Private ruling: Proposed return of capital and the application of section 45B
Published: February 2015
Ruling period: Year ended 30 June 2015
Date scheme commenced: 1 July 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 X makes a payment to its shareholders in respect of the shares? | A1: Yes | Q2: Will the proposed return of capital be a dividend as defined in section 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 scheme to be a dividend and hence assessable for income tax purposes? | A4: No | Q5: Will the Commissioner make a determination under section 45C(3) of the ITAA 1936 that a franking debit should arise to the company in respect of the capital benefit? | A5: No

Relevant facts and circumstances: General Background Company X is a private company, primarily involved in investments in commercial properties and equity investments. Proposed Return of Capital As a consequence of the winding up of a large investment, Company X has determined that the company now has surplus capital and proposes to use some of the sale proceeds to fund a return of capital to all of its shareholders. Company X has determined that after the return of the surplus capital the company will still be in a position to provide the desired annual returns to shareholders moving forward through dividend payments and capital growth. The return of capital will be made on the basis that the sale has released a significant portion of the capital invested in the asset and the capital is surplus to the requirements of Company X. The proposed return of capital is to be debited to the share capital account with no shares being cancelled. Ownership interests will remain the same as before the distribution. Company X plans to continue paying annual dividends to its shareholders depending of its Net Earnings of the group. Company X has advised there have been no transactions undertaken that would taint the share capital account.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 6(1) | Income Tax Assessment Act 1936 subsection 44(1) | Income Tax Assessment Act 1936 section 45A | Income Tax Assessment Act 1936 subsection 45A(2) | Income Tax Assessment Act 1936 paragraph 45A(3)(b) | Income Tax Assessment Act 1936 section 45B | Income Tax Assessment Act 1936 subsection 45B(2) | Income Tax Assessment Act 1936 subsection 45B(3) | Income Tax Assessment Act 1936 subsection 45B(5) | Income Tax Assessment Act 1936 subsection 45B(8) | Income Tax Assessment Act 1936 subsection 45B(9) | Income Tax Assessment Act 1936 section 45C | Income Tax Assessment Act 1936 section 47 | Income Tax Assessment Act 1936 subsection 177A(1) | Income Tax Assessment Act 1936 subsection 177D(b) | Income Tax Assessment Act 1936 section 318 | Income Tax Assessment Act 1997 subsection 104-135(3) | Income Tax Assessment Act 1997 Division 197 | Income Tax Assessment Act 1997 section 975-300

Reasons for decision: Summary: CGT event G1 will happen when Company X makes a payment to its shareholders in respect of the shares. | Detailed Reasoning - Detailed reasoning: Section 104-135 of the ITAA 1997 contains the rules dealing with CGT event G1. CGT event G1 happens where the following occurs: 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 X pays a return of capital to a shareholder in respect of a share they own 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 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 return of capital (subsection 104-135(4) of the ITAA 1997). If a shareholder did make a capital gain when CGT event G1 happens, the cost base and reduced cost base of the share is reduced to nil. A 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 section 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 the amount standing to the credit of Company X's share capital account. Company X has confirmed no amount has been transferred to the share capital account from another account. As the share capital account of the taxpayer 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. | Detailed Reasoning - Detailed reasoning: Section 45A of the ITAA 1936 is an anti-avoidance provision which applies where capital benefits are streamed to certain 'advantaged' shareholders who derive a greater benefit from the receipt of capital than other 'disadvantaged' shareholders. 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 X 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 scheme to be a dividend and hence assessable for income tax purposes. | Detailed Reasoning - Detailed reasoning: Section 45B of the ITAA 1936 is an anti-avoidance provision which 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. The taxpayer'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 X's share capital account, Company X will provide its 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, 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 of the taxpayer) 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 shareholders, regardless of individual circumstances, paragraphs 45B(8)(d) 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), 45B(8)(c) and 45B(8)(k) of the ITAA 1936, which are considered in detail below. | Detailed Reasoning - 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. A return of capital must, in substance, be from the excess capital of a company rather than profits. 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, Company X proposes to return to shareholders part of the share capital that was realised upon the sale of an investment. Company X believes a portion of the proceeds generated from the sale are excess to its capital requirements and therefore proposes to distribute them back to its shareholders. Paragraph 73 of PSLA 2008/10 states a 'reasonable approach' should be taken in determining the extent to which share capital was invested in the disposed assets and is available to be distributed to shareholders. The proposed capital return is a reasonable allocation of the share capital of Company X that was invested in the asset. No part of the proposed capital return is attributable to profits, realised or unrealised of Company X. The proposed capital return represents surplus capital following an isolated transaction being the sale of a major investment. Therefore, this factor does not incline towards the requisite purpose. | Detailed Reasoning - 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 X has a history of annual dividend payments. Company X plans to continue to make annual dividend payments subject to the Group having sufficient attributable profits. 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 current requirements. This factor does not incline towards the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(c) of the ITAA 1936- Capital Losses: The third factor identified in section 45B(8) considers whether a not incidental purpose for undertaking a capital distribution is as a result of shareholder's having carried forward capital losses. Given the relevant circumstances of the proposed scheme, this factor does not incline for or against the requisite purpose. | Detailed Reasoning - 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 subparagraphs 177D(b)(i) to 177D(b)(viii) 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 paragraph 177D(b) 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 X has demonstrated that the scheme, being a proposed return of capital to its shareholders, seeks to legitimately return an amount of excess share capital raised. The return will release capital which 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 subsection 45C(3) of the ITAA 1936 that a franking debit should arise to the company in respect of the capital benefit. | Detailed Reasoning - Detailed reasoning: As the Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 or subsection 45B(3) of the ITAA 1936 in relation to the scheme as described, section 45C of the ITAA 1936 will not deem any part of the proposed return of capital to be an unfranked dividend for the purposes of the ITAA 1936 or the ITAA 1997.