Private ruling: Capital Return
Published: February 2015
Ruling period: Year ended 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Will the Capital Component of 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 Capital Return? | A2: No | Q3: Will Capital Gains Tax event G1 under section 104-135 of the Income Tax Assessment Act 1997 (ITAA 1997), happen to Company X's shares upon the Capital Return? | A3: Yes

Relevant facts and circumstances: General Background Company X is a privately owned company. Proposed Return of Capital The Company X is considering a Capital Return to its shareholders. The Capital Return will involve a distribution in specie of all of the shares held by Company X in Company Y to the Company X shareholders in proportion to their ownership interest in Company X. Shareholder Structure Company X's issued shares are owned by multiple shareholders. All issued shares are ordinary shares, which carry rights to dividend and capital distributions, the right to vote and to attend meetings. Commercial rationale of Capital Return It is proposed to return the capital contributed by Company X shareholders in the form of an in-specie distribution of its shares in Company Y. The commercial rationale for the Capital Return is the desire to separate the Company X group into its two operating constituents. Dividend History Company X does not have a formal dividend policy. Other matters Company X and Company Y are residents of Australia for income tax purposes. Company X's share capital account is untainted for the purpose of Division 197 of the ITAA 1997.

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 45B | Income Tax Assessment Act 1936 section 45C | Income Tax Assessment Act 1997 section 104-135

Reasons for decision: Summary: The Capital Component of the Capital Return 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 on or 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. The Capital Component of the Capital Return will be debited against an 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 Company X 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 Capital Component of the Capital Return 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 scheme , deeming the Capital Return 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) of the ITAA 1936); • 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) 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 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) of the ITAA 1936). 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 X's Capital Return 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 Capital Component of the Capital Return will be debited to Company X's share capital account, Company X will provide shareholders with a capital benefit under subsection 45B(5) of the ITAA 1936 in the form of ownership interests in Company Y issued to the Company X shareholders. | 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 of the ITAA 1936, 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 X shareholders will obtain a tax benefit from the Capital Return. | 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). 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 (shareholders) 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 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. 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, share capital that is attributable to Company Y via an in-specie distribution of the Company Y shares to Company X 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. In this case Company X can trace the amount of capital invested in Company Y. The Commissioner accepts the proposed capital return is a reasonable allocation of the share capital of Company X that was invested in Company Y. 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 does not have a formal current dividend policy. Dividends were paid by Company X in the 2008 and 2009 income years. In this case a fully franked dividend will be paid as part of the scheme. Therefore, this factor does neither incline towards or against the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(c) of the ITAA 1936- Capital losses: This circumstance is concerned with whether there is an advantage to the taxpayer in dealing in capital rather than income. Where shareholders have capital losses that can be applied against the capital benefit this would suggest that the capital benefit was provided for the purpose of securing a tax benefit. In the present circumstances, Company X shareholders do not have carried forward capital losses as at 30 June 2014. Accordingly, this factor does not incline towards the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(d) of the ITAA 1936- Pre CGT ownership interests: This circumstance considers whether the taxpayer owns interests in the company acquired before 20 September 1985. The shares in Company X are not pre-CGT interests and therefore this factor is not relevant and does not incline for, or against, the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(e) of the ITAA 1936- Residency: The implication of non-residency is that it would normally point towards a tax preference for a distribution of capital over profit. Non-residents are normally taxed on dividends at the rate of 15%, but they are not exposed to capital gains on the disposal of shares unless those shares are 'indirect Australian real property interests' as defined in section 855-25 of the ITAA 1997 (paragraph 87 of PS LA 2008/10). One of Company X shareholders is a non-resident of Australia which on face value would indicate a tax preference towards capital. This benefit may however be reduced if its shareholding in Company X constitutes an 'indirect Australian real property interests'. The other three shareholders in Company X are Australian residents for income tax purposes. It is considered based on these features and the nature of the scheme as a whole that this factor does not incline for, or against, the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(f) of the ITAA 1936- Cost base of ownership interests: Paragraph 45B(8)(f) of the ITAA 1936 draws a comparison of the value of the Capital Return relative to the cost base of the shares. The Capital Return per share is less than the cost base of each share. As such the cost base of all the shares is more than the value of the capital benefit, and as such this circumstance does not incline for, or against, the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(h) of the ITAA 1936- Nature of interest after the distribution: This provision requires a comparison of the respective interests held by shareholders after the distribution of capital. The Capital Return will not change the number of interests held by shareholders in Company X. The return of capital will however reduce the cost base of each Company X share pursuant to the proposed equal share capital reduction. This factor does not incline towards the requisite purpose. Paragraph 45B(8)(i) of the ITAA 1936- Provision of ownership interests and later disposal The small changes in shareholding are in respect to the introduction of an employee share plan. There are no further plans or current intention to dispose of any Company X or Company Y shares after the restructure. This factor does not incline towards the requisite purpose. | Detailed Reasoning - Paragraph 45B(8)(j) of the ITAA 1936- Transactions between entity and associates: This factor is not relevant in the current circumstances as it only applies to demergers under Division 125 of the ITAA 1997. | 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 of the ITAA 1936. The matters are applied in the context of the 'more than incidental purpose test' in section 45B of the ITAA 1936. 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 Capital Return to its shareholders, seeks to return an amount of share capital raised that is attributable to its investment in Company Y. The return will release capital which Company X has stated is commercially desirable and will enable the group to pursue independent growth and expansion plans. In this case, the practical implications of the scheme are consistent with it being, in form and substance, a return of capital via an in-specie distribution of shares. After consideration of the subparagraphs in 177D(b) of the ITAA 1936 and having regard to the relevant circumstances of the scheme it cannot be concluded that the scheme was entered into for a more than incidental purpose of enabling the relevant taxpayers to obtain a tax benefit. 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 whole, or any part, of the capital benefit provided to the Company X shareholders under the proposed scheme. | Summary: Capital Gains Tax event G1 will happen when Company X makes the payment of the Capital Return to the Company X 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 when: • a company makes a payment to a shareholder in respect of a share they own in a company; • some or all of the payment is not a dividend (as defined in subsection 995-1(1) of the ITAA 1997) or an amount that is taken to be a dividend under section 47 of the ITAA 1936; and • the payment is not included in the shareholder's assessable income. The Capital Component is not a dividend. Accordingly, CGT event G1 will happen when Company X pays the Capital Return to the Company X shareholders in respect of a share they own in Company X 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 Capital Component be a dividend or deemed dividend under section 47 of the ITAA 1936. As the Capital Component is less than the cost base of the Company X share at the time of the payment, the cost base and reduced cost base of the share will be reduced by the amount of the payment (subsection 104-135(4) of the ITAA 1997).