Capital management in uncertain times or the construction of s 6(4) of the ITAA 1936
The following article was written by Peter Donovan, Tax Director at Toohey Reid. It was published in the Thomson Reuters Weekly Tax Bulletin (issue 52) on the 13th of December 2016.
Capital management, and in particular the desire to return capital to shareholders, is generally viewed as a treacherous task given the associated tax uncertainty that can attach to such distributions when compared to the mere payment of a dividend.
In terms of the provisions that must be examined in a return of capital context, the usual suspects include ss 45A, 45B, 45C,177EA and Part IVA of the ITAA 1936 and Subdiv 204-D of the ITAA 1997.
Commercially, there are a number of reasons why a company may wish to return share capital to its shareholders including a return of capital that is thought to be in excess of a company’s requirements where the company has built up sufficient net wealth over a period of time and a partial return of capital to foundation shareholders so that fresh share capital can be injected by new shareholders.
Whilst the reasons for a return of capital are usually abundantly clear and often commercially driven, many such transactions, when viewed through the uncompromising tax lens, may either stall, need to be reshaped or, at the very least, require a binding ruling given the associated tax uncertainty that often attaches to the transaction.
Indeed, obtaining certainty absent the possession of a binding ruling in a return of capital transaction, even in seemingly straightforward cases, is often difficult to achieve. Clearly, the number of private binding rulings and class rulings that issue on this topic supports this contention.
A provision that requires close examination in a return of capital context, but is often overlooked or not given the attention it deserves, is s 6(4) of the ITAA 1936.
Indeed, s 6(4) may potentially be a deal breaker in certain circumstances, irrespective of the motivations driving the transaction, requiring companies to rethink the nature of the transaction in order to avoid the risk of having the entire distribution branded as a dividend.
Section 6(4) of the ITAA 1936
Section 6(4) is an integrity provision that modifies the operation of paragraph (d) of the definition of a “dividend” as it appears in s 6(1), as follows:
Excluding paragraph (d) of the definition of a “dividend”
“[a dividend] . . . does not include:
(d) moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company;”
“[Exception] Paragraph (d) of the definition of dividend in subsection (1) does not apply if, 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 the property so paid, credited or distributed.”
On its face, s 6(4) appears both broad and mechanical in its operation, lacking a requirement to uncover the purpose behind the transaction and a subsequent assessment as to whether such purpose is impugned or innocuous. Hence, on one reading, the provision is in a sense akin to a strict liability provision.
That is, if there is a credit to a company’s share capital account upon receipt or crediting of monies or property by a person followed by payment or credit of moneys or property by the company to another person and a subsequent debiting of the company’s share capital account, s 6(4) would appear to be enlivened, thus branding the transaction as a dividend, irrespective of circumstance or motive.
Curiously, the historical development of s 6(4) shows it to be a provision of limited application which, in part, may explain why to date it has not received the publicity in the tax press that many other integrity type provisions have.
Historical development of s 6(4)
The former s 6(4) was designed to impugn share premium schemes in circumstances where shares were issued at a premium with those premiums being distributed via a share premium account to shareholders of the company in a preferentially-taxed manner in substitution of an ordinary profit distribution.
Section 6(4) was substituted by Act No 63 of 1998 in view of the changes to the Corporations Law abolishing the notion of par value for shares. The redesigned s 6(4) was said to serve a similar function in relation to distributions out of a company’s share capital account, as the Explanatory Memorandum to the Taxation Laws Amendment (Company Law Review) Bill 1998 (“EM“), at paragraphs 1.106 – 1.08 states:
“1.106 As a result of the Corporations Law changes that abolish the concept of share premiums and associated terms, the amendments introduce an equivalent rule to subsection 6(4) that applies to the share capital account. The rule will prevent companies entering into arrangements where a company raises share capital from certain shareholders and then makes a tax-preferred capital distribution to other shareholders.
1.107 Where appropriate, the amendments will also replace references to the share premium account and paid up capital with references to share capital accounts.
1.108 As a result, where currently a particular distribution made in a return of capital is deemed to be a dividend to the extent it exceeds the sum of the amount to which the share is paid up and debits to a share premium account, under the new Corporations Law the distribution will, subject to the anti-avoidance rules and the treatment of preference shares, be a dividend only to the extent it exceeds the amount debited to the share capital account.”
Based on the above extract, it is clear that s 6(4) was designed to cure the mischief of companies raising share capital from certain shareholders and then making tax-preferred distributions to other shareholders.
Despite this, there are a multitude of innocuous type arrangements that were clearly not thought to be caught by s 6(4), but may well be.
A particular example that springs to mind, which calls into question whether the limbs of s 6(4) must be applied in the order in which they are written, is as follows.
Assume a company has been in existence for a decade and is trading profitably. A potential purchaser would like to acquire a 50% stake in the company and requires the company to reduce its net asset value (“NAV“) to a certain level so that the acquisition can occur at an agreed price in estimation of market value.
The directors of the company, in consultation with the company’s foundation shareholders, agree to reduce the company’s NAV of the company by engaging in a partial return of capital to the foundation shareholders.
The question for consideration, amongst other things, is whether s 6(4) can operate to impugn the transaction and deem it to be a dividend?
Order of application of section 6(4)
As s 6(4) is written, it may be reasonable to assume that paragraphs (a) and (b) must be applied in the order in which they appear. That is, it will only have operation where a credit to the company’s share capital account occurs followed by a debit thereto, with the relevant dealings in money or property occurring in accordance with both paragraphs.
However, in the above Example, the debit to the company’s share capital account precedes a credit to that account. That is, share capital is returned to the foundation shareholders prior to an allotment of shares to the incoming shareholder with a subsequent crediting to the share capital account then occurring.
The question is, does s 6(4) have potential operation?
Examples of the operation of section 6(4)
An analysis of the ATO database suggests that the Commissioner has taken an “ordered” approach to the operation of s 6(4), requiring a raising of capital to proceed a return of capital from/to different persons/shareholders.
Examples of this approach are found in the following documents:
- Class Ruling CR 2008/43 entitled “Income Tax: conversion by Mackay Sugar Co-operative Association Limited to a company registered under the Corporations Act 2001” – refer for example paragraph 60.
- Class Ruling CR 2008/77 entitled “Income tax: return of capital: Olea Australis Limited” – refer for example paragraph 34.
- PS LA 2007/9 entitled “Share buybacks” – refer for example paragraph 161.
The above ordered approach is consistent with the aim of s 6(4) as stated in the EM. The use of the adverb “then” in the EM deliberately serves to order paragraphs (a) and (b) of s 6(4). Unfortunately, that adverb does not appear in the text of s 6(4) itself.
Without dwelling on matters of statutory construction, it is evident that this omission is problematical in that it potentially broadens the scope of the provision to capture innocuous type transactions, such as the above Example, which were arguably never envisaged to be caught by the provision. However, to be caught by the provision, it must be read in reverse.
It is clear that there are 2 competing constructions reasonably open on the proper interpretation of s 6(4). Whether a court will seek to confine its operation to that described in the EM, and in so doing, take an ordered approach to the provision, is difficult to predict.
It is understood that the Commissioner does not believe that an ordered approach to s 6(4) is required, hence it has broad application.
In view of this, it would be helpful if the Commissioner were to officially publish his view on the operation of s 6(4) and either confirm his position or state that his view is consistent with many of the rulings that he has issued on its operation. Until he does, it may be prudent for a taxpayer to seek a ruling on the operation of s 6(4) especially if a taxpayer has cause to seek a ruling on the other integrity provisions mentioned above when seeking to undertake a return of capital transaction.
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