Private ruling: Business - Division 7A
Published: July 2013
Ruling period: 1 July 2012 to 30 June 2013

Ruling: Question and answer | Will the Commissioner, under subsection 109Y(2) of the Income Tax Assessment Act 1936 , substitute the market value of Company Y assets when calculating the company's distributable surplus for the relevant financial year? | No.

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. Company Y is a start-up Australian based company which focuses on innovatively developing a class of drug. Company Y's aim is to research and develop the science behind the drugs, overcome the safety and efficacy issues and then take the products to market. Company Y funds its research through investor capital, government grants and the R&D Tax Incentive. Currently Company Y is still in the research phase and with the exception of government grants, the R&D Tax Incentive and minor licence fees, Company Y does not yet derive any income from the subject of its research. The minor licence fees derived are from an Overseas Company for a potential product still being researched by Company Y. The licence gives the Overseas Company rights to develop and commercialise the product within a specified country. Company Y will derive a royalty from Overseas Company should it be successful in bringing the particular product to market. There will be no new licence agreements entered into with third parties before the end of the financial year by Company Y. Company Y is currently in a loss position, there are no "profits" in an accounting or commercial sense and it is expected that the losses will continue. The only income Company Y anticipates to earn in the remainder of the financial year is from government grants and the R&D Tax Incentive. Company Y is a private company funded principally with equity contributions. Company Z is a wholly owned subsidiary of Company Y that joined Company Y tax consolidated group. Company Z holds a minor part of Company Y's intellectual property value and is dormant. The majority of Company Y's intellectual property value is held by the Company Y entity itself. Company Y raised funds using a Director valuation of the company. This initial capital raising was to facilitate major milestones in its research, and to encourage strategic suitors that would consider follow-up investments. Company Y is currently meeting with external investors seeking to further raise funds. For the purposes of this capital raise, the company Y board has valued the company for an amount pre-money. This was resolved by the Board of Directors and expressed to potential investors. Establishing a market value of the intellectual property of a start up company is very difficult because it is subject to significant levels of uncertainty. Investments made by the founders and outside investors are in exchange for ordinary and/or preference shares. The Shareholder Agreement includes an "anti dilution" clause to prevent any dilution of existing share value by issuing new shares at a discount. The Employee Share Scheme In order to incentivise management, Company Y has developed an Employee Share Scheme (ESS) with an associated Loan Plan, which among other things will allow the management to hold a stake in the business without tripping up the "anti-dilution" clause within the Shareholder Agreement. As part of the Employee Share Plan, it is proposed that Company Y employees will enter into a loan agreement with Company Y, and the loan provided will be secured by the company against the shares issued to management on subscription. The loan is interest free can be repaid through surrendering the Company Y ESS shares held. The loan agreement states that management must only use the loan to subscribe for shares under the ESS. Due to the "anti-dilution" clause all shares must be subscribed for at their full value (i.e. not at a discount). In effect, the ESS loan arrangement is akin to having been made from subscribed capital. If a management shareholder were to cease his/her employment with company Y, they are obliged to either repay the loan via cash or through surrendering the shares. It is anticipated that some of the loans will not be repaid until an exit event such as a trade sale or IPO, and accordingly the loans are not expected to be fully repaid before the lodgement day of the Company Y income tax return. After the implementation of the ESS but before the next round of capital raising, Company Y expects the share register to consist of preference shares (various 3rd partner venture capital funds), founder and original shareholdings, with a small percentage being issued pursuant to the employee share plan. Distributable Surplus based on Special Purpose Financial Statements The market value of the intellectual property is greater than zero and is sufficiently large enough to push Company Y into a position of distributable surplus. Company Y anticipates that the distributable surplus should not significantly change before the end of the financial year (with the exception of additional equity fund raising which should remain neutral to the total amount of distributable surplus) subject to the Commissioner's view on the questions raised.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 109D(1) | Income Tax Assessment Act 1936 Section 109NB | Income Tax Assessment Act 1936 subsection 109Y(2) | Income Tax Assessment Act 1997 Section 83A-20

Reasons for decision: Summary: Under subsection 109D(1) of the Income Tax Assessment Act 1936 (ITAA 1936) a private company is taken to pay a dividend to an entity at the end of one of the private company's years of income (the current year) if: (a) the private company makes a loan to the entity during the current year; and (b) the loan is not fully repaid by the end of the current year; and (c) Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and (d) either: (i) the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or (ii) a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time. Under section 109NB of the ITAA 1936 a private company is not taken under section 109D to pay a dividend because of a loan made solely for the purpose of enabling the shareholder, or an associate of the shareholder, to acquire an Employee Share Scheme (ESS) interest under an employee share scheme (within the meaning of the Income Tax Assessment Act 1997 (ITAA 1997)) to which: (a) Subdivision 83A-B and subsections 83A-35(3) to (9) of that Act apply; or (b) Subdivision 83A-C of that Act applies. Subdivision 83A-B ITAA 1997, Immediate inclusion of discount in assessable income; under the operative provision, section 83A-20 of the ITAA 1997, applies to an ESS interest if you acquire the interest under an employee share scheme at a discount. Distributable surplus is defined in section 109Y(2) of the ITAA 1936. A private company's distributable surplus for its year of income is the amount worked out using the formula: Distributable surplus = Net assets - Non-commercial loans - Paid up share value - Repayments of non-commercial loans where: net assets means the amount (if any), at the end of the company's year of income, by which the company's assets (according to the company's accounting records) exceed the sum of: (a) the present legal obligations of the company to persons other than the company; and (b) the following provisions (according to the company's accounting records): (i) provisions for depreciation; (ii) provisions for annual leave and long service leave; (iii) provisions for amortisation of intellectual property and trademarks; (iv) other provisions prescribed under regulations made for the purposes of this subparagraph. If the Commissioner considers that the company's accounting records significantly undervalue its assets or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate. The Accounting Standards AASB 138 at paragraph 54 states; No intangible asset arising from research (or from the research phase of an internal project) shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an expense when it is incurred. Taxation Determination TD 2009/5 at paragraph 4 states; Where the company's accounting records understate the value of the company's assets because they are required to do so (for example where accounting standards require the value of internally generated goodwill to be omitted), the understatement is not itself an attempt to circumvent the operation of Division 7A. Subject to the qualification which follows, the Commissioner will not exercise his power under subsection 109Y(2) whenever accounting standards require the total value of assets to be understated; to do so would defeat the compliance simplification objective of the provision. Paragraph 31 of TD 2009/5 states; 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 - Application to your circumstances: Company Y does not yet derive any income from its research activities and, as an incentive to management, the company has developed an ESS. The employees will enter into a loan agreement with Company Y, the loan will be secured by the company and the loan can only be utilised for the purpose of subscribing for shares in the company. Therefore, the proposed ESS is not an informal distribution of earnings. Company Y is in research phase, as set out in paragraph 54 of the Accounting Standards AASB 138, intangible assets arising from research are not recognised. Taxation Determination TD 2009/5 states that where a company understates the value of its assets because it is required to do so, the understatement is not in itself a deliberate attempt to circumvent the operation of Division 7A and the Commissioner will not exercise his power under subsection 109Y(2) of the ITAA 1936. Accordingly, the Commissioner will not exercise his discretion under subsection 109Y(2) of the ITAA 1936 to substitute the value of Company Y's assets in calculating the distributable surplus of Company Y for the relevant financial year.

Does Part IVA apply to this ruling?: Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable. | We have not considered the application of Part IVA to the arrangement you asked us to rule on.