NSW 9th Annual Tax Forum · The ASX 200 is relatively heavily weighted towards banks. Australian banks are particularly profitable by world standards and have some of the highest

© Author’s name, Company 2015

Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests. 510715420

NSW 9th Annual Tax Forum

Capital Management Update

Written by:

Tim Kyle

Director

Greenwoods & Herbert Smith Freehills

Presented by:

Tim Kyle

Director

Greenwoods & Herbert Smith Freehills

NSW Division

2-3 June 2016

Sofitel Wentworth, Sydney

Tim Kyle Capital Management Update

© Tim Kyle, Greenwoods & Herbert Smith Freehills 2016 2

CONTENTS

1 Introduction .................................................................................................................................... 4

1.1 The capital management universe ............................................................................................ 4

1.2 The focus of this paper ............................................................................................................. 4

2 Part A: returns on investment....................................................................................................... 6

2.1 Current dividend trends ............................................................................................................. 6

2.2 Impairments and dividends ..................................................................................................... 12

2.2.1 Overview .......................................................................................................................... 12

2.2.2 Accounting impairments .................................................................................................. 12

2.2.3 Dividends under corporate law ........................................................................................ 13

2.2.4 Remediating the impact of impairments .......................................................................... 15

2.2.5 Tax issues ........................................................................................................................ 17

2.3 Dividends paid out of current year profits accumulated losses .............................................. 18

2.4 Equity funding dividends ......................................................................................................... 19

2.4.1 Overview .......................................................................................................................... 19

2.4.2 underwritten DRPs ........................................................................................................... 19

2.4.3 special dividends combined with share issues ................................................................ 20

2.4.4 TA 2015/2 ........................................................................................................................ 20

3 Hybrid mismatch arrangements ................................................................................................. 22

4 Part B: returns of investment...................................................................................................... 23

4.1 Overview ................................................................................................................................. 23

4.2 Trends ..................................................................................................................................... 23

5 Capital returns .............................................................................................................................. 25

5.1 Context .................................................................................................................................... 25

5.2 Class rulings learnings ............................................................................................................ 25

5.2.1 Qantas return of capital: CR 2015/101 ............................................................................ 27

5.3 PS LA 2008/10: ATO practice in relation to s.45B .................................................................. 28

5.3.1 Overview .......................................................................................................................... 28



5.3.2 Need for PS LA 2008/10 updating ................................................................................... 29

5.4 Share consolidations ............................................................................................................... 29

6 Off-market buy-backs .................................................................................................................. 31


6.2 The Cable & Wireless case..................................................................................................... 33

6.2.1 Context ............................................................................................................................ 33

6.2.2 Conventional accounting ................................................................................................. 33

6.2.3 CMH ................................................................................................................................. 34

6.2.4 C&W................................................................................................................................. 35

7 Demergers..................................................................................................................................... 38


8 In specie distributions ................................................................................................................. 39

8.1 Some interesting aspects of the three in specie distributions ................................................. 40

8.1.1 Macquarie Group in specie distribution of Sydney Airport securities .............................. 40

8.1.2 BHP Billiton demerger of South32 ................................................................................... 42

8.2 National Australia Bank demerger of CYBG ........................................................................... 42

9 Share capital tainting ................................................................................................................... 44

9.1.1 Context ............................................................................................................................ 44

9.1.2 The provisions ................................................................................................................. 45

9.1.3 Things we are relatively certain about ............................................................................. 45

9.1.4 Some potentially problematic areas ................................................................................ 46

9.1.5 Observations .................................................................................................................... 47

10 Part C: raising capital ............................................................................................................... 48

10.1 Overview ............................................................................................................................. 48

10.2 Retail premiums generally ................................................................................................... 48

10.3 Rights issues and employee share trusts ........................................................................... 50



1 Introduction

1.1 The capital management universe

The common thread in general definitions of capital management (CM) is that it is the management

strategy directed towards maintaining efficient levels of the components of working capital: assets and

liabilities.

CM involves the confluence of the corporate law, tax and accounting disciplines.

Conventionally, as tax practitioners, we would tend to focus is on a subset of the universe of CM

strategies:

raising capital from investors; and

returning capital to investors.

This covers most transactions reflected in the debt and equity sections of a company’s balance sheet

and includes:

raising capital by way of issue of shares, debt and hybrid instruments;

returns on investment by way of payment of dividends and interest;

returns of investment by way of capital returns, demergers and buy-backs.

1.2 The focus of this paper

What is covered

As usual, the recent CM activities of Australian resident corporates reveal a fascinating array of tax

issues.

This paper:

focusses on interesting themes emerging from these CM activities over the period since the start

of 2014;

provides an update on key CM Australian income tax issues; and

identifies emerging trends in CM activities and associated Australian income tax issues.



What is not covered

In order to be of manageable size, this paper does not attempt to cover the entire universe of CM-

related activity. Rather, it focuses on Australian corporates raising and returning equity capital. In

that regard:

why only corporates? There are more than enough issues involving corporates, without

considering the specific tax issues associated with the CM activities of trusts, stapled entities and

other types of entities.

why only equity? The debt-related transactions of Australian corporates are less visible than

equity-related transactions and rarely raise contentions tax issues.

There are four further restrictions on the scope of this paper:

There are many issues that relate specifically to hybrid regulatory capital raising in the

banking/insurance industries. These financial services sector specific issues are addressed in my

paper “Update on capital management issues”, prepared for the Tax Institute’s 2015 Financial

Services Taxation Conference, and so are not addressed in this paper.

Given the express updating purpose of this paper, it is not a “capital management tax issues 101”

paper. There are many papers documenting the well-known tax issues associated with CM

transactions.

There have been 6 class rulings on special dividends in a takeover context. They are excluded

on the basis that this is more of an M&A issue than a capital management issue.

We found 97 on-market buy-back announcements in 2015 and 27 in 2016 so far. However, on-

market buy-backs don’t raise tax issues for shareholders and only raise tax issues for the

company if some part of the purchase price is debited other than to share capital, which is rare.

Other initial points

All legislative references in this paper are to the provisions of the Income Tax Assessment Act 1936

and the Income Tax Assessment Act 1997, unless indicated otherwise.

At various points through this paper I make observations about ATO practices in relation to CM

activities. They are intended to be constructive observations. They are made in the following context:

I think the ATO generally does an effective job administering what is in many cases a technically

difficult area; and

the ATO is generally very accommodating when commercial factors require rulings or draft rulings

to be issued by a particular deadline.

The views expressed in this paper are the personal views of the author.



2 Part A: returns on investment

This Part A focusses on returns on investment. Given the focus on equity related CM activities of

Australian corporates, this means dividends.

Dividends are generally thought of as one of the most “vanilla” CM tools. However, unusually, in

recent years, dividends haven given rise to some of the more interesting CM trends and tax issues.

The following sections examine:

the current dividend trends for Australian corporates: section 2.1;

the impact of impairments on dividends: section 2.2;

equity funding dividends: section 2.3; and

hybrid mismatch arrangements: section 2.4.

2.1 Current dividend trends

On any measure, Australian corporates are prodigious payers of dividends.

Dividend yield

The dividend yield of ASX listed companies (ie, dividends as a percentage of current trading price) is

very high by world standards.

Source: Citi Research “Global Equity Strategist” report dated 5 May 2016



Payout ratio

Australian corporates have a very high payout ratio (ie, percentage of profits paid as dividends) – both

relative to the rest of the world and in terms of the long run median payout ratio: source Citi Research

“Global Equity Strategist” report dated 5 May 2016.

We have been on a two decade long relentless upward journey when it comes to payout ratios, as the

following two graphs demonstrate.




Source: RBA Bulletin March Quarter 2016 article by Michelle Bergmann

Dividend yield v earnings trends

Moreover, it appears that Australian corporates – like a number of their foreign counterparts – have

steadfastly been maintaining their dividends per share despite falling earnings per share as the

following two graphs demonstrate.





Why the obsession with dividends?

There are a number of factors in play when it comes to explaining these relativities.

The composition of the ASX 200

The ASX 200 is relatively heavily weighted towards banks. Australian banks are particularly profitable

by world standards and have some of the highest dividend payout ratios in the world. In the 2015

calendar year alone, the big 4 banks and Macquarie paid over $23b of dividends on their ordinary

shares alone – not even including distributions on their hybrid regulatory capital. This involved $10

billion in franking credits passing to shareholders.

The impact of global interest rates

As was shown in the first diagram above, we are now in an extremely low interest environment where

dividend yields now significantly exceed 10 year government bond yields. This drives investor

demand for yield in equities.

As we have seen over the last few years, any potential drop off in dividend yield usually has a strongly

negative impact on trading price.

This has led many corporates to try to maintain their share price through elevated dividends – even,

as we have seen, despite falling earnings.

Franking

Almost uniquely by world standards, Australian corporates are able to franked dividends with

refundable tax offsets. This makes their dividends very attractive to Australian investors – particularly

to those with a tax rate below the corporate tax rate, such as super funds.



The Reserve Bank of Australia draws a clear link between the franking system and the high rate of

Australian dividends1.

Recent developments

As earnings fall, dividends will naturally come under pressure.

There lots of speculation about dividends in various sectors having peaked and the RBA questions

the sustainability of current dividend practices2.

The recent banking sector reporting season is consistent with this theory.

And it’s certainly true of the resources sector, which suffered a dramatic fall in earnings per share. It

is well documented that both BHP Billiton and Rio Tinto had for many years paid “progressive

dividends” – that is, broadly, paying increasing annual dividends (since 1988 in the case of BHP

Billiton).

Following a period of intense press speculation in late 2015, in February 2016 both BHP Billiton and

Rio Tinto returned to a more conventional policy that links the quantum of dividends with a measure of

profits.

1 http://www.rba.gov.au/publications/bulletin/2016/mar/pdf/bu-0316-6.pdf 2 Ibid page 48

http://www.rba.gov.au/publications/bulletin/2016/mar/pdf/bu-0316-6.pdf



The following table gives a sense of the current dividend policies of ASX20 entities.




2.2 Impairments and dividends

2.2.1 Overview

A range of Australian corporates have experienced significant accounting impairments in recent

years. This has been particularly keenly felt in the energy and resources sector, as evidenced in the

chart below.

Source: Australian Financial Review article by Simon Evans3

Accounting impairments can put a company into accounting loss in the year of impairment.

This impacts the company’s ability to pay dividends in two ways:

first, unless the company has sufficient retained earnings, it may not be able to pay a dividend in

the year of impairment; and

secondly, the ability to pay dividends in future profitable periods is restricted by the presence of

accumulated accounting losses.

However, companies have the ability to mitigate these impacts. Going forward, I expect that

companies will more often exercise this ability, as they become more familiar with it.

2.2.2 Accounting impairments

Broadly, an accounting impairment arises when the fair value of an asset falls below its carrying

value.

3 http://www.afr.com/business/why-investors-are-wary-of-companies-making-big-writedowns-20160303-gn98sg

http://www.afr.com/business/why-investors-are-wary-of-companies-making-big-writedowns-20160303-gn98sg



It is important to keep in mind that:

an impairment amount is just a measure of an unrealised loss – it’s a purely notional amount as

the loss may never be realised; and

there is no direct relationship between the company’s trading position and the impairment of its

assets - put differently, a company may suffer impairments yet still be trading profitably.

Accounting impairments have both balance sheet and P&L consequences:

for the company that holds the impaired asset (primary company), the accounting value of the

impaired asset in the primary company’s stand-alone accounts is reduced by the impairment

amount;

asset impairments can then “trickle up” through the corporate group by way of impairments to

interposed equity interests – thereby reducing the accounting value of these assets in the

respective companies’ stand-alone accounts; and

the stand-alone profit for each company that has assets impaired will be reduced by the

impairment amount. This may eliminate any trading profit for the period – or even put the

company into an accounting loss position.

The following section explains why profits are relevant to the ability to permissibly paying dividends.

2.2.3 Dividends under corporate law

The ability of a company to permissibly pay dividends is governed by s.254T of the Corporations Act.

The continued role of profits is best understood by following the evolution of s.254T.

The period to June 2010

Prior to June 2010, s.254T simply provided:

“A dividend may only be paid out of profits of the company.”

The “out of profits test” was subject to some criticism and these criticisms, together with the decision

to adopt International Financial Reporting Standards (IFRS), led ultimately to the 2010 changes to

s.254T.

The period from June 2010 to present

The Corporations Amendment (Corporate Reporting Reform) Act 2010 replaced the existing s.254T

with the following:



254T Circumstances in which a dividend may be paid

A company must not pay a dividend unless:

a. the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is

sufficient for the payment of the dividend; and

b. the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and

c. the payment of the dividend does not materially prejudice the company’s ability to pay its creditors.

The clear intent of the change was to abandon the need to determine whether a dividend was paid

out of “profits”.

However, it is widely accepted that this intention miscarried, because the new section is expressed as

a prohibition rather than a permission4.

As a result, confusion abounds:

the opinion authored by AH Slater QC and JO Hmelnitsky, which accompanies TR 2012/55 argues

that it is still necessary to establish that the company has paid a dividend out of profits;

Ford concludes that “counsel may have put that proposition too high” and perhaps certain other

reserves could also support a dividend6; and

most corporate lawyers would say that the 2010 amendments do not allow a dividend to be paid

directly or indirectly out of share capital, even where each of the requirements in section 254T(1)

are satisfied.

Given this confusion, the safest course for a company appears still to be paying dividends only out of

profits.

The challenge then becomes identifying what constitutes profits for s.254T purposes (see below).

Opportunity missed

It is worth noting that exposure draft legislation7 would clarified that a dividend can be paid out of

capital, provided certain other requirements are met – thereby achieving the intent of the 2010

amendments.

Unfortunately, the s.254T aspects of the exposure draft were not reflected in the ensuing bill and its

seems to have dropped off the legislative radar for the time being.

4 Ford, Austin & Ramsay’s Principles of Corporations Law RP Austin & I M Ramsay 14th Ed, Butterworths Aust 2010 (Ford) 5 http://law.ato.gov.au/pdf/pbr/slater_and_hmelnitsky-payment_and_franking_of_dividends.pdf 6 Ford at [18.090.6] 7 http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2014/Deregulatory-Bill-2014

http://law.ato.gov.au/pdf/pbr/slater_and_hmelnitsky-payment_and_franking_of_dividends.pdf

http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2014/Deregulatory-Bill-2014



Relationship between s.254T profits and accounting profits

In an ideal world, there would be perfect alignment between accounting profits and profits for s.254T

purposes.

However, case law indicates that there have always been areas of potential difference.

These differences have grown following adoption of IFRS. It is quite disconcerting that the

differences have not been mapped out. Two examples are set out below.

The first example is “other comprehensive income”. The ATO view is that it does not contribute to

profits for s.254T purposes8. To my knowledge, this view has not been tested.

The second example is this: where a parent entity lends $100 to a subsidiary on an interest-free

basis, IFRS accounting requires that:

the parent record an asset, being an investment in the borrower (rather than a loan);

the asset’s accounting value be the fair value of the right to receive the $100 - say $60 due to net

present value discounting; and

the $40 differential is released to the parent’s P&L as income over the loan term.

That is, the accounting for the transaction departs dramatically from its legal form – and $40 of loan

principal is effectively recharacterised as accounting income in the hands of the parent.

It’s difficult to conceive a rational basis for concluding that the parent’s $40 accounting profit should

support a dividend and so constitutes profit for s.254T.

Consequently, determining whether there are sufficient profits for s.254T purposes is not as simple as

looking at accounting profits – although inevitably accounting profits will be the starting point.

Importantly, profits are determined on a stand-alone legal entity basis. This means that the starting

point is a particular company’s stand-alone accounts – and the existence of its profits should not be

impacted by either:

accounting consolidation9; or

income tax consolidation10.

2.2.4 Remediating the impact of impairments

As we have seen, impairments can seriously impede a company’s ability to permissibly pay dividends.

Fortunately, where a company has suffered impairments, it has the ability to eliminate its accounting

losses, rendering it once again in a dividend paying position. This can be achieved by a capital

reduction under either s.258F or s.256B of the Corporations Act.

8 TR 2012/5 paragraph 2 9 See paragraph 52 of TR 2012/5 – despite its potential mixed messages 10 See ATO ID 2009/65



It is important to point out at this stage that there is a significant difference between a capital reduction

and a capital return: no consideration moves from the company to its shareholders under a capital

reduction.

s.258F

A s.258F capital reduction is permissible where the following cumulative requirements are satisfied:

the cancelled capital “is lost or is not represented by available assets” (see below);

the company doesn’t also cancel shares; and

the cancellation of paid up share capital is not inconsistent with the requirements of any

accounting standard.

A s.258F capital reduction can be effected by directors resolution alone.

Determining whether s.258F can permissibly be applied raises a number of corporate law and

accounting considerations. The tax consequences of s.258F being applied must also be considered.

s.256B

A s.256B capital reduction (as distinct from a s.256B capital return) is very similar to a s.258F capital

reduction, except that shareholder approval is required and it is not necessary to establish sufficient

permanence of the relevant impairment.

Accounting consequences

It is understood that, where a company has accumulated accounting losses a s.258F/s.256B capital

reduction would be accounted for by way of a reduction in share capital and a corresponding

reduction in accumulated accounting losses.

When capital is “lost/not represented by available assets”

The explanatory memorandum to the bill that introduced s.258F indicates that the section

is intended to apply in cases where company assets disappear (for example, are stolen, or

destroyed by fire); but

will not apply in the case of trading losses incurred in the ordinary course of business.

These situations fall towards opposite ends of the factual spectrum and the EM does not provide any

guidance as to how far along that spectrum a fact pattern need be in order to activate s.258F.

There is no Australian case law directly on point. Nevertheless, case law on the equivalent UK

provisions indicates that capital should properly be regarded as “lost/not represented by available

assets” where three cumulative requirements are satisfied:



the loss is to “fixed capital” (as opposed to “circulating capital”), such as an investment in a

subsidiary where the company is not in the business of selling subsidiaries;

the loss is sufficiently permanent (see below); and

the loss is independently and reliably measured.

sufficient permanence

There is some debate about the circumstances in which this requirement can be satisfied.

On one view, only irretrievably lost share capital or share capital irreversibly not represented by

available assets would suffice.

This view appears overly conservative.

Rather, sufficient permanence should be able to be exhibited if the situation is permanent as far as is

reasonably foreseeable, based on all the relevant information available at the particular time.

There is a threshold question of whether unrealised losses are capable of satisfying the sufficient

permanence requirement. After all, accounting impairments are just a measure of the movement in

fair value – and unrealised losses that may never be realised.

There is no Australian guidance on point. However, persuasive UK case law supports the proposition

that s.258F should be capable to applying at least certain accounting impairments. For example, it

would be expected to apply where the impairments are caused by structural changes to a market,

which can be rationally distinguished from short term fluctuations.

2.2.5 Tax issues

Impact of a capital reduction on share capital account for tax purposes

A capital reduction reduces the company’s share capital for corporate law and accounting purposes.

It would be expected that a capital reduction reduces the amount standing to the credit of the

company’s share capital account for tax purposes – although some ATO guidance on this point would

be welcome in light of nuances in the s.975-300(1) “share capital account” definition.

Impact of a capital reduction on franking

Where a company has implemented a capital reduction, it is necessary to consider whether future

dividends may be characterised to any extent as “sourced directly or indirectly from share capital”.

If so, those dividends are unfrankable to that extent by application of s.202-45(e).

The nexus described in s.202-45(e) is potentially very broad and there is very little guidance in

extrinsic materials on the circumstances in which dividends are to be regarded as sourced directly or

indirectly from share capital.



Moreover, the ATO public guidance on s.202-45(e) in TR 2012/5 is not directly on point.

Nevertheless, ATO ID 2010/25 confirms that s.202-45(e) will not apply to a dividend paid out of profits

that arose in a company following a s.258F capital reduction – a view that is consistent with the

private rulings with authorisation numbers 36249, 77950 and 101264749756.

More formal ATO guidance on this point would be appreciated.

Subsequent reversal of impairments

Care should be taken with the accounting entries in order to ensure that no share capital tainting

issues arise from any reversal of impairments.

2.3 Dividends paid out of current year profits accumulated losses

It may be that a company has an accumulated loss (eg, due to impairments), but then makes a profit

in the current accounting period or part period.

Unlike the UK, Australian companies with accumulated accounting losses can pay dividends out of

current year profits without first eliminating the accumulated loss: Marra Developments v Rofe [1977]

2 NSWLR 616, ICM Investments Pty Ltd v San Miguel Corporation [2014] VSCA 246.

However, case law indicates that a number of restrictions apply.

The most significant restriction applies to interim dividends. The company’s directors must be

satisfied that the full period profits will be at least equal to the dividended profit. Directors may well

exercise caution in an environment where further impairments are possible.

The ATO summarised the other restrictions as follows:

in paying the dividend, the company complies with the company’s constitution;

in paying the dividend, the company does not breach s.254T;

the company is a going concern;

the current year profits have been booked in the head company legal entity’s accounts (whether

interim or final accounts);

accounting standards and “sound accounting practice” permit current year profits to be recognised

separately, rather than being applied against prior year losses; and

either of the following applies:

the current year profits are booked in a profit reserve account and that account is debited

when the dividend is paid; or

alternatively, if the current year profits have been applied against prior year losses in the

interim/final accounts, it is very clear from the directors resolution that the dividend is being

paid out of current year profits.



2.4 Equity funding dividends

2.4.1 Overview

Very few companies pay out all their profits as dividends. This means that most companies have

accumulated a store of profits and franking credits.

As a result, many such companies feel investor pressure to pay dividends in order to release those

franking credits to shareholders, where their value can be realised.

However, they are typically also under pressure to preserve cash and maintain their balance sheet

strength.

These are clearly competing pressures.

Equity funding franked dividends is potentially a way to accommodate these competing pressures.

Broadly, there are two ways in which companies can equity fund a dividend:

by underwriting their dividend reinvestment plan (DRPs); or

by paying dividends at the same time as issuing shares.

However, the ATO taxpayer alert issued on 7 May 2015 (over a year ago) raises the prospect of

s.177EA denying franking credits in relation these transactions.

As a result, equity funded dividends remain in a state of flux.

2.4.2 underwritten DRPs

Starting at the end of 2014, the large Australian retail banks “switched on” underwritten DRP

arrangements following adoption of the Financial Services Inquiry’s recommendation that the banks

increase their Tier 1 capital levels.

Broadly, the retail bank will engage an investment bank to substantially underwrite the dividend

reinvestment plan. This means that the retail bank knows that it will receive cash of at least a

particular amount for issuing shares under its DRP, and so can quantify in advance the net cash

outflow associated with the dividend.

For example, a bank may pay a fully franked ordinary dividend of $700m and the DRP is underwritten

as to $500m. This means that the bank outlays $200m of cash while releasing $300m of franking

credits. Obviously, the bank’s financial position has changed: it has more shares on issue, with a

consequential downward impact on earnings per share.

Typically the retail banks only employ this technique in relation to ordinary dividends.

Vita Group used an underwritten DRP in relation to a special dividend in 2015. The ATO confirmed in

CR 2015/17 that s.177EA did not apply in relation to the transaction, but the class ruling was



subsequently withdrawn in connection with the ATO’s review of the area following TA 2015/2 (see

below).

2.4.3 special dividends combined with share issues

This type of transaction emerged in 2014 and it is a matter of public record that it was employed by

MACA, Harvey Norman and Tabcorp.

Under this style of transaction, the dividend is effectively funded from the proceeds of issuing shares.

This means that the dividend involves no cash outflow from the company’s perspective - as the

dividend and the subscription proceeds are closely aligned in terms of quantum and timing.

By way of example, a company pays a $70 franked dividend and simultaneously issues new shares

for $70 subscription proceeds. This releases $30 of franking credits in a cash neutral way. Of course

the company’s position has changed, there are more shares on issue and its earnings per share are

diluted.

It may be that the shares are issued pursuant to a rights issue. The rights issue may be

renounceable and/or discounted. It may be that the rights issue is underwritten.

It may be that the dividend is a special dividend, as was the case for all of MACA, Harvey Norman

and Tabcorp. But it may equally be the case that the dividend is an ordinary dividend.

2.4.4 TA 2015/2

The ATO released Taxpayer Alert TA 2015/2: Franked distributions funded by raising capital to

release franking credits to shareholders on 7 May 2015.

TA 2015/2 was heralded by an “early warning” on 17 April – an unusual step.

The ATO’s concern is that equity funding transactions may activate s.177EA, the franking credit

specific anti-avoidance provision – in which case either franking credits would be denied to

shareholders or a franking debit would arise to the company.

The transactions the subject of TA 2015/2 display all – or at least most – of particular identified

features. Seemingly, the taxpayer alert will apply to:

special dividends funded by a contemporaneous rights issue involving a corresponding

subscription amount;

special dividends paid in connection with a fully underwritten dividend reinvestment plan; and

share buy-backs funded by a contemporaneous rights issue involving a corresponding

subscription amount.

However, the listed features are framed in a general way so as to cast the potential net as widely as

possible – and so could conceivably extend to other transactions such as ordinary dividends funded

by a rights issue or a fully underwritten DRP. (Although it is understood that the ATO has provided



banks with some assurance that conventional underwritten DRPs are not intended to be within the

scope of the taxpayer alert.)

The cumulative requirements of s.177EA are that:

there be a “scheme for a disposition of shares” as (very specifically) defined; and

the company had an objectively determined non-incidental purpose of shareholders obtaining the

franking credits, having regard to specified matters.

I expect that the ATO would face considerable challenges in establishing these requirements in

relation to most equity funded special dividends. The challenges would be even greater in relation to

an equity funded ordinary dividend.

It’s reasonable to expect that the ATO shares this view, given that it’s been more than a year since TA

2015/2 was issued and we haven’t yet seen any further ATO guidance. It is understood that the ATO

has approached Treasury about the prospect of law change and that there will be consultation.

But clearly the ATO finds these transactions offensive from a policy perspective.

As a threshold matter I struggle to see the mischief: why shouldn’t shareholders be allowed to access

franking credits that accrued to the company while they were shareholders? Otherwise, franking

credits will almost inevitably accumulate – in which case they will either be trapped forever or released

at some point in the future, likely to a different set of shareholders (eg, by way of off-market buy-back)

- which I would have thought should be more offensive rather than less offensive from a principle

perspective.

There is no indication in the legislation or any extrinsic materials that the ATO-preferred outcome was

contemplated. Nevertheless, it may be that the ATO has “unearthed” an additional implied franking

credit wastage principle (ie, in addition to the wastage principle unearthed in the late 1990’s that was

offended by franking credit trading and streaming, and which led to the introduction of s.177EA).

It will be necessary to monitor any changes in this area.



3 Hybrid mismatch arrangements

One of the cornerstones of the OECD’s BEPS project has been Action Item 2 in relation

to Neutralising the Effects of Hybrid Mismatch Arrangements, which is aimed at preventing

asymmetrical tax treatments in relation to cross border ‘hybrid’ arrangements.

The OECD released its final report on Action Item 2 in October 2015. The Board of Taxation

consulted on the OECD final report and provided its report to Government in March 2016. The

Government released the Board’s report and announced as part of the 2016 Federal budget that it will

implement the OECD’s principles taking into account the recommendations of the Board.

One example of a hybrid mismatch arrangement is redeemable preference shares (RPS) issued by

an Australian corporate to a foreign investor in circumstances where:

the RPS dividends are deductible to the Australian corporate (eg, because the RPS are debt

interests for tax purposes); and

the RPS dividends are not assessable in the investor’s jurisdiction (eg, because the RPS are

respected as equity interests for tax purposes and the participation exemption applies).

The RPS dividends will cease to be deductible in Australia where they are not assessable in the

investor’s country.

However, this only applies where the arrangement is structured or involves related parties and will

apply from 1 January 2018 at the earliest.

Australian corporates in this position may well look to restructure before the start date. The Board of

Tax report recommends that the ATO provide guidance on whether, and the circumstances in which,

Part IVA will be applied to such restructures.

This puts the ATO in a challenging position: although they now provide “law companion guidelines” in

relation to draft legislation, it may be quite some time before any draft legislation is released – and so

it may be quite some time before ATO guidance is forthcoming, absent an extension in ATO guidance

products.

Senior ATO officers have said that replacing a hybrid with “vanilla” debt would not be expected to give

rise to Part IVA issues, as that is consistent with the preferred outcomes of the OECD work. Rather,

any issues are likely to revolve around structuring to “subvert” those outcomes. Moreover, the ATO is

encouraging any taxpayers considering a restructure to discuss it with the ATO.



4 Part B: returns of investment

4.1 Overview

Part B focusses on the themes emerging in relation of returns of investment – that is, where some

part of an investor’s investment is returned to them by way of:

capital return: section 5;

off-market buy-back: section 6; or

demerger: section 7.

Typically these transactions involve the company paying cash to shareholders. However, there have

been a number of instances where returns of investment have been effected by way of in specie

distribution. Those instances are discussed in section 8.

Most returns of capital involve a debit to share capital – and so share capital tainting is a perennial

issue: see section 9.

4.2 Trends

The table below charts the number of class rulings issued since 2005 in relation to:

off-market buy-backs;

returns of capital; and

demergers.



Off-market buy-backs and capital returns

The chart reveals three distinct phases for off-market buy-backs and capital returns:

Phase #1: lots of activity in 2005 to 2007 in the lead up to the GFC

Phase #2: a lull from 2007 to 2013

Phase #3: an uptick in activity beginning in 2014

Phases #1 and #2 are readily explicable:

the period leading up to the GFC was marked by significant asset sales and excess cash from

operations in a climate of increasingly limited prudent investment options – and so companies

chose to return capital to shareholders; and

the post-GFC lull reflects companies either focussing on raising capital (rather than returning it)

or, if they are returning it, doing so by way of increased dividends.

At first blush, one might think that the uptick in activity in phase #3 indicates good corporate health.

However, as the qualitative examination below reveals, this is not necessarily the case. Rather, it is a

reflection of generally challenging conditions: see section 5 below.

Demergers

The demerger activity is almost the inverse of the off-market buy-back/capital return activity. This is

consistent with the proposition that demergers tend to occur when a particular business is getting

insufficient capital and is seen as impacting the performance of the overall group. These issues are

likely to emerge when challenging conditions prevail.



5 Capital returns

5.1 Context

A capital return involves a company reducing its share capital and providing consideration (generally

cash) to shareholders.

A capital return can be effected with or without share cancellation.

The main potentially contentious tax issue in a capital return is whether s.45B can be engaged to treat

some (or all) of the capital return as an unfranked dividend.

In this regard, as we know, the mischief to which s.45B is directed is where a capital return is made to

any extent in substitution for a dividend – the theory being that capital is generally tax-preferred

relative to dividends (although this is not the case for all shareholders). Restated, outside a demerger

context, there is a risk that s.45B will be applied where too much capital is returned to shareholders.

In this section we look at:

the general learnings from class rulings issued during the period;

the specific learnings from the Qantas class ruling;

the ATO’s practice statement PS LA 2008/10; and

the trend for share consolidations to accompany a capital return.

5.2 Class rulings learnings

Given the very low s.45B purpose threshold (anything more than an incidental purpose will suffice)

and the significantly adverse potential outcomes for shareholders (a capital receipt recharacterised as

an unfranked dividend), it is market practice for listed corporates to seek a class ruling on capital

returns. Indeed, boards are generally only prepared to approve a capital return if the ATO has first

issued a favourable draft class ruling.

Consequently, class rulings are a relatively comprehensive source of information on capital returns.

There have been 31 class rulings issued on capital returns since the beginning of 2014. None of

them concludes that s.45B applies. This is hardly surprising as, if the ATO view were that s.45B did

apply, the transaction would likely not go ahead in that form.

It is frustrating reading those class rulings and trying to divine what exactly it is about the particular

facts that caused the ATO to get comfortable that s.45B did not apply. This seems to be a deliberate

course of action on the part of the ATO, driven by concern that corporates might regard class rulings

as precedential.



This raises a systemic issue about whether rulings on a particular set of facts should have any

relevance to a different, but very similar, set of facts.

I would have thought that consistency of approach on the circumstances in which s.45B applies is

highly desirable from a system integrity perspective. If so, then it would follow that transparency of

ATO reasoning, and the ability to logically defend that reasoning, is also desirable.

Given that it is difficult for us to access the ATO’s specific reasoning, what learnings can we

nevertheless draw from these class rulings?

There are certainly fact patterns that occur numerous times and which generally produce the same

result. I have attempted to extract them in the table below.

fact pattern occurrences observations

asset sale at a loss 7 capital returns without dividends shouldn’t

activate s.45B where it is possible to trace the

company’s share capital to the relevant asset

asset sale at a profit 11 these capital returns are accompanied by a

dividend to flush out the profit where share

capital can be traced to the relevant asset

there was at least one instance where absence

of distributable profits prevented s.45B from

applying – presumably on the basis that tracing

was not possible

repayment of loan principal 4 it seems that a capital return sourced from a

repayment of loan principal will generally not

activate s.45B – at least where tracing of share

capital to the loan is possible

capital return unconnected to

asset disposal/loan repayment

6 capital returns unaccompanied by a dividend will

not generally activate s.45B where the group has

an accumulated loss

existence of current year profits doesn’t seem to

disturb this outcome where they are applied

against accumulated losses (see further 5.2.1

below)

selective capital return 2 selective capital returns are rare and usually

motivated by atypical circumstances such as a

means of exiting minority shareholders or for

giving up preference rights



5.2.1 Qantas return of capital: CR 2015/101

The Qantas capital return raises two interesting issues.

The facts

The relevant facts are as follows:

the Qantas consolidated accounting group had made a loss of $2.8b in the 2014 accounting year

which became a significant accumulated loss for accounting purposes;

the Qantas consolidated accounting group made a $560m profit in the 2015 accounting year;

the 2015 profit was applied to reduce accumulated accounting losses; and

Qantas returned $505m of share capital on 6 November 2015.

Other points to note are that Qantas:

raised $761.6 million share capital in 2009 during the global financial crisis.

had paid no dividends since 2011;

had only limited franking credits; and

had bought back $99.6m of shares on-market in the income years ended 30 June 2014.

The ruling

The ATO confirmed that s.45B was not activated in the circumstances.

There are two noteworthy aspects of CR 2015/101.

The surplus capital point

The first is that it is clear that the ATO accepted the proposition that the returned capital was excess

to Qantas’s needs, based on a number of metrics.

That is, the ATO got comfortable that, to use the language of PS LA 2008/10:

“ the share capital distributed is genuinely surplus to the company's need of it and that it is not merely a cash

distribution debited against share capital on the basis of shareholder tax preference”

But many companies raised capital during the GFC which would now be regarded as surplus – can

they now return that surplus capital without fear of s.45B applying, regardless of their profit position?

It is unlikely that the ATO would regard CR 2015/101 as standing for such a universal proposition11.

11 http://www.asx.com.au/asxpdf/20160503/pdf/436z8zb9xc0gyz.pdf

http://www.asx.com.au/asxpdf/20160503/pdf/436z8zb9xc0gyz.pdf



Rather, it is understood that there were additional facts, not reflected in the class ruling, that helped

get the ATO comfort that the Qantas capital returned was properly referable to the, now surplus, GFC

funding.

The profit elimination issue

The second noteworthy aspect is that, had it wanted to, Qantas could have chosen to put the 2015

profits into a dividend reserve and paid a dividend of up to $560m. There would have been limited

franking credits to attach to such a dividend.

If so, the very important first relevant circumstance (ie, existence of profits to which the capital return

is attributable) would have pointed towards from the requisite non-incidental purpose being present.

However, the default position prevailed and the 2015 profit was automatically applied against

accumulated losses – thereby eliminating the 2015 profit.

As a result, that relevant circumstance pointed away from the requisite non-incidental purpose being

present.

But is the s.45B purpose analysis affected in any way by the existence of the choice that was

available to Qantas?

It would seem not – although, regrettably this important point was not addressed in the class ruling.

It is submitted that this is an appropriate result, as paying dividends out of current year profits should

be regarded as a relatively rare exception to the more conventional approach of applying current year

profits against accumulated accounting losses. (Indeed, dividends must be applied against

accumulated losses in foreign jurisdictions such as the UK.)

There was at least two other class rulings issued during the period that demonstrate the same ATO

approach on this issue.

It is hoped that the ATO will confirm that it will not seek to apply s.45B in a capital return context

merely because there are profits that could conceivably be paid as dividends if they were placed into

a dividend reserve rather than (automatically) applied against accumulated losses.

5.3 PS LA 2008/10: ATO practice in relation to s.45B

5.3.1 Overview

PS LA 2008/10 sets out the ATO practice in relation to share capital reductions (other than buy-backs

and demergers to which Division 125 applies). Salient points include that:

the ATO accepts that s.45B is not a profits first rule;

the ATO generally adopts a “slice approach” under which the ATO will consider that s.45B applies

to a capital return to the extent that capital and profits are not returned proportionately; and



the ATO generally only departs from the slice approach if the group has disposed of an asset and

share capital in the top company can be traced (actually or inferentially) to that asset.

5.3.2 Need for PS LA 2008/10 updating

Practical guidance/instruction role

Practice statements are corporate policy instructions to ATO officers on the way in which they should

apply the relevant law.

How does PS LA 2008/10 fare given this purpose?

The technical aspects of PS LA 2008/10 are useful up to a point. They are however (necessarily)

expressed in general terms – and its only through their application to particular fact patterns that ATO

practice can truly be discerned.

The six examples at the end of the practice statement are designed to assist in this regard. However,

the examples are a mixed bag of relatively unusual fact patterns and so are of limited utility.

The ATO practice “gap”

PS LA 2008/10 is now eight years old.

In the intervening period, the ATO issued 31 class rulings since 2014 alone. And searching “section

45B” in the ATO’s private rulings register gives over 400 hits.

So, when an ATO officer (or taxpayer or tax adviser) is considering whether there is any precedent

ATO decision that would inform the likely ATO approach to a particular fact pattern, they must read

PS LA 2008/10, check the six examples, then trawl through the class rulings and the ATO’s private

rulings register to determine whether any of the many hundreds of them are on point.

This is highly unsatisfactory.

While it is true that each s.45B inquiry turns on its own particular facts, it must be possible for the ATO

to update the PS LA 2008/10 by reference to the principles extracted from fact patterns that it sees

with sufficient regularity through the ruling process.

It is incumbent on the ATO to assist its own officers (and, derivatively, taxpayers and tax advisers) by

updating the PS LA to provide guidance on the outcomes in those fact patterns.

For example, it would be useful to see examples addressing the application of s.45B to scenarios

discussed in this section 5.

5.4 Share consolidations

There is a growing trend for capital returns to be accompanied by a share consolidation pursuant to

s.254H of the Corporations Act: eg, Qantas, Macquarie and Wesfarmers.



This preserves year to year comparability of metrics like earnings per share.

The ATO regularly accepts that such a share consolidation involves a merger of shares rather than

the ending of particular shares and so there is no CGT event: s.112-25(4).

Rather, cost base apportionment is required. However, class rulings tend to be silent on how exactly

to perform this apportionment should be performed. It is clear that companies have wrestled with

whether:

a “global blended cost base” approach applies; or

cost base consolidation should be performed on a parcel by parcel basis.



6 Off-market buy-backs


Conventional off-market buy-backs can be a very efficient CM tool: they allow shares to be bought

back at up to 14% discount to the prevailing trading price, participation is optional and can generate

franked dividends as well as tax losses for participating Australian shareholders.

It is market practice for listed corporates to seek a ruling on off-market buy-backs and so class rulings

are a relatively comprehensive source of information on off-market buy-backs.

There have been 12 class rulings issued on off-market buy-backs since the start of 2014.

Interestingly, only 3 of these represented the traditional combination of tender style off-market buy-

backs with a large franked dividend component: Telstra, Rio Tinto and Caltex. The attractiveness of

those buy-backs to shareholders is reflected in the high scale back percentages. Information on

these three buy-backs is set out in the table below for ease of reference.

Caltex12 Rio Tinto13 Telstra14

Size (m) $270 $560 $1,000

Buy-back price $29.39 $48.44 $4.60

Buy-back discount 14% 14% 14%

Capital component $2.01 $9.44 $2.33

Dividend component

(fully franked)

$27.38 $39.00 $2.27

Tax market value $34.11 $55.78 $5.04

Scale back 86.08% 91.02% 69.79%

With that exception, it is hard to identify any other clear themes emerging from the off-market buy-

backs.

12 http://www.asx.com.au/asxpdf/20160411/pdf/436f9p9357m6ll.pdf. 13 http://www.asx.com.au/asxpdf/20150407/pdf/42xqymxm8dn3gl.pdf. 14 http://www.asx.com.au/asxpdf/20141006/pdf/42spqrmbdyvykj.pdf.

http://www.asx.com.au/asxpdf/20160411/pdf/436f9p9357m6ll.pdf

http://www.asx.com.au/asxpdf/20150407/pdf/42xqymxm8dn3gl.pdf

http://www.asx.com.au/asxpdf/20141006/pdf/42spqrmbdyvykj.pdf



Feature Number Observations

Part of “normal”

capital management

programme?

2 4 followed asset sales

2 followed change of corporate strategy

1 was a legally required repurchase of IPO shares

1 was to remove minority shareholders from illiquid company

2 related to the same entity and were part of a broader scheme

to achieve mutual status

Tender style? 6 no common reasons for fixed price style

14% discount? 3

Average share capital

per share

6 departures mainly related to asset disposals (4) in which case it

is presumed that asset capital / profit split was used – although

this is often not stated

Fully franked dividend 7 4 had no dividend component at all, 1 had an unfranked dividend

Dividend > 50% of

purchase price

4 5 if Telstra (at just under 50%) is included

Perhaps the only over-arching observation that can be made is that the ATO is still very wedded to

the “average share capital per share” basis for determining an appropriate capital component, absent

“exceptional circumstances” such as where a buy-back follows an asset disposal.

This basis can lead to companies making larger franked distributions than is necessary to achieve the

maximum 14% discount to trading price. Effectively, this means that participants can enjoy more

franking credits than necessary, which risks upsetting the delicate balance of interests inherent in an

off-market buy-back.

I see little systemic risk in the ATO accepting additional capital being returned to shareholders, as it

reduces participants’ tax losses and leaves a greater number of franking credits undistributed.

Accordingly, perhaps there is room for the ATO to build more flexibility into their practice so that an

alternative acceptable method would be a 50/50 dividend / capital split. This would generally be

sufficient for the company to secure the maximum 14% discount.



6.2 The Cable & Wireless case

6.2.1 Context

The prima facie income tax consequences of an off-market buy-back depend on how the company

accounts for the transaction.

Unfortunately there is very little rigour as to the precise accounting entries to be used. In that regard:

the Corporations Law doesn’t specify the accounts to be debited; and

as for accounting discipline guidance, beyond the need to debit the buy-back purchase price

(BBPP) to equity section account, UIG 22 only indicates that the accounting should have regard

to the “substance” of the transaction.

This dearth of proper guidance has allowed accountants - permissibly it seems - to create and debit a

“buy-back reserve account” (BBRA).

We now have two sets of cases (4 cases in total) on whether a BBRA is a “share capital account” as

defined:

if it is then, broadly speaking, the amount debited to the BBRA determines the shareholders'’

disposal proceeds; and

if it is not, then the amount debited to the BBRA is a dividend for tax purposes.

The two sets of cases are:

FCT v Consolidated Media Holdings Ltd [2012] HCA 55 (CMH); and

Cable & Wireless Australia & Pacific Holdings BV (in liquidatie) v FCT [2016] FCA 78 (C&W).

Frustratingly, the cases come to opposite conclusions in relation to similar fact patterns.

BBRAs appear to have little or no relationship with the real world, and their use highlights the risks in

effectively outsourcing tax outcomes to (rubbery) accounting treatment.

6.2.2 Conventional accounting

Tax is the only discipline that has definitive views on the amount of share capital that should be

debited under an off-market buy-back. The ATO view in PS LA 2007/9 is that generally a debit

reflecting the “average share capital per share” should be applied in order to fall within the de facto

safe harbour from the application of s.45B.

Conventionally, the balance of the BBPP would be debited to the retained earnings account.

However, there is a reluctance (in Australia at least) to account for a transaction so that the retained

earnings account has a negative balance.



The balance of the BBPP could be debited to issued capital – although it would be expected that the

amount to be debited is capped at the issued capital account balance (although not addressed in

C&W, Optus would have had negative share capital if the BBPP was debited entirely to share capital).

It is clear from both CMH and C&W that it is acceptable from an accounting perspective to debit some

or even all of the BBPP to a BBRA.

A BBRA starts life with nil balance and then goes negative. It never has a positive balance.

Often the BBRA is later set off against the issued share capital account. This was the case in both

CMH and C&W. Where this happens it would be reasonable to assume that this should be fatal to the

argument that the BBRA is not a share capital account – but seemingly not.

6.2.3 CMH

The facts

The facts of CMH are familiar to us. In summary:

CMH was the sole shareholder of Crown Ltd;

in 2002 approximately 30% of Crown’s shares were bought back by for $1bn consideration;

Crown had created a BBRA with a nil balance and debited that account by $1bn; and

Crown’s audited financial report for the year to 30 June 2002 showed a $1bn reduction in its

“contributed equity”.

Why the issue matters

If the BBRA:

were not a share capital account, then the $1bn purchase price would be a tax free rebatable

dividend for CMH; and

were a share capital account, then the $1bn purchase price would be capital proceeds that

generated a $400m capital gain for CMH.

That is, $120m of primary tax turned on the characterisation of the BBRA.



What the court held

The High Court held that the BBRA was a share capital account (ie, the ATO wins).

The High Court regarded the Corporations Law record keeping requirements as forming the relevant

context for the share capital account definition. On that basis, the High Court concluded that a share

capital account was an account (however described) that either:

records a transaction in relation to the company’s share capital; or

is a record of the financial position of the company in relation to its share capital.

6.2.4 C&W

The facts

The facts of C&W are more complex than CMH, as the buy-back (a bilateral transaction) occurred in a

triparty (takeover) context.

In summary:

C&W is a Dutch subsidiary of a UK based group.

In 2001 C&W held 52% of Optus.

The C&W group made a strategic decision to exit Australia.

SingTel was the only formal bidder for C&W’s Optus shares.

SingTel wanted to acquire 100% of Optus.

SingTel offered all Optus shareholders two sets of choices:

choice as to consideration: cash/scrip/cash + scrip; and

choice as to disposal method: transfer/off-market buy-back.

The Optus issued capital account balance was $5.3b.

Optus bought back 43% of its shares in 2001 – effectively all of them from C&W.

Of the approximately $6.2b BBPP:

$2.3b (37%) was debited to issued capital; and

$3.9b (63%) was debited to the BBRA.

The debit to Optus issued capital represented 43% of the balance of that account – reflecting the

percentage of shares bought back.

Optus funded the $6.2b BBPP using a loan from SingTel.



It was “reasonable to infer” from the way that the loan was structured that Optus would repay the

loan through the proceeds of issuing shares to SingTel – and this is in fact what happened.

However, that outcome was “neither obligatory nor a certainty” and it was possible that the loan

may have stayed on foot.

Why the issue matters

The parties treated the BBRA as not being a share capital account. On that basis they treated the

$3.9b debited to the BBRA as an unfranked dividend and paid $452m dividend withholding tax.

After the CMH decision, C&W requested a refund of the dividend withholding tax.

However, the ATO refused to refund the withholding tax on the basis that – despite the outcome in

CMH - the BBRA was a share capital account.

That is, $452m of tax turned on the characterisation of the BBRA.

Accounting evidence

There was conflicting expert accounting evidence about the substance of the buy-back:

McGregor concluded that the buy-back was both a return of investment and a return on

investment (the implication being that only part of the BBPP should be debited to a share capital

account); and

Lonergan concluded that the buy-back was a return of investment only (the implication being that

all of the BBPP should be debited to a share capital account). Lonergan was influenced by the

clear link to the change of control of Optus – so that the substance of the buy-back was a transfer

of Optus shares – rather than being a “stand-alone” buy-back.

What the court held

Pagone J held that whether BBRA is a share capital account is a factual inquiry and distinguished

CMH on the facts.

Pagone J preferred McGregor’s evidence – although it is difficult to discern the basis for doing so.

On that basis, Pagone J held that the BBRA was not a share capital account (ie, the ATO wins and

keeps the $452m withholding tax).

Curious aspects

Unfortunately, there is no easy path to the characterisation of a BBRA.

On the facts, it seems that just enough was done to uncouple the buy-back from the takeover in order

to support the ATO’s characterisation.



That is, the (very technical) lack of certainty that SingTel would subscribe for Optus shares seems to

have been the key, despite the transactions being highly integrated and the subscription being likely

to occur – and it did in fact occur.

I find it hard to reconcile the outcome with the objective of determining the “substance” of the

transaction.

Reconciliation is even more difficult given the accounting entries in the Optus issued capital account:

$5.3b opening value

($2.3b) debit under the buy-back

$6.2b credit for subscription by SingTel (equal to the total BBPP)

$9.2b closing value

The closing value is $3.9b greater than opening value, being the precise debit balance of the BBRA.

Moreover, in 2013 Optus netted the issued capital account and the BBRA account balances.

One wonders whether the Optus audited financial reports report would have recorded a $3.9b

reduction in its “contributed equity” – which was a pivotal fact in the CMH case.

Appeal status

Notice to appeal C&W was lodged on 3 March 2016.



7 Demergers

The application of the CGT aspects of the demerger provisions is relatively mechanical - although

there can be issues about the precise scope of the relevant “restructuring”.

There are more issues when it comes to the demerger dividend and s.45B aspects of the demerger

provisions:

Any approach to the ATO will involve a discussion about whether the demerger is “genuine” (a

requirement which doesn’t appear in the legislation).

Any connection with a possible later disposal will be scrutinised.

Generally, there is a risk of s.45B applying if insufficient share capital is returned to shareholders

– that is, the complete opposite of the s.45B approach to returns of capital and off-market share

buy-backs.


It is market practice for listed corporates to seek a ruling on demergers and so class rulings are a

relatively comprehensive source of information on demergers.

The technical issues mentioned above are rarely ventilated in demerger rulings. Rather, these issues

are typically resolved behind the scenes between the ATO and the applicant. Again, this raises a

transparency issue that may warrant further consideration.

There have been 12 class rulings issued on demergers since the start of 2014. There are few themes

that can be extracted:

with the exception of the BHPB Billiton/South32 and Brambles/Recall demergers, they involve

relatively small companies;

half of them involve the energy and resources industry; and

the BHP Billiton demerger is the only one debited entirely to a non-share capital account (this is

understood to be a first).

The demerger of South32 by BHPB Billiton is discussed further in section 8 below by way of

comparison with other forms of in specie distribution.



8 In specie distributions

As tax professionals, we tend to pigeonhole CM transactions by reference to the different tax regimes

that apply to them.

However, these distinctions are often irrelevant to management or analysts who see a potential

transaction in terms of its economic outcome rather than its particular tax “pigeonhole”.

The classic example is the in specie distribution of assets (eg, shares in a subsidiary) to shareholders.

The distribution could potentially be effected by way of capital return, dividend, off-market buy-back or

a combination of those things. It may be that Division 125 demerger relief applies, or it may not.

But the tax outcomes can vary significantly depending on the precise method adopted.

For example, the following table sets out the ATO practice in relation to the acceptable level of share

capital to be debited in different scenarios unless share capital is traceable to the distributed asset.

transaction type default rule PS LA

capital return relative proportions of share capital and profits 2008/10

buy-back average share capital per share 2007/9

demerger percentage that market value of demerged entity

represents of total market value applied to share

capital account balance

2005/21

Three in specie distributions during the period highlight almost the full spectrum of different tax

outcomes.

BHP Billiton Macquarie NAB

demerged asset 100% of South32 17% or Sydney Airport

securities

75% of CYBG

legal mechanism 100% dividend 70% capital return,

30% dividend

100% capital return

CGT event G1? no yes yes

Division 125? yes no no

dividend treatment 100% NANE income 40% franked, 60% CFI n/a (as no dividend)



BHP Billiton Macquarie NAB

distributed asset cost

base

proportion of existing

cost base

market value market value

s.45B applied? no no no

asset acquisition date distribution date distribution date distribution date

class ruling 2015/40 2014/10 and 14 2016/13

taxable disposal by

head company?

no yes yes

8.1 Some interesting aspects of the three in specie distributions

8.1.1 Macquarie Group in specie distribution of Sydney Airport securities

The dividend/capital split

It was not possible to trace MGL share capital to the SYD securities held by members of the MGL

group.

In those circumstances, the ATO applies a “slice” approach to arrive at what it considers an

appropriate capital component for a distribution: see paragraphs 60 to 76 of PS LA 2008/10.

This involved computing the relative proportions of “capital” and “retained earnings”, then applying

that ratio to the market value of the distributed SYD securities, with that market value determined as

at the Distribution Date (ie, 13 January 2014).

Practicalities

How should the capital amount be determined?

MGL’s accounts show a significant difference between its stand-alone contributed capital and its

consolidated accounting group contributed capital because of the interposition of MGL between MBL

and its shareholders (ie, the NOHC interposition).

The ATO accepted that the capital amount was the issued capital shown in the MGL stand-alone

accounts.



How should the retained earnings amount be determined?

The ATO accepted that it was the retained earnings amount shown in the MGL stand-alone accounts.

However, the difference between the stand alone and accounting consolidated retained profit

amounts were not significant – and the ATO may well focus on the accounting consolidated retained

profit amount in different circumstances.

When should the capital and retained earnings amounts be struck?

MGL did not strike accounts as at the Distribution Date. Moreover, it is more digestible for

shareholders to be presented with a particular capital/dividend split when voting on a proposed

transaction, rather than a formula. Fortunately, the ATO took those issues on board and accepted

that the capital/profit split could be based on the immediately preceding half year accounts, adjusted

for certain items such as intervening dividends received and paid by MGL as well as the Distribution

itself.

When should the market value be struck?

Even where the capital/dividend split is known in advance, it must be applied to the market value of

the SYD securities as at the Distribution Date in order to arrive at the quantum of both the capital and

dividend components.

This is relevant to MGL to complying with its s.202-70 obligation to give shareholders a distribution

statement on or before the Distribution Date.

This would have been pretty straight forward if the SYD Securities were unlisted securities as a

relatively stable market value could be arrived at. However, the issue was complicated by the fact that

SYD securities are ASX listed securities. The traded price of listed securities is generally seen as a

proxy for their market value – but obviously it fluctuates daily – as well as intra-day.

Our research did not uncover any examples of distributions of listed securities fixing in advance

either/both the dividend/capital components.

Again, the ATO took these issues on board and accepted the closing price of the SYD securities on

the last trading day before the Distribution Date as their market value.

TFN withholding from an in specie distribution

The payer of an unfranked or partially franked dividend is liable to deduct TFN withholding in respect

of the unfranked portion of dividends paid to an Australian resident where no TFN has been quoted.

Where a company pays a $100 unfranked cash dividend to a non-quoter, the company simply

deducts and remits $49 cash in respect of its TFN withholding obligation - and is statutorily

indemnified for doing so.

However, an specie distribution does not involve cash moving from company to shareholder – so the

company cannot deduct an amount of cash from the distribution. Rather, the dividend paying

company has to pay the TFN withholding and only has a statutory right to (separately) recover the

TFN withholding amount as a debt from the shareholder. Importantly, the dividend paying company



does not have a statutory right to sell (or retain) part of the property comprising the in specie

distribution to fund its TFN withholding obligation.

It is therefore, important to ensure that the dividend paying company’s constitution gives it such a

power.

8.1.2 BHP Billiton demerger of South32

The in specie distribution was debited solely to BHP’s retained earnings account.

Normally, ATO practice would require that the share capital account be debited to some extent in

order to be satisfied that s.45B does not apply.

For an in specie distribution to which Division 125 does not apply, taxpayers are generally

advantaged where the share capital component is maximised. However, different considerations

apply to a Division 125 demerger. That is because a demerger dividend is non-assessable non-

exempt – and so shareholders are typically advantaged if the dividend component is maximised, as

this allows shareholders to retain the maximum amount of cost base in the shares of both entities.

The basis upon which the ATO typically gets comfortable on the dividend/capital component split is

set out in paragraph 57 of PS LA 2005/21. Where share capital of the top company cannot be traced

to the investment in the demerged entity, then the acceptable proxy for the amount of share capital to

be debited in the demerger can be represented as follows:

Share capital debit = total share capital x market value of the demerged entity/total market value of the corporate

group

It is understood that this formula produced – in relative terms – a de minimis amount and so not

debiting any amount to share capital did not constitute a factor pointing towards the presence of the

requisite non-incidental purpose.

8.2 National Australia Bank demerger of CYBG

Division 125 was not capable of applying

The arrangement resulted in:

a distribution of 75% of CYBG shares to eligible NAB shareholders debited to NAB’s share capital

account; and

a sale by NAB of 25% of CYBG shares to institutional investors under an IPO.

At first blush, one might have thought that the 75% demerger was calibrated at less than 80% to

ensure that Division 125 did not apply. (Where the head entity would otherwise crystallise a loss on

distributing the demerged entity, it might be incentivised to ensure that Division 125 does not apply to

disregard that loss).



However, Division 125 demerger relief would not have been available to shareholders because of the

existing NAB shareholding held by MLC Limited, a 100% subsidiary of NAB15.

Why 100% share capital?

It is understood that the ATO was satisfied in the very particular circumstances that none of the

amount returned was attributable to NAB group profits.

How did NAB deal with the market value practicalities?

NAB determined the market value of the shares in CYBG – and so the debit to share capital – based

on the daily volume weighted average price (VWAP) of CYBG securities on each day of (deferred)

trading on the ASX and London Stock Exchange over the five trading days after 2 February 2016.

CYBG capital reduction

Interestingly, the newly created CYBG company issued shares as consideration for acquiring assets

under the asset assembly process. This resulted in CYBG having a large amount of share capital and

no profits. This would have left its dividend policy susceptible to the effect of any future impairments.

To manage this, one of the shareholder resolutions was for CYBG to undertake a capital reduction

under the UK equivalent of s.256B, thereby creating distributable reserves.

15 Division 125.



9 Share capital tainting

9.1.1 Context

A key issue in any transaction involving an element of capital return is whether the company’s share

capital account is “tainted”.

This is because a tainted share capital account is generally taken not to be a share capital account for

tax purposes, with the effect that:

for an off-market share buy-back, the amount otherwise debited to the share capital account will

be a dividend for tax purposes16;

for a return of share capital, the amount otherwise debited to the share capital account will also be

a dividend for tax purposes17; and

in both cases, the (deemed) dividend will not be frankable as it is sourced directly from the

company’s share capital account18.

In addition, a franking debit and untainting tax may arise for the company.

These are seriously adverse outcomes.

Yet there is precious little guidance on the share capital tainting provisions. In this regard:

there are only a small number of ATO IDs and edited private rulings on point;

the ATO did issue a useful fact sheet, but it has been removed from the ATO website for reasons

that have not been publicly communicated19; and

The ATO has more recently issued a very high level fact sheet20.

An ATO officer has confirmed that there have been only a handful of instances of untainting tax being

paid since the share capital tainting provisions were reintroduced in 2005.

One has the impression that there is a lot of iceberg lurking beneath the water in this area.

16 Refer s.975-300(3) and s.159GZZZP(1). 17 Refer s.975-300(3) and paragraph (d) of the definition of dividend in s.6(1). 18 Refer s.975-300(3)(ba) and s.202-45(e). 19 It can still be accessed here:

http://web.archive.org/web/20090817092028/http:/www.ato.gov.au/print.asp?doc=/content/00106952.htm 20 https://www.ato.gov.au/Business/Imputation/In-detail/Simplified-imputation/Fact-sheets/Share-capital-account-tainting/

http://web.archive.org/web/20090817092028/http:/www.ato.gov.au/print.asp?doc=/content/00106952.htm

https://www.ato.gov.au/Business/Imputation/In-detail/Simplified-imputation/Fact-sheets/Share-capital-account-tainting/



9.1.2 The provisions

The policy background to the share capital tainting rules can be put succinctly:

“… the share capital tainting rules are integrity rules designed to prevent a company from disguising a distribution of

profits as a tax-preferred capital distribution by transferring profits into its share capital account and subsequently

making distributions from that account.”21

The primary provisions are found in Subdivision 197-A.

The principal provision is s.197-5(1) which provides as follows:

“(1) Subject to subsection (2), this Division applies to an amount (the transferred amount) that is transferred to a

company's *share capital account from another of the company's accounts, if the company was an Australian resident

immediately before the time of the transfer.

As can be seen, Division 197 applies to any transfer to a share capital account from an account that is

not a share capital account. That is, Division 197 is not confined to the capitalisation of profits.

The balance of Subdivision 197-A is made up of transfers that otherwise satisfy s.197-5(1) but which

are excluded from the operation of the share capital tainting provisions.

The categories of excluded transfers are summarised below:

transfers of amounts that could at all times be identified as share capital22;

transfers of amounts transferred under debt/equity swaps, subject to a cap;

transfers of amounts on certain companies ceasing to have par value shares;

transfers from option premium reserves; and

transfers associated with certain demutualisations.

9.1.3 Things we are relatively certain about

A number of concepts that are key to Subdivision 197-A are undefined, raising uncertainty.

Nevertheless, we can be relatively certain about the following matters:

a “transfer” requires a reduction in one account and an increase in another account23;

“increase both sides” journal entries do not constitute a “transfer”24;

21 para 4.4 of in the Explanatory Memorandum to the Taxation Laws Amendment (2006 Measures No.3) Bill 2006

(Division 197 EM) 22 The example commonly given is the amount subscribed for convertible notes which, before conversion, are recorded in a

liability account 23 Paragraphs 4.12 and 4.13 of the Division 197 EM 24 Paragraphs 4.12 and 4.13 of the Division 197 EM



a transfer between two accounts, each of which is treated under s.975-300(2) as part of the

company’s single share capital account is not a transfer to which Division 197 applies;

paragraph (a) of the definition of “share capital account” extends to both:

a record of a transaction into which the company had entered in relation to the value

provided by its shareholders for the issue of shares; and

a record of the financial position of the company in relation to the value provided by

shareholders for the issue of shares25;

an “account” is a reference to the accounting concept of a record of debits and credits26;

stand alone company accounts are the relevant accounts (not accounting group consolidated

accounts)27; and

the accounting entries expected by ASIC when RPS are redeemed out of profits result in share

capital tainting28.

However, even where the relevant accounting entries do not prima facie produce share capital

tainting, the ATO practice appears to be to apply a “backstop” approach by asking whether there is a

divergence between the form and substance of the transaction and, if so, whether the substance of

the transaction offends the policy of the provisions.

9.1.4 Some potentially problematic areas

Potentially problematic areas in relation to Division 197 include the following:

identifying precisely which accounts in the equity section of a company’s balance sheet are (and

are not) share capital accounts;

great care in particular must be taken with credit entries in respect of employee share and option

plans29;

entries in relation to treasury shares; and

credit entries to the share capital account made in error which are subsequently remediated

through correcting and reversing journals.

25 FCT v Consolidated Media Holdings [2012] HCA 55, Ford’s Principles of Corporations Law RP Austin & I M Ramsay 14th Ed,

Butterworths Aust 2010 at [17.100] , Archibald Howie Proprietary Ltd & Ors v. Commissioner of Stamp Duties (NSW) (1948) 77

CLR 143, St George Bank Ltd v. FCT (2009) 176 FCR 424; [2009] FCAFC 62, paragraphs 31 and following of TR 2012/1 26 FCT v Consolidated Media Holdings [2012] HCA 55 27 ATO ID 2009/94 28 https://www.ato.gov.au/Tax-professionals/TP/Finance-and-Investment-Sub-committee-minutes---8-August-2006/?page=12 29 For example, the ATO may no longer hold the views expressed in the private rulings with authorisation numbers 90710 and

1011712550009

https://www.ato.gov.au/Tax-professionals/TP/Finance-and-Investment-Sub-committee-minutes---8-August-2006/?page=12



9.1.5 Observations

Many Australian resident taxpayers would regard their share capital account as an “asset”. After all,

they would expect that it could support tax deferred capital returns to shareholders. And where the

share capital account has a multi-billion dollar balance, it is a material asset on any view.

However, share capital tainting does not have a purpose requirement nor does it have a de minimis

carve out. The outcomes are binary – either the whole share capital account is tainted or it is not.

And the consequences of tainting a share capital account are draconian.

Favourable rulings on returns of capital and buy-backs will only be issued on the basis that the

company’s share capital account is not tainted. This is manifested in the “other relevant matters”

section of every ruling dealing with a capital return or buy-back. The relevant paragraph will be along

these lines:

This ruling is prepared on the basis that immediately before the return of capital/buy-back the relevant company’s

share capital account was not tainted for Division 197 purposes.

A statement to this effect will have been included in the relevant ruling application, which will have

been signed off by the company.

Experience indicates that there is some variation in the degree of rigour applied to issuers’ verification

of these statements. For example, some companies focus only on the accounting for major

transactions, rather than all share capital account credit entries.

Best practice in terms of a verification process involves the following steps:

Step #1: identify which of the accounts in the equity section of the head company’s stand alone

balance sheet are (and are not) a share capital account in light of the test described above.

Step #2: identify all credit entries to the identified share capital accounts since I July 1998.

Step #3: analyse those credit entries and form a view as to whether any tainting has occurred.

Step #4: calculate and pay untainting tax, if required.

To best ensure that no tainting subsequently occurs (and simplify the verification process for future

capital returns/buy-backs), it is vital that group tax has an approval/supervisory role in relation to any

credits proposed to be made to the accounts identified under step #1. That is, processes should be

put in place so that no such entries can be made without group tax sign off.



10 Part C: raising capital

10.1 Overview

There have been significant capital raisings by Australian corporates in the period since the start of

2014. The resources industry has been heavily represented with Santos raising $3b, Origin Energy

$2.5b and AGL $1.2b.

However, not many capital raisings involve class rulings – as capital raisings aren’t generally

associated with significant tax issues.

Nevertheless, capital raisings can involve interesting tax issues relating to:

retail premiums: see 10.2 below;

rights issues and share plans: 10.3 below;

hybrid capital: see 10.4 below;

equity funded dividends: see 2.4 above.

10.2 Retail premiums generally

Retail premiums have been with us for a while now. They are designed to increase the perceived

fairness of rights issues by ensuring that generally unsophisticated retail shareholders can receive an

amount in respect of their rights despite neither selling them nor exercising them.

The tax issues associated with retail premiums were covered comprehensively by my colleagues

Richard Hendriks and Cameron Blackwood in their “Capital Management” paper at the Tax Institute

NSW 7th Annual Tax Forum. Accordingly, the commentary below provides a summary of the issues

and an important update on the ATO thinking in this area.

The relevant aspects of a typical retail premiums are as follows:

a company makes a “retail entitlement offer” under which it grants rights to existing retail

shareholders to subscribe for shares at a discount to their prevailing trading price (there will

typically also be either an institutional share placement or rights issue);

the rights are exercisable within a specified period;

the rights are typically “renounceable” – meaning that they can be transferred, typically on market,

during the specified period;

if the retail shareholder doesn’t either exercise or transfer the rights within the specified period,

then the unexercised rights (or shares equivalent in number to the unexercised rights) are offered

to institutional investors under a book-build tender for a price (clearing price); and



if the clearing price exceeds the exercise price of the rights, then the retail shareholder receives

the difference (retail premium).

It will be recalled that s.59-40 was enacted following the High Court decision in McNeil30. Its effect is

that shareholders are not taxed on the grant of entitlements under a rights issue.

Moreover, the tax consequences of retail shareholders either selling rights or exercising rights and

subscribing for shares are well known.

However, determining the tax consequences of receiving the retail premium raises a number of

issues.

TR 2012/1 sets out the ATO view on a particular retail premium structure that was prevalent in the

market at that time.

The ATO view is that a retail premium under that particular structure is either an unfrankable dividend

or ordinary income. This produces adverse outcomes for retail premium recipients:

resident shareholders are not eligible for the CGT discount on the retail premium. Moreover,

where resident shareholders have not quoted a TFN, ABN or other relevant exemption, the

company may be required to withhold TFN withholding; and

non-resident shareholders will not necessarily receive the retail premium tax-free – rather, they

may be subject to dividend withholding tax.

Critical aspects of the market practice on retail premium structures have evolved from the structure to

which TR 2012/1 is directed.

TR 2012/1 structure current market practice

rights are non-transferrable? yes no

rights lapse? yes no - sold into the book-build

retail premium paid by

company?

yes no – paid by investment bank

The analysis and conclusions in TR 2012/1 seem not to apply to the current market practice for retail

premiums.

Despite this, the offer documents provided to shareholders have been very cautious – regularly

stating that there is a risk that the ATO views still apply. This puts companies in a difficult position in

terms of the decision whether or not to withhold.

This uncertainty is unsatisfactory.

30 FCT v McNeil [2007] HCA 5



In that regard, senior ATO officers have publicly expressed the view in The Tax Institute’s 2016

National Convention that resident shareholders are eligible for the CGT discount on the retail

premium and no TFN withholding is applicable.31 However, they said that the ATO is still considering

its position in relation to non-resident shareholders.

It is hoped that the ATO quickly forms a view on the outcomes for non-resident shareholders and

updates TR 2012/1 as a matter of urgency.

10.3 Rights issues and employee share trusts

As indicated above, the effect of s.59-40 is that shareholders are not taxed directly on the grant of

entitlements under a rights issue.

However, employees who hold their shares under an employee share trust can be taxed indirectly on

the grant of entitlements.

This would be the case where the trustee first receives the entitlement and then secondly makes the

employee absolutely entitled to the entitlement so that they can direct the trustee how to deal with the

entitlement. In that fact pattern the CGT analysis is as follows:

CGT event E5 happens to the employee – but they are not taxed (directly) as the entitlement is

acquired for no consideration;

CGT event E5 also happens to the trustee - and a capital gain equal to the market value of the

entitlement upon grant is included in the trust’s net income;

the trustee would typically allocate the capital gain to the employee;

the ATO accepts that the employee gets a cost base equal to the market value of the entitlement

upon grant;

if the employee sells their entitlement or receives a retail premium, they will make a capital gain or

loss equal to the difference between their cost base and the proceeds – so perhaps being taxed

on grant produces no discernible detriment; and

however, if the employee exercises their entitlement and subscribes for shares, the cost base of

the entitlement is included in the shares acquired (together with the amount subscribed) – in

which case being taxed up on grant produces a real detriment to the employee.

These outcomes should not arise if the trust constitution provides that the employee is absolutely

entitled to the entitlement on receipt by the trustee. However, it may be necessary to change the trust

constitution to achieve this outcome.

31 http://law.ato.gov.au/atolaw/view.htm?DocID=rtf/ntlg20160302

http://law.ato.gov.au/atolaw/view.htm?DocID=rtf/ntlg20160302

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NSW 9th Annual Tax Forum · The ASX 200 is relatively heavily weighted towards banks. Australian banks are particularly profitable by world standards and have some of the highest