Private ruling: Off-market share buy-back
Date of advice: 8 November 2016
Published: March 2017
Ruling period: Year ended 30 June XX | Commencement date of scheme: | Year ended 30 June XX

Ruling: Q1: Will the Buy-Back and the subsequent cancellation of shares be disregarded for the purposes listed in section 159GZZZN of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: Yes. | Q2: Will the Commissioner accept that the Dividend Component of the Buy-Back is a dividend paid by the company to the shareholder in accordance with subsection 159GZZZP(1) of the ITAA 1936? | A2: Yes. | Q3: Will the Dividend Component of the Buy-Back Price be a frankable distribution as defined in section 202-40 of the Income Tax Assessment Act 1997 ( ITAA 1997)? | A3: Yes. | Q4: Will the Commissioner make a determination under subsection 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole, or a part, of the Capital Component of the Buy-Back Price, or a further determination under subsection 45C(3) of the ITAA 1936 in respect of any part of the Capital Component of the Buy-Back Price? | A4: No. | Q5: Will the Commissioner make a determination under paragraph 204-30(3)(a) of the ITAA 1997? | A5: No. | Q6: Will the Commissioner make a determination under paragraph 177EA(5)(a) of the ITAA 1936? | A6: Yes.

Relevant facts and circumstances: The company announced its intention to return surplus funds to shareholders through an off-market buy-back of its own shares. The company's shareholder base was comprised of residents and foreign residents. The terms of the Buy-Back were approved by the company's Board. The Buy-Back formed part of the company's capital management strategy that aims to return capital that is surplus to its needs. The Dividend Component of the Buy-Back was sourced from operating profits. The Dividend Component of the Buy-Back was debited to the retained profits account and was 100% franked. The Capital Component of the Buy-Back was debited from the company's untainted share capital account. The Volume Weighted Average Price (VWAP) was calculated over a number of trading days to be $X. The Board of the company announced the outcome of the tender, prior to which no shareholder had certainty concerning the sale of their offered shares. The company announced that: ● it had successfully completed the Buy-Back of shares ● the final price for the Buy-Back was $Y per share (Buy-Back Price), representing a percentage discount to the VWAP of $X of the company's shares over the period up to and including the Closing Date of the Buy-Back ● shares tendered at a Tender Discount greater than or equal to the final percentage discount or as a Final Price Tender were bought back in full ● shares tendered at discounts less than or equal to the final percentage discount and tenders conditional upon a Minimum Price above the Buy-Back Price were not bought back, and ● to the extent that the number of shares tendered at and below the final Buy-Back Price exceeded the number of shares the company had determined it wished to buy back, individual shareholders with tenders at the final Buy-Back Price were scaled back on a pro-rata basis. The Buy-Back Price of $Y was less than the market value of a share. The Buy-Back Price of $Y was apportioned as follows: (a) An amount was debited against the company's share capital account (Capital Component); and (b) The balance of the Buy-Back Price was debited against an amount standing to the credit of the retained earnings account of the company (Dividend Component). An amount of the franking credit was attached to the Dividend Component of each share bought back. The Buy-Back Price (including the ratio of dividend to capital) was the same for each share, regardless of the identity or status of the shareholder. All shares accepted under the Buy-Back, were cancelled with proceeds sent to Participating Shareholders. For the purposes of this Ruling, shareholders who had their tender accepted are referred to as 'Participating Shareholders'. Other matters A percentage of non-resident shareholders were not able to participate in the tender process. The company has paid dividends to its shareholders out of operating profits over time and it intends to continue to pay dividends to its shareholders in the future. The cost base of the shares bought back was not substantially less than the value of the Capital Component of the Buy-Back Price.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 45B | Income Tax Assessment Act 1936 Section 45C | Income Tax Assessment Act 1936 Subsection 159GZZZK(a) | Income Tax Assessment Act 1936 Section 159GZZZN | Income Tax Assessment Act 1936 Subsection 159GZZZP | Income Tax Assessment Act 1936 Subsection 177D(2) | Income Tax Assessment Act 1936 Section 177EA | Income Tax Assessment Act 1936 Subsection 177EA(5)(a) | Income Tax Assessment Act 1997 Subdivision 202-C | Income Tax Assessment Act 1997 Subsection 202-40(1) | Income Tax Assessment Act 1997 Section 202-45 | Income Tax Assessment Act 1997 Subdivision 204-D | Income Tax Assessment Act 1997 Section 204-30

Reasons for decision: Summary: An essential aspect of the Buy-Back is the 'split' between the return of capital and dividend paid to the Participating Shareholders. Subsections 159GZZZP(1) and (2) of the ITAA 1936 relevantly provide that: (1) For the purposes of this Act, but subject to subsection (1A), where a buy-back of a share or non-share equity interest by a company is an off-market purchase, the difference between: (a) the purchase price; and (b) the part (if any) of the purchase price in respect of the buy-back of the share or non-share equity interest which is debited against amounts standing to the credit of: (i) the company's share capital account if it is a share that is bought back; or (ii) the company's share capital account or non-share capital account if it is a non-share equity interest that is bought back; is taken to be a dividend paid by the company: (c) to the seller as a shareholder in the company; and (d) out of profits derived by the company; and (e) on the day the buy-back occurs. (1A) If the dividend is included to any extent in the seller's assessable income of any year of income, it is not taken into account to that extent under section 188-20 of the Income Tax Assessment Act 1997 . (2) The remainder of the purchase price is taken not to be a dividend for the purposes of this Act. According to Law Administration Practice Statement PS LA 2007/9 - Share buy-backs (PSLA 2007/9) at paragraph 12, the ACPS method is the preferred methodology for determining the 'Dividend/Capital split' in an off-market share buy-back unless companies can demonstrate exceptional circumstances for the use of an alternative method (paragraph 69 of PSLA 2007/9). The ACPS is worked out by dividing a company's ordinary issued capital by the number of shares on issue (paragraph 62 of PSLA 2007/9). The Commissioner accepts that the ACPS methodology used by the company is the appropriate method for determining the 'dividend/capital split' of the Buy-Back price. As a result, for the purposes of section 159GZZZP, an amount will represent the Capital Component of the Buy-Back Price and the balance of the Buy-Back Price will be the Dividend Component for each share bought back. | Detailed Reasoning - Question 3: Subsection 202-40(1) of the ITAA 1997 provides that: A distribution is a frankable distribution , to the extent that it is not unfrankable under section 202-45. The term 'distribution' is defined in section 960-120 of the ITAA 1997. Pursuant to item 1 of the table in subsection 960-120(1) of the ITAA 1997, it includes a dividend or something that is taken to be a dividend. As discussed above in Question (2), section 159GZZZP of the ITAA 1936 will apply to the Buy-Back. Accordingly, the difference between the Buy-Back Price of $Y and the Capital Component to be debited to the company's share capital will be taken to be a dividend paid by the company (the Dividend Component) to the Participating Shareholders out of the profits derived by the company on the day the Buy-Back occurs. Therefore, the Dividend Component of the Buy-Back Price will be a 'distribution' within the meaning given by section 960-120 of the ITAA 1997. Section 202-45 of the ITAA 1997 provides a list of unfrankable distributions. Paragraph 202-45(c) of the ITAA 1997 provides that: (c) where the purchase price on the buy-back of a share by a company from one of its members is taken to be a dividend under section 159GZZZP of that Act - so much of that purchase price as exceeds what would be the market value (as normally understood) of the share at the time of the buy-back if the buy-back did not take place and were never proposed to take place; In the present case, as the Buy-Back Price did not exceed the market value of each share for the purposes of section 159GZZZP, there was no amount which could be treated as an unfrankable distribution under paragraph 202-45(c). Therefore, the Dividend Component is a frankable distribution under subsection 202-40(1) of the ITAA 1997. | Detailed Reasoning - Question 4: Pursuant to subsection 45B(2) of the ITAA 1936, section 45B of the ITAA 1936 applies when: (a) there is a scheme under which a person is provided with … a capital benefit by a company; and (b) 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; and (c) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer (the relevant taxpayer ) to obtain a tax benefit. For section 45B of the ITAA 1936 to apply, each of the requirements set out in paragraphs (a) to (c) of subsection 45B(2) of the ITAA 1936 must be present. The Buy-Back constitutes a 'scheme' within the meaning given by subsection 995-1(1) of the ITAA 1997. As identified previously, Participating Shareholders will be 'provided with a capital benefit' under the Buy-Back as share capital will be distributed to Participating Shareholders under the Buy-Back (paragraph 45B(5)(b)). As a result, paragraph 45B(2)(a) is satisfied in respect of the Buy-Back. Broadly, a Participating Shareholder 'obtains a tax benefit' under the Buy-Back if the amount of tax payable by a Participating Shareholder in respect of the Buy-Back would be less than the amount of tax that would have been payable had the Capital Component of the Buy-Back Price instead been an assessable dividend (subsection 45B(9)). The determination of whether a Participating Shareholder would obtain a tax benefit under the Buy-Back depends on each Participating Shareholder's particular circumstances, and would need to be considered on a case by case basis. The company's shares are held by a wide variety of shareholders. As a result, it is possible that certain Participating Shareholders may obtain a tax benefit under the Buy-Back and paragraph 45B(2)(b) may be satisfied. Paragraph 45B(2)(c) provides that it is necessary to have regard to the 'relevant circumstances' of the Buy-Back to determine whether the company or a Participating Shareholder entered into or carried out the Buy-Back for a more than incidental purpose of enabling a Participating Shareholder to obtain a tax benefit. The relevant circumstances to be considered are listed in subsection 45B(8) and include any of the matters listed in subsection 177D(2) of the ITAA 1936. Having regard to the relevant circumstances of the Buy-Back, it is considered that neither the company nor a Participating Shareholder entered into or carried out the Buy-Back for a more than incidental purpose of enabling a Participating Shareholder to obtain a tax benefit, in particular: ● the Dividend and Capital Components of the Buy-Back Price as determined by use of the ACPS method in PS LA 2007/9 are acceptable in the company's circumstances; ● there is no evidence indicating that the Capital Component is attributable to the profits of the company; ● the Capital Component will not be sourced from the company's retained earnings; ● the company's dividend history and policy indicates that the Buy-Back or the Capital Component of the Buy-Back Price is not a substitute for ordinary dividends; ● the dividend policy of the company will not be affected by the Buy-Back; ● the company is unaware of the tax profiles of each Participating Shareholder; ● the Buy-Back involves the buy-back and cancellation of the entire shares to be bought back and is not merely a distribution of capital with the effect of a proportionate reduction in the cost base of the Participating Shareholder's cost base; and ● the company will be dealing with the Participating Shareholders on an arm's length basis in the Buy-Back. The form and substance of the Buy-Back is consistent with an off-market share buy-back. Therefore, paragraph 45B(2)(c) is not satisfied in respect of the Buy-Back. Accordingly, the Commissioner will not make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C applies to the whole, or a part, of the capital benefit provided under the Buy-Back. Also, the Commissioner will not make a further determination under subsection 45C(3) in respect of any part of the capital benefit provided under the Buy-Back. | Detailed Reasoning - Question 5: Section 204-30 gives the Commissioner the power to make a determination when distributions and other benefits are streamed. Subsection 204-30(1) of the ITAA 1997 states: (1) This section empowers the Commissioner to make determinations if an entity streams one or more *distributions (or one or more distributions and the giving of other benefits), whether in a single *franking period or in a number of franking periods, in such a way that: (a) an *imputation benefit is, or apart from this section would be, received by a *member of the entity as a result of the distribution or distributions; and (b) the member would *derive a *greater benefit from franking credits than another member of the entity; and (c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits. The member that derives the greater benefit from franking credits is the favoured member . The member that receives the lesser imputation benefits is the disadvantaged member . If section 204-30 of the ITAA 1997 applies, the Commissioner may make a determination in writing: (a) that a specified franking debit arises in the franking account of the entity for a specified distribution or other benefit to a disadvantaged member (paragraph 204-30(3)(a) of the ITAA 1936); (b) that a specified exempting debit arises in the exempting account of the entity, for a specified *distribution or other benefit to a disadvantaged member (paragraph 204-30(3)(b) of the ITAA 1936); (c) that no imputation benefit is to arise in respect of a distribution that is made to a favoured member and specified in the determination (paragraph 204-30(3)(c) of the ITAA 1936). For section 204-30 of the ITAA 1997 to apply, shareholders who participate in the Buy-Back to whom distributions are streamed must derive a greater benefit from imputation benefits than the shareholders who do not participate in the Buy-Back. Subsection 204-30(8) of the ITAA 1997 provides that A *member of an entity *derives a greater benefit from franking credits than another member of the entity if any of the following circumstances exist in relation to the other member in the income year in which the distribution giving rise to the benefit is made, and not in relation to the first member: (a) the other members is a foreign resident; (b) the other members would not be entitled to any *tax offset under Division 207 because of the distribution; (c) the amount of the income tax that, apart from this Division, would be payable by the other members because of the distribution is less than the tax offset to which the other member would be entitled; (d) the other member is a *corporate tax entity at the time the distribution is made, but no *franking credit arises for the entity as a result of the distribution; (e) the other member is a *corporate tax entity at the time the distribution is made, but cannot use *franking credits received on the distribution to *frank distributions to its own members because: (i) it is not a *franking entity; or (ii) it is unable to make *frankable distributions; (f) the other member is an *exempting entity. A key driver for an off-market share buy-back arrangement is the substantial discount to the market value of the shares to be bought back (which enables a company to buy-back shares in itself for a lesser amount than on-market). Prima facie, from the perspective of shareholders, selling shares through a buy-back at a discount to the market value would not be attractive when shareholders could otherwise sell more profitably in cash terms on-market. However, a shareholder may be inclined to participate if the combined lower cash consideration and provision of imputation benefits gives a better outcome than the higher cash consideration from an on-market sale. Foreign resident shareholders however do not benefit from franking credits. The company has a diverse range of shareholders, including a percentage of which are foreign residents. Most of the foreign resident shareholders were not be able to participate in the Buy-Back. Given the structural franking credit streaming incentive afforded by the Buy-Back for Australian resident shareholders, the Commissioner is of the view that an Australian resident shareholder would derive a greater benefit from franking credits than would foreign residents who hold membership interests (paragraph 204-30(8)(a) of the ITAA 1997). The Commissioner is therefore empowered to make a determination (paragraph 204-30(1)(b) of the ITAA 1997). Although, section 204-30 of the ITAA 1997 applies to the company in relation to the Buy-Back, the Commissioner will not make a determination pursuant to subsection 204-30(3)(a) of the ITAA 1997 noting that the Commissioner will make a determination under paragraph 177EA(5)(a) of the ITAA 1936 (see Question 6 below). | Detailed Reasoning - Question 6: The taxation consequences of a share buy-back are primarily contained in Division 16K of Part III of the ITAA 1936. In an off-market share buy-back the purchase price paid to a shareholder who participates in the Buy-Back is generally divided into a dividend component and a capital component. Subsection 159GZZZP(1) of the ITAA 1936 provides that the difference between the purchase price and the part of the purchase price which is debited against amounts standing to the credit of the company's share capital account is taken to be a dividend paid out of profits by the company to the seller on the day the Buy-Back occurs. The dividend component is a frankable distribution — subject to various integrity rules including section 177EA of the ITAA 1936. Section 177EA is directed at schemes involving franking credit trading and dividend streaming. The section applies if a scheme involving a disposition of shares is entered into with a purpose of enabling the taxpayer to obtain franking credit benefits. In these circumstances, it enables the Commissioner to deny the franking credit benefits arising from the scheme or, if the company is a party to the scheme, to post a debit to the company's franking account. Section 177EA applies if subsection 177EA(3) is satisfied. That is: (a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and (b) either: (i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or (ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and (c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and (d) except for this section, the person (the 'relevant taxpayer') would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and (e) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit. Where the provision applies, the Commissioner may make a determination that a debit arises in the franking account of the corporate tax entity which made the distribution pursuant to paragraph 177EA(5)(a). Alternatively, the Commissioner may make a determination that no imputation benefit arises for the relevant (recipient) taxpayer pursuant to paragraph 177EA(5)(b). In arriving at a conclusion that section 177EA applies to the dividend component of a buy-back, the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17). As the threshold requirements of section 177EA have been met, it is necessary to consider the 'relevant circumstances' of the scheme in determining whether it could be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit. The 'imputation benefit' is defined in subsection 177EA(16) to be simply the availability of a tax offset pursuant to Division 207 of the ITAA 1997. It is not in dispute that shareholders who have their shares bought back under the Buy-Back receive an 'imputation benefit'. It is considered, then, that the application of section 177EA in this case will turn on the conclusion in respect of purpose under paragraph 177EA(3)(e). In this regard, it should be noted that the High Court decision in Mills v Commissioner of Taxation (2012) 250 CLR 171 has clarified some aspects of the basis for ascertaining purpose under section 177EA: ● The relevant circumstances referred to in subsection 177EA(17) are only relevant to the extent that they are probative of the ultimate question as to purpose. ● The relevant circumstances referred to in subsection 177EA(17) are mandatory considerations but are not exhaustive of the circumstances that might be probative of the ultimate question. ● A purpose will be incidental if it does no more than further or follow as a consequence of some other purpose. ● A purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose. ● Purpose is a matter for inference, incidentally is a matter of degree, and counterfactual analysis may be relevant to the ascertainment of both franking purpose and whether that purpose is or is not incidental to some other purpose. These relevant circumstances encompass a range of matters which taken individually or collectively will reveal whether or not the requisite purpose exists. Due to the diverse nature of these circumstances, some may not be present at any one time in any one scheme. In all cases however, the terms of the disposition and the relevant circumstances must be considered to determine whether they tend towards or against, or are neutral, as to the conclusion of a purpose of enabling the relevant taxpayer to obtain an imputation benefit. The requisite purpose is further clarified when read in conjunction with the objective of section 177EA which was explained in paragraph 8.124 of the Explanatory Memorandum (EM) to the Taxation Laws Amendment Bill (No 3) 1998 as follows: One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them undermines this principle. Similarly, dividend streaming (i.e. the streaming of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings. Therefore, in determining whether or not the requisite purpose is present, the relevant circumstances will reveal whether the scheme seeks to undermine the principles of the dividend imputation system by franking credit trading or streaming franking credits to select shareholders as envisaged in the preceding extract of the EM or some other abuse of the imputation system. In the context of this selective off-market share Buy-Back where the franked distribution is selectively directed to a single class of, relevant taxpayers, the Commissioner considers that paragraphs 177EA(17)(b), (c) and (f) are relevant. These are the factors which are most probative of the ultimate question as to purpose in that factual context, particularly paragraph 177EA(17)(f). The Commissioner considers that each of these paragraphs supports a conclusion that the requisite purpose is present - or will be present - in the circumstances of the Buy-Back. Further support for a conclusion as to requisite purpose is found in paragraph 177EA(17)(j). On balance, and having regard to the relevant circumstances of subsection 177EA(17), the Commissioner considers that the purpose of enabling a Participating Shareholder in the Buy-Back, the relevant taxpayer, to obtain an imputation benefit is more than incidental, rather than merely an incident of the Buy-Back. Accordingly, the Commissioner will make a determination under paragraph 177EA(5)(a) of the ITAA 1936 to debit the company's franking account, to compensate for the revenue avoided, wasted or streamed franked dividends in respect of the dividend component of the Buy-Back. The amount of the franking debit to be made is calculated as follows: Number of shares x Franking credit x Non-residents (treaty) x 0.5* Bought back attaching to each * Non-residents in treaty nations have their 15 % Dividend Withholding Tax liability satisfied by a fully-franked dividend. Where non-resident shareholders in treaty nations do not participate in off-market share buy-backs, their level of avoided wastage of franking credits is therefore one-half (30% franking/15% DWT).

Question 1: Under section 159GZZZN of the ITAA 1936, if a company buys back a share then the buy-back, and any subsequent cancellation of the share, are disregarded for the purposes of: | (a) determining for the purposes of ITAA 1936 or the ITAA 1997: | (i) whether an amount is included in the assessable income of the company under a provision of the ITAA 1936 or the ITAA 1997 (other than a provision of Part 3-1 or 3-3 of the ITAA 1997 (about CGT); or | (ii) whether an amount is allowable as a deduction to the company; or | (b) determining whether the company makes a capital gain or capital loss. | As provided in paragraph 159GZZZK(a) of the ITAA 1936, a company that buys a share in itself from a shareholder in the company will undertake a buy-back for the purposes of section 159GZZZN. As the Buy-Back meets this definition, the Buy-Back and subsequent cancellation of the company's shares will be disregarded for the purposes of determining whether: | (a) an amount is included in the assessable income of the company under a provision of the ITAA 1936 or the ITAA 1997 (other than a provision of Part 3-1 or 3-3 of the ITAA 1997 (about CGT); | (b) an amount is allowable as a deduction to the company under the ITAA 1936 or the ITAA 1997; and | (c) the company makes a capital gain or capital loss under Part 3-1 or 3-3 of the ITAA 1997.