Private ruling: Income Tax: Capital Gains Tax - Share Buy-Back.
Published: January 2014
Ruling period: Financial year ended 30 June 2014 | Financial year ended 30 June 2015 | Financial year ended 30 June 2016 | Financial year ended 30 June 2017
Date scheme commenced: 1 July 2013

Ruling: Q1: Will the Commissioner make a determination under subsection 45B(3) of the Income Tax Assessment Act 1936 (ITAA 1936) that 45C of the ITAA 1936 applies to the share buy -back price as it came 100 % from the share capital account? | A1: No | Q2: Will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that 45C of the ITAA 1936 applies to a share buy-back price that is determined by application of a share capital/ retained earning ratio (slice approach)?. | A2: No

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. The company is a firm of solicitors. It is currently operating as a private company. Prior to 2012 the company had a service entity arrangement in place with S Pty Ltd as trustee for the X Unit Trust. During the income year 2011 the company issued new shares to Mr K as trustee for J Trust (trustee) as part of a merger with Mr K's company W Pty Ltd. The entire purchase price was credited to the share capital account at the time. The share capital account has not changed in value since this transaction. The share price paid was based on a valuation report. The goodwill of each business was combined with in and outs of various assets and liabilities. The share structure has not changed in the company since the 1/7/2011. Unfortunately the merger has not worked and the company will be buying back the shares from Mr K at a reduced price. The money to be repaid for the shares will be obtained by increasing the current commercial bills or bank overdraft facilities. The retained earnings from 2011 to 2013 has decreased. This is the result of the dividends paid being larger than the profit after tax for both 2012 and 2013 income years. The existing shareholders will be adversely impacted if any of the buy-back price was allocated against retained earning (dividend). Accordingly, Mr K has received a dividend over the last two years greater than the profit derived. It is proposed the shares subject to the buy -back will be cancelled after being required


Reasons for decision: Summary: Section 45B of the Income Tax Assessment Act (ITAA) 1936 applies where certain payments are made to shareholders in substitution for dividends. Subsection 45B(2) of the ITAA 1936 sets out the conditions under which the Commissioner will make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies In this case, having regard to the relevant circumstances of the scheme, it would not be concluded that the company will enter into or carry out the scheme for a more than an incidental purpose of enabling the relevant taxpayer to obtain a tax benefit. Accordingly, the Commissioner will not make a determination under subsection 45B (3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the return of capital. | Detailed Reasoning - Detailed Reasoning: A share buy-back involves the purchase and cancellation of shares issued by the company. Division 16K of Part III of ITAA 1936 provides that the purchase price paid by the company to the shareholder is the amount of money and the value of other property (if any) the shareholder receives as consideration for the buy-back under section 159GZZZM of the ITAA 1936. In an off-market buy-back of shares the difference between the purchase price and the part of the purchase price, in respect of the buy-back which is debited against the company's share capital account is taken to be a dividend paid by the company to the seller, as a shareholder in the company, out of profits derived by the company on the day the buy-back occurs under section 159GZZZP of the ITAA 1936. Such a dividend will constitute a frankable distribution for the purposes of section 202-40 of the ITAA 1997, subject to any amount of the consideration exceeding the market value being specifically unfrankable pursuant to subparagraph 202-45(c) of the ITAA 1997. The balance (being the amount debited against the company's share capital account) will be taken to be a return of capital and will determine both the CGT position of the seller and, for assessable profits or deductible losses, the amount of that gain or loss: section 159GZZZQ of the ITAA 1936. That is, the consideration for CGT purposes and for shares held on revenue account is determined having regard to whether there is a 'reduction amount' for the purposes of subsection 159GZZZQ (3) of the ITAA 1936. Ordinarily, that amount is the part of the purchase price that is taken to be a dividend in accordance with section 159GZZZP of the ITAA 1936. An essential aspect of any off-market share buy-back is the 'split' between the return of capital and dividend paid to participating shareholders. Section 159GZZZP of the ITAA 1936 prescribes that: · 'capital' is debited against the company's share capital account, and · the balance of the purchase price is a dividend. The 'split' is nominated by the company. However, the ATO will have regard to the various anti-avoidance and integrity rules in the provision of written advice to the company. For example, a 'split' that has too low a capital component will both stream dividends and artificially increase capital losses to vendor shareholders. Conversely, a capital component that is too high will provide or stream capital benefits at the expense of dividends. Neither of these outcomes is desirable. The ATO considers that there are a number of acceptable methodologies for ascertaining capital/dividend split, although not all have equal applicability in every case. Paragraph 62 of the Law Administration Practice Statement PSLA 2007/9 (PSLA 2007/9 stats that: One method used to determine the 'split' is for the company to work out its average capital per share (ACPS). This is obtained by dividing a company's ordinary issued capital by the number of shares on issue. The amount so derived is a reasonable estimate of any capital component of the split. The balance of any buy-back price would be a dividend. The Applicant argued that the average capital per share method is not suitable for this transaction as it takes into consideration the average capital per share. A number of the shares were purchased several years ago which is well below the market values prevailing when the shares were originally issued to Mr K and bought back from him making those value irrelevant.. Also, they mentioned in another e-mail that the retained earnings from income years 2011 to 2013 have decreased. This is the result of the dividend paid being larger than the profit after tax both income years 2012 and 2013. The existing shareholders will be adversely impacted if any of the buy-back price was allocated against retained earnings (dividend). Further, paragraph 63 of PSLA 2007/9 states that: Another acceptable method of determining the capital/dividend split, in an established company, is to calculate the ratio of share capital to retained earnings on a company's most recent balance sheet. It is sometimes referred to as the 'Slice Approach'. This ratio should then be reflected in any capital/dividend split proposed. This method seems to more accurately reflect splits in established companies as newer companies do not have a history of retained earnings. However, companies that conduct successive off-market share buy-back may contribute to significant dilution of share capital over time if they continue to use this method. This may require an examination for possible breaches of section 45B of the ITAA 1936. For this reason, it is preferable to use the ACPS method. | Detailed Reasoning - In this case:: · The ratio of share capital to retained earnings on the company's most recent balance sheet is approximately 75% capital and 25.% dividend. · This methodology is suited to an established company. The facts indicate the company has had current shareholders & directors from several years. | Detailed Reasoning - Dividend: Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income a dividend, as defined by subsection 6(1) of the ITAA 1936, which is paid to the shareholder out of company profits. The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders. However, paragraph (d) of section 6(1) of the ITAA 1936 in the definition of 'dividend' excludes a distribution from the meaning of 'dividend' if the amount of a distribution is debited against an amount standing to the credit of the company's 'share capital account'. Share capital account' is defined in section 975-300 of the ITAA 1997 as an account which the company keeps of its share capital, or any other account created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital. Subsection 975-300(3) of the ITAA 1997 states that an account is not a share capital account if it is tainted. Section 197-50 of the ITAA 1997 states that a share capital account is tainted if an amount, to which Division 197 of the ITAA 1997 applies, is transferred to the account and the account is not already tainted. The proposed return of capital will be debited against the company's share capital account. There have been no transfers into the company's share capital account as defined in section 975-300 of the ITAA 1997. Therefore, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 applies and the proposed return of capital would not constitute a dividend. | Detailed Reasoning - Section 45B - schemes to provide capital benefits in substitution for dividends: Subsection 45C(3) of the ITAA 1936 provides that part of a capital benefit was paid under a scheme for which there was a more than incidental purpose of avoiding franking debits arising in relation to the distribution. This determination may only be made if the Commissioner has first made a determination under section 45B of the ITAA 1936. Section 45B of the ITAA 1936 applies where certain payments are made to shareholders in substitution for dividends. Subsection 45B(2) of the ITAA 1936 sets out the conditions under which the Commissioner will make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies. These conditions are that: a. there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a) of the ITAA 1936); b. under the scheme, a taxpayer (the relevant taxpayer) who may or may not be the person provided with the capital benefit, obtains a tax benefit (paragraph 45B(2)(b) of the ITAA 1936); and c. having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(c) of the ITAA 1936). | Detailed Reasoning - Each condition is considered below.: The proposed return of capital will be a 'scheme' for the purposes of section 45B of the ITAA 1936. The return of capital will occur through a share buy-back from Lindsay (one of the shareholders) The company will buy the shares back from the trustee pursuant to subsection 256B (2) Corporations Act 2001 and cancellation of the shares. The payment will be made to Mr K from share capital account. Paragraph 45B(2)(b) of the ITAA 1936 refers to a taxpayer (the relevant taxpayer) who may or may not be the person provided with the capital benefit obtaining a tax benefit. A capital benefit includes a distribution to a person of share capital. As the company proposes to debit the proposed return of capital against its untainted share capital account, its shareholder Lindsay will be provided with a capital benefit. Subsection 45B(2)(b) of the ITAA 1936 causes the Commissioner to examine the circumstances of the relevant taxpayer to ascertain if a tax benefit forms part of the scheme. A relevant taxpayer 'obtains a tax benefit', as defined in subsection 45B(9) of the ITAA 1936, if: a) the amount of tax payable; or b) any other amount payable under the ITAA 1936 or the ITAA 1997, c) would, apart from the operation of section 45B of the ITAA 1936, d) be less than the amount that would have been payable; or e) be payable at a later time than it would have been payable, f) if the capital benefit had instead been a dividend. Mr K is one of the shareholders of the company and he will receive the capital benefit from the share buy-back. If the company had paid a dividend it could allocate franking credits to the distribution such that it would be fully franked. However it would be required to utilise some of its franking credits in doing so. The preservation of such franking credits for later utilisation is considered to constitute a tax benefit in the present circumstances. Therefore, there is a tax benefit present in the scheme which requires the Commissioner to look to the relevant circumstances contained in subsection 45B(8) of the ITAA 1936. | Detailed Reasoning - Relevant circumstances: For the purposes of paragraph 45B (2)(c) of the ITAA 1936, the Commissioner is required to consider the circumstances set out under subsection 45B(8) of the ITAA 1936 to determine whether any part of the scheme would be entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit. The test of purpose is an objective one. The question is whether, objectively, it would be concluded that a person who entered into or carried out the scheme or any part of the scheme did so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit. The purpose does not have to be the most influential or prevailing purpose, but it must be more than an incidental purpose. The relevant matters for this Ruling are those covered by the circumstances described in paragraphs 45B (8)(a), (b) and (k) of the ITAA 1936 for the reasons set out below. | Detailed Reasoning - Paragraph 45B (8)(a) of the ITAA 1936: Paragraph 45B (8)(a) of the ITAA 1936 refers to the extent to which the capital benefit is attributable to capital and profits (realised and unrealised) of the company or an associate (within the meaning of section 318) of the company. The ratio of share capital to retained earnings on the company's most recent balance sheet is approximately 75% share capital & 25% dividend. This methodology is suited to an established company. The company is considered as an established company. · The average capital per share approach should not be used as it does not take into account that some of the shareholders originally purchased their for lesser price. | Detailed Reasoning - Paragraph 45B (8)(b) of the ITAA 1936: Paragraph 45B (8)(b) of the ITAA 1936 refers to the pattern of distributions made by a company or an associate (within the meaning of section 318) of the company. The last dividend paid by the company was during the year ended 30 June 2013. Mr K has received a dividend over the last two years greater than the profit derived by the company. This pattern of distributions shows that there is no inclination towards the requisite purpose required for the application of section 45C of the ITAA 1936. | Detailed Reasoning - Paragraphs 45B (8)(c) to (h) of the ITAA 1936: The relevant circumstances under subsection 45B(8) of the ITAA 1936 also cover the circumstances of the company and the tax profile of the shareholders. In this instance, as the proposed return of capital is made to Mr K - the shareholder in the company. Paragraphs 45B(8)(c) to (h) of the ITAA 1936 do not incline for or against a conclusion as to purpose. | Detailed Reasoning - Paragraphs 45B (8)(i) and (j) of the ITAA 1936: The circumstances covered by paragraphs 45B (8)(i) and (j) of the ITAA 1936 pertaining to the provision of ownership interests and demerger are not relevant here. | Detailed Reasoning - Paragraph 45B (8)(k) of the ITAA 1936: Paragraph 45B (8)(k) of the ITAA 1936 refers to the matters in subparagraphs 177D(b)(i) to (viii) of the ITAA 1936. These are matters by reference to which a scheme is able to be examined from a practical perspective in order to identify and compare its tax and non-tax objectives. The matters include the manner in which the scheme is carried out, the timing of the scheme, its form and substance and the financial and other implications for the parties involved. The applicant has demonstrated that the scheme, being a share buy-back due to a merger with Mr K's company, did not work out as planned. Therefore, having regard to the relevant circumstances of the scheme, it would not be concluded that the company will enter into or carry out the scheme for a more than an incidental purpose of enabling the relevant taxpayer to obtain a tax benefit. Accordingly, the Commissioner will not make a determination under subsection 45B (3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the return of capital.