G1 only applies to a share as defined in section of the ITAA 1997 (which does not expressly include a non-share equity interest). Depending on the terms of the instrument, CGT event C2 may apply to the return as a partial redemption of the interest. The traditional securities rules 48 would also need to be considered Section of the ITAA Note 1, subsection (3) of the ITAA Paragraph (1)(a) of the ITAA Subsection (3) of the ITAA Subdivision 115-A of the ITAA Section 26BB and section 70B of the ITAA See also comments as paragraphs 113 and 114 of PS LA 2008/10. Andrew Foster and Simon Jenner

16 2.1.2 Tax treatment of company As discussed above, where section 45B applies, the Commissioner may make a determination that section 45C applies, with the result that the capital distribution is treated as an unfranked dividend paid by the company to the shareholder (deemed to have been paid out of company profits). 50 The Commissioner may then make a further determination under subsection 45C(3) that the capital benefit was paid under a scheme for which a purpose, other than an incidental purpose, was to avoid franking debits arising in relation to the distribution. If this further determination is made, a franking debit arises in the company s franking account as if the distribution had instead been paid as a fully franked dividend. 51 This recognises that preservation of a company s franking credits may be a more than incidental purpose of the parties to a scheme to provide capital benefits in substitution for dividends. 52 Subsection 45C(3) of the ITAA 1936 refers to a class C franking debit arising. The concept of a class C franking debit was removed from the income tax law with the introduction of the imputation rules contained in Part 3-6 of the ITAA 1997 from 1 July Footnote 47 to PS LA 2008/10 acknowledges this. Footnote 47 of the draft version of PS LA 2008/10, being PS LA 1552 (draft), referred to Media Alert C104/02 dated 27 September 2002 as authority for expecting that the government will amend the rules to adjust for this. This announcement is now more than 5 years old and is an announcement from the former government. The note in PS LA 1552 (draft) advised Tax office staff considering the application of subsection 45C(3) to contact the Finance and Investments Centre of Expertise for assistance. It will be important for the company to assess its franking account balance in this regard as a debit which puts the account balance into deficit could result in a liability to franking deficits tax. It is often recommended that class and private rulings be obtained in relation to a share capital reduction scheme in order to assist in managing the uncertainty surrounding the potential application of section 45A and section 45B of the ITAA Special dividends An ordinary dividend or a special dividend paid by a company is, prima facie, a frankable distribution. 53 A franking debit will arise to the company s franking account to the extent that franking credits are attached to the distribution. The company will need to consider the provisions of the benchmark franking rule in Division 203 of the ITAA 1997 in assessing the extent to which the company franks the dividend. The benchmark rule is that an entity must not make a frankable distribution whose franking percentage differs from the entity s benchmark franking percentage for the franking period in which the distribution is made. 54 The benchmark franking percentage is set for an entity for a franking period based on the franking percentage for the first frankable distribution made by the entity within the period. 55 If an entity breaches the benchmark rule, the distribution will still be a frankable distribution. However, the company can be liable for over-franking tax if the franking percentage for the distribution exceeds the entity s benchmark franking percentage for the franking period in which the distribution made. If the franking percentage for the distribution is less than the entity s benchmark franking percentage for the franking period in which the distribution made, a franking debit arises in the entity s franking account. 56 The benchmark rule does not apply to a listed public company with only one class of membership interest on issue at all times during the relevant franking period Subsection 45C(1) of the ITAA Subsection 45C(3) of the ITAA 1936, 52 See paragraph 133 of PS LA 2008/10 53 Sections and of the ITAA 1997, subject to the anti-avoidance rules such as section 177EA of the ITAA 1936 and Subdivision 204-D of the ITAA Section of the ITAA Section of the ITAA Section of the ITAA Section of the ITAA 1997 Andrew Foster and Simon Jenner

17 A resident shareholder in direct receipt of a franked distribution is required to include the amount of the distribution in its assessable income. Further, the resident shareholder in receipt of a franked distribution directly must also include the amount of the franking credit attached to the distribution in its assessable income, and is entitled to a tax offset equal to the amount of that franking credit so included, if the imputation system has not been manipulated. 58 In relation to the payment of special dividends, it is worth noting the recent public guidance from the Commissioner in respect of the implications when a franked dividend is paid by a takeover target in the context of a takeover. A recently issued class ruling is particularly relevant in this regard. 59 In summary, the ATO has ruled that a franked dividend paid by a takeover target as part of a takeover scheme can be included as capital proceeds of the shareholders of the target as a result of CGT event A1 happening on disposal of their shares to the acquirer, as well as being assessable as a dividend, where certain circumstances exist. Generally, the anti-overlap rule in section of the ITAA 1997 should prevent double taxation arising in respect of the dividend as that section would reduce the capital gain by the amount of the dividend already included in assessable income pursuant to section 44 of the ITAA However, where a taxpayer makes a capital loss, no such provision applies to adjust the capital proceeds to restore the amount of the capital loss to the amount it would have been had the dividend not been paid. It is understood that the ATO is in the process of considering releasing a public ruling on these matters. The Public Rulings Program dated 3 October 2008 indicated that a draft public ruling could be expected to be issued on 17 December Off-market share buy-backs The Corporations Act provides that companies may undertake buy-backs of their shares in certain circumstances. Such buy-backs can take the form of equal access buy-backs, where all shareholders participate, or selective buy-backs, where only certain shareholders participate. The income tax law contains Division 16K of the ITAA 1936 which sets out the income tax rules that apply to share buy-backs. Those rules apply based on whether the buy-back is an off-market share buy-back or an on-market share buy-back. The rules in Division 16K are relatively straight-forward. However, as off market share buy-backs, in particular, have become popular, and as their method of execution has evolved over time, the Commissioner has sought to apply various anti-avoidance rules throughout the ITAA 1936 and the ITAA 1997 in order to supplement the rules in Division 16K. The policy of the Commissioner with regard to the application of the anti-avoidance rules in relation to offmarket share buy-backs has developed to a point of relative consistency. Accordingly, the Commissioner has issued a Practice Statement the purpose of which is to provide instruction and practical guidance to staff of the ATO on the application of various taxation laws in connection with on-market and off-market share buy-backs. 60 The discussion in this section of the paper steps through many of the common issues surrounding offmarket share buy-backs and provides references to the Practice Statement for illustration of the Commissioner s views. The discussion is primarily focussed on issues arising from off-market share buybacks undertaken by listed companies using a tender process for setting the buy-back price. 58 Section of the ITAA 1997 and section of the ITAA CR 2007/98 60 Practice Statement Law Administration PS LA 2007/9 Andrew Foster and Simon Jenner

18 2.3.1 Components of the buy-back price Where a company purchases a share in itself from a shareholder in the company, and the purchase is a buy-back (from the shareholder, as seller, to the company, as buyer) and the purchase is not undertaken in the ordinary course of trading on a stock exchange (where the share is quoted in the official list of that exchange) the buy-back will be an off-market share buy-back for the purposes of the tax law. 61 In relation to an off-market share buy-back, the tax law states that the difference between the purchase price paid to buy-back each share and the amount per share that is credited to the share capital account of the company undertaking the buy-back is taken to be a dividend paid by the company out of profits derived by the company. That is, the prima facie accounting treatment of the buy-back price in the accounts of the company undertaking the buy-back will determine for income tax purposes the amount of the purchase price that is a dividend and the amount of the purchase price that is taken to represent sales proceeds in the hands of a participating shareholder on disposal of a share. 62 The tax law does not prescribe that the balance of the buy-back price not debited to the share capital account must be debited to the retained earnings account in order for it to be deemed to be a dividend. Rather, the amount that is not debited to the share capital account is deemed to be a dividend. The tax law also does not make reference to the balance of the account to which the amount is debited and does not prescribe that the balance of that account must necessarily be in credit balance. The tax rules do not necessarily pre-suppose that a company must actually have distributable profits in its accounts in order for a component of the purchase price to be deemed to be a dividend. There are no specific rules in the tax law that provide guidance to a company in relation to determining the actual amounts of the dividend and capital components of an off-market share buy-back price. The Commissioner s Practice Statement provides helpful guidance in understanding the approach that the ATO will be likely to take in assessing the income tax implications of an off-market share buy-back. As discussed above, it is the accounting treatment of the buy-back price that prima facie determines the dividend and capital components of the buy-back price for income tax purposes. If the capital component is not an amount that the ATO accepts, the Commissioner may seek to make a determination that one of the capital benefit anti-avoidance rules (either section 45A or section 45B of the ITAA 1936 refer discussion above as to their operation) is to apply to deem some or all of the capital component of the buy-back price to be a dividend. Accordingly, although prima facie the accounting treatment is determinative of the components of the buy-back price, regard needs to be had to the Commissioner s views and the potential application of the anti-avoidance rules. In deciding on the appropriate accounting treatment, the following comments are relevant in respect of the capital component: The amount of the capital component could be based on the amount of paid-up ordinary share capital appearing on the balance sheet of the company immediately prior to the time of the buyback, as allocated to the number of ordinary shares on issue by the company at that time. That is, divide the share capital by the number of shares on issue to determine the share capital per share. That amount per share is the capital component that will be debited to the share capital account of the company. The balance of the buy-back price is debited to a different account (usually retained earnings) and therefore becomes the dividend component. This method of working out the dividend and capital components of the buy-back price (often referred to as the average capital per share approach) is the one that the Tax Office currently favours so as to reduce the likelihood of a determination being made that section 45B applies in respect of the capital component. 63 An alternate method of calculating the capital and dividend components of the buy-back price is based on the accounting balance sheet of the company as an individual entity (not necessarily an accounting consolidated entity, although the composition of the relevant accounting consolidated group balance sheet should be considered) and considering the proportion of retained earnings to paid-up share capital. The percentage calculated by dividing share capital by share capital plus 61 Section 159GZZZK of the ITAA Section 159GZZZP of the ITAA Refer to paragraph 69 of PS LA 2007/9. Andrew Foster and Simon Jenner