Advance Tax
Introduction
The body of rules that govern the tax issues relating to off-market share buybacks are found in Division 16K of the Australian Income Tax Assessment Act of 1936. Tax implications in a buyback differ depending on whether the company itself is the subject or the shareholder. Before attempting the question at hand, this paper will first explore the crucial rules and terms associated with the tax implications of share buybacks off-market to set the ground for proper analysis of the scenario.
The Mechanisms of a Share Buy-back
The process of buying back shares commences when a company makes the decision offering to buy back a certain amount of its shares from shareholders.[1] If shareholders give a nod to the offer, they sell back their shares to the company. The company then immediately cancels those shares from the share register hence reducing the number of shares issued by the company. There are different types of buy-backs that a company can opt for, but the two common ones are equal access and selective. In equal access buy-back, the whole buy-back process is open to shareholders generally, and the terms are the same for all shareholders. In selective buy-back, the offer may be made to selected shareholders or an individual shareholder.
Tax Treatment for the Company
Arguing from the perspective of the company, share buy-backs outside the market are tax neutral because no deductible tax loss or assessable gain is occasioned by the buyback.[2] Consequently, when determining the tax position of the company in this case, the buyback transaction is deemed not to have taken place. In instances where the buyback results in a dividend for the shareholder, the dividend is considered a frankable distribution, which should be franked to the benchmark franking percentage of the company during the franking period for which the payment of that dividend is made. As a result, the franking account of the company should reflect the share buy-back’s dividend component in its debit side.
Tax Treatment for the Shareholder
Arguing from the perspective of the shareholder, the debited part of the buy-back price to the company’s retained earnings is considered a dividend. On the other hand, the debited part of the buy-back to the share capital is treated as a consideration for share disposal for the purposes of capital gains tax (CGT) but subject to several potential adjustments.[3]
Tax Issues to Consider
The following pertinent tax issues spring from an off-market share buy-back:
- The mode of calculating the buyback price
- The entitlement to franking credits
- The application of anti-avoidance rules
Based on these issues, this paper will discuss the tax implications for EW Australia Ltd, Duncan and Debbie as a result of the buy-back process.
Tax Treatment (Shareholder)
As already mentioned, share buy-backs outside the market are tax-neutral from the perspective of the company. On the contrary, the Australian tax rules governing share buy-backs outside the market contain two major implications for those shareholders who sell their shares to the company in the buy-back process:
Deemed Dividend
Any bit of the proceeds of a buy-back debited to the retained earnings account of the company is deemed assessable dividends to a shareholder. Under the franking rules, these dividends can be franked to the extent of the company’s allocation of anticipated or existing franking credits.[4]
The CGT Implications
On the basis of CGT, a shareholder is regarded to have disposed of his shares for consideration of an amount equal to the price of buy-back minus the dividend component that is assessable (this amount represents the portion of the buy-back price that goes to the debit side of the share capital account of the company). If this consideration exceeds the cost base of the shareholder in the shares, there could be a resultant capital gain. On the contrary, if the cost base of the shareholder in the shares exceeds the consideration, there could be a resultant capital loss.[5]
For those corporate shareholders who are entitled to an intercorporate dividend rebate, it is important to take note that there could be a resultant double tax benefit because:
- The resultant deemed dividend from share buy-back off-market could inflate a tax loss through a reduction of the consideration on share disposal; and
- The shareholder also has an entitlement to the intercorporate dividend rebate.
The rules of share buy-back outside market also make provision for some adjustments to the buy-back price allocation as a measure to prevent shareholders from reaping the double tax benefit. In addition, these rules provide that share buy-back price is to be treated as consideration with regards to share disposal for CGT and income tax purposes generally. On the contrary, there could be circumstances where the consideration on deemed market value of the shares could be substituted.
Calculating the Buy-back Price
The Commissioner of Taxation’s powers to enforce the anti-avoidance rules for franking credit and capital benefit hinder the usual flexibility that companies have in as far as structuring their buy-back proceeds is concerned.[6] Much of recent experiences point towards the Australian Taxation Office’s use of the franking credit rules to demand of companies to restructure their buy-buck proceeds so that inappropriate tax outcome do not arise.
The mechanisms of applying these rules create much uncertainty. The Commissioner can apply the anti-avoidance rules for franking credit when he has reasonable grounds to believe that the company has made excessive allocations to its retained earnings. The Commissioner can also apply the anti-avoidance rules for capital benefit if he has reasonable grounds to believe that there has been an excessive allocation to share capital.[7] Worse still, the uncertainty is increased by the fact that no guidelines in tax rulings by the courts publicly exist to give a clue as to the determination of the manner of allocating buy-back proceeds.[8] Reliable arguments have established that the Commissioner could consider any of the allocation criteria[9] summarized below. The Commissioner has not given any one criterion more emphasis than the rest. Rather, ATO considers each criterion based on the facts and circumstances of each individual case.
Criterion A
This approach is otherwise known as the share capital to retained profit ratio. Based on this approach, a company’s buyback proceeds composition is an impression of the relative proportions of the company’s retained earnings and share capital as at the buyback. Experts have revealed that this criterion is the one that the Commissioner uses most in his determination of the proper allocation of proceeds from a buy-back.
Criterion B
This approach is otherwise known as the percentage interest in a company’s share capital. Under this approach, the company may alternatively allocate the proceeds from its buy-back in a manner acceptable to the Commissioner by basing the allocation on the respective interests of the shareholder in the company’s share capital.
Criterion C
This approach is otherwise known as the percentage interest in a company’s retained earnings. Under this approach, the company may alternatively allocate the proceeds from its buy-back in a manner acceptable to the Commissioner by basing the allocation on the respective interests of the shareholder in the company’s retained profits.
Market Value and Anti-avoidance Rules
Anti-avoidance rules come to play whenever there is a calculation of the buy-back price. According to these rules, any value in excess of the buy-back price in comparison to the market value of the shares in question is not frankable.[10] It means, therefore, that the company should see to it that it can adduce evidence to show that the buy-back price it offered to its shareholders never exceeded the market value of those shares. On the contrary, if the market value of the shares exceeds the buy-back price as at the buy-back (assuming no buy-back ever occurred nor was intended), then, the market value of the shares in this case will be regarded as consideration for the share disposal. When this occurs, the capital gain and capital loss occasioned to the shareholder due to the buy-back will go down and up respectively.[11]
None of the above adjustments would arise if the company sets its buy-back price in such a way that ATO will view the price as equal to the market value of the shares as at the buy-back (assuming no buy-back ever occurred nor was intended). For instance, ATO recently issued the Taxation Determination 2004/22[12] that outlines its views on the determination of the market value of shares for listed companies that exercise buy-back outside the market.
Employee Share Schemes
Financial reward is one way of motivating employees. Business owners are more than willing to see their businesses blooming up in the skies. Giving their staff certain stakes in the enterprise through shares is a kind of incentive and a reward at the same time. Most companies have used this formula. The formula is best known as an employee share scheme. When employees have some stake in the enterprise they work for, they feel motivated and will have a sense of participation. This gives them the urge to work harder so that the enterprise grows. Share options under the employee share schemes are availed to the employees at costs that are normally below the market value of the shares. The difference between the market value of the shares and what the employee actually pays is known as “discount.” The Australian Tax Office treats the discount as income during the assessment of income. Accordingly, the discount is often taxed as part of income.
Legislative Change
The legislation on employee share schemes has since changed. This necessitates the distinction between pre-July 2009 schemes and post-June 2009 schemes (that is, there was a change in treatment of the employee share schemes that took effect between the periods).[13] These changes did not appeal to most employers who in turn pushed for reforms. Shares that were acquired prior to the switch are to be taxed based on the provisions of the previous provisions for share schemes whereas shares acquired thereafter are to be taxed based on the new provisions.
One attractive feature of the schemes was the huge allowance to the tune of $1,000 maximum being exempted from tax if the employee in question opted for the taxation of the discounted value of his shares in their year of acquisition.[14] Under the “qualifying” scheme, it was possible for an employee to defer tax until the disposition of the shares if he chose so, but this option came with the detriment of forfeiting the $1,000 tax-free allowance.[15]
As per the new provisions, employees are still liable to pay tax on the discount. This tax applies for the year of acquisition of the shares. However, unlike the previous rules, employees cannot defer the tax save for “real risk of forfeiture” situations and where the employee acquires the interests under some kind of salary sacrifice arrangement.[16] Today, the tax exemption is only available to those whose salaries are below $180,000.
A more limited option to defer has been brought about by the new rules. This option places a time limit of 7 years on the deferring tax, and it is available only where the schemes exhibit a genuine risk of forfeiture or where an employee receives shares worth $5,000 and below under a salary sacrifice arrangement.[17] A genuine risk of forfeiture refers to the fact that an employee is highly likely to lose or never benefit from the shares or their entitlement options under the scheme in question.[18] For instance, conditions may be put for the availability of shares such as the enterprise reaching certain targets in its finances. Alternatively, the risk could occur in a falling market in which the value of the shares is highly likely to fall. Moreover, the risk of the business undergoing liquidation cannot be ignored. However, a condition to the effect that the employee cannot for a certain duration sell the shares cannot qualify for a genuine risk of forfeiture.
Income Tax Calculations for Duncan and Debbie
DUNCAN
The buy-back of the shares was done off-market, and the price of the shares was significantly less than the market value of the shares had the buy-back not taken place. Duncan will calculate his capital gain for taxation purposes as follows.
| Capital proceeds | ||
| Market value | $7.50 | |
| less dividend | $1.00 | |
| ($6.50 x 1,000 shares) | = $6,500 | |
| less cost base | ($6 x 1,000 shares) | = $6,000 |
| Capital gain (before applying any discount) | $500 | |
Duncan will use his capital gain to complete item no. 18 in his tax return (at the supplementary section). Moreover, he will factor in his dividend at item no. 11 on his tax return.
DEBBIE
The buy-back of the shares was done off-market and the price of the shares was significantly less than the market value of the shares had the buy-back not taken place. Debbie will calculate his capital gain for taxation purposes as follows.
| Capital proceeds | ||
| Market value | $7.50 | |
| less dividend | $1.00 | |
| ($6.50 x 1,000 shares) | = $6,500 | |
| less cost base | ($6 x 1,000 shares) | = $6,000 |
| Capital gain (before applying any discount) | $500 | |
Debbie will use his capital gain to complete item no. 18 in his tax return (at the supplementary section). Moreover, he will factor in his dividend at item no. 11 on his tax return.
Current Income Tax Rates in Australia
| Taxable income | Tax on this income |
| 0 – $18,200 | Nil |
| $18,201 – $37,000 | 19c for each $1 over $18,200 |
| $37,001 – $80,000 | $3,572 plus 32.5c for each $1 over $37,000 |
| $80,001 – $180,000 | $17,547 plus 37c for each $1 over $80,000 |
| $180,001 and over | $54,547 plus 45c for each $1 over $180,000 |
Adopted from the Australian Tax Office
Duncan’s taxable income is $75,000, which falls in the third bracket. To this amount of taxable income will be added the capital gain of $500 from the share buy-back. Therefore, Duncan’s taxable income will be $75,500.
Debbie’s taxable income is $135,000, which falls in the fourth bracket in the table above. To this amount of taxable income will be added the capital gain of $500 from the share buy-back. There is also the aspect of the company car that should be factored in in Debbie’s taxable income calculation. The cost of the car is stated to be $45,000. This is treated as income as it is part of capital gain within the income year. Therefore, the cost of the car will be added to Debbie’s total taxable income (that is, $135,500 + $45,000) giving the total of $180,500. This is the final taxable income for Debbie.
References
Australian Tax Office (2014). Commissioner of Taxation v. Consolidated Media Holdings Ltd.
Retrieved 28 October 2014 from http://law.ato.gov.au/atolaw/view.htm?DocID=LIT/ICD/S228of2012/00001
Australian Tax Office (2014). Employee Share Schemes – Guide for Employees. Retrieved 28
October 2014 from https://www.ato.gov.au/general/employee-share-schemes/in-detail/what-you-need-to-know/employees/employee-share-schemes—guide-for-employees/
Australian Tax Office (2014). Individual Tax Rates. Retrieved 28 October 2014 from
https://www.ato.gov.au/rates/individual-income-tax-rates/
Australian Tax Office (2014). Deductions for Businesses. Retrieved 28 October 2014 from
https://www.ato.gov.au/business/deductions-for-business/
Australian Tax Office (2014). Share Buy-backs. Retrieved 28 October 2014 from
Caldwell, Rod (2014). Taxation for Australian Businesses: Understanding Australian Business
Taxation Concessions Wrightbooks
King & Wood Mallesons (2014). Test case regarding the income tax share buy-back rules –
Commissioner of Taxation v Consolidated Media Holdings. Retrieved 28 October 2014 from http://www.mallesons.com/publications/marketAlerts/2012/Pages/Test-case-regarding-the-income-tax-share-buy-back-rules-Commissioner-of-Taxation-v-Consolidated-Media-Holdings.aspx
Law Gazette (2014). Memorandum on Share Buybacks. Retrieved 28 October 2014 from
http://www.lawgazette.com.sg/2001-4/April01-focus3.htm
Prince, Jimmy B. (2011). Property & Taxation: A Practical Guide to Saving Tax on Your
Property Investments Wrightbooks
Raftery, Adrian (2014). 101 Ways to Save Money on Your Tax – Legally! 2014-2015
Wrightbooks
Taxpayers Australia Inc. (2014). The Taxpayers Guide 2014-2015. Wrightbooks
Tax Interpretations (2014). Australian Tax Consequences of the Intrepid Share Buy-back will
Turn on the Post Transaction Ruling. Retrieved 28 October 2014 from http://taxinterpretations.com/?p=30670
The Tax Institute (2014). High Court grants special leave in share buyback case – Consolidated
Media. Retrieved 28 October 2014 from http://www.taxinstitute.com.au/news/high-court-grants-special-leave-in-share-buyback-case-consolidated-media
Usa, Ibp (2008). Australia Tax Guide. USA: International Business Publications
[1] Ibp Usa, Australian Tax Guide (International Business Publications) 65.
[2] Australian Tax Office, Share Buy-backs (2014) https://www.ato.gov.au/General/Capital-gains-tax/In-detail/Shares,-units-and-similar-investments/Share-buy-backs/
[3] Ibid.
[4] Ibid.
[5] Ibid.
[6] Law Gazette, Memorandum on Share Buy-backs (2014) http://www.lawgazette.com.sg/2001-4/April01-focus3.htm
[7] Ibid.
[8] Commissioner of Taxation v. Consolidated Media Holdings Ltd (2012) FCAFC 36.
[9] Adrian Raftery, Ways to Save Money on Your Tax – Legally! 2014-2015 (Wrightbooks) 88.
[10] Australian Tax Office, Deductions for Businesses (2014) https://www.ato.gov.au/business/deductions-for-business/
[11] Ibid.
[12]Caldwell Rod, Taxation for Australian Businesses: Understanding Australian Business Taxation Concessions (Wrightbooks) 140.
[13]Taxpayers Australia Inc., The Taxpayers Guide 2014-2015 (Wrightbooks).
[14]Australian Tax Office, Employee Share Schemes – Guide for Employees (2014).
[15] Ibid.
[16] Ibid.
[17]Tax Interpretations, Australian Tax Consequences of the Intrepid Share Buy-back will Turn on the Post Transaction Ruling (2014) http://taxinterpretations.com/?p=30670
[18] Ibid.
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