Private ruling: Off-Market Share Buy-Back
Ruling period: Year ended 30 June XX | Commencement date of scheme: | Year ended 30 June XX | The scheme that is the subject of the ruling: | Company A is to undertake an off-market buy-back of its own shares (buy-back). The shareholders in company A are a mix of individuals, companies, superannuation funds and other institutional investors, some of whom are non-residents. | The buy-back forms part of company A's capital management strategy that aims to return capital that is surplus to its needs. Company A also anticipates that the buy-back will have positive effects on earnings per share and returns on equity. | Under the buy-back, $XX per share will be debited to company A's untainted share capital account and the balance of the buy-back price will be debited to the company's retained profits. | All shares bought back under the buy-back will be cancelled. | Relevant provisions: | Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 204-30 | Income Tax Assessment Act 1936 subsection 45B | Income Tax Assessment Act 1936 subsection 45C(3) | Income Tax Assessment Act 1936 section 177A | Income Tax Assessment Act 1936 section 177D | Income Tax Assessment Act 1936 section 177EA | Explanation: (This does not form part of the notice of private ruling) | Issue 1 | The interest on borrowings to fund the buy-back will be deductible under section 8-1 of the ITAA 1997 to the extent that it replaces capital which will be used in the business of the taxpayer to produce assessable income, and the exclusions of section 8-1 do not apply. | The support for this position may be found in the decision of Federal Commissioner of Taxation v. Roberts; Federal Commissioner of Taxation v. Smith (1992) 37 FCR 246; 92 ATC 4380; (1992) 23 ATR 494 and Taxation Ruling TR 95/25. | Section 8-1 of the ITAA 1997 is the general provision that deals with deductibility of certain expenditure. The requirement for deductibility under paragraph 8-1(1)(b) of the ITAA 1997 is that expenditure is necessarily incurred in carrying on a business for the purpose of producing the assessable income of the taxpayer and the exclusions in subsection 8-1(2) of the ITAA 1997 do not apply. Hence, the expenditure needs to have been necessarily incurred in carrying on the taxpayer's business for the purpose of producing assessable income, and the expenditure is not of a capital, private or domestic nature or in relation to producing exempt income. | Pursuant to TR 95/25, interest expenses incurred must have a sufficient connection with the operations or activities which more directly gain or produce the assessable income of the taxpayer, and cannot be of a type of exclusion mentioned above (subsection 8-1(2) of the ITAA 1997). This implies a test of characterisation. The essential character of an expense is a question of fact, having regard to all the circumstances. | The character of interest is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put to by the borrower. This involves looking at all the circumstances, including the character of the business and its undertaking, the objective purpose of the borrowing and the nature of the transactions of which the borrowing of the funds is an element. | In relation to borrowing by companies, interest is deductible where the borrowing is used to fund a repayment of share capital to shareholders in circumstances where the repaid capital was employed as capital or working capital in the business carried on by the company for the purpose of deriving assessable income. | Company A contends that the interest on borrowings to finance the buy-back falls within the situation covered by paragraph 13 of TR 95/25. | According to paragraph 13 of TR 95/25, interest on a borrowing by a company will generally be deductible where the borrowing is used to fund a repayment of share capital to the shareholders in situations where the repaid capital was employed as capital in the company's business to produce assessable income. This is further clarified by Example 5, which deals specifically with company share buy-backs. A company which runs a business to produce assessable income and wants to reduce its shareholder entitlements to the real assets of the company (for example, via a share buy-back arrangement) and it borrows the funds to be paid to the shareholders because it is short of liquid assets, then the company has in effect replaced the equity with debt. Hence, interest on borrowing would be deductible to the extent that the borrowing replaced equity which is employed in the business to produce assessable income. | Company A will borrow funds in order to fund a portion of the buy-back and hence will incur an interest cost on the borrowed funds. As the borrowing to fund a portion of the buy-back will be used to replace working capital, the interest expense incurred on the loan to fund that portion will be deductible to company A pursuant to section 8-1 of the ITAA 1997. | Issue 2 | Subsection 45B(2) of the ITAA 1936 applies where: | "(a) there is a scheme under which a person is provided with a demerger benefit or a capital benefit by a company; and | (b) under the scheme, a taxpayer, who may or may not be the person provided with the demerger benefit or 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 the purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the taxpayer to obtain a tax benefit." | A 'scheme' is defined in section 177A of the ITAA 1936 to mean: | "(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and | (b) any scheme, plan, proposal, action, course of action or course of conduct" | In this case, the Buy-Back would constitute a 'scheme'. | A capital benefit is defined in subsection 45B(5) of the ITAA 1936 as any of the following: | "(a) the provision of shares 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." | It is considered that the shareholders of Company A will be provided with a capital benefit under the Buy-Back (i.e. the Capital Component of the Buy-Back). This is consistent with the Commissioner's view that "…..the balance of the purchase price, which is debited against the share capital, would be taken to be a distribution of share capital….." (refer paragraph 101 of PS LA 2007/9). Accordingly, the shareholders participating in the Buy-Back will be provided a capital benefit under section 45B(5)(b) of the ITAA 1936. | Subsection 45B(2)(b) of the ITAA 1936 requires that, under the scheme, a taxpayer obtains a tax benefit. Subsection 45B(9) of the ITAA 1936 broadly provides that a taxpayer obtains a tax benefit if an amount of tax payable would be less than the amount of tax otherwise payable (or payable at a later time) had the capital benefit been a dividend. | The determination of whether a taxpayer would obtain a tax benefit depends on each taxpayer's particular circumstances and would need to be considered on a case by case basis. Company A is held by a wide variety of shareholders, including companies, trusts, individuals and superannuation funds. It is therefore possible that certain shareholders may obtain a tax benefit under the scheme. | Subsection 45B(2)(c) of the ITAA 1936 provides that it is necessary to have regard to the relevant circumstances of the scheme to determine whether a person or persons entered into the scheme for the purpose of enabling a taxpayer to obtain a tax benefit. | The relevant circumstances to be considered are listed in subsection 45B(8) of the ITAA 1936. | From consideration of the factors contained in subparagraphs 177D(b)(i) to (viii), it is considered that Company A did not enter into or carry out the Buy-Back or any part of the arrangement for the purpose of enabling a shareholder to obtain a tax benefit. The tax benefit, if any, that arises to shareholders is not known to Company A and is incidental to the main or substantial purpose of the Buy-Back of Company A's shares. As previously outlined, the main purpose of the Buy-Back is to reduce the average cost of capital, to maintain target gearing levels, to utilise surplus capital in a manner that optimises EPS over time and to maximise shareholder value. | Having regard to all of the above factors, section 45B of the ITAA 1936 does not apply to the Buy-Back and the Commissioner will not make a determination to deem any part of that Capital Component to be an unfranked dividend in the hands of the shareholders under section 45C(1) of the ITAA 1936. | Issue 3 | Section 204-30 of the ITAA 1997 applies where a corporate tax entity streams the payment of dividends, or the payment of dividends and the giving of other benefits, to its members 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; (paragraph 204-30(1)(a) of the ITAA 1997) | (b) the member would derive a greater benefit from franking credits than another member of the entity (paragraph 204-30(1)(b) of the ITAA 1997); 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 (paragraph 204-30(1)(c) of the ITAA 1997). | If section 204-30 of the ITAA 1997 applies, the Commissioner is vested with a discretion under subsection 204-30(3) of the ITAA 1997 to make a determination in writing either: | (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 1997); or | (b) that no imputation benefit is to arise in respect of any streamed distributions made to a favoured member and specified in the determination (paragraph 204-30(3)(c) of the ITAA 1997). | For section 204-30 of the ITAA 1997 to apply, members to whom distributions are streamed must derive a greater benefit from imputation benefits than the members who do not participate in the buy-back. The words 'derives a greater benefit from franking credits' (imputation benefits) are defined in subsection 204-30(8) of the ITAA 1997 by reference to the ability of the members to fully utilise imputation benefits, that is, the gross-up and tax offset. | In the present case, the conditions of subsection 204-30(1) of the ITAA 1997 are met as: | · there exists a group of shareholders that have a greater ability to use the franking credits under the terms of subsections 204-30(7) and 204-30(8) of the ITAA 1997, being the resident minority shareholders (favoured members). The non-resident shareholders, who have a lesser ability to use the franking credits, are called the disadvantaged members; | · a substantial portion of company A's shareholding was held by non-residents who do not benefit from franking to the same extent as resident shareholders; and | · the buy-back was structured in such a way that it would be more attractive to resident shareholders who were able to fully utilise the franking credits, streaming them to residents away from non-residents. | Section 204-30 of the ITAA 1997 counters strategies to avoid the wastage of imputation benefits. Although company A intends to continue paying fully franked dividends to its remaining shareholders into the future, this does not necessarily prevent the arrangement from amounting to streaming. Thus, it is not accepted that the continuation of the payment of franked dividends after the buy-back leads to the conclusion in this case that streaming is not occurring. | However, the Commissioner will not make a determination under section 204-30 of the ITAA 1997 to deny imputation benefits that arise in respect of the dividend component of the buy-back paid to participating shareholders. | Instead, the Commissioner will exercise his discretion under section 177EA of the ITAA 1936, as one of the relevant circumstances in the application of section 177EA is the fact that resident shareholders receive a greater benefit from franking credits than non-resident shareholders. | Issue 4 | Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies to a wide range of schemes to obtain a tax advantage in relation to imputation benefits. In essence, it applies to schemes for the disposition of shares or an interest in shares, where a franked distribution is paid or payable in respect of the shares or an interest in shares. This would include a buy-back with a franked dividend component. | Specifically, subsection 177EA(3) of the ITAA 1936 provides that section 177EA of the ITAA 1936 applies if: | (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 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, a 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. | In the present case the conditions of paragraphs 177EA(3)(a) to 177EA(3)(d) of the ITAA 1936 are satisfied. Accordingly, the issue is whether having regard to the relevant circumstances of the scheme, it would be concluded that, on the part of company A, its shareholders or any other relevant party, there is a purpose, more than merely an incidental purpose, of conferring an imputation benefit under the scheme. Under this arrangement the relevant taxpayer is the participating shareholder and the scheme comprises the circumstances surrounding the buy-back. | In arriving at a conclusion 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) of the ITAA 1936. | The relevant circumstances listed there encompass a range of circumstances which taken individually or collectively could indicate the requisite purpose. Due to the diverse nature of these circumstances, some may not be present at any one time in any one scheme. | The Commissioner has come to the view that section 177EA of the ITAA 1936 applies to the buy-back. In coming to this conclusion the Commissioner had regard to all relevant circumstances of the arrangement, as outlined in subsection 177EA(17) of the ITAA 1936. Among the circumstances reflected in those paragraphs are: | · the delivery of franking credits in excess of what would have otherwise been distributed in the ordinary course of dividend declaration; | · the greater attraction of the buy-back to resident shareholders who could fully utilise the franking credits than to non-resident shareholders who could not; | · the greater attraction of the buy-back to some resident shareholders with a lower marginal tax rate than other resident shareholders (for example whereas superannuation funds are taxed at 15% and corporations at 30%, individuals can be taxed at a marginal tax rate of up to 45%); and | · participating shareholders are likely to make a tax loss, but an economic gain from the buy-back. | Where section 177EA of the ITAA 1936 applies the Commissioner has a discretion, pursuant to subsection 177EA(5) of the ITAA 1936, to make a determination to debit company A's franking account pursuant to paragraph 177EA(5)(a) of the ITAA 1936, or deny the imputation benefit to each shareholder pursuant to paragraph 177EA(5)(b) of the ITAA 1936. | The Commissioner will exercise his discretion in such a way as to debit company A's franking account pursuant to paragraph 177EA(5)(a) of the ITAA 1997. | It would be inappropriate, given the large and diverse shareholding of the company, to make a determination to deny imputation benefits in relation to each participating shareholder. | The Commissioner will calculate the franking debit under paragraph 177EA(5)(a) of the ITAA 1936 using the following formula: | Franking debit = | Franking credit per share | x | Total number of shares bought back | x | Non-resident percentage ownership | x 0.5 | where: | Franking credit per share= | ( | Buyback price | - | Capital component | ) | x | 30% | (1 - 30%) | The determination amount in respect of company A's buy-back will not exceed the debit to the franking account occasioned by the dividend attaching to the buy-back price (subparagraph 177EA(10)(b)(ii) of the ITAA 1936).

Ruling: Q1: Will interest incurred on borrowings by Company A to fund the Buy-Back be deductible pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: Will the Commissioner make a determination under subsection 45C(3) of the Income Tax Assessment Act 1936 (ITAA 1936) that a franking debit arises in respect of the Capital Component of the Buy-Back price? | A2: No. | Q3: Will the Commissioner make a determination under paragraph 204-30(3)(a) of the ITAA 1997 that a franking debit arises in respect of the Dividend Component of the Buy-Back price? | A3: No. | Q4: Will the Commissioner make a determination under paragraph 177EA(5)(a) of the ITAA 1936 that a franking debit arises in respect of the Dividend Component of the Buy-Back price? | A4: Yes.




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