On Wednesday the High Court of Australia (High Court) unanimously allowed an appeal from a decision of the Full Court of the Federal Court of Australia and upheld an assessment by the Commissioner of Taxation (Commissioner) that Consolidated Media Holdings Limited (formerly Publishing and Broadcasting Ltd) (CMH) made a capital gain (rather than an assessable (but rebateable) dividend) when shares it held in Crown Ltd (Crown) were bought back by Crown in an off-market share buy-back.
The case was a test case regarding the meaning of the phrase “debited against amounts standing to the credit of the company’s share capital account” in section 159GZZZP(1) (which sets out how much of the purchase price for an off-market share buy-back is taken to be a dividend paid by the company to the seller out of profits derived by the company). Whilst the case was decided on its facts (in particular, the corporate documentation giving effect to the share buy-back, Crown’s statement of financial position for the income year ended 30 June 2002 and CMH’s tax return for the 2002 income year), the High Court made some observations regarding the definition of a “share capital account” (in the context of a debiting against amounts standing to the credit of a company’s share capital account) that may have a broader income tax application. These are discussed below.
CMH owned all of the ordinary shares in Crown. On 28 June 2002, CMH and Crown entered into an agreement for CMH to sell some of its shares back to Crown for $1 billion. Crown recorded a debit of $1 billion in a new account labelled "Share Buy-Back Reserve Account". It also maintained a "Shareholders Equity Account", which had a credit balance and in which no entry was recorded in relation to the share buy-back.
In an off-market share buy-back, the difference between the purchase price and any part of the purchase price that is debited against amounts standing to the credit of the company's share capital account is treated for income taxation purposes as a dividend paid by the company. At the relevant time, "share capital account" was defined in section 6D of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). The Commissioner took the view that the $1 billion purchase price was debited against amounts standing to the credit of Crown's share capital account, so that no part of the purchase price was to be taken to be a dividend. Therefore, the Commissioner assessed CMH to have made a capital gain on the sale of its Crown shares. CMH objected to the Commissioner's assessment and the Commissioner disallowed the objection. CMH appealed to the Federal Court against the disallowance of its objection. The primary judge dismissed the appeal on the basis that Crown's share capital account comprised both its Shareholders Equity Account and its Share Buy-Back Reserve Account. The Full Court of the Federal Court allowed an appeal, holding that Crown's share capital account did not include its Share Buy-Back Reserve Account.
The High Court held that an account that is a record of a transaction into which a company has entered in relation to its share capital, or that is a record of a company's financial position in relation to its share capital, is “an account which the company keeps of its share capital”, and thus a "share capital account" within the meaning of section 6D(1)(a) of the ITAA 1936. It also held that section 6D(2) required all share capital accounts to be treated as a combined "share capital account".
In the context of the buy-back of shares in Crown, the High Court held that Crown’s Share-Buy-Back Reserve Account was a record of the transaction by which Crown had, on 28 June 2002, entered into an executory contract to reduce its share capital by $1 billion and, therefore, that the Share Buy-Back Reserve was an account which Crown kept of its share capital and thus a share capital account. Accordingly, the High Court held that the $1 billion consideration CMH received under the share buy-back agreement was debited against amounts standing to the credit of Crown's share capital account and the Commissioner was correct to have assessed CMH as having made a capital gain.
Implications of the decision
Whilst the High Court decided the case on its particular facts, the Court made some observations regarding the definition of a “share capital account” (in the context of a debiting against amounts standing to the credit of a company’s share capital account) that may have a broader income tax application.
Definition of a “dividend”
“Dividend” is defined in section 6(1) of the ITAA 1936 to include any distribution made by a company to any of its shareholders, but does not include “moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders … where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company” (emphasis added).
Therefore, the High Court’s views as to what constitutes a “share capital account” will likely be relevant in determining when an amount paid, credited or distributed by a company to its shareholders is a dividend. This is important in the context of the views of the Australian Taxation Office (ATO) about the taxation of dividends paid in compliance with section 254T of the Corporations Act 2001 (Corporations Act) from 28 June 2010, which are expressed in Taxation Ruling TR 2012/5 (TR2012/5). In particular, TR2012/5 sets out the ATO’s view about the definition of a dividend for taxation purposes, the assessment and franking of dividends and the circumstances in which a dividend will be paid out of profits. Although expressing the view that the decision of the Federal Court and the comments of the primary judge relied upon are not central to TR2012/5, it is possible that the ATO may now clarify some of its views in TR2012/5 and provide further examples of situations where distributions by a company to its shareholders would not be a dividend for taxation purposes and, if they were a dividend, where they would not be frankable. Unless the Corporations Act is amended to clarify whether section 254T permits a dividend to be paid when a company has no profits (or whether such a distribution is a reduction in capital), the Commissioner is likely to be more resolute in his view (expressed in TR2012/5) that, for the purposes of the Corporations Act and company accounting, dividends can only be paid from profits.
King & Wood Mallesons released an alert on TR2012/5, which can be found here.
Proposed new share buy-back provisions
The exposure draft legislation regarding the proposed replacement share buy-back provisions also uses the phrase “debited against amounts standing to the credit of the company’s share capital account”, in the context of determining the capital component for a share or non-share equity interest bought back under an off-market buy-back. This will, in turn, be relevant in the context of determining when a dividend is taken to be paid by a company conducting an off-market buy-back (and, if so, the amount of such a dividend).
Therefore, if the share buy-back rules are re-written along the lines of the exposure draft legislation, we would expect that the High Court’s views as to what constitutes a “share capital account” will be equally relevant in determining when a dividend is paid in respect of an off-market buy-back.
What is an “account”?
Central to the High Court’s views as to whether an account would answer the description of “an account which the company keeps of its share capital” was the contemporaneous commencement on 1 July 1998 of Part 2M.2 of the Corporations Law and sections 6D and 159GZZZP of the ITAA 1936. That is, the High Court held that section 6D must be read in light of Part 2M.2’s replacement of concepts of a company having “accounts” and “accounting records” with the notion of a company having “financial statement” and “financial records” (and, more generally, in a context in which the relevant record-keeping obligation of a company was to keep written financial records that correctly recorded and explained its transactions and financial position and performance and that would enable true and fair financial statements to be prepared and audited).
Therefore, it might be expected that the High Court would come to a similar view in respect of other references to an “account” in the ITAA 1936 and the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) that commenced contemporaneously with Part 2M.2 of the Corporations Law. Conversely, it might now be the case that all references to an “account”, regardless of when they were introduced into the ITAA 1936 and ITAA 1997, should be read in this light.
Urgent Issues Group Interpretation 1052 (Tax Consolidation Accounting) sets out, amongst other things, the circumstances where tax consolidation equity adjustments arise between a subsidiary and the head entity of a consolidated group (being a contribution by, or distribution to, the head entity). In light of the High Court’s comments, consideration may need to be given to whether an equity contribution by a head entity to a subsidiary is “a record of a transaction into which a company has entered in relation to its share capital”, and thus whether the account to which such adjustments are made is a “share capital account” (to the extent to which they are classified as “contributed equity” rather than being made to the company’s ordinary share capital account). This may be relevant in an M&A context (e.g. where a subsidiary of a consolidated group is disposed of and, more particularly, whether the subsidiary has a tainted share capital account). Consequently, corporate groups may wish to revisit their tax funding agreements to ensure that tax consolidation equity adjustments do not arise.