Tax Brief 16 November 2011 Exposure Draft on Share Buybacks Treasury has released exposure draft legislation to rewrite the share buyback rules into the Income Tax Assessment Act 1997. The draft gives effect to the recommendations of the Board of Taxation 2008 report on the topic which was accepted by the Government in the 2009 Budget and followed by a discussion paper. The major changes relate to off-market buybacks of shares in listed companies where the intention is in many cases to eliminate the need to obtain class and private rulings from the Australian Taxation Office (ATO). Whether that result has been achieved is unclear. Submissions on the draft are due by 2 December 2011. The changes take effect for off-market and on-market buybacks announced by the company after the date of Royal Assent. Hopefully assent should occur in the first half of 2012. Off-market buybacks The basic structure of current law is maintained, though the general drafting approach is different in two respects: first, shares and non-share equity interests are dealt with specifically throughout the draft rather than partly by shorthand which is an improvement; secondly, the rules for off-market and on-market buyback rules are fully specified in separate subdivisions even though this leads to some repetition the rules for each are now in one place. An off-market buyback is effectively defined by exclusion from the definition of on-market buyback (as currently, though in the draft this is done by repetition). Subject to the comments below, the dividend component of the buyback consideration is the purchase price (the cash and value of property received in exchange for the shares) less the amount debited to share capital account or non-share capital account. The draft in this part, like current law, recognises that a non-share equity interest may encompass a share (such as a stapled share and bond). However, the actual debits to capital accounts must comply with the statutory methods in the exposure draft for determining the appropriate capital/dividend split of the buyback consideration. If this is not the case, then it seems that none of the buyback price will be treated as a dividend under the buyback rules. Based on views previously expressed by the ATO, the resulting all-capital outcome may then be susceptible to an application of the capital
benefit-for-dividend substitution rule with any dividend determined under that rule not being frankable. Unlike current legislation the determination of a capital gain or loss, or an assessable revenue gain or deductible loss, starts with the capital amount (purchase price less the dividend) and then in various cases increases that amount (which has the effect of increasing gains or decreasing losses), rather than starting with the full purchase price and decreasing or increasing that amount. It is thus no longer necessary to turn off the capital gain double counting reduction rule for amounts that are otherwise assessable as dividends. Major changes Currently an off-market buyback potentially attracts a number of anti-avoidance rules. The ATO has released a practice statement setting out its approach to such buybacks and listed companies find it necessary to obtain a class ruling from the ATO to get certainty of tax treatment for shareholders and a private ruling to protect the company s position. The main issues revolve around the following ATO views from the practice statement: the preferred methodology for determining the amount debited to the share capital account in the buyback is average capital per share; the discount in the buyback price to the stock exchange price of a listed company should be a maximum of 14% (where it is more, the ATO has indicated it will make a determination denying franking credit benefits to shareholders participating in the buyback, apparently because it considers a greater than 14% discount suggests a purpose of streaming of imputation credits to low tax rate shareholders like superannuation entities); the company should debit its franking account to take account of streaming of imputation credits away from non-resident shareholders (who it is assumed are very unlikely to participate in a buyback with a franked dividend component as those non-residents in tax-comparable jurisdictions only get a 50% benefit from franking); and the shareholder is deemed to receive the stock exchange price of the shares, not the discounted price received in the buyback (which reduces potential capital losses arising from the exclusion of the dividend element in the buyback from the capital proceeds). The Board of Taxation recommended that the law be changed to a greater or lesser extent in relation to these ATO views, the main purpose being to maintain integrity in the rules while eliminating the need for listed companies to obtain ATO rulings when making standard types of off-market buybacks. The draft legislation generally achieves this effect with some possible qualifications noted below. 2 Exposure Draft on Share Buybacks
Average capital per share The ATO practice of using average capital per share as the primary method for allocating share capital in a buyback is made the default method in the draft. If it is used then there is no need to seek a ruling from the ATO on the capital/dividend split. If another method is proposed to be used, then it is necessary to approach the ATO for approval. The mechanism for such approval is not spelt out, although currently it would seem to involve seeking an ATO ruling, given that the integrity measures are not automatically turned off. Average capital per share is defined without regard to classes of shares. Many listed companies now have more than one class of shares. Company directors may be concerned about using an averaging of share capital across classes, given directors duties about treating classes fairly. Even if this is not an issue, widely different amounts of share capital per share may distort average capital inappropriately in a buyback. The major problem case is likely to be where redeemable preference shares have been issued at a substantial amount per share while ordinary shares are issued at much lower amounts per share. For a variety of inter-related corporate law and tax reasons redeemable preferences shares are usually bought back rather than being redeemed so that the buyback rules apply. The ATO practice statement recognises classes of shares by specifying the methodology as dividing a company s ordinary issued capital by the number of shares on issue. Similarly the Treasury discussion paper of 2009 used a formula for ordinary shares. If a company is unwilling to use the average capital method for all shares, then ATO approval will be necessary. It is not evident from the draft whether in providing that approval, the ATO could distinguish between classes of shares, either to approve the use of different methods for different classes of shares or the same method (eg, average capital) but on a class-by-class basis. The latter seems less likely in the case of the average capital method (as currently drafted) because the concept of capital is based on a company s share capital account. That account is defined simply as an account a company keeps of its share capital, without distinguishing between share capital attributable to different classes of shares. Further, the draft raises similar issues in relation to the average capital methodology for non-share equity interests. The draft seems to overlook that a non-share equity interest can be constituted by a combination of a share and some other interest even though this possibility is contemplated in the rules for the dividend component discussed above. Average capital for non-share equity is determined by reference only to the non-share capital account and it is not clear how the measure will work for such interests involving a share. Again this will likely lead to requests for ATO rulings. (The issue about classes also applies to non-share equity). The change from the ATO practice and discussion paper may have been intended to deal with other classes of shares besides ordinary shares. It is possible that classes of shares could better be dealt with by using the total market 3 Exposure Draft on Share Buybacks
value of shares in different classes to allocate share capital which would eliminate the classes problem in all cases except buybacks of non-share equity interests that include a share. A clear solution for non-share equity interests is not so easy to find. The average capital rules may have adopted these simplifications to provide the necessary certainty for a statutory rule designed to eliminate the need for ATO rulings in common cases. Clients should consider these issues and let us know if they are likely to pose problems. Switching off anti-avoidance rules for off-market buybacks by listed companies The ATO practice in relation to a 14% cap on the discount is removed by turning off the relevant anti-avoidance rules on which it relies (imputation and capital streaming and imputation and capital benefits) in the case of listed companies, but only if the buyback uses the statutory default average capital methodology for determining the capital/dividend split. Since the Board s report was written it has become clear that the ATO is using a very broad interpretation of another anti-avoidance rule which prevents franking of amounts sourced directly or indirectly from share capital. Although the related streaming rule is turned off by the buyback amendments, the franking rule is not, which may create uncertainty in certain buyback scenarios and require ATO rulings. It is unclear from the way the provision is expressed whether the anti-avoidance rules are turned off for a buyback of unlisted shares where the company also has listed shares on issue. This ambiguity occurs at a number of points in the draft as there seems to be an assumption that all shares and non-share equity interests of a listed company are listed. Franking debit in respect of non-resident shareholders In lieu of the current practice whereby the ATO will only issue favourable rulings in share buybacks if the company accepts a franking debit in respect of streaming imputation credits away from non-resident shareholders, the new draft sets out a specific debit, the relevant anti-avoidance rule having been switched off where average capital per share is used. The application of this debit, however, does not depend on the anti-avoidance rules having been switched off, so there is a possibility of double franking debits where methods other than average capital are used. It is considered that a rule against such doubling up should be included for clarity in the draft. The debit only applies if the buyback involves a franked distribution and is calculated as the total amount of franking credits allocated in the buyback multiplied by non-resident interests not bought back as a proportion of the total interests in the company. The calculation of the debit is designed to cater for the possibility of companies having different classes of interests (compare the 4 Exposure Draft on Share Buybacks
average capital method above). It may, however, not work appropriately if a buyback involves more than one class of interests in the company as all franking credits involved in the buyback seem to be allocated to the calculation for each class of interests rather than just the franking credits allocated to the particular class. In determining the franking debit by reference to non-resident interests not bought back, the statutory formula at least corrects a technical defect in the formula specified in the ATO s practice statement which assumes a zero rate of non-resident participation, although in practice non-resident participation is usually minimal. In working out the debit under the proposed rule it is only the difference between the corporate tax rate and the dividend withholding tax rate that is captured, this being the appropriate rate differential to measure of the effect of assumed franking credit streaming to residents as established in current ATO practice. The difficulty is that there are varying withholding tax rates for dividends under domestic law and treaties. The draft recognises the differences by requiring the use of the weighted average of withholding rates but does not fully cater for these differences. In the case where domestic law applies, the rate is treated as 30% even if the particular foreign resident is exempt from the tax, such as many foreign pension funds. In the case where a treaty applies the rate is that applicable under the treaty. The draft assumes that only one rate is applicable under tax treaties but modern treaties typically have three rates for dividends, zero, 5% and 15%. The identification of foreign residents also raises some issues. The debit depends on interests being held by foreign residents, with no definition of what held means in this context. In determining withholding rates under treaties, however, the draft specifies the use of a simple variant of the address system that applies to withholding tax which may or may not correspond with what is meant by held. It is not suggested that all these matters should be catered for by the provision as the main purpose of the franking debit is to express in clear statutory form the amount of the franking debit so that companies do not need, in most cases, to obtain a ruling from the ATO on the issue. Nonetheless clarification of the calculation would seem to be required if it is to achieve that purpose. Stop loss rule for off-market buybacks by listed companies In lieu of the application of the ATO interpretation of the market value substitution rule in the buyback context, the Board of Taxation recommended that interests in listed companies not be subject to that rule but that no revenue or capital loss could arise on the buyback of the interests. Hence, capital gains will no longer be increased by the amount of the discount in a buyback but no loss will generally arise. This is achieved by increasing the consideration for the interests to equal their cost if a loss would otherwise arise, except where the amount of the dividend in the buyback is less than the loss (in which case a loss can still be made for the difference). This is not a pure solution as it involves an element of double taxation 5 Exposure Draft on Share Buybacks
still but was seen by the Board of Taxation as a trade-off for removing the cap on the discount and also aligning with the tax outcome in liquidations. The former market value rule will, however, continue to apply to unlisted companies. In this and the listed company case it is unclear what happens if a listed company buys back unlisted interests, similarly as for the turning off of anti-avoidance rules. The current rules relating to untaxed dividends and losses incurred by companies in buybacks involving the receipt of franked dividends are maintained in the draft though the latter is now limited to unlisted companies (with the same ambiguity) in view of the stop loss rule for listed companies. Imputation rules The Board of Taxation recommended that a listed company making a buyback be given an (unspecified) extended time in which to give a distribution statement to shareholders to deal with stock exchange rules concerning the timing aspects of buybacks. The draft proposes to legislate this extension but only to 7 days after the distribution. There is no express power in the draft legislation for the ATO to extend that time in the provision. In this case it is clear that the rule only applies to listed interests. The current rule which makes a dividend arising in a buyback unfrankable if the purchase price exceeds market value as if the buyback did not occur and was never intended to occur is retained with the quirk that it refers to market value as generally understood. There is no explanation of what this addition achieves. In the light of past debates between companies and the ATO it may be intended to indicate that, for listed companies, it will be the stock exchange price on the day of the buyback. Oddly where language otherwise the same in relation to market value appears in the rule for unlisted companies referred to above, the additional words do not appear odd because that is where the debates have occurred. On-market buybacks The current treatment of on-market buybacks is maintained. The interest holder is treated for tax purposes as having disposed of the interest in the normal way and so calculates gain or loss without reference to any part of the purchase price being a dividend. A franking debit arises in respect of the buyback. The possible ambiguity regarding the amount of the debit if a buyback occurs within a franking period and the company then pays the first dividend in that period franked to a particular extent is not resolved. 6 Exposure Draft on Share Buybacks
Tax neutral effect of buyback on company The current rule for the tax neutral effect of buybacks on the company is maintained, though repeated separately for off-market and on-market buybacks. The language reflects current ambiguities that can arise for foreign companies which can be subject to the rules in certain cases, eg if companies do not cancel the shares but hold them as treasury shares with the possibility of later disposing of them. For further information, please contact Sydney Chris Colley chris.colley@gf.com.au phone +61 2 9225 5918 [ Melbourne Toby Eggleston toby.eggleston@gf.com.au phone +61 3 9288 1454 Tim Neilson tim.neilson@gf.com.au phone +61 3 9288 1259 These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN 60 003 146 852) www.gf.com.au Sydney Level 39 MLC Centre Martin Place Sydney NSW 2000 Australia Ph +61 2 9225 5955, Fax +61 2 9221 6516 Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph +61 3 9288 1881 Fax +61 3 9288 1828 510174018_1.DOC 7 Exposure Draft on Share Buybacks