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Share Buy-Backs Practice Statement
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Andrew O’Bryan,
Partner and Marcus Desmond, Lawyer |
In anticipation of the Board of Taxation’s review of the taxation treatment of off-market share buybacks the ATO has issued a Practice Statement (PS LA 2007/9) setting out its approach to share buy-backs.
PS LA 2007/9
The contentious issue regarding share buy-backs and particularly off-market share buyback, is the extent to which a company can to debit the share buy-back amount to share capital (taxable as a capital gain) in preference to retained profits (taxable as a dividend).
Where the ATO is dissatisfied with the allocation between share capital and retained profits, it can alter the allocation via the anti-avoidance provisions, such as section 45B of the Income Tax Assessment Act 1936 (“the 1936 Act”). For this reason, we often advise our clients to seek private rulings or class rulings when an off-market share buy-back is being considered.
The Commissioner’s three allocation methods for off-market share buy-backs
The ATO’s practice statement outlines three alternative methods to calculate the split in off-market share buy-backs.
The ATO’s preferred method is the Average Capital Per Share (“ACPS”) method, which if used, is unlikely to attract the operation of the anti-avoidance provisions. The ACPS is simply the company’s share capital divided by the number of shares on issue. For instance, assume a company has 1 million shares on issue with a total share capital of $1 million and proposes to buy back its shares for $2.50 per share. Under the ACPS method, only $1 per share ($1 million / 1 million shares) can be debited against share capital. The remaining $1.50 would need to be debited against retained earnings.
The ATO’s second listed method is the slice approach. This approach involves calculating the ratio of share capital to retained earnings on a company’s most recent balance sheet. In the above example this would be 1:1. This ratio is then used to calculate the split between share capital and retained earnings. In the above example, $1.25 per share would be debited each to share capital and retained earnings.
The final method is the embedded value method. This method should only be used if a recently demutualised entity is considering a share buy-back.
It should be noted that the use of these methods is not mandatory. Even if these methods are not used, the Commissioner must determine that there a tax benefit arises before the relevant anti-avoidance provisions (either sections 45A, 45B or 177EA of the 1936 Act) can apply. This is also confirmed in his practice statement.
In considering whether a tax benefit can arise, a simple calculation can be performed to illustrate how the Commissioner may analyse the situation.
If a share buy-back were treated as a fully franked dividend and assessed to a shareholder at the top marginal tax rate (46.5%), the “top up” tax would be 23.57% of the cash dividend (eg. a $70 fully franked dividend would result in a further $16.50 tax payable). By comparison, a capital gain made by the same shareholder would be taxed at a rate of 23.25% if the 50% CGT discount were available (eg. a $70 capital gain after allowing for the 50% discount results in $16.28 tax payable).
Applying this analysis to the above example and using the ATO’s preferred ACPS approach, the dividend component would be $1.50 per share or $1.5 million. If paid as a fully franked dividend, the top up tax would be $353,550. If taxed as a discounted capital gain, the tax would be $348,750. The difference - $4,800 – is clearly negligible in the overall scheme of things.
Finally, a taxpayer’s use of another method will still be valid if the Commissioner cannot find a tax benefit. However, the use of an alternative method may be higher risk and could come at a greater cost if the Commissioner subsequently challenges the allocation split.
Board of Taxation review
In the Board of Taxation’s discussion paper on the taxation treatment of share buybacks, the Board notes that the capital/dividend split generally results in participating shareholders realising a capital loss on the sale of the shares back to the company in circumstances where they would have made a capital gain if the full sale price had been regarded as capital. This treatment ensures that those shareholders are not subject to double taxation.
However, as some shareholders can receive the dividend component effectively tax free, they will be better off than if they had sold the shares to a third party.
The Board has flagged that, as part of its review, it will consider the appropriate methodologies for determining the capital/dividend split and whether it is appropriate for shareholders who receive tax free dividends to realise a capital loss by participating in an off-market share buyback.
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