Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton, Ciro

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1 Understanding Taxation Law 2012 by Gilders, Taylor, Walpole, Burton, Ciro Suggested answers to Activities and Questions by John Taylor and updated by Amy Koit Chapter 13: Taxation of Shareholders 2012 Reed International Books Australia Pty Limited trading as LexisNexis Permission to download and make copies for classroom use is granted. Reproducing or distributing any material from this website for any other purpose requires written permission from the Publisher. Questions 13.1 Excessive payments for services rendered by associates would be assessable income to the associates in any event. Deeming the payments to be dividends will not increase the amount that is regarded as income in the associate s hands. Why then would s 109 discourage a private company from making excessive payments to associated persons? A payment of salary to an associate would (in the absence of s 109) be deductible to the paying company. By deeming excessive payments to be dividends, s 109 has the effect of denying the company a deduction for the payment. Activity 13.1 List some reasons why a company s financial accounting profit might differ from its taxable income. There are numerous reasons why a company s taxable income and its financial accounting profit may differ. Some important ones are: Tax might not regard some items as income that financial accounting regards as distributable profit. An example would be a gain on a pre-cgt asset. Tax might recognise an item as income at a different time to when financial accounting includes it as distributable profit. An example would be income of controlled foreign companies (CFCs) attributed to Australian controllers prior to a dividend being received from the CFC. Tax might deny a deduction for an expense that financial accounting recognises. An example would be client entertainment expenses. Tax might allow a deduction for something that financial accounting might not recognise as an expense. An example would be building depreciation. Financial accounting might allow an expense for something that tax does not allow as a deduction. An example can be allowing the cost of purchased goodwill to be amortised. Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 1

2 Questions Is a wash out of corporate tax preferences on distribution consistent with a policy that the tax system should be neutral as between different forms of business organisations? 2. Some countries, such as New Zealand and the USA, permit corporate tax preferences enjoyed by small closely held companies to pass through to natural person resident shareholders (that is, the preferred corporate income is not taxed at all at the shareholder level). Is there any justification for allowing the pass through of preferences in closely held companies but not allowing pass through in widely held companies? 3. If a company s distributable profit exceeded its taxable income so that it could not frank a dividend equal to the amount of its after-tax distributable profit to 100%, what could the company do if it still wished to pay a dividend that was franked to 100%? 1. Where tax preferences are enjoyed by sole traders, or are allowed to pass through partnerships, or are only subject to deferred taxation in the case of trusts, the answer to this question must be no. In the case of preferences that are enjoyed only by companies, neutrality between different forms of business organisation would demand that the preference be washed out on distribution. 2. The rationale for this treatment appears to be that small closely held companies are more analogous to a partnership or a sole trader operation and hence should be treated in a similar way to those forms of business organisation. Another way of saying this is that, in the case of a large public company, shareholders have so little control of the company s affairs that it behaves more like a separate legal entity from its members. 3. A franking credit arises when a company pays income tax. However, a company cannot generate franking credits by voluntarily paying income tax. For a payment of income tax to give rise to a franking credit, the entity must have a liability to pay the income tax: s (3). Where there is a shortfall of franking credits (that is, because the company has overfranked its dividends) at the end of the income year, a franking deficit tax (FDT) arises. As the FDT is imposed at year end, it is possible for a company to pay franked dividends in anticipation of paying income tax at year end. If it eventuates that the franking account is in deficit, the payment of FDT will generate franking credits. Therefore, if the company fully franks a dividend for which there is insufficient franking credit, the company will pay the FDT at year end to bring the franking account to a nil balance. As discussed at 13.42, when franking credits are allocated to a distribution, they will represent either corporate tax that has been paid (or anticipated to be paid at year end) or a future FDT liability. Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 2

3 Questions Draw a diagram that represents the receipts that will be regarded as income derived by the company for the purposes of ITAA36 s 47(1). 2. Identify any profits that will form part of a company s distributable profits for company law purposes that will not form part of its taxable income. If the company derives these profits and then goes into liquidation, which of them, if distributed in the liquidation, will represent income derived by the company as defined in s 47(1A)? 1. The following diagram is one possibility. Income under ordinary concepts Amounts deemed by ITAA to have characteristics that would make them income under ordinary concepts Amounts deemed by ITAA36 s 47(1A) to be income derived by the company Amounts that are exempt income excluded Income derived by the company 2. There could be numerous examples. Two that are discussed in the text are the indexation component on any pre-21 September 1999 corporate capital gain and a gain on a pre- CGT asset. The former will be included in income derived by the company but the latter will not. Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 3

4 Questions What planning would be possible if s could never apply to an interim liquidator s distribution? 2. In both Example and Example 13.14, the prima facie capital gain made by shareholders was reduced by s Can you think of a situation where s would not reduce the capital gain to zero? 1. As the distribution would not represent a disposal of the shares, it would be possible to go on almost indefinitely making interim distributions of amounts that did not represent income derived by the company without triggering any capital gain. 2. If the capital gain does not exceed the amount included in assessable income, the capital gain is reduced to zero: s (2). If the capital gain exceeds the amount included in assessable income, the capital gain is reduced by the amount so included: s (3). This could happen if either an interim dividend or a final dividend is funded from sources other than the company s paid up capital account or retained profits reserve (for example, through borrowed funds). Activity 13.2 Benson Pty Ltd is an Australian resident private company for tax purposes. Its only shareholders are Ben and Son who are both resident natural persons who prior to the receipt of distributions from Benson Pty Ltd are on a 45% marginal tax rate. Both Ben and Son subscribed $50,000 for their shares in Benson Pty Ltd pre-cgt. Benson Pty Ltd s balance sheet is as follows: Current assets Cash $300,000 Liabilities Shareholders equity Paid-up capital $100,000 Capital profits reserve* $200,000 * Profit arose from the sale of a pre-cgt asset Benson Pty Ltd is no longer involved in active trading and Ben and Son want the assets of the company distributed to them in the most tax-effective way. Advise them as to what is the most tax-effective way to distribute the assets of the company. A voluntary liquidation will produce the best after-tax return for shareholders. A distribution of a gain on a pre-cgt asset will not be within the definition of income derived by the company in s 47(1A). See the extract of s 47(1A) at Hence no part of the distribution will be deemed to be a dividend under s 47(1). Although the cancellation of the shares will give rise to CGT event C2, any capital gain or loss on the shares will be disregarded as the shares are pre-cgt assets. If the shares were post-cgt assets, any capital gain can be reduced by the discount concessions available to Ben and Son. It may be necessary to consider the Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 4 Nil

5 operation of s in calculating any capital gain, if there are any interim distributions by the liquidator. The cash proceeds of the sale will be considered to be an underlying asset for the purposes of CGT event K6 (discussed at ). This will mean that CGT event K6 will be triggered when CGT event C2 happens as 100% of the assets of the company at that time will be post-cgt assets. However, CGT event K6 will not produce a capital gain in these circumstances as the capital proceeds of Australian currency can never exceed its cost base. See the discussion of TD 24 (now withdrawn and replaced by TR 2004/18) at An equivalent result could be obtained by a sale of shares to a third party but it would be necessary to find a buyer willing to pay a price equal to the net asset backing of the shares without discounting the price for any tax payable by the buyer on future profit distributions or sales. This will be possible if a buyer values a future capital loss on a sale of shares ex dividend as being equal to a full deduction. If not, then a buyer should pay a price that represents less than the net asset backing of the shares. At such a price, Ben and Son will be worse off than if they liquidated the company. An amount equal to the company s share capital account could be distributed tax free as a return of capital without cancellation. After that, any distribution would have to come from profits and would be a dividend or would come from a tainted share capital account and would be deemed to be a non-frankable non-rebatable dividend. A reduction in capital with cancellation funded from a share capital account would not be a dividend and would not produce capital gains for Ben and Son but the amount able to be returned tax free under this method would be limited to the amount in Benson Pty Ltd s share capital account. If the untaxed capital gain were distributed as a dividend then, to the extent that it was sourced in the untaxed gain, the dividend would be unfranked. The unfranked portion of the dividend would be taxed at Ben s and Son s marginal rates. An off-market buy-back could not be used to distribute all of the assets of the company and any portion of the buy-back price that was not debited against the share capital account would be a dividend. For the reasons stated in the previous paragraph, the dividend would be unfranked to the extent that it was funded from the untaxed corporate capital gain. Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 5

6 Activity 13.3 Assume the facts in Example with the variation that the recipient company has no deductions other than the $60,000 loss carry forward. What is the maximum amount of loss carried forward that s 37-17(5)(b) will permit the recipient company to deduct in the income year? The corporate tax entity member s position would be as follows: Dividend $70,000 Section (1) inclusion $30,000 Grossed-up dividend $100,000 Assessable income $100,000 Allowable deduction $0 Taxable income $100,000 Tax payable (at 30%) $30,000 Section (2) tax offset $30,000 Excess tax offset $0 As the entity would not have an amount of excess franking offset for the year, the entity cannot choose to apply any amount of the $60,000 carried forward loss: s 36-17(5)(b). Questions What tax advantages did the trustees in Slutzkin obtain from the arrangement with Cadiz Corporation Pty Ltd? Even in the absence of specific rules directed against dividend stripping would this sort of arrangement be as advantageous to the trustees if it were carried out today? 2. What tax advantages did Cadiz Corporation Pty Ltd gain from the dividendstripping operation? Since the abolition of undistributed profits tax, what other advantages might a company like Cadiz Corporation Pty Ltd be able to obtain through a dividend-stripping operation? 3. If you were asked to draft legislation specifically designed to combat dividend stripping, what approach would your legislation take? 1. They were able to sell the shares in the company tax free. As the sale proceeds were not assessable income they were not included in the calculation of the net income of the trust estate. This meant that they could be distributed to the beneficiaries tax free. Otherwise, if the dividends had been paid to the trustees they would have been included in the net income of the trust estate. Depending on whether there was a distribution, either the trustee or the beneficiaries would have been assessed on the net income of the trust estate which included the dividends. Now this strategy would be less attractive as any net capital gain made on the sale of the shares would be included in calculating the net income of the trust estate. Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 6

7 2. Cadiz Corporation obtained a tax-free dividend (because of the then form of the ITAA36 s 46 rebate). The tax-free dividend effectively reimbursed it for the purchase price of the shares. It then sold the shares for more than the value of the net assets of the company. In effect, this represented a tax-free gain above what it had paid for the company. It was able to do this because the company had made an excessive distribution, thus making it attractive to a private company purchaser with an undistributed profits tax liability. Following the abolition of undistributed profits tax dividend, but prior to changes in the inter-corporate dividend rebate, stripping could still be particularly attractive to share trader companies. If the shares were purchased for the value of the net assets of the company or more, the profits could be stripped through a dividend which was exempt to the recipient company because of the s 46 rebate. The shares could then be sold for little or nothing to an independent purchaser. If the dividend stripper was a share trader it would obtain a deduction for the loss that it made on the sale of the shares to the independent purchaser. 3. This is a question of opinion but students should consider the following possibilities: (i) imposing a capital gains tax on share sales (thus making the operation less attractive to the Slutzkin trustees); (ii) denying the s 46 rebate where dividend stripping is involved; (iii) excluding shares from being trading stock; (iv) applying the general anti-avoidance provision to the Slutzkin trustees; and (v) applying the general anti-avoidance provision to the dividend stripper. Questions 13.6 What would be the CGT effects if a company issued shares for no consideration to a shareholder who then sold them for their market value of $5 each? As s (5)(c) means that CGT event D1 will not apply to an issue or allotment of equity interests for no consideration, s (1)(a) will mean that the market value substitution rule will not apply to the issue. This will mean that the cost base of the shares to the shareholder will be the amount paid for them, namely zero. This will mean that the shareholder will make a capital gain of $5 per share when the shares are sold. Even if the shareholder and the company were not dealing at arm s length in relation to the issue, market value would only be substituted for the shareholder if the non-arm s length cost was more than the market value of the shares. Hence, there would be no substitution here as the cost was zero while the market value was $5 per share. Questions 13.7 Review your answer to Activity How, if at all, would consideration of s affect your response? In the situation where the shares were pre-cgt assets, consideration would need to be given to s As the proceeds of the sale will be a CGT asset for these purposes, consistently with TD24 (now withdrawn and replaced by TR 2004/18), and as they will represent 100% of the assets of the company, CGT event K6 will be triggered when the shares are sold. As the capital proceeds of the shares in the liquidation cannot exceed the net assets of the company, there will be no capital gain for Ben and Son if the company is liquidated as the capital proceeds will equal the cost base of the cash asset. If the shares were sold for more than the Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 7

8 net assets of the company, CGT event K6 would produce a capital gain equal to the excess of the capital proceeds for the shares over the cost base of the cash asset. Activity 13.4 Review the facts in Example What additional information would you require before you could establish whether Dad and Dave were affected owners of down interests and that Mabel was an affected owner of up interests? There is nothing further to establish whether Dad and Dave were affected owners of down interests as Dad and Dave are controllers. Mabel is not a controller, therefore, it is necessary to establish whether Mabel is an associate of either Dad or Dave or whether she is an active participant in the scheme. Activity 13.5 Given the statement of the preconditions for the demerger roll-over set out in Diagram 13.4, identify any further information you would require before you could determine whether the demerger roll-over was available in the circumstances set out in Diagram You would need to know whether Amundsen and Nansen were residents. If they were nonresidents you would need to know whether the interest in Terra Nova Pty Ltd had the necessary connection with Australia. This would require knowing whether Terra Nova Pty Ltd was a resident company or not. Solutions for Gilders et al, Understanding Taxation Law 2012, Ch 13 8