Private ruling: Share capital reduction
Date of advice: 17 February 2016
Published: April 2016
Ruling period: 1 July 2015 to 30 June 2016

Ruling: Q1: Will the proposed distribution constitute a dividend as defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: No | Q2: Will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole, or a part, of the capital benefit under the return of capital? | A2: No | Q3: Will Capital Gains Tax event G1 under section 104-35 of the Income Tax Assessment Act 1997 (ITAA 1997) happen to the shares upon the return of capital? | A3: Yes

Relevant facts and circumstances: In 200X, Company B acquired the assets of a company known as Company C. Company C consisted of primarily two divisions (Retail and Commercial). Each division contributed to the profitability of the business in approximately equal shares. Following completion of the asset purchase, Company B renamed itself Company C. At the time of the acquisition in 200X, the business operated two manufacturing facilities. In 20XX Company C accepted an offer from another entity to acquire the assets of the retail business of Company C, including the company brand name. The remaining business was renamed Company A. Company A is an Australian resident private company. Company A is proposing a return of capital to its shareholders. The proposed return of capital represents surplus capital to Company A. The proposed return of capital represents a X% reduction in the share capital account. The retained commercial division represents approximately X% of the retained asset base in Company A. Company A does not have a formal dividend policy. However, during the year ended 30 June 20XX, Company A paid dividends fully franked at X%. In addition, since the end of the reporting period, a further dividend has been paid on 1 July 20XX fully franked at X%. Upon acquisition, Company A had a senior debt facility. Throughout the period until the retail division was sold, Company A paid down that facility to its current level of $XXX. Following the sale, Company A has renegotiated an increase in its senior debt facility. Company A envisages that these funds will be used as working capital. The increase in the senior debt facility means that Company A has capital surplus to its requirements. The directors as part of the investment and funding strategy prefer to have a mix of senior debt and equity. Following the sale of the retail business the directors considered the relative mix of debt and equity to be below that of the preferred range set under the investment and funding strategy. The current shareholders of Company A are all resident Australian entities.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 6(1) | Paragraph 6(1)(a) | Paragraph 6(1)(d) | Subsection 6(4) | Subsection 44(1) | Section 45B | Section 45C | Part IVA | Subsection 177D(2) | Paragraphs 177D(2)(a) - (h) | Income Tax Assessment Act 1997 Section 104-135 | Section 975-300 | Subsection 995-1(1) | Corporations Act 2001 Part 2J.1 | Section 256B

Reasons for decision: 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 Income Tax Assessment Act 1997 (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 of the ITAA 1997 applies is transferred to the account and the account is not already tainted. Subsection 6(4) of the ITAA 1936 provides that the exclusion in paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITA 1936 will not apply where, 'under an arrangement': a) a person pays or credits any money or gives property to the company and the company credits its share capital account with the amount of the money or the value of the property; and b) the company pays or credits any money, or distributes property to another person, and debits its share capital account with the amount of the money or the value of property so paid, credited or distributed. The proposed return of capital will be debited against Company A's share capital account and there is no arrangement to pay or credit any amounts to the share capital account in relation to the proposed share capital reduction. According to the facts the proposed return of capital will be sourced from cash reserves of Company A. Therefore the proposed return of capital will not be a dividend as defined in subsection 6(1) of the ITAA 1936. | 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 scheme to be a dividend and hence assessable for income tax purposes. | Detailed Reasoning - Detailed reasoning: Section 45B Section 45B of the ITAA 1936 applies where certain capital payments 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. The effect of such a determination is that all or part of the distribution of capital received by the shareholder under the return of capital is treated as an unfranked dividend. Section 45B of the ITAA 1936 applies where certain capital payments are paid to shareholders in substitution for dividends. In broad terms, section 45B applies where: • there is a 'scheme' under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a) of the ITAA 1936), • under the scheme a person (the relevant taxpayer), who may or may not be the person provided with the capital benefit, obtains a tax benefit (paragraph 45B(2)(b) of the ITAA 1936), and • having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, entered into or carried out the scheme or any part of the scheme for a purpose (other than an incidental purpose) of enabling a taxpayer to obtain a tax benefit (paragraph 45B(2)(c) of the ITAA 1936). For the purposes of paragraph 45B(2)(c), the Commissioner is required to consider the 'relevant circumstances' set out in subsection 45B(8) to determine whether any part of the scheme would be entered into for a purpose, other than an incidental purpose, of enabling a relevant taxpayer to obtain a tax benefit. However, the list of relevant circumstances in subsection 45B(8) is not exhaustive and regard may be had to other circumstances on the basis of their relevance. The test of purpose is an objective one. The question is whether it would be concluded that a person who entered into or carried out the scheme did so for the purpose of obtaining a tax benefit for the relevant taxpayer in respect of the capital benefit. The requisite purpose does not have to be the most influential or prevailing purpose but it must be more than an incidental purpose. The purpose which causes section 45B to apply may be the purpose of any party to the scheme. What is the scheme? A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided in subsection 995-1(1) of the ITAA 1997. That definition is widely drawn and includes any arrangement, scheme, plan, proposal, action, course of action or course of conduct whether unilateral or otherwise. In the present circumstances it is appropriate that the scheme for the purposes of section 45B be widely cast. A key incident of any scheme will, of course, be the distributions or 'things done' which constitute the provision of a capital benefit. Equally however, those events or circumstances under which tax benefits are provided, including the main purpose for the provision of those benefits, are also key incidents of the scheme to which section 45B has regard. As such, the present 'scheme' is properly to be regarded as encompassing the proposed distribution by Company A its shareholders, to be divided proportionally to their respective shareholdings. What is the capital benefit? The phrase 'provided with a capital benefit' is defined in subsection 45B(5). Relevantly, it includes the provision of ownership interests in a company to a person, and the distribution to a person of share capital (paragraphs 45B(5)(a) and (b)) of the ITAA 1936). The term capital benefit is defined in subsection 45B(5) of the ITAA 1936. That subsection provides as follows: "A reference to a person being provided with a capital benefit is a reference to any of the following: (a) the provision of ownership interests in a company to the person; (b) the distribution to the person of share capital or share premium; (c) something that is done in relation to an ownership interest that has the effect of increasing the value of an ownership interest (which may or may not be the same interest) that is held by the person." In the present circumstances, the shareholders of Company A are provided with a capital benefit as the distribution will be paid out of the share capital account. What is the Tax benefit? A shareholder 'obtains' a 'tax benefit', as defined in subsection 45B(9), where: • the amount of tax payable; or • any other amount payable under the ITAA 1936 or the ITAA 1997, by the taxpayer 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. In the present circumstances, the shareholders of Company A will obtain a tax benefit by receiving a distribution that will not be assessable income. | Detailed Reasoning - Relevant circumstances: The objective conclusion as to the requisite purpose in relation to the tax benefit arising from the capital distribution is made having regard to the relevant circumstances of the scheme, including those set out in subsection 45B(8). The relevant circumstances listed in subsection 45B(8) of the ITAA 1936 include the tax and non-tax (i.e. business and other financial) implications of the scheme, the latter covered largely by the matters in paragraph 177D(b) of the ITAA 1936, which are included in subsection 45B(8) by virtue of paragraph (k). All of the circumstances listed in subsection 45B(8) must be considered in order to determine whether or not, individually or collectively, they reveal the existence of the requisite purpose. Paragraph 45B(8)(a) refers to the extent to which the capital benefit is attributable to capital or profits (realised and unrealised) of the company or an associate (within the meaning of section 318 of the ITAA 1936) of the company. Despite the fact that the distribution is taking the form of share capital it can in fact be attributed to the profits of Company A. The return of capital will be funded from available cash. It is also important to note that Company A has clearly stated that there will be no realised profit from the sale of the retail segment of their business or any other profits (realised or unrealised) on their balance sheet that will form part of the proposed return of capital. The applicant has stated that capital is in excess to its needs. It is this excess capital that will be returned to the shareholders of Company A. Since 200X, Company A has paid down its long term debts to minimal amount and now plans to increase their senior debt facility to around $XXX. Company A has given a satisfactory explanation for replacing some of Company A's equity with senior debt: it is all related to adhering to their investment and funding strategy. As the scheme in this case has been identified as a distribution of share capital that is in excess to Company A's requirements, none of the distribution can be attributed to the profits of Company A. Therefore the capital benefit is entirely attributed to share capital and so, no requisite purpose exists. Paragraph 45B(8)(b) refers to the pattern of distributions made by a company or an associate of the company. Company A has a (recent) history of paying out substantial dividends from its profits. As Company A has paid out a good proportion of its profits already, it cannot be argued that the capital return is in any way a substitution for a dividend. The proposed distribution will therefore be sourced from share capital. Therefore, no requisite purpose exists. Paragraph 45B(8)(c) refers to whether the relevant taxpayer has any capital losses that may be utilised in the scheme. In this case, the applicant has given an assurance that only one of the shareholders has capital losses. Therefore, on balance, no requisite purpose exists. Paragraph 45B(8)(d) refers to whether the relevant taxpayer has any pre-CGT shares. In this case, the shares in Company A were acquired by its shareholders after 20 th September 1985. Paragraph 45B(8)(e) refers to the issue of shareholders being non-residents. In this instance, the shareholders of Company A are Australian residents for taxation purposes and therefore this circumstance does not indicate a requisite purpose. Paragraph 45B(8)(f) refers to whether the CGT cost base of the shares is not substantially less than the applicable capital amount. The taxpayer has indicated that the cost base of the shares will exceed the capital benefit. Therefore no requisite purpose exists. Paragraph 45B(8)(g)- repealed. Paragraph 45B(8)(h) refers to whether the proportionate interests of the shareholders after the distribution remains the same as the interest would have been if an equivalent dividend have been paid instead. In this case, after the proposed return of capital, the proportionate interests of each of the shareholders will remain the same. The proportionate interests would be identical whether a return of capital or an equivalent dividend was made. Therefore no requisite purpose exists. Paragraph 45B(8)(i) deals with the provision of ownership interests and the later disposal of those interests This paragraph is not applicable because it is a return of capital only. Paragraph 45B(8)(j) is not applicable because this does not involve a demerger. Paragraph 45B(8)(k) refers to the matters in subparagraphs 177D(b)(i) to (viii). These 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 parties involved. In the present case, the practical implication of the proposed scheme is for Company A to return capital to its shareholders. The capital return proposal was formulated by the directors of Company A as an effective way to return excess capital that is no longer needed and to rebalance their debt/equity ratio in line with their business strategy. An analysis of paragraph 177D(b) is set out below: (i) subparagraph 177D(b)(i): The manner of scheme was entered into or being carried out - The scheme consists of the distribution to shareholders of capital. The scheme was entered into as the most effective manner to return excess capital back to its shareholders. After considering the manner of how this scheme, in its entirety, is proposed to be entered into, it could not be concluded that the manner of the scheme could be said to be entered into for the purposes of obtaining a tax benefit for the shareholders of Company A. (ii) subparagraph 177D(b)(ii): The form and substance of the scheme - The amount of capital to be returned to shareholders corresponds with the amount of capital that is in excess of Company A's operational requirements. Therefore, having regard to the form and substance of the proposed capital return, it could not be concluded that the scheme is being entered into or carried out to obtain a tax benefit. (iii) subparagraph 177D(b)(iii): Timing of the scheme - The timing of the capital return is effectively after a substantial proportion of available profits have been paid to the shareholders. The timing of the proposed capital return is not indicative of a scheme entered into in obtaining a tax benefit. (iv) subparagraph 177D(b)(iv): The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme - Because the distribution will be debited against Company A's share capital account, the distribution falls outside the definition of 'dividend' in subsection 6(1) of the ITAA 1936, and is therefore, not received as income in the shareholders hands. Instead, under CGT Event G1, the cost base of the shares for those shareholders subject to CGT will be reduced by the amount of the capital returned. (v) subparagraph 177D(b)(v): The change in financial position of the taxpayers (shareholders) who choose to participate in the scheme - The shareholders financial position will be altered because they will be receiving a cash distribution. Having said this, this is not indicative of Company A entering into a scheme with the purpose of obtaining a tax benefit. (vi) subparagraph 177D(b)(vi): The change in financial position of any person who has a connection with the relevant taxpayer - With exception of the shareholders, there are no parties related to Company A that stand to benefit from the proposed scheme. With this in mind, it could not be said that Company A has entered this scheme for the purpose of obtaining a tax benefit. (vii) subparagraph 177D(b)(vii): Any other consequence for the taxpayer as a result of the proposed scheme - This requires consideration of the nature of the company's business and how this impacts on its ability to pay dividends, as well as objective shareholders expectations in relation to Company A's distributions. Although there is no formal dividend policy in place, the commercial assets are still in place giving Company A the option to resume paying dividends in the future. So, the return of capital is a payment out of excess funds, and will not affect the profitability of the company. Given the company's recent history of paying dividends, it is considered that the return of capital in this instance is not indicative of a tax scheme entered into for the purpose of obtaining a tax benefit. (viii) subparagraph 177D(b)(viii): Connection between the taxpayer and any other person referred to in subparagraph 177D(b)(vi) : This subparagraph has no relevance as there is no other entity connected to Company A that stands to obtain a tax benefit as a result of the scheme. It is concluded, therefore, that the results achieved by the scheme, unaffected by section 45B of the ITAA 1936, were not tax driven results and the requisite purpose of enabling the shareholders of Company A to "obtain a tax benefit" is not present. Having regard to the 'relevant circumstances' of the scheme as set out in subsection 45B(8), it cannot be concluded that a person would enter into, or carry out, the capital return for a more than incidental purpose of enabling the nine shareholders of Company A to obtain a tax benefit. Accordingly, section 45B has no application to the scheme proposed by Company A. | Detailed Reasoning - Conclusion: Having regard to all the relevant circumstances of this scheme, the Commissioner would not therefore come to the objective conclusion that a non-incidental purpose of providing the capital benefit to the shareholders of Company A is to obtain a tax benefit. The Commissioner would therefore not make a determination under subsection 45B(3)(b) that section 45C applies. | Summary: CGT event G1 will happen to the shares in Company A under section 104-135 of the ITAA 1997. The cost base in each of the shares in Company A will be reduced by the amount of the capital returned in respect of each share. | Detailed Reasoning - Detailed reasoning: Section 104-135 of the ITAA 1997 provides that CGT event G1 happens where: (a) a company makes a payment to you in respect of a share you own in the company (except for CGT event A1 or C2 happening in relation to the share); and (b) some or all of the payment (the non-assessable part ) is not a dividend, or an amount that is taken to be a dividend under section 47 of the Income Tax Assessment Act 1936 ; and (c) the payment is not included in your assessable income. The shareholders in Company A will receive a payment in respect of their shares. The payment will not be a dividend, and will not be included in the assessable income of the shareholders. CGT event G1 will happen when Company A makes the payment under the proposed return of capital to its shareholders (subsection 104-135(2) of the ITAA 1997). Subsection 104-135(4) of the ITAA 1997 provides that: …if the amount of the non-assessable part is not more than the share's cost base, that cost base and its reduced cost base are reduced by the amount of the non-assessable part. According to the facts of the scheme, the capital amount to be returned by Company A to its shareholders will be less than the cost base of all of the shares. Therefore the cost base for each share in Company A will be reduced in accordance with subsection 104-135(4) of the ITAA 1997.