Private ruling: Income tax exemption and refund of franking credits
Published: September 2014
Ruling period: 1 July 2013 - 30 June 2014 | 1 July 2014 - 30 June 2015
Date scheme commenced: 1 July 2013

Ruling: Q1: Are the proceeds received by the entity under the arrangement exempt from income tax under section 50-1 of the Income Tax Assessment Act 1997 (ITAA 1997) if the entity is endorsed under section 50-110 of the ITAA 1997? | A1: Yes | Q2: If the proceeds are exempt, is the entity eligible to obtain a refund of any imputation credits received from the arrangement under section 207-117 of the ITAA 1997? | A2: Yes

Relevant facts and circumstances: • The entity is a registered charity and is entitled to receive tax deductible donations. • The entity was bequeathed the residual of a deceased estate. • The deceased owned AAA shares. • AAA company and the entity reached an agreement on W date. The AAA shares would be transferred to the entity and AAA company would buy-back the shares through a share buy-back arrangement. • The terms of the share buy-back agreement set out the buy-back price which was determined through an independent valuation conducted at a prior date. • The share buy-back agreement is subject to shareholder approval. • The shares were legally transferred into the entity's name on X date. • The shareholders approved the share buy-back agreement more than 45 days after the shares were transferred to the entity on Y date. • A distribution statement has been provided showing the capital ($C) and dividend component ($D) and the amount it has been franked. • On Z date, the share buy-back was completed and the proceeds paid from AAA company to the entity. The shares were subsequently cancelled on that day.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 50-1 | Income Tax Assessment Act 1997 Section 50-5 | Income Tax Assessment Act 1997 Section 50-110 | Income Tax Assessment Act 1997 Section 207-115 | Income Tax Assessment Act 1936 Subsection 160APHM(2) | Income Tax Assessment Act 1936 Subsection 160APHM(3) | Income Tax Assessment Act 1936 Section 160APHO

Reasons for decision: Summary: Section 50-1 of the ITAA 1997 provides that the total ordinary and statutory income of the entities covered in the tables in section 50-5 to 50-45, are exempt from income tax. In this case, the entity is a registered charity and has satisfied the endorsement conditions in section 50-110. That is, the Society: • Is an entity covered by item 1.1 - registered charity in section 50-5 of the ITAA 1997 • Has an ABN • Satisfied the special conditions Therefore, the proceeds from the sale of the shares pursuant to the share buy-back agreement with AAA company is exempt from income tax under section 50-1 of the ITAA 1997. Under section 207-115 of the ITAA 1997 an entity, referred to in the legislation as an 'exempt institution that is eligible for a refund', is eligible for tax offsets for franking credits attached to the franked distributions that they receive. These tax offsets are refundable under Division 67 of the ITAA 1997. The eligible institutions are: 1. Income tax exempt charities 2. Income tax exempt deductible gift recipient; 3. Income tax exempt specified deductible gift recipients 4. Prescribed income tax exempt entities The entity falls under two of the above eligible institutions as it is both a tax exempt charity and a deductible gift recipient. The entity was bequeathed the residual of a deceased estate. The deceased owned AAA shares. AAA company and the entity reached an agreement on W date. The AAA shares would be transferred to the entity and AAA company would buy-back the shares through a share buy-back arrangement. Share buy-backs are mainly governed by Division 16K of Part 111 of the Income Tax Assessment Act 1936 (ITAA 1936). The Division applies where a company buys a share in itself from a shareholder. On-market buy backs are defined in section 159GZZZK of the ITAA 1936. If the share is listed on the stock exchange and the purchase is made in the ordinary course of business of that stock exchange, the buy-back will be an on-market purchase. All other buy-backs are treated as off-market purchases. In the entity's case, as the AAA shares are not listed on the stock exchange it is an off-market buy-back in accordance with section 159GZZZK of the ITAAA 1936. Law Administration Practice Statement (PSLA) 2007/9 Share buy-backs , provides at paragraph 32: 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. This dividend is paid to the seller as a shareholder out of the profits derived by the company on the day the buy-back occurs: section 159GZZZP of the ITAA 1936. Franking credits may be available in respect of this dividend. AAA company has provided the entity with a share buy-back distribution statement for the period ending 30 June 2014. The return of capital component is $C and the dividend component is $D. The dividend has been franked. Paragraphs 75-79 of PSLA 2007/9 provide guidance on the 'holding period rule' and how it interacts with share buy-back arrangements. The holding period must be satisfied to enable the shareholder to receive a tax offset in relation to the franking credits: The Holding Period Rule 75. Where a company is buying back its ordinary shares, the holding period rule in section 160APHO of the ITAA 1936 requires a shareholder to have held their shares on which a dividend has been paid for at least 45 days 'at risk' within a certain period. It is a once and for all test. That period is 90 days if the shares are preference shares (broadly, defined as shares that have a fixed dividend entitlement or are less risky than ordinary shares). 76. The period in which the shareholder must have held their shares at risk begins on the date those shares were acquired and ends 45 days (or 90 days in the case of preference shares) after the shares become ex-dividend. This is called the 'primary qualification period' in paragraph 160APHO(1)(a) of the ITAA 1936. 77. In counting the number of days that a shareholder has held the shares during the primary qualification period, one must exclude the days of acquisition and disposal, and those days where the shareholder is not 'at risk', that is, where the shareholder has materially diminished risks of loss or opportunities for gain in respect of the shares. 78. It is possible to work out the last day upon which a shareholder can acquire shares, dispose of them into the buy-back and still satisfy the holding period rule. This is done by taking the day on which the shares are disposed of into the buy-back, and counting back 45 clear days. Generally this day will be the date that the offer to sell shares is accepted by the company undertaking the buy-back. 79. For example, a company states that it will determine acceptances on 15 May 2005. Ignoring 15 May 2005 (day 135 of the year) and counting back 45 clear days, one must have acquired shares no later than 30 March 2005 (day 89 of the year) in order to be a qualified person Section 160APHO was repealed and has not yet been re-enacted but the these rules still have application via the anti-manipulation rule in paragraph 207-145(1)(a) of the ITAA 1997 (Taxation Determination TD 2007/11 Income tax: imputation: franked distributions: qualified persons… ) The AAA shares were transferred into the entity's name on X date. The share buy-back was approved by the shareholders on Y date and the AAA company bought-back the shares on Z date. Therefore, the entity has held the shares for at least 45 days. However, the shares must be held 'at risk' to satisfy the holding period, paragraph 83-84 of PSLA 2007/9 states: 83. Tax officers may need to consider whether the company's announcement of the share buy-back process will result in a materially diminished risk of loss or opportunities for gain. 84. The Commissioner does not regard the making of a detailed announcement of a buy-back process as having an effect on whether the shares are held at risk in circumstances where the company is not under any obligation to proceed with the buy-back until acceptances are completed. Subsection 160APHM(2) of the ITAA 1936 defines when a taxpayer has materially diminished risk in respect of their shares: A taxpayer is taken to have materially diminished risks of loss or opportunities for gain on particular day in respect of shares held by the taxpayer of an interest held by the taxpayer in shares, if the taxpayer's net position on that day in relation to the shares or interest has less than 30% of those risks and opportunities. According to subsection 160APHM(3) of the ITAA 1936, a taxpayer's net position is worked out by reference to 'delta'. Taxation Determination TD 2007/29 Income tax: holding period rule: is an embedded share option a position… states at paragraph 10 that 'delta' is a financial concept that measures the change in price of a derivative for a given small change in the price of an underlying asset. If a derivative has a delta in relation to an equity interest it can be used to diminish the risks of loss or opportunities for gain associated with owning the interest. According to paragraph 4.50 and 4.63 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 2) 1999 : 4.50 In calculating whether a taxpayer has satisfied the requisite holding period, any days during which there is a materially diminished risk in relation to the relevant shares or interest are not counted. In other words, it is as if the taxpayer did not hold the shares those days. There would be a material diminution of risk, for example, if a taxpayer has forward sold the shares or has taken a position in derivatives which eliminates the upside and downside risk of holding shares. 4.63 If a taxpayer acquires shares or interest in shares and takes a position in relation to the shares or interest, provided the taxpayer continues to hold the shares or interests and does not enter into any other positions in relation to the shares or interests, the delta of the positions remains the delta of the position on the day in which the shares were acquired or the position was entered into, whichever is the later. On W date the entity and AAA company signed the share buy-back agreement, where AAA company agreed to buy the AAA shares from the entity for a certain price. However, the share buy-back agreement was subject to shareholder's approval. Shareholder approval was given on Y date. It is considered that until the shareholders approved the share buy-back, AAA company was not obligated to purchase the AAA shares from the entity and the entity was subject to risk. Therefore for the period X date until the day before the shareholder's approved the share buy-back on Y date, the entity held the shares 'at risk'. This is greater than 45 days and the entity will satisfy the holding period rule. Consequently, the entity is entitled to a refund of imputation credits under section 207-117 of the ITAA 1997.