Share Capital Tainting Rules
The Government has finally acted to re-instate legislation dealing with the tax consequences of share capital tainting – a new Bill was introduced into Parliament on 25 May 2006 and is expected to pass without delay or difficulty. This Tax Brief examines the kind of transactions that are labelled “share capital tainting” and the tax consequences that follow.
Share Capital Tainting
Rules dealing with share capital tainting were announced in 1997 as a consequence of Treasury’s corporate law economic reform program. The Company Law Reform Act 1997 relaxed existing corporate law requirements and processes for capitalising profits – for example, a company would be allowed to add to its share capital account without having to issue bonus shares. This new flexibility meant that a company could now, by journal entry, in effect eliminate its retained and current year profits and increase its share capital account at will. This caused an obvious difficulty for the tax system – a distribution from retained or current year profits would of course be assessable as a dividend, while a distribution from share capital would be treated as a return of capital triggering, in most cases, a deferral or reduction in tax.
So, share capital tainting rules were introduced into the tax legislation modelled on existing rules which dealt with the tainting of share premium accounts. The idea behind tainting rules was that crediting share capital with current year or retained profits would taint the account and distributions debited to a tainted account would be treated as unfranked dividends for tax purposes. Of course, when the legislation was drafted, tainting was triggered in many more circumstances. It applied when anything other than share capital was credited to the share capital account, not just when current year or retained profits polluted the account.
These rules remained in place until 30 June 2002 when they were – perhaps inadvertently – turned off by the legislation which introduced the new imputation system. The Minister announced in September 2002 that new legislation would be introduced into Parliament to rectify this position and would be backdated to 1 July 2002.
Further pressure to re-enact – and at the same time to qualify – the tainting rules was added by the adoption of the Australian equivalent of the international financial reporting standards (“AIFRS”) from 1 January 2005. Some of the accounting policies mandated by AIFRS posed the serious risk of requiring accounting entries which would trigger the impending and back-dated tainting rules.
The new legislation attempts both to fill the void left by the 2002 amendments and to deal with some of the issues of the transition to AIFRS. It is modelled on the former legislative framework and has the same substantive effects, although with some modifications.
Commencement and remedying the black hole of history
The Bill does not implement the Minister’s announcement in September 2002 that any new legislation would be backdated to 1 July 2002. Rather the new measures will (when enacted) apply only from 26 May 2006 – the day after the Bill was introduced into Parliament.
There are thus three relevant periods to consider:
-
the original tainting rules apply from 1 July 1998 (the date of proclamation of the original legislation) to 30 June 2002. Note, however, that some of the rules which applied during this period are amended retrospectively by this new Bill;
-
during the period 1 July 2002 to 25 May 2006, no tainting rules operated. The Explanatory Memorandum (“EM”) to the Bill implies that this was a deliberate policy decision to eliminate any one-time exposure arising from the initial shift to AIFRS which occurred in 2005; and
-
on and after 26 May 2006, the new legislation will apply.
The Bill also amends the former legislation to bring a degree of conformity to the position of companies which had tainted their share capital accounts prior to 1 July 2002 and those which undertook similar transactions in the period between 1 July 2002 and 25 May 2006 – a period in which, it now turns out, no tainting rules operated, despite the Minister’s Press Release. For companies which had a tainted share capital account as at 30 June 2002, the Bill contains a provision which effectively brings it into the new regime as a tainted account from 26 May 2006. But the process by which this is done untaints a tainted share capital account for the intervening period between 1 July 2002 and 25 May 2006. Thus a distribution made from a tainted share capital account in this period will not be affected by tainting rules. If a company paid untainting tax during this period or a shareholder treated a return of capital as an unfranked dividend because of the tainting rules, the position should now be reviewed.
New legislation
3.1 Tainting the share capital account
The Bill retains the notion that tainting occurs where an amount is transferred to a company’s share capital account from another of the company’s accounts.
The EM for this part of the Bill stresses the second element of the definition – that the amount must be transferred from one of the company’s existing accounts, rather then being an initiating entry in the company’s share capital account. In particular, the EM notes that there is no transfer “if an expense account is debited at the same time that the share capital account is credited.” This passage is an oblique reference to the AIFRS requirement that equity-based remuneration – employee share and option plans – be treated as an expense of the company. The EM takes the view that the accounting entries made should not result in the tainting of the share capital account, even if the expense account entry will ultimately have an indirect effect on the current year profits or retained profits recorded in the balance sheet.
The Bill re-enacts and expands the list of accounting events that will not cause the share capital account to be tainted. The most common exceptions will arise from debt-equity swaps and the conversion or demutualisation of companies. But the ongoing consequences of the AIFRS requirements – a major industry concern which has been the subject of extensive consultation with Treasury over several years – does not merit specific inclusion in this list. The only comfort offered to businesses is an extract in the EM referred to above.
3.2 Consequences of tainting the share capital account
Where a company taints its share capital account, the immediate consequence for the company is that it will suffer a debit to its franking account at the end of the franking period. The amount is the debit that would have arisen if the company had paid a dividend to its shareholders of the transferred amount. Hence transferring $700 into the company’s share capital account will trigger a debit of $300 in the company’s franking account assuming the company has a franking benchmark for the period of 100%. If the company’s franking benchmark is 80%, the debit to the franking account would be $240. If the company has no franking benchmark for the period, it will be treated as having a benchmark of 100%.
Additional consequences follow for shareholders if the company thereafter attempts to return share capital to them. Distributions from a tainted share capital account are treated as unfranked dividends for tax purposes, rather than returns of capital.
3.3 Remedying a tainted share capital account
The effects of tainting can be reversed by the company, but at a price.
If a company wishes to untaint its share capital account it can do so by paying untainting tax. The amount of untainting tax depends upon (a) who are the company’s shareholders, and (b) whether the company’s franking rate was 100% in both the year in which the share capital account was tainted and the year in which the untainting election is made:
-
If the company is owned entirely by taxpayers with a marginal tax rate on dividend income at or below 30% (for example, complying superannuation funds, other companies or non-residents) and its franking rate was 100% in both years, no untainting tax is payable. The logic of this position is that no further tax liability would have arisen in the shareholders’ hands if the company had paid a franked dividend to its shareholders of the transferred amount.
-
If the company is owned only by shareholders which are complying superannuation funds, other companies or non-residents, but its franking rate was less than 100%, untainting tax is payable. The amount of untainting tax is calculated to approximate the amount of additional tax that would have arisen in the shareholders’ hands if the company had paid a dividend to its shareholders of the transferred amount, assuming (a) all shareholders were liable to pay tax at 30% and (b) were entitled to the benefit of the franking debits generated at the time that the share capital account became tainted and when the untainting election was made.
-
If the company has any individual shareholders, again untainting tax is payable. The amount of untainting tax is calculated to approximate the amount of additional tax that would have arisen in the shareholders’ hands if the company had paid a dividend to its shareholders of the transferred amount, assuming (a) all shareholders were liable to pay tax at the highest personal marginal tax rate and (b) were entitled to the benefit of the franking debits generated at the time that the share capital account became tainted and when the untainting election was made.
In addition, the company will suffer a further debit to its franking account if its benchmark rate in the untainting year is higher than the rate in the year in which the account became tainted.
3.4 Application to consolidated groups
The EM to the Bill mentions some of the implications of the tainting rules for consolidated groups and MEC groups. There are no express provisions in the Bill to bring about these consequences; the EM apparently operates on the assumption that the proposed law will bring about these results for groups without the need for any express provisions.
The EM provides that:
-
where a subsidiary member transfers an amount to their share capital account, it is the subsidiary member (rather than the head entity) whose share capital account is tainted. Presumably this means that tainting by subsidiary members will almost never have any effect on distributions – the head entity can return capital from its untained share capital account, and distributions by the subsidiary member to the head entity are disregarded under the single entity rule. Distributions by the subsidiary on shares that are debt interests would, however, remain susceptible to the rules.
-
However, the debit to the franking account will arise in the single group franking account;
-
The calculation of the amount of untainting tax will depend on the identity of the shareholders in the subsidiary member, rather than the head company which (a) seems inconsistent with the first proposition that it is the subsidiary which suffers tainting consequences and (b) does not obviously follow from the single entity rule.
That much analysis is helpful but there are a myriad of other issues that will arise in the context of consolidated groups – for example, what consequences follow if the subsidiary with the tainted share capital account leaves the group and then elects to untaint the account? Again it is disappointing that such important matters are not given specific attention in the legislation.
For further information, please contact
Michael Moschner
61 2 9225 5969
michael.moschner@gf.com.au