ATO ID 2011/78: Capital Allowances: business related costs - limitation of deduction - return of an equity interest
Date of decision: 3 October 2011
Year of income: Year ended 30 June 2009
Business line: Public Groups and International

Issue
If the head company of a consolidated group is taken to have issued an equity interest to another entity and later purchases the equity interest from that entity for an amount that is less than the issue price, is the expenditure incurred by the head company an amount that, for that other entity, is a return of an equity interest for the purpose of subparagraph 40-880(9)(b)(i) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
Yes. If the head company of a consolidated group is taken to have issued an equity interest to another entity and later purchases the equity interest from that entity for an amount that is less than the issue price, the expenditure incurred by the head company is an amount that, for that other entity, is a return of an equity interest for the purpose of subparagraph 40-880(9)(b)(i) of the ITAA 1997.

Facts
All statutory references are to the ITAA 1997 unless otherwise stated. Sub Co is a subsidiary member of Head Co's consolidated group. Head Co is the head company. Sub Co and a third party entered into an agreement whereby Sub Co issued convertible notes to the third party. Because of the single entity rule, Head Co is taken to have issued the convertible notes to the third party. The convertible notes were an equity interest for the purposes of Division 974. In a later income year Head Co itself purchased the convertible notes from the third party. The expenditure incurred by Head Co to purchase the convertible notes was less than the amount paid by the third party when the convertible notes were issued to it. The expenditure incurred by Head Co was capital expenditure incurred in relation to its current business for the purposes of paragraph 40-880(2)(a).

Reasons for decision
Summary: Subparagraph 40-880(9)(b)(i) states that: You cannot deduct anything under this section for an amount of expenditure you incur: (b) to the extent that, for another entity, the amount is a *return on or of: (i) an *equity interest Head Co incurred the capital expenditure to purchase the convertible notes from the third party vendor. The third party vendor is 'another entity' for the purposes of subparagraph 40-880(9)(b)(i). The convertible notes were an equity interest held by that third party. They were therefore an equity interest of another entity. The expenditure incurred by Head Co to acquire the equity interest is an amount incurred by it to acquire another entity's equity interest. The interpretative issue is the meaning of the expression 'return of' in the context of subparagraph 40-880(9)(b)(i). In this case, the specific question associated with this issue is, for an amount of expenditure to be a return of another entity's equity interest, must the expenditure exactly correspond with the amount paid by that other entity when it acquired the equity interest? The word 'return' is defined in subsection 995-1(1) to mean: Return on a *debt interest or *equity interest does not include a return of an amount invested in the interest. It is clear that this definition does not resolve the meaning of the expression 'return of' for the purposes of subparagraph 40-880(9)(b)(i). Recourse must therefore be had to the ordinary meaning of the expression. The Macquarie Dictionary revised 5th Edition relevantly defines the word 'return' as: 18. the act or fact of returning; a going or coming back; a bringing, sending, or giving back. 20. reciprocation, repayment, or requital: profits in return for outlay The word 'of' is relevantly defined as: 9. objective relation An amount that, for another entity, is a 'return of an equity interest' is therefore an amount which gives back to that entity a sum for its interest in equity. Here, the amount Head Co has given back to the third party is a sum that is a requital for the third party selling its equity interest. In other words, it is a return of the third party's investment in equity. The ordinary meaning of the expression 'return of' does not introduce a requirement that the amount given back to another entity must exactly correspond with the amount paid by that entity when it acquired the equity interest. It is not uncommon, for example, for an entity to incur expenditure to buy back its shares at market value. The market value will usually differ from the issue price. This would not of itself disqualify the expenditure from being an amount that, for another entity, is a return of an equity interest. The explanatory memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 (the EM) provides some guidance as to the meaning of the expression 'return of' for the purpose of subparagraph 40-880(9)(b)(i). Although the EM gives the example of payments made by a company to buy back its own shares as an expenditure which is excluded by subsection 40-880(9) the EM makes it clear that expenditures excluded by the provision are not limited to the examples given. The relevant paragraphs of the EM state: Returns of capital 2.79 Some capital amounts are not considered legitimate blackhole expenditures as they comprise the transfer or distribution of funds, repayments, or do not give rise to any income tax consequences. As such, the expenditure does not represent an economic loss to the taxpayer and is not deductible. [Schedule 2, item 30, subsection 40-880(9).] 2.80 Expenditures excluded by this provision include, but are not limited to: • dividends paid by companies; • distributions by trustees; • margin calls; • payments made by a company to buy back its own shares; and • repayments of loan principal. Therefore, if Head Co (because of the single entity rule) is taken to have issued an equity interest to another entity and later purchases the equity interest from that entity, for an amount that is less than the issue price, its expenditure is an amount that, for another entity, is a return of an equity interest for the purpose of subparagraph 40-880(9)(b)(i).

Legislative references: Income Tax Assessment Act 1997 section 40-880 paragraph 40-880(2)(a) subsection 40-880(9) paragraph 40-880(9)(b) subparagraph 40-880(9)(b)(i) Division 974 subsection 995-1(1)
Related public rulings and determinations: Taxation Ruling TR 2010/D7
Related ATO interpretative decisions: ATO ID 2011/79
Other references: Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 1) Bill 2006 The Macquarie Dictionary, 5th Edn, The Macquarie Library Pty Ltd, NSW, 2009
Subject references: Blackhole expenditure Business related costs Capital expenditure Equity Non-share equity interest