Private ruling: Income tax - return of capital and dividend
Date of advice: 23 November 2015
Published: February 2016
Ruling period: The income year ended 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Will any part of the proposed return of capital by Company X to its shareholders under the proposed scheme, be a dividend for the purposes of subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: No | Q2: Will the Commissioner make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the proposed return of capital deeming all or part of the capital benefit to be an unfranked dividend? | A2: No. | Q3: Will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the proposed return of capital deeming all or part of the capital benefit to be an unfranked dividend? | A3: No. | Q4: Will the Commissioner make a determination under subsection 45C(3) of the ITAA 1936 that a franking debit could arise to Company X in respect of the capital benefit? | A4: No. | Q5: Will Capital Gains Tax (CGT) Event G1 under section 104-135 of the Income Tax Assessment Act 1997 (ITAA 1997) happen to all or part of the return of capital? | A5: Yes. | Q6: Will a franking debit be generated under section 204-15 of the ITAA 1997 in relation to the payment of the dividend? | A6: No. | Q7: Will the Commissioner make a determination under subsection 204-30(3) of the ITAA 1997 in relation to the payment of the dividend? | A7: No. | Q8: Will the Commissioner make a determination under section 177E of the ITAA 1936 to give rise to a franking debit in the franking account of Company X or deny the whole, or any part, of the imputation benefits received by Company X shareholders? | A8: No. | Q9: Will the Commissioner make a determination under section 177EA of the ITAA 1936 to give rise to a franking debit in the franking account of Company X or deny the whole, or any part, of the imputation benefits received by Company X shareholders? | A9: No. | Q10: Will Company X be required to notify the Commissioner that there is a significant difference in its benchmark franking percentage pursuant to sections 204-70 and 204-75 of ITAA 1997? | A10: No

Relevant facts and circumstances: This distribution under the proposed scheme involves a return of capital and dividend payment to the Company X shareholders as a result of the sale of Company X's assets. Company X is an Australian private company limited by shares. Company X's principal activity is research and development and related applications. Since commencing research and development activities, Company X has experienced recurring net losses and negative cash flows from operations. At the time of the distribution, Company X will have two separate classes of shares with paid-up capital. Prior to the distribution, Company X has never made a distribution to any of its shareholders. Company X is a stand-alone Australian tax resident private company. Company X has carried forward tax losses and no capital losses. Company X's share capital account (as defined in section 975-300 of the ITAA 1997) is not tainted (within the meaning of Division 197 of the ITAA 1997). Company X was registered for GST. All of Company X's shareholders are Australian tax residents, except one shareholder that holds a nominal interest. All of Company X's shareholders hold their interests on capital account. The shareholders comprise a mix of entities. Company X entered into a purchase agreement to the transfer of all its assets to the purchaser and provides for the purchaser to pay consideration over a period of time subject to specified performance criteria (the Transaction). Following the initial payment upon its signing, any remaining payments will be contingent on up a number of performance milestones. Many elements of the consideration are deferred and contingent on regulatory, commercialisation and sales milestones. Any additional net proceeds received in excess of the dividend and the return of capital will be distributed pro rata to all Company X shareholders as dividends, franked to the extent possible. This is expected to be undertaken over a number of tranches, depending on the timing of the proceeds being received. Company X will make the distribution in accordance with the requirements of the Corporations Act 2001. No shares in Company X are proposed to be cancelled as a result of the distributions.

Relevant legislative provisions: Income Tax Assessment Act 1936 section 6(1) | Income Tax Assessment Act 1936 section 45A | Income Tax Assessment Act 1936 section 45B | Income Tax Assessment Act 1936 section 45C | Income Tax Assessment Act 1936 section 177D | Income Tax Assessment Act 1936 section 177E | Income Tax Assessment Act 1936 section 177EA | Income Tax Assessment Act 1936 section 318 | Income Tax Assessment Act 1997 section 104-135 | Income Tax Assessment Act 1997 section 204-15 | Income Tax Assessment Act 1997 section 204-30 | Income Tax Assessment Act 1997 section 204-70 | Income Tax Assessment Act 1997 section 204-75 | Income Tax Assessment Act 1997 section 975-300 | Income Tax Assessment Act 1997 section 995-1

Reasons for decision: Summary: The return of capital by Company X will not be a dividend as defined in subsection 6(1) of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: 'Dividend' is defined in subsection 6(1) of the ITAA 1936 to include any distribution made by a company to any of its shareholders. This broad definition is however confined by later paragraphs in the definition which expressly exclude certain items from being a dividend for income tax purposes. One such specific exclusion is paragraph (d) of the definition of dividend which provides: 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 The term '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 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, except for certain purposes, 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. As the return of capital will be debited to Company X's share capital account, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 will apply. Company X has stated that its share capital account is not tainted within the meaning of Division 197 of the ITAA 1997. Accordingly, the return of capital is not a dividend as defined in subsection 6(1) of the ITAA 1936. | Summary: The Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole, or a part, of the capital benefit. | Detailed Reasoning - Detailed reasoning: Section 45A of the ITAA 1936 applies where capital benefits are streamed to some shareholders (the Advantaged Shareholders), who would derive a greater benefit from the capital benefits than other shareholders (the Disadvantaged Shareholders) and these Disadvantaged Shareholders receive, or are likely to receive, dividends. In the current circumstances, the capital benefit will be provided to all Company X shareholders in the same proportion as their share holdings. Accordingly, section 45A of the ITAA 1936 does not apply to the return of share capital payment and the Commissioner will not make a determination under subsection 45A(2) that section 45C applies in relation to the whole, or a part, of the return of share capital. | Detailed Reasoning - Question 3: Summary The Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to deem all or part of the capital benefit to be an unfranked dividend. Detailed reasoning Section 45B of the ITAA 1936 applies where certain capital payments are made to shareholders in substitution for dividends. Specifically, the provision applies where: (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). Scheme Subsection 45B(10) of the ITAA 1936 provides that 'scheme' for the purposes of section 45B has the meaning given in subsection 995-1(1) of the ITAA 1997. 'Scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean any arrangement or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. In the current circumstances the 'scheme' for the purposes of section 45B of the ITAA 1936 is considered to include the return of capital paid to all Company X shareholders. The phrase 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936 and includes a distribution to the person of share capital or share premium. Company X will be distributing an amount to each Company X shareholder and debiting the amount to its contributed share capital account. The return of capital by Company X constitutes the provision of a capital benefit within the meaning of paragraph 45B(5)(b) of the ITAA 1936. Tax benefit A relevant taxpayer 'obtains a tax benefit', as defined in subsection 45B(9) of the ITAA 1936, if an amount of tax payable, or any other amount payable under the ITAA 1936 or ITAA 1997, by the relevant taxpayer would, apart from section 45B of the ITAA 1936, 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 an assessable dividend. Ordinarily, a return of capital would be subject to the CGT provisions under the income tax law. Unless the amount of the distribution exceeds the cost base of the shares, there will only be a cost base reduction under CGT event G1 (section 104-135 of the ITAA 1997). It is only to the extent (if any) that the distribution exceeds the cost base of the shares that a capital gain arises. A capital gain may not arise at all for certain foreign shareholders. By contrast, a dividend would generally be included in the assessable income of a resident shareholder or, in the case of a non-resident, would potentially be subject to dividend withholding tax. Therefore, Company X shareholders will obtain a tax benefit from the capital return. Purpose The critical factor when determining whether a distribution of capital would attract the operation of section 45B is whether the reason for entering into the scheme was, having regard to the relevant circumstances of the scheme, for the purpose of obtaining a tax benefit as paragraph 45B(2)(c) of the ITAA 1936. The test of purpose is an objective one. The question is whether 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. The purpose does not have to be the most influential or prevailing purpose, but it must be more than an incidental purpose. The relevant circumstances contained in subsection 45B(8) of the ITAA 1936 cover the circumstances and the tax profile of the shareholders. In this instance, it is considered that the matters covered by paragraphs 45B(8)(a), (b), and (k) of the ITAA 1936, are the most relevant and are considered below. 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 Company X or its associates. Company X does not have any prior year profits and the investment in Company X was sourced out of share capital. The attribution under the scheme correctly reflects the extent of share capital and profit in the distribution to the shareholders. Paragraph 45B(8)(b) of the ITAA 1936 covers the relevant circumstance that includes the pattern of distributions of dividends and return of capital by the company. Company X has no accounting profit in the previous financial years and therefore has not been in a position under the Corporations Act 2001 to declare and distribute a dividend to Company X shareholders. Therefore the distribution cannot be said to be in any way a substitute for any distribution of Company X, nor can it be viewed as a substitute for the absence of such distributions. Paragraph 45B(8)(k) refers to matter in paragraphs 177D(2)(a) to (h) 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, its form and substance, and its financial and other implications for the parties involved. Having regard to the relevant circumstances of the scheme, set out in subsection 45B(8) of the ITAA 1936, it cannot be concluded that any of the parties to the scheme entered into or carried out the scheme for more than an incidental purpose of obtaining a tax benefit. Accordingly, the Commissioner will not make a determination pursuant to subsection 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole, or any part, of the return of capital provided to Company X shareholders under the proposed scheme. | Summary: The Commissioner will not make a determination under subsection 45C(3) of the ITAA 1936 that a franking debit could arise to Company X in respect of the capital benefit. | Detailed Reasoning - Detailed reasoning: If the conditions for application in subsection 45B(2) of the ITAA 1936 are met, the Commissioner is empowered under subsection 45B(3) to make a determination that section 45C applies in relation to the whole, or a part, of the capital benefit. As the Commissioner has not made a determination under subsection 45B(3) of the ITAA 1936 that subsection 45C(1) of the ITAA 1936 applies to the capital benefit, the Commissioner will not make a further determination, under subsection 45C(3) of the ITAA 1936, that would result in an additional franking debit arising in the Company X's franking account. Question 5 | Summary: CGT event G1 will happen when Company X pays the return of capital to a Company X shareholder in respect of a Company X share. | Detailed Reasoning - Detailed reasoning: CGT event G1 (section 104-135 of the ITAA 1997) happens when a company makes a payment to a shareholder in respect of a share they own and some or all of the payment (the non-assessable part) is not a dividend or an amount that is taken to be a dividend under section 47 of the ITAA 1936. Accordingly, CGT event G1 will happen when Company X makes payments under return of capital A and return of capital B to Company X shareholders in respect of Company X shares they own. A Company X shareholder will make a capital gain if the return of capital amount is more than the cost base of the shares it relates to. The amount of the capital gain is equal to that excess (subsection 104-135(3) of the ITAA 1997). If a Company X shareholder makes a capital gain from CGT event G1 happening, the cost base and reduced cost base of the Company X share is reduced to nil. A Company X shareholder cannot make a capital loss from CGT event G1 happening (subsection 104-135(3) of the ITAA 1997). If the return of capital amount is equal to or less than the cost base of the Company X share, the cost base and reduced cost base of the ordinary share will be reduced by the amount of the payment (subsection 104-135(4) of the ITAA 1997). | Detailed Reasoning - Question 6: Summary The dividend will not be subject to section 204-15 of the ITAA 1997. Detailed reasoning Section 204-15 of the ITAA 1997 applies where a member of an entity makes a choice, or fails to exercise a choice, with the effect of determining that another entity makes, to one of its members, an unfranked distribution (or a distribution franked to a different extent than the first entity's benchmark franking percentage) that is in substitution for a distribution by the first entity to that member. As the Transaction does not involve the exercise or non-exercise of a choice by a member of one corporate tax entity results in a linked distribution being made by another corporate tax entity in substitution for a distribution by the first entity, it does not involve a 'linked distribution', It is therefore concluded that the circumstances for the payment of the dividend are not subject to section 204-15 of the ITAA 1997. | Summary: The Commissioner will not make a determination under subsection 204-30(3) of the ITAA 1997 in relation to the payment of the dividend. | Detailed Reasoning - Detailed reasoning: Section 204-30 of the ITAA 1997 applies where a corporate tax entity streams the payment of dividends, or the payment of dividends and the giving of other benefits, to its members in such a way that: (a) an imputation benefit is, or apart from section 204-30 of the ITAA 1997 would be, received by a member of the entity as a result of the distribution or distributions; (b) the member would derive a greater benefit from franking credits than another member of the entity; and (c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits. If section 204-30 of the ITAA 1997 applies, the Commissioner has discretion under subsection 204-30(3) of the ITAA 1997 to make a determination in writing: (a) that a specified franking debit arises in the franking account of the entity, for a specified distribution or other benefit to a disadvantaged member; (b) ...; and (c) that no imputation benefit is to arise in respect of any streamed distributions made to a favoured member and specified in the determination. For section 204-30 of the ITAA 1997 to apply, members to whom distributions are streamed must derive a greater benefit from imputation benefits than other members. The words 'derives a greater benefit from franking credits' (imputation benefits) are defined in subsection 204-30(8) of the ITAA 1997 by reference to the ability of the members to fully utilise imputation benefits. In this case, as the distribution is to be franked and paid to the same extent to all shareholders, it cannot be argued that Company X has directed the flow of distributions in such a manner so as to ensure that imputation benefits are derived by Company X shareholders who derive greater benefits from franking credits, while other shareholders receive lesser or no imputation benefits. As the conditions in subsection 204-30(1) of the ITAA 1997 will not be met, the Commissioner will not make a determination under subsection 204-30(3) of the ITAA 1997 to deny the whole, or any part, of the imputation benefit received in relation to the dividend. | Summary: The Commissioner will not make a determination under section 177E of the ITAA 1936 to give rise to a franking debit in the franking account of Company X or deny the whole, or any part, of the imputation benefits received by Company X shareholders. | Detailed Reasoning - Detailed reasoning: Broadly, section 177E of the ITAA 1936 applies where: • a company's property is disposed of under a scheme in the nature of, or that has a similar effect to, a dividend stripping scheme; • the Commissioner concludes that the disposal represents in whole or in part a distribution of the company's past, present or future profits; and • if immediately before the scheme was entered into the company notionally paid a dividend out of the profits represented by the disposal of the property, the amount represented by the dividend would have been, or might reasonably be expected to have been, included in the assessable income of a taxpayer. In relation to this arrangement, the transaction is not considered to constitute a scheme in the nature of, or that has a similar effect to, a dividend strip. As such section 177E of the ITAA 1936 does not apply to the pro rata return of capital and the Commissioner will not make a determination under subsection 177E(1). | Summary: The Commissioner will not make a determination under section 177EA of the ITAA 1936 to give rise to a franking debit in the franking account of Company X or deny the whole, or any part, of the imputation benefits received by Company X shareholders | Detailed Reasoning - Detailed reasoning: Section 177EA provides that the Commissioner may impose a franking debit or cancel a franking credit in circumstances where there is a scheme which has been entered into for a purpose (whether or not the dominant purposes but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit. Subsection 177EA(3) of the ITAA 1936 provides that section 177EA applies if: (a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; … In the present case the conditions in paragraph 177EA(3)(a) of the ITAA 1936 are not satisfied and therefore, subsection 177EA(3) does not apply. | Summary: Company X will not be required to notify the Commissioner that there is a significant difference in its benchmark franking percentage pursuant to sections 204-70 and 204-75 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Subdivision 204-E of the ITAA 1997, comprising sections 204-65 to 204-80 of the ITAA 1997, sets out the disclosure requirement that is triggered where there is a significant difference in the entity's benchmark franking percentage over time. In such a case, the entity must notify the Commissioner. This alerts the Commissioner to the possibility of streaming. Section 204-70 makes it clear that Subdivision 204-E (the disclosure requirement) does not apply to an entity to which the benchmark rule does not apply. The benchmark rule in section 204-70 of the ITAA 1997 (which provides the circumstances in which changes to franking percentages need to be notified to the Commissioner) will not apply if the dividend is franked to the extent of available franking credits and any further dividends paid during a franking period will be franked with the same percentage franking credits as stated in the ruling application. As the benchmark rule under section 204-70 of the ITAA 1997 should not apply, section 204-75 should not apply to require Company X to notify the Commissioner.