Private ruling: Return of share capital
Published: 29 January 2024
Ruling period: 1 July XXXX to 30 June XXXX

Ruling: Q1: Will the proposed share capital reduction in the Company, with the distribution to the Taxpayer as the sole shareholder being wholly made out of the share capital account, constitute a payment, allocation or distribution made in substitution of dividends within the meaning of section 45B of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: Yes | Q2: Will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the proposed share capital reduction? | A2: Yes

Relevant facts and circumstances: The Company is an Australian domiciled private company, with X ordinary shares on issue. The Taxpayer is the sole shareholder of the Company. The Taxpayer is a resident of Australia for taxation purposes. The amount credited to the share capital account of the Company upon the issue of these ordinary shares for the amount paid up on these shares was $X. No amount has been credited to the share capital account that would cause the share capital account to be become tainted. The Company has been an investment company since incorporation. The Company is a family investment entity controlled and operated by the Taxpayer and provides auxiliary finance and investment services as its main business. The Company invests primarily in interest bearing bank accounts and securities, and has a portfolio of share and equities in listed corporations and trusts. Between the years X and X, with the exception for the income year ending 30 June X, the Company has made a yearly distribution by way of a franked dividend to the Taxpayer In the year ended 30 June X, the franked dividend which paid to the Taxpayer by Company was in the amount of $X with a $X franking credit attached to it. As at 30 June X, the shareholder's equity in the Company was in an amount of $X and the main asset held by the Company was shares held in Company A. The Company held X shares in Company A which were valued at $X. The Taxpayer was a director and senior executive of Company A. It was envisaged for the Company to be a growth company on the basis of its investment strategy as a long-term investor in Company A, with particular regard paid to the Taxpayer's close association with Company A. However, over the years, the association between the Taxpayer and Company A decreased. Currently, as it stands, there is no association between the Taxpayer and Company A. As at 30 June X, the shareholder's equity in the Company was in an amount of $X. As the Company is currently now a passive investment company, it does not require the issued and paid-up capital in the sum of $X. Therefore, it is proposed to carry out a share capital reduction in the Company in the amount of $X. The Company's franking account balance as at 30 June XXXX is $X. Proposed share capital reduction There is a proposed share capital reduction in the Company of $X where the distribution to the Taxpayer as a result of the share capital reduction will be wholly out of the share capital account (the Proposed Share Capital Reduction). Taxpayer's contentions The Company has historically made consistent payments of dividends as evidenced in the Schedule of Dividends paid between XXXX and XXXX. It is envisaged that the Company will continue to declare and pay dividends annually, which will continue to reduce retained earnings. Therefore, the entire amount of the proposed share capital reduction amount of $X will be made from the share capital account. It is important to bear in mind that the $X was a contribution of capital to the Company made by the Taxpayer and is merely being returned to them because that capital is now surplus to the needs of the Company. It is not a substitution for a dividend. On XXXX, the Company had liquid funds in the amount of $X million, and a portfolio of listed equity investments with a market value of $X million, primarily consisting of growth stocks. The Company intends to sell this portfolio in accordance with the Company's strategic realignment. CGT Event G1 will occur when the Company pays the return of capital to the Taxpayer where the effect of the CGT Event G1 will be to reduce the cost base of the shares to $X, being the difference between the share capital amount of $X and the proposed share capital reduction amount of $X. Accordingly, there is no capital gain under CGT Event G1.

Relevant legislative provisions: Income Tax Assessment Act 1936 section 45B | Income Tax Assessment Act 1936 section 45C

Reasons for decision: Summary: Section 45B of the ITAA 1936 would apply to treat the amount of the capital reduction under the Proposed Share Capital Reduction scheme as an unfranked dividend paid out of the profits of the company. Subsection 45B(3) of the ITAA 1936 permits the Commissioner to make a determination that section 45C of the ITAA 1936 applies to treat the distribution as an unfranked dividend. | Detailed Reasoning - Detailed reasoning: Section 45B of the ITAA 1936 applies where certain capital payments are paid to shareholders in substitution for dividends. In broad terms, section 45B of the ITAA 1936 applies where: • 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) • 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 • 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)(a) of the ITAA 1936). | Detailed Reasoning - Paragraph 45B(2)(a) of the ITAA 1936: A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided by section 995-1 of the ITAA 1997 (subsection 45B(10) of the ITAA 1936). Broadly, in this context, the term scheme takes the same meaning as provided in Part IVA of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan, or proposal. In particular, a scheme is anything that satisfies any of the terms in the statutory definition. The phrase 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936. It states that a reference to a person being provided with a capital benefit is a reference to any of the following: (a) the provision of ownership interests in a company to the person; (b) the distribution to the person of share capital or share premium; or (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. | Detailed Reasoning - Application to the proposed share capital reduction: The Proposed Share Capital Reduction constitutes a 'scheme' within the meaning given by subsection 995-1(1) of the ITAA 1997. There is a provision of a capital benefit as defined by subsection 45B(5) of the ITAA 1936 as the Taxpayer, the sole shareholder of the Company, will be 'provided with a capital benefit' under the Proposed Capital Reduction as the distribution will be debited against the Company's share capital account. Therefore, paragraph 45B(2)(a) of the ITAA 1936 will be satisfied. | Detailed Reasoning - Paragraph 45B(2)(b) of the ITAA 1936: Relevantly, subsection 45B(9) of the ITAA 1936 provides that a relevant taxpayer 'obtains a tax benefit' if an amount of tax payable by that taxpayer would, apart from the operation of section 45B, be less than the amount that would have been payable if the capital benefit had been a dividend. | Detailed Reasoning - Application to the proposed share capital reduction: As a result of the Proposed Share Capital Reduction, the tax payable by the Taxpayer would be lower than if the payment was an assessable dividend. Accordingly, the Taxpayer would obtain a tax benefit for the purposes of subsection 45B of the ITAA 1936. It is noted that the operation of CGT Event G1 in relation to the Proposed Share Capital Reduction will not give rise to a capital gain in these circumstances. It is also noted that franking credits would no longer be available for use in future income years as they would have been if a capital benefit had been paid instead of a dividend. As explained in paragraph 1.27 of the Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998 (the Explanatory Memorandum) and paragraph 49 of Practice Statement Law Administration PS LA 2008/10 Application of section 45B of the Income Tax Assessment Act 1936 to share capital reductions , the preservation of franking credits for the use at a future time (and therefore reduce tax payable in those years) would still constitute a tax benefit within the meaning of subsection 45B(9) of the ITAA 1936. Therefore, paragraph 45B(2)(b) of the ITAA 1936 will be satisfied. | Detailed Reasoning - Paragraph 45B(2)(c) of the ITAA 1936: For the purposes of paragraph 45B(2)(c) of the ITAA 1936, the Commissioner is required to consider the relevant circumstances of the scheme determine whether any part of the scheme was entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit. The relevant circumstances to be considered include the non-exhaustive factors set out in subsection 45B(8) of the ITAA 1936 and include any of the matters listed in subsection 177D(2) of the ITAA 1936. The test of purpose is an objective one. The Explanatory Memorandum explains that the question is whether, objectively, it would be concluded that a person who entered into or carried out the scheme did so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit, but the purpose does not have to be the most influential or prevailing purpose, but it must be more than an incidental purpose: | Detailed Reasoning - Determining purpose: 1.29 The test of purpose under new section 45B is a test of objective purpose. The question posed by the rule is whether, objectively, it would be concluded that a person who entered into or carried out the scheme, did so for the purpose of obtaining a tax benefit in respect of the capital benefit. In determining the purpose of the scheme, the purpose of one of the persons who entered into or carried out the scheme (whether or not that person is the person receiving the capital benefit) will be sufficient to attract the rule. 1.30 For example, if a taxpayer enters into a scheme with another taxpayer for the purpose of enabling either of the taxpayers to obtain a tax benefit, the fact that the second taxpayer does not share that purpose will not prevent the rule from applying. Also, if a taxpayer enters into such a scheme with two or more purposes, neither of which is merely incidental, the fact that one purpose is not that of obtaining a tax benefit relating to a capital benefit will not prevent the section from applying. 1.31 New section 45B requires a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit. The words in parentheses are inserted for more abundant caution; a reference to a purpose of a scheme is usually understood to include any main or substantial purpose of the scheme, and the words in parentheses clarify that this is the intended meaning here. Thus while new section 45B does not require the purpose of obtaining a tax benefit to be the ruling, most influential or prevailing purpose, neither does it include any purpose which is not a significant purpose of the scheme. 1.32 A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with one of the main or substantial purposes of the scheme, or merely follows that purpose as its natural incident. In broad terms: • Paragraph 45B(8)(a) of the ITAA 1936 refers to the extent to which the distribution is attributable to the profits of the company. • Paragraph 45B(8)(b) of the ITAA 1936 refers to the pattern of distributions. • Paragraphs 45B(8)(c) to (g) of the ITAA 1936 concern the particular taxation status of shareholders. • Paragraph 45B(8)(h) of the ITAA 1936 requires a comparison of the respective interests held by shareholders after the distribution. • Paragraphs 45B(8)(i) and (j) of the ITAA 1936 pertain to the provision of ownership interests and demergers. • Paragraph 45B(8)(k) of the ITAA 1936 refers to matters listed in section 177D of the ITAA 1936. PSLA 2008/10 explains that although section 45B of the ITAA 1936 does not apply on a profits first basis, by implication it does presuppose some objective non-tax basis for distributing capital rather than profits, where both are available. It summarises the differences between profits and share capital in the following terms. Essentially, profits are a gain to the company which, when surplus to the company's needs, are meant to be divided amongst the shareholders; hence the word 'dividend'. Share capital, on the other hand, is the money contributed by the company's members for carrying out its objects until some event or circumstance renders its retention unnecessary, whereupon it may be returned. In broad terms, if a company can choose to distribute either capital or profits, for the purposes of section 45B of the ITAA 1936, there should be compelling, objective and commercial reasons why a company would choose the difficulty of distributing share capital over the relative simplicity of distributing profits, other than the tax preference of shareholders. PSLA 2008/10 sets out the relevant considerations regarding the return of share capital and explains that where there are retaining earnings, the choice to distribute share capital over retained earnings makes it difficult for the taxpayer to refute that the requisite degree of purpose of enabling a shareholder to obtain a tax benefit exists: 63. A capital distribution that is attributable to share capital should reflect circumstances which show that the share capital distributed is genuinely surplus to the company's need of it and that it is not merely a cash distribution debited against share capital on the basis of shareholder tax preference. For instance, the capital distribution may coincide with the disposal of a significant part of the business structure which can be identified as releasing share capital. However, if the disposal also realises a profit the ensuing distribution should, subject to all the other relevant circumstances, be considered in terms of its attribution to both share capital and the profit from the disposal. 64. Broadly, the capital of a company is the money contributed, or agreed to be contributed by its members for carrying out its objects. Generally, the money so contributed is to be retained as a permanent fund while the company pursues its objects. Company law requires, in the case of a company limited by shares, that the capital subscribed by the shareholder be maintained as a fund for the protection of creditors (the doctrine of maintenance of capital). One consequence of this doctrine is that a company may not pay a dividend except out of distributable profits. Another consequence is that a company must not distribute its issued capital to members prior to winding up. As discussed however, the Corporations Act contains a number of exceptions to the doctrine of maintenance of capital, including the case of an authorised share capital reduction. The exceptions generally contemplate some special event or circumstance affecting the enterprise of the company which renders the retention of capital unnecessary. 65. Whatever the circumstances may be, they would not ordinarily include generating more money than required for the purposes of the business. The generation of surplus funds from carrying on the business of the company in the ordinary way is the occasion for the distribution of a dividend, not a return of capital. 66. The doctrine of maintenance of capital continues to be an important part of company law. Share capital maintains its character as the shareholders' proportionate contribution to, and their measurement of, ownership of the corporate business. It is also the fixed sum by reference to which the growth of the business is measured and identified as distributable profits. Under the corporate paradigm, contributed capital is meant to be invested in the objects of the business and, generally, to provide lasting support to the business. Profits which are excess to the requirements of the business are meant to be distributed to the shareholders. 67. As mentioned previously in paragraphs 35 to 37 of this practice statement, a distribution of profits to the members is a discretionary matter for the company's board of directors, whose responsibility it is to supervise the management of the corporation's business on behalf of the members. In contrast, a distribution of share capital to the members, though recommended by the board of directors, must be approved by a majority of the members as it is a matter which goes to the essential structure of the business. 68. Therefore, a distribution of profit would normally be expected to be a relatively ordinary corporate event and a distribution of capital a relatively extraordinary one. 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. It should be noted, however, that the fact that the capital distribution has been funded from debt does not preclude it from being attributable to profits. 69. The profit to be taken into account under paragraph 45B(8)(a) includes profits, whether realised or unrealised, of the company making the distribution, or of an associate of the company. This means, for instance, that profits of subsidiaries may be taken into account for the purposes of determining whether the capital distribution is attributable to profits. 70. The term 'profits' is not defined in the income tax law and takes its ordinary meaning. It has a wide scope and is not limited to the Corporations Act's conception of the term. [40] The word profits, as it is generally understood, implies a gain made by a business and disclosed by a comparison between the state of that business at one point in time and its state at another. [41] Thus, in strict legal terms, an unrealised gain, whether or not it is of a 'permanent character' and whether or not it meets the technical requirements for distribution of the Corporations Act, constitutes profits for the purposes of paragraph 45B(8)(a). [42] It should also be noted that a company can pay dividends out of current year profits despite having accumulated losses. [42] The discussion in Taxation Ruling TR 2003/8 Income tax: distribution of property by companies to shareholders - amounts to be included as an assessable dividend, of the meaning of 'profits derived' in the context of subsection 44(1) is also relevant in determining whether there are profits or not. 71. Therefore, the notion of 'profits' in paragraph 45B(8)(a) may be wider than that under the Corporations Act. The attribution inquiry extends beyond profits legally distributable by the company to profits which, as a practical matter of fact, are available to be harvested by the company for distribution at that time or at a future time. 72. Nevertheless, tax officers should also take account of the nature and circumstances of the particular company, its distribution culture and whether there are commercial concerns with distributing the profits, including distributing any unrealised profits if relevant, in determining whether section 45B applies. For example, a corporate group could have some unrealised profit that may be so ephemeral as to render its distribution imprudent. Aspects of corporate distributions are discussed further with respect to the relevant circumstances identified in paragraphs 45B(8)(b) and 45B(8)(k). 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 in the attribution inquiry posed by paragraph 45B(8)(a). 73. As discussed at paragraph 57 in PS LA 2005/21, if the capital distribution is attributable to 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 and is available to be distributed to shareholders. 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 valuing assets according to their market value. This is sometimes referred to as the 'slice approach' to the compilation of assets as between capital and profit. 74. Similarly, if the occasion for the share capital reduction is to increase the company's gearing ratio (the debt to equity ratio) it should be borne in mind that equity includes both retained profits and share capital and that this is an occasion that affects both. This means that an increase in the gearing ratio can be achieved just as effectively by returning profits as reducing share capital, including by way of dividend. Generally, in the absence of other relevant factors which indicate otherwise, tax officers should regard the capital distribution as being attributable to the share capital and retained earnings on a proportionate basis. Example 4 of PSLA 2008/10 illustrates these principles where a sole shareholder receives a return of share capital rather than a distribution sourced from available earnings: 151. In 2004 Fred Alcove borrowed $100,000, on the security of a First Mortgage over his private residence and, with his savings of $20,000, used the borrowed money to capitalise a newly formed company, Niche Pty Ltd (Niche), to carry on a modest transport business he controlled. Niche invested the capital in the acquisition of a second hand prime mover. 152. After three years of successful trading, Mr Alcove's equity in Niche comprises share capital of $120,000 and retained earnings of $250,000. 153. Mr Alcove wants to remove the Mortgage Security over his home and thus free his main private asset from exposure to creditors. He understands the different tax consequences between paying a dividend and distributing capital. 154. As the guiding mind of Niche, Mr Alcove decided to reduce the company's capital by $100,000 and distribute it to himself as shareholder so he could pay back his loan and disencumber his private residence. Mr Alcove's essential purpose therefore was to recover his equity in Niche to repay the private loan which financed it. His equity in Niche included Niche's paid up capital and its realised profit (retained earnings). 155. Setting aside tax implications, in terms of withdrawing equity from the company it would appear that it makes no difference to Mr Alcove whether the distribution is sourced in share capital or profit, or both. Nor does it make any real financial difference to Niche whether it distributes capital and retains profits, or distributes profits and retains capital. Also, the legal formality which differentiates a distribution of capital from one of profit is less likely to be an impediment where the company's executive and membership are indistinguishable. 156. Notwithstanding that share capital and profit might appear to be substantially interchangeable in the case of closely held companies, the fact remains that from the company's perspective the fund of profit that might have been divided and distributed as a dividend has been impounded to replace the capital of the business de facto and the fund of paid up capital has been reduced simply to provide a cash distribution to the shareholder, Mr Alcove. 157. In these circumstances, the shareholder's tax preference for capital over profits would appear objectively to be a significant factor in the decision to distribute the money from the company as return of share capital rather than a dividend out of profit. This suggests the presence of the requisite purpose in paragraph 45B(2)(c). | Detailed Reasoning - Section 45C of the ITAA 1936 - effect of determinations under section 45B for capital benefits: Section 45C of the ITAA 1936 broadly provides that if the Commissioner makes a determination under subsection 45B(3) of the ITAA 1936, the amount of the capital benefits is taken to be paid out of company profits and to be an unfranked dividend that is paid by the company to the shareholder or relevant taxpayer at the time the capital benefit is provided. | Detailed Reasoning - Application to the proposed share capital reduction: Notwithstanding the contentions, the Company did not carry on a business at any point (that is, it was a passive investor at all times - as reflected in the financial information of the Company). Relevantly, the Company's business structure had remained intact, and its recent operations had not included any significant divestment. There is no indication that a surplus equity capital had been generated which may tend toward against the existence of the requisite degree of purpose. The regularity of dividend payments in itself is not sufficient to indicate that the requisite degree of purpose was not present. The Company only has one shareholder which may tend toward of the requisite degree of purpose. As explained above, the Proposed Share Capital Reduction would satisfy subsection 45B(2) of the ITAA 1936. Having regard to the relevant circumstances of the Proposed Share Capital Reduction, the Commissioner considers that the scheme will be entered into or carried out for a more than an incidental purpose of enabling the shareholder to obtain a tax benefit (that is, the tax payable by the Taxpayer would be lower than if the payment was an assessable dividend and franking credits will be preserved for future use). As all the conditions of subsection 45B(2) of the ITAA 1936 would be satisfied, section 45B would apply to the distribution and the Commissioner would make a determination pursuant to subsection 45B(3) that section 45C would apply to treat the distribution as an unfranked dividend.