Private ruling: Return of capital
Published: April 2014
Ruling period: Income year ended 30 June 2014 | Income year ended 30 June 2015
Date scheme commenced: 30 June 2014

Ruling: Q1: Will Capital Gains Tax (CGT) event G1 under section 104-135 of the Income Tax Assessment Act 1997 (ITAA 1997) happen when Company Z makes a payment to its shareholders under the proposed share capital reduction? | A1: Yes | Q2: Will the proposed return of capital be a dividend as defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A2: No | Q3: 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 the capital benefits to be a dividend and hence assessable for income tax purposes? | A3: No | Q4: 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 the capital benefits to be a dividend and hence assessable for income tax purposes? | A4: No | Q5: Will the Commissioner make a determination under section 177F of the ITAA 1936 that Part IVA of the ITAA 1936 applies to the proposed return of capital? | A5: No | Q6: Will Division 7A of the ITAA 1936 apply to deem any part of the payment under the proposed return of capital to be a dividend under section 109C of the ITAA 1936? | A6: No | Q7: To the extent that a capital gain arises to shareholders from CGT event G1, will it be a 'discount capital gain' under Division 115 of the ITAA 1997? | A7: Yes

Relevant facts and circumstances: Company Z is a privately owned company. The Company's share capital account comprises of only ordinary shares. All of the Company Z shareholders are Australian residents. The directors of Company Z have determined that the share capital is surplus to its requirements. Company Z has paid significant dividends in the past 5 years. Under the specified scheme, the company proposes a capital return of an amount in aggregate by way of an equal share reduction under section 256B of the Corporations Act 2001 . There will be no cancellation of shares. The proposed return of capital will be made to all shareholders equally and on the same terms and will result in a payment in respect of each ordinary share. The whole of the payment will be debited to an amount standing to the credit of the share capital account of Company Z; no part of the payment will be debited to an account recording Company Z's retained earnings or profits. Company Z's share capital account, or equivalent account, is not tainted within the meaning of Division 197 of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 6(1) | Income Tax Assessment Act 1936 Division 7A | Income Tax Assessment Act 1936 section 44 | 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 47 | Income Tax Assessment Act 1936 section 109C | Income Tax Assessment Act 1936 section 109L | Income Tax Assessment Act 1936 section 177A | Income Tax Assessment Act 1936 section 177D | Income Tax Assessment Act 1936 section 177F | Income Tax Assessment Act 1936 section 318 | Income Tax Assessment Act 1997 section 104-135 | Income Tax Assessment Act 1997 Division 115 | Income Tax Assessment Act 1997 section 115-5 | Income Tax Assessment Act 1997 section 115-10 | Income Tax Assessment Act 1997 section 115-15 | Income Tax Assessment Act 1997 section 115-20 | Income Tax Assessment Act 1997 section 115-25 | Income Tax Assessment Act 1997 Division 197-50 | Income Tax Assessment Act 1997 section 975-300

Reasons for decision: Summary: Capital Gains Tax (CGT) event G1 under section 104-135 of the ITAA 1997 will happen when Company Z makes a payment to its shareholders under the proposed share capital reduction. | Detailed Reasoning - Detailed reasoning: Section 104-135 of the ITAA 1997 contains the rules dealing with CGT event G1. CGT event G1 happens if: a. a company makes a payment to a taxpayer in respect of a share the taxpayer owns in the company; and b. some or all of the payment is not a dividend, or an amount that is a distribution by a liquidator which is taken to be a dividend under section 47 of the ITAA 1936; and c. the payment is not included in the taxpayer's assessable income. CGT event G1 will happen when Company Z pays a return of capital to a Company Z shareholder in respect of a share they own in Company Z at the Record Date and continue to own at the time of that payment (section 104-135 of the ITAA 1997). The payment does not occur as a result of a disposal or cancellation of shares, nor will the payment be a dividend or deemed dividend under section 47 of the ITAA 1936. If the return of capital is equal to or less than the cost base of the Company Z share at the time of the payment, the cost base and reduced cost base of the share will be reduced (but not below nil) by the amount of the payment (subsection 104-135(4) of the ITAA 1997). If a Company Z shareholder makes a capital gain when CGT event G1 happens, the cost base and reduced cost base of the Company Z share is reduced to nil. A Company Z shareholder cannot make a capital loss when CGT event G1 happens (subsection 104-135(3) of the ITAA 1997). | Summary: The proposed return of capital will not be a dividend as defined in subsection 6(1) of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined in subsection 6(1) of the ITAA 1936, paid to the shareholders out of profits derived by the company from any source (if the shareholder is a resident of Australia) and from an Australian source (if the shareholder is a non-resident of Australia). The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders. However, paragraph (d) specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution 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 limited 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 applies is transferred to the account and the account is not already tainted. The proposed return of capital will be debited entirely against an amount standing to the credit of Company Z's share capital account. Company Z has confirmed no amount has been transferred to the share capital account from another account. As the share capital account of Company Z is not tainted within the meaning of Division 197 of the ITAA 1997, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 will apply. Accordingly, the proposed return of capital will not be a dividend as defined in subsection 6(1). | Summary: The Commissioner will not 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 the capital benefits to be a dividend and hence assessable for income tax purposes. | 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 receipt of capital than other shareholders (the Disadvantaged Shareholders) and these Disadvantaged Shareholders receive, or are likely to receive, dividends. A reference to the 'provision of a capital benefit to a shareholder in a company' is defined in paragraph 45A(3)(b) of the ITAA 1936 to include the distribution to the shareholder of share capital. Company Z will provide its shareholders with a 'capital benefit' as defined in paragraph 45A(3)(b). The capital benefit will be provided to all shareholders and in direct proportion to the number of shares held. No shareholders are advantaged over other shareholders. Therefore, section 45A of the ITAA 1936 will not apply to the proposed return of capital. Accordingly, the Commissioner will not make a determination under subsection 45A(2) that section 45C of the ITAA 1936 applies in relation to the whole, or a part, of the proposed return of capital. | 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 the proposed return of capital, deeming the capital benefits to be a dividend and hence assessable for income tax purposes. | Detailed Reasoning - Detailed reasoning: Section 45B of the ITAA 1936 applies where certain capital payments, including a return of capital, are paid to shareholders in substitution for dividends. It allows the Commissioner to make a determination that section 45C of the ITAA 1936 applies to a capital benefit. Specifically, the provision applies where: • there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a)); • 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)); and • having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, entered into the scheme or carried out the scheme or any part of the scheme for a purpose, other than an incidental purpose, of enabling the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(c)). Each of these conditions is considered below. | Detailed Reasoning - Scheme: A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided in subsection 177A(1) of Part IVA of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise undertaking, scheme, plan or proposal. Company Z's proposed return of capital would be captured within this broad definition. The phrase 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936. It states that a person is provided with a capital benefit if: • an ownership interest in a company is issued to the person; • there is a distribution to the person of share capital; or • the company does something in relation to an ownership interest that has the effect of increasing the value of the ownership interest (which may or may not be the same interest) held by that person. As the proposed return of capital will be debited to Company Z's share capital account, Company Z will provide shareholders with a capital benefit under paragraph 45B(5)(b) of the ITAA 1936 in the form of distributions of share capital. | Detailed Reasoning - Tax benefit: A relevant taxpayer 'obtains a tax benefit' as defined in subsection 45B(9) of the ITAA 1936 if: • the amount of tax payable; or • any other amount payable under the ITAA 1936 or the ITAA 1997, would, apart from the operation of section 45B, be less than the amount that: • would have been payable; or • be payable at a later time than it would have been payable, if the capital benefit had instead been a dividend. Ordinarily, a return of capital would be subject to the CGT provisions of 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. By contrast, a dividend would generally be included in the assessable income of a resident shareholder. Therefore, Company Z shareholders will obtain a tax benefit from the proposed return of capital. | Detailed Reasoning - Relevant circumstances: Paragraph 45B(2)(c) of the ITAA 1936 requires the Commissioner to consider the 'relevant circumstances' of the scheme as set out in subsection 45B(8) of the ITAA 1936. A consideration of these circumstances determines whether any part of the scheme will be entered into for a purpose, other than an incidental purpose, of enabling the relevant taxpayer (an ordinary shareholder in Company Z) to obtain a tax benefit. Each of the circumstances must be considered in order to determine whether or not, individually or collectively, they reveal the existence of the requisite purpose. The test of purpose is an objective one. The question is whether it would be concluded that a person who enters into or carries out the scheme does so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit. 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 of the company and the tax profile of the shareholders. In this instance, because the proposed return of capital will be made to all Company Z shareholders, regardless of individual circumstances, paragraphs 45B(8)(c) to 45B(8)(h) of the ITAA 1936 do not incline for or against the requisite purpose. The circumstances covered by paragraphs 45B(8)(i) and 45B(8)(j) of the ITAA 1936, pertaining to the provision of ownership interests and demerger respectively are not relevant. The relevant matters are those covered by the circumstances described in paragraphs 45B(8)(a), 45B(8)(b) and 45B(8)(k) of the ITAA 1936, which are considered in detail below. Paragraph 45B(8)(a) of the ITAA 1936- Appropriate capital and profit allocation 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 the company or an associate (within the meaning of section 318 of the ITAA 1936) of the company. Paragraph 1.35 of the Explanatory Memorandum to Taxation Laws Amendment (Company Law Review) Bill 1998 provides the following guidance on the expected operation of this test: if a company makes a profit from a transaction, for example the disposal of business assets, and then returns capital to shareholders equal to the amount of the profit, that would suggest that the distribution of capital is a substituted dividend. On the other hand, if a company disposed of a substantial part of its business at a profit and distributed an amount of share capital which could reasonably be regarded as the share capital invested in that part of the business, the distribution of capital would not be seen as a substituted dividend because no amount would be attributable to profits. In this case, the directors of Company Z have determined that a share capital amount is surplus to its requirements as its operations can now be funded by recurrent business income. Therefore, the company proposes to return the amount of share capital by way of an equal distribution to Company Z shareholders. No part of the proposed capital return is attributable to profits, realised or unrealised of Company Z. Also, Company Z proposes to continue its policy of annual dividend payments as a means of distributing profits to shareholders. Therefore, this factor does not incline towards the requisite purpose. Paragraph 45B(8)(b) of the ITAA 1936- Pattern of distributions Paragraph 45B(8)(b) of the ITAA 1936 directs attention to the pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or an associate (within the meaning in section 318 of the ITAA 1936) of the company. The inference here is that an interruption to the normal pattern of profit distribution and its replacement with a capital return would suggest dividend substitution. Company Z has a history of paying substantially all of its annual profits to ordinary shareholders. In the Commissioner's view, the proposed return of capital is not an interruption to the normal profit distribution pattern, but rather a mechanism to return accumulated capital to shareholders which is considered excess to requirements. This factor does not incline towards the requisite purpose. Paragraph 45B(8)(k) of the ITAA 1936- Part IVA matters This circumstance requires regard to be had to any of the matters referred to in paragraphs 177D(2)(a) to 177D(2)(h) of the ITAA 1936. The incorporation of the Part IVA factors into section 45B of the ITAA 1936 does not introduce a different (dominant) purpose test into section 45B. The matters are applied in the context of the 'more than incidental purpose test' in section 45B. The eight matters in subsection 177D(2) of the ITAA 1936 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 persons involved. Company Z has demonstrated that the scheme, being a proposed return of capital to its shareholders, seeks to legitimately return an amount of excess share capital. The return will release capital which Company Z has stated is excess to its current needs. In this case, the practical implications of the scheme are consistent with it being, in form and substance, a return of capital. Accordingly, the Commissioner will not 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. | Summary: The Commissioner will not make a determination under section 177F of the ITAA 1936 that Part IVA of the ITAA 1936 applies to the proposed return of capital. | Detailed Reasoning - Detailed reasoning: The Commissioner has the discretion to cancel all or part of a 'tax benefit' that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies. Before the Commissioner can exercise the discretion in subsection 177F(1) of the ITAA 1936, the requirements of Part IVA must be satisfied. These requirements are that: a) a 'tax benefit', as identified in section 177C or 177CA, was or would, but for section of the ITAA 1936, have been obtained; a) the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A of the ITAA 1936; and b) having regard to section 177D of the ITAA 1936, the scheme is one to which Part IVA applies. In this case, all shareholders will participate in the proposed return of capital. Company Z has demonstrated that the scheme seeks to legitimately return an amount of excess share capital. The return will release capital which Company Z has stated is excess to its current needs. Having regard to the manner and the facts of this arrangement, Part IVA will not apply as it cannot be concluded that Company Z entered into the scheme for the dominant purpose of enabling Company Z shareholders to obtain a tax benefit as defined in section 177C of the ITAA 1936. Therefore, the Commissioner will not make a determination under subsection 177F(1) of the ITAA 1936 in relation to the proposed return of capital as it does not constitute a scheme to which Part IVA applies. | Summary: Division 7A of the ITAA 1936 will not apply to deem any part of the payment under the proposed return of capital to be a dividend under section 109C of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: Subsection 109L(2) of the ITAA 1936 provides, relevantly, that a private company is not taken under section 109C to pay a dividend because of a payment the private company makes to an entity, to the extent that a provision of the ITAA 1936 has the effect that the payment would not be included in the entity's assessable income even though it would otherwise be included. Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined in subsection 6(1) of the ITAA 1936, paid to the shareholders out of profits derived by the company from any source (if the shareholder is a resident of Australia) and from an Australian source (if the shareholder is a non-resident of Australia). The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders. However, paragraph (d) specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the company. As the proposed return of capital is excluded from being assessable as a dividend due to the operation of subsection 6(1) of the ITAA 1936, it is also not assessable under Division 7A of the ITAA 1936 due to the operation of subsection 109L(2) of the ITAA 1936. | Summary: To the extent that a capital gain arises to shareholders from CGT event G1, it will be a 'discount capital gain' under Division 115 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Section 115-5 of the ITAA 1997 applies to a Company Z shareholder that is an individual, the trustee of a trust or a complying superannuation fund that makes a capital gain on the receipt of the payment that effects the pro-rata return of capital where that shareholder acquired their Company Z shares at least 12 months before the date of the payment. Section 115-5 of the ITAA 1997 sets out the conditions which must be satisfied in order for a capital gain to be a discount capital gain. In circumstances where a capital gain is a discount capital gain, Division 115 of the ITAA 1997 effectively provides that an individual or a trustee of a trust is only required to include 50% of the capital gain in the calculation of its net capital gain or loss for an income year. Further, Division 115 of the ITAA 1997 effectively provides that a complying superannuation fund is only required to include two-thirds of a discount capital gain in its calculation of its net capital gain or loss for an income year. In order for a capital gain to qualify as a discount capital gain the following requirements must be satisfied: a) The capital gain can only be made by individuals, trusts or complying superannuation funds (and life insurance companies in respect of particular assets) (section 115-10 of the ITAA 1997 ). Company Z has a range of shareholders and these shareholders are likely to include the type specified for these purposes. The question asked in this ruling application is only relevant to shareholders that satisfy this requirement. b) The capital gain can only be made as a result of a CGT event happening after 21 September1999 (section 115-15 of the ITAA 1997 ). The proposed return of capital will give rise to CGT Event G1 pursuant to subsection 104-135(1) of the ITAA 1997. c) The capital gain must not have been worked out using an indexed cost base (section 115-20 of the ITAA 1997). d) For these purposes, any resulting capital gain under CGT Event G1 must be calculated without regard to indexation. e) The CGT asset to which the CGT event relates must have been acquired at least 12 months before (section 115-25 of the ITAA 1997). f) This requirement may or may not be satisfied depending on the circumstances surrounding the shareholders who hold shares in Company Z. The question asked in this ruling application is only relevant to shareholders that satisfy this requirement. g) The capital gain did not arise from a CGT Event which is excluded under subsection 115-25(3) of the ITAA 1997. CGT Event G1 is not among the list of CGT events from which capital gains are excluded from being discount capital gains under subsection115-25(3) of the ITAA 1997. Accordingly, to the extent that a Company Z shareholder is an individual, a trustee of a trust or a complying superannuation fund and acquired their shares in Company Z at least 12 months before the date of the proposed return of capital, if that shareholder makes a capital gain under CGT Event G1, the capital gain will be a discount capital gain for the purposes of 115-5 of the ITAA 1997.