Private ruling: Share capital account tainting
Date of advice: 17 September 2020
Published: November 2020
Ruling period: Income year ended 30 June 20XX to 30 June 20YY
Date scheme commenced: A particular date

Ruling: Q1: Did the dividend payments and share issues in the relevant years by Head Co result in an amount to which Division 197 of the Income Tax Assessment Act 1997 (ITAA 1997) applied? | A1: No

Relevant facts and circumstances: Head Co is a company incorporated in Australia and a resident for tax purposes. Head Co is a head company of an income tax consolidated group comprising itself and its wholly-owned subsidiary, Sub Co. Head Co is a holding company that does not perform any business activities in its own capacity. Its sole asset is its investment in Sub Co. A shareholders' agreement is in place between the shareholders of Head Co to govern the management and operation of Head Co and Sub Co. Sub Co's distribution policy is to declare a dividend in respect of all of its distributable profit for each half of the financial year. Upon Sub Co's dividend declaration, Head Co will also declare a dividend for a corresponding amount. In the relevant years, Sub Co sought to distribute its retained earnings in accordance with the shareholders' agreement. Sub Co declared unfranked dividends in the relevant years. Similarly, Head Co declared fully franked dividends in the relevant years. At the times when the dividends were declared, Sub Co and Head Co did not have sufficient cash to pay their respective shareholders the full amount owed. Instead, Sub Co and Head Co elected to raise additional share capital from its respective shareholders. Following the declaration of the unfranked dividends, Head Co entered into a share subscription agreement with Sub Co for additional shares with a total price equal to the declared dividends. Under this subscription agreement, Head Co must pay the subscription price for the additional shares and may pay by directing Sub Co to credit the dividends payable to them against the subscription price. Head Co provided irrevocable directions to Sub Co to use the dividends owed to Head Co as consideration for the additional shares. Around that time, following the declaration of the fully franked dividends, Head Co's shareholders entered into a share subscription agreement with Head Co for additional shares with a total issue price equal to the declared dividends. Under this subscription agreement, each shareholder must pay the subscription price for the additional shares on settlement and may pay by directing Head Co to credit the dividends payable to them against the subscription price. Each shareholder provided irrevocable directions to Head Co to use the dividends owed to them as consideration for the additional shares. Sub Co and Head Co made the following accounting entries for the relevant years: Sub Co Debit Credit Day 1 Retained Earnings $Xm Payable $Xm Declaration of dividend to Head Co Day 2 Receivable $Xm Share Capital $Xm Issue of shares to Head Co Day 4 Payable $Xm Receivable $Xm Set-off of dividend with subscription price for shares Head Co Debit Credit Day 1 Receivable $Xm Retained Earnings $Xm Recognition of declared Sub Co dividend Day 2 Investment in Sub Co $Xm Payable $Xm Subscription of shares in Sub Co Day 2 Retained Earnings $Xm Payable $Xm Declaration of dividend to Head Co shareholders Day 3 Receivable $Xm Share Capital $Xm Issue of shares to Head Co shareholders Day 4 Payable $2Xm Receivable $2Xm Set-off of dividend with subscription price for shares between Sub Co and Head Co, and between Head Co and Head Co shareholders

Relevant legislative provisions: Section 197-5 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Section 197-5 of the ITAA 1997 provides that Division 197 applies to an amount (the 'transferred amount') that is transferred to a company's share capital account from another of the company's accounts, if the company was an Australian resident immediately before the time of transfer. The expression 'transferred amount' is not defined within Division 197 or section 995-1 of the ITAA 1997. Paragraph 4.12 of the Explanatory Memorandum (EM) to the Tax Laws Amendment (2006 Measures No. 3) Bill 2006 provides that an amount is transferred from one account to another where that amount is moved from one account to another. This requires the balance of the first account to be reduced, while the balance of the second account is increased by the same amount. Paragraph 4.13 of the EM provides that an amount is not transferred from one account to another where the particular accounting entries result in the balances of both accounts increasing in size. That is, an accounting entry to the form 'debit asset, credit share capital account' does not represent a transfer in the relevant sense. Furthermore, a transfer to the share capital account will not arise if an expense account is debited at the same time that the share capital account is credited. The dividend payments and share issues in the relevant years involved the debiting of a receivable account (an asset account) and a corresponding crediting of Head Co's share capital account. These particular accounting entries resulted in the balances of both accounts increasing in size. As both accounts have increased, there is no transfer for the purposes of section 197-5.