Private ruling: Commissioner's distributable surplus discretion
Date of advice: 27 August 2021
Published: November 2021
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Will the Commissioner exercise his discretion, under subsection 109Y(2) of the Income Tax Assessment Act 1936 to substitute the market value of XYZ 's net assets, in calculating XYZ 's distributable surplus for the income year ending 30 June 20XX? | A1: No

Relevant facts and circumstances: XYZ Pty Ltd (XYZ) is an Australian incorporated proprietary company. XYZ is the head entity of an Australian economic group (the Group). The Group was established to commercialise the results of research completed by another entity. XYZ is consolidated for financial reporting purposes with a number of Australian and overseas subsidiaries. XYZ prepares parent-entity disclosures on a standalone basis. XYZ has had a long-term incentive plan (LITP) in place since March 20XX. The LITP grants share appreciation rights (SARs) to select employees and directors who are residents for purposes of Australia and specified foreign countries. Each SAR represents an entitlement, subject to conditions, to receive an allocation of ordinary shares in XYZ equal to the increase in the value of a share in XYZ (at the time the SAR is settled) over the exercise price of the SAR. SARs can be settled by XYZ's board of directors (the Board) by paying a cash equivalent amount in lieu of an allocation of XYZ ordinary shares. New employee share plan The Board has approved, in principle, the adoption of a new loan-funded share Plan (New Share Plan). The objectives behind the implementation of a New Share Plan are: • to incentivise and retain senior XYZ employees not limited to those that are Australian residents for tax purposes; and • to allow participants in the New Share Plan to realise value from their rights the same way XYZ shareholders do when XYZ disposes of shares in a subsidiary. Under the New Share Plan, participants are offered interest-free limited recourse loans by XYZ for the sole purpose of funding the acquisition of XYZ shares for consideration at market value as determined by an independent valuation. The loans will be structured so that where the value of the loan-funded shares are less than the outstanding loan balance when the loan is required to be repaid, the participant may surrender the loan-funded shares to effect settlement of the loan. The shares offered may be from a new class of ordinary shares that have distribution rights but do not confer the right to attend and vote at general meetings. Repayment of the loan is to occur on the earlier date the participant disposes of the loan-funded shares and the tenth anniversary of the loan being provided. The loan-funded shares will be subject to disposal restrictions. Finances/Accounting Records XYZ has historically made losses on a standalone basis and the Group has historically made losses on a consolidated basis. It is currently in a loss position on a standalone and consolidated basis. For the year ended 31 December 20XX, XYZ's management reports kept an accounting loss of $XXX on a standalone basis and $XXX on a consolidated basis. On a standalone basis for the year ended 31 December 20XX, XYZ's management reports kept an accumulated loss of $XXX. Per XYZ's standalone management accounts for the year ending 31 December 20XX, its distributable surplus is -$XXX. Management of XYZ is of the belief that XYZ's market value is greater than its accounting records indicate. This is a result of the way that it accounts for its subsidiaries' internally generated goodwill. The internally generated goodwill and other intangible assets of XYZ's subsidiaries are not included in its accounting records pursuant to AASB 138 as they are a result of research as defined in AASB 138. XYZ's investments in its subsidiaries are valued at historical cost pursuant to AASB 127. Representations XYZ prepares management accounts on a monthly basis. These accounts are used for internal management purposes only. XYZ's management accounts are prepared pursuant to Australian accounting standards and are consistent with the reporting principles in XYZ's consolidated financial statements. Any documentation prepared by XYZ in respect of the market value of XYZ and/or its subsidiaries is only prepared to support internal management and have no connection to amounts recognised in its financial statements. Assumptions Throughout the ruling period and all times prior to the ruling period, XYZ and the Group will: • be in an accumulated loss position on a standalone and consolidated basis; • not be in a position to pay dividends in both an accounting and commercial sense; • not have acted in a way that deliberately circumvents the operation of Division 7A of the Income Tax Assessment Act 1936 (Cth); • prepare its financial statements in accordance with Australian accounting standards; and • prepare its management accounts in accordance with Australian accounting standards. The proposed employee share plan will be implemented as described in the 'relevant facts and circumstances' section of this ruling.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 109Y(2)

Reasons for decision: Summary: Subsection 109Y(2) provides: ...If the Commissioner considers that the company's accounting records significantly undervalue or overvalue its assets or undervalue or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate. Taxation Determination TD 2009/5 Income tax: Division 7A: in exercising the discretion under subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936 to substitute an appropriate value for a private company's assets, can the Commissioner take into account the value of the company's assets not shown in the company's accounting records? (TD 2009/5) sets out what the Commissioner will take into account when deciding whether it is appropriate to exercise the discretion set out in subsection 109Y(2). It provides at paragraphs 27 and 28: 27. It is possible for a taxpayer to value its assets properly in accordance with accounting standards, but for the accounting standards to result in the undervaluation of the assets. The clearest example is 'goodwill', which if internally generated is generally not permitted to be valued by the standards. Goodwill is an asset in the legal and ordinary meaning of the word, and to omit the value of goodwill from a calculation of the surplus value of a company's assets will result in its understatement. The considerations which cause accounting standards to preclude valuation of goodwill are not directly, or even at all, relevant to the taxation of informal company distributions. Just as it is not to the point to show that 'profits' for company law purposes may diverge from the 'distributable surplus' for tax purposes, so it is not in itself conclusive against the exercise of the power to revalue assets to show that the company's accounting records are correctly prepared in accordance with the accounting standards. 28. However, as a matter of practice, the Commissioner would not adjust the book value of assets shown in properly prepared accounts merely because the value of internally generated goodwill is omitted, and, more generally, would respect book values shown in proper accounts in the absence of matters pointing to an attempt to circumvent the Division. When, however, it is plain that the company, its shareholders and directors have acted in a way that treats the real and higher value of assets as the true value, regardless of the books, and that the mischief against which Division 7A is directed is present, the Commissioner will substitute those values. In other words, the discretion is there to protect the integrity of the Act, and it will be exercised when it is necessary to do so for that purpose. should be applied against significant undervaluations. Paragraph 21 of TD 2009/5 gives: The focus must be on whether it is necessary to exercise the discretion to tax what is in substance an informal distribution of earnings, not simply on whether asset values are understated. | Detailed Reasoning - Accounting records: The term 'accounting records' is considered at paragraph 21 of TD 2009/5: These 'accounting records' include, but are not confined to, the company's books of account, financial statements and balance sheet. In the Commissioner's opinion, records of asset valuations (or costs of acquisition) would form part of the accounting records in the relevant sense provided that it was evident that they were adopted or relied upon by the company at the relevant time as showing the value of the assets. XYZ's accounting records have understated the value of: • its investments in its subsidiaries; and • internally generated goodwill and other internally generated intangible assets. These undervaluation of assets in XYZ's accounting records occurred as a result of keeping those records in accordance with Australian accounting standards. As a result, they are considered to be 'proper accounts' as described in TD 2009/5. | Detailed Reasoning - Division 7A 'mischief': While XYZ does create documentation with respect to its market value, these are used solely to support internal management. XYZ and the Group is currently in an accounting loss position and has not earned a profit. It is considered that the market value of XYZ that is not reflected in its accounting records is not accessible such that XYZ could pay dividends. Division 7A was inserted by the Taxation Laws Amendment Act (No. 3) 1998 (Cth). Paragraph 9.2 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No.3) 1998 provided: The purpose of the amendments is to ensure that private companies will no longer be able to make tax free distributions of profits to shareholders (and their associates) in the form of payments or loans. The objectives informing the implementation of the New Share Plan, and the manner in which it will be implemented, indicate that its purpose is not to facilitate the informal distribution of profits in a manner intended to circumvent the operation of Division 7A. | Detailed Reasoning - Conclusion: The Commissioner will not exercise the discretion under section 109Y(2) to substitute the net asset value of XYZ for the purpose of calculating its distributable surplus.