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Tax Management

INTRODUCTION

Unlisted Pty Ltd ("Unlisted"), a company of Australia. Currently “Unlist” is the biggest shareholder Listed Limited ("Listed"). Currently, shares of Listed are incorporated on the Australian Securities Exchange ("ASX"). Listed currently has 100 million ordinary shares. Unlisted holds 25 million of ordinary shares. Listed is planning to enter into a selective off market share held by its parent company. Some reasons for the Buy-Back have been pointed out. The reasons for such decision are discussed in the underlying section.

Due to share price overhang, Unlisted has indicated a desire to sell its share. The second reason pointed out is that the bareback will allow Listed to meet the capital management aspirations. The valuation will benefit the other shareholders of Listed are expected to be material. The buy-back will not occur as a substitution for a dividend. The impact of the different division has been discussed briefly in the following sections.

Listed is proposing an off-market share buy-back the rules for which are contained in Division 16K.ITAA1936. Subdivision C allows a split of the buy-back price into the dividend and capital component. There are two main tax consequences for Unlisted namely the deemed dividends and the capital gains tax (CGT) consequences of the buy-back. The split of the buy-back is structured by Listed and this can give rise to tax benefits to Unlisted and therefore there is a need to consider the anti dividend streaming rules anti avoidance, and integrity rules. The market value of the shares will be governed by TD 2004/22 since the buyback price consists of a dividend and capital component. Currently the shares are trading on the ASX at a $40 mark and the buy-back price is $34.40 per share (14% discount to VWAP) therefore s159GZZZQ(2) ITAA1936 applies and Unlisted is entitled to receive as a consideration in respect o ........

ordinary shares. Unlisted holds 25 million of ordinary shares. Listed is planning to enter into a selective off market share held by its parent company. Some reasons for the Buy-Back have been pointed out. The reasons for such decision are discussed in the underlying section.

Due to share price overhang, Unlisted has indicated a desire to sell its share. The second reason pointed out is that the bareback will allow Listed to meet the capital management aspirations. The valuation will benefit the other shareholders of Listed are expected to be material. The buy-back will not occur as a substitution for a dividend. The impact of the different division has been discussed briefly in the following sections.

Listed is proposing an off-market share buy-back the rules for which are contained in Division 16K.ITAA1936. Subdivision C allows a split of the buy-back price into the dividend and capital component. There are two main tax consequences for Unlisted namely the deemed dividends and the capital gains tax (CGT) consequences of the buy-back. The split of the buy-back is structured by Listed and this can give rise to tax benefits to Unlisted and therefore there is a need to consider the anti dividend streaming rules anti avoidance, and integrity rules. The market value of the shares will be governed by TD 2004/22 since the buyback price consists of a dividend and capital component. Currently the shares are trading on the ASX at a $40 mark and the buy-back price is $34.40 per share (14% discount to VWAP) therefore s159GZZZQ(2) ITAA1936 applies and Unlisted is entitled to receive as a consideration in respect of the sale an amount equal to the market value as if the buy-back never occured. In this present case the buyback-price is lower than the market value. Adjusting the buy-back price to the the market value of the shares will have an effect on the CGT consequence for Unlisted by reducing the tax benefits available in the form of capital losses.

IMPACT OF DIVISION 16K ITAA1936

From the facts of the case it can be assumed that the capital management aspirations of Listed is to return excess cash or to take advantage of undervalued share price by buying back its shares at the price stated above. The capital component of 80M will be debited against Listed’s capital account. This part of the buyback will form the share capital which provokes the application of several rules due to the tax benefits that comes along with it. Under s159GZZZP(1) the deemed dividend is 264.4M (buy-back price minus capital proceeds) and this dividend will be paid out of Listed’s profits (80%). The deemed dividend will be a part of the assessable income of Listed but seeing that the repurchase price is lesser than the market value, the dividends will be frankable under s44(1) ITAA1936. There is also a requirement that these dividends require franking credits attached to it when distributed to Unlisted.

The Taxation is done by the government in order to restrict certain activities. Sometimes these activities have a negative impact on the society and those activities are taxed by the government. For each and every government across the world, the taxation is one of the greatest sources of income generation. In both, the case of the firms and consumers there are a number of taxes are imposed on them. These include property tax, income tax, and production tax (Cvrlje 2015 p.156). Among all the types the income tax is one of the greatest bases of tax. The income tax and the property tax are the only direct taxes payable to the government (Saad 2014, p.47).

In each and every department of tax, there are a lot of subdivisions and subsections each underlying different significances. Each subsection and each division of the income tax has the individual power and their place of implication is set up by the constituency of that country.

Unlisted will receive fully frankable dividends ($264M) as a shareholder. Listed has more than enough franking credits for this purpose which will result in Unlisted receiving an imputation benefit as per S207-20 ITAA1997.There is no mention of any cost base in the question but there could be a capital loss or capital gain for Unlisted which is calculated by deducting capital proceeds from the cost base. In the case that there is a capital loss it will create tax benefit for Unlisted as the loss can be used to offset current or future tax liabilities s159GZPPQ(3). Unlisted being a resident shareholder receiving franked distribution directly from Listed which is the franking entity will receive a 30% tax offset of ___ (franked distribution) and ___ (credit). Following 159GZZQ(3) there is a reduction amount which is the actual consideration minus the substituted amount which for CGT purposes can be a capital loss or capital gain thereby possibly giving Unlisted a tax benefit. TD 2004/22 lessens the tax benefits that shareholders receive by reducing the capital loss thereby enabling taxpayers to lesser tax offset. It also increases the consideration provided for CGT (Burkhauser, Hahn and Wilkins 2015, p.181).

TAX CONSEQUENCES FOR UNLISTED

Application of anti-avoidance rules

There are no guidelines from the ATO explaining to what extent the repurchase price can be assigned to the capital account of Listed. Since this allows Listed to construct the terms of the buyback accommodating to its needs, anti-avoidance rules are necessary to cancel any capital benefit or credit streaming.

These rules may apply as Listed is streaming franking credits worth ___ to Unlisted which provides it with imputation benefit. There is dividend of ___ and Listed can obtain a class ruling showing an ATO approval of the split between the buyback price (dividend and capital component) in the meantime to provide certainty to its shareholders and prevents confusion if there are future losses.

The consequence of any type of taxation acts as the negative impact on any company. The consequence of income tax is also not favorable for any firms or households. In most of the country, the income tax is directly proportional to incomes generated which means that a firm or household will have to give more number of tax with the one unit increase in the income generation. Most firms and households tend to hide part of their productions and income in order to escape from the bars of income tax (Saad 2014, p.1069).

In this context, the Unlisted Company is going to purchase the share of Listed Company. It is obvious that the Listed Company is going to face the consequence as they now have to pay more income tax. This is because the purchase of the share of their parent company will surely increase the productivity of the company “Unlisted" as buying of share is considered as the spending done by the company on investment. Though the parent company Listed is going to sell off its undervalued share the company will always have the advantage of buying back the shares by overvalued price. This procedure is more like the process of the lease to some extent where the agency who is giving lease can get back its property after a certain period of time (Burkhauser and Hahn and Wilkins 2015, p.181).

Division 202 ITAA1997: In order to frank the distributions to Unlisted Listed will have to make sure that the dividends are franked for the purposes of this division (s202-40 ITAA1997). Listed satisfies the requirements given in s202-10(__) (namely, it is an Australian resident corporate tax entity to frank the distributions (profits s202-25(__) that it provides to Unlisted. Under the operative provision S202-60 the franking credit for the distribution is $113.10M. This is calculated for the maximum franking credit that Listed currently has using the formula given in s202-60(2) ITAA1997. In case the commissioner makes a determination under 45C ITAA1936 or s177EA ITAA1936 that capital benefits of the profits become unfrankable then s202-45 ITAA1997 applies.

Unlisted should receive a distribution statement from Listed on the day that the buy-back is closed (s202-80(3) ITAA1997). In s202E there is a requirement for Unlisted to receive a distribution statement on the day or before the date when distributions are made to Unlisted. This statement should set out the details of all the distributions that will be received by Unlisted.

Division 207 ITAA1997: As a general rule the amount of franking credit (___) is included in Unlisted’s assessable income and it is entitled to a tax offset equaling to the stated amount. Since Unlisted would receive franked dividend directly it future it must be a 'qualified person' under subsection 207-20(2) ITAA1997 to receive the tax offset. If not, there will be appropriate adjustment to cancel the effect of it. Furthermore this provision is operative if the commissioner makes a determination under 177EA (5)(b) that there should be no imputation benefit. To be entitled to tax offset under 207-145(1)(a) ITAA1997 Unlisted should have held the shares it is selling for at

least 45 days ‘at risk’ (160APHO ITAA1936: holding period rule - primary qualification period).

These 45 days are exclusive of the acquisition and disposal dates. This risk test will be satisfied if Unlisted has held the ordinary shares at a minimum of 30% risk (160APHM(2) ITAA1936). The test will also be affected by various other circumstances such as future contracts of the shareholder and therefore Unlisted can obtain a class ruling to obtain the tax consequences of this rule but will have to satisfy that it has held the shares at risk for the stated period of time. This period also requires Unlisted to dispose off its most recently acquired shares and a risk assessment of the

dividends of those shares.

In addition to the the holding period rule there is the related payments rule which applies here as Listed will be passing on the advantage of dividends to Unlisted. Unlike the holding period rule Unlisted can not obtain a class ruling to check if this rule applies.

Further there is also a need to satisfy the ASX Listing Rules which require at least seven business days between the Announcement Date of an equal access share buy-back and the Record Date. This is to keep up the underlying policy of the imputation system which is to have fair spread of imputation benefits to shareholders.

Integrity Rules Apply

The main criteria for these rules to apply are that there is a capital benefit which Unlisted will receive while other shareholders do not. For this present case $80M that is debited to the capital account of Listed is share capital which is available for distribution to Unlisted.

Section 45A ITAA1936: Distribution of share capital is considered provision of capital benefit for the purposes of s45A(_). Share capital also includes the return of non-share distribution to Listed (__3A). Once the Board approves Unlisted will receive 80% of net profit for several years which for the purposes of Section 45A constitutes provision of greater capital benefits and will make Unlisted an ‘advantaged shareholder’ while Listed continues its policy of regularly paying dividends to its

shareholders. Unlisted is receiving this capital benefit which it would not receive if not for the buyback. Furthermore, from the facts of the question one of the reasons for the buy-back is to resolve the problem of share price overhang. Lower number of shares could ultimately increase share price in the long term as it will attract investors who will gain confidence a the company that repurchases

its shares.

Section 45B ITAA1936: This section works by ensuring that certain benefits in form of distributions will be included in the assessable dividends of Unlisted. Capital benefits include the distribution of share capital as it is less taxing, as well as something that has the effect of increasing share value. If Unlisted receives capital share it will receive greater capital benefit than other shareholders. It could be argued that Listed is proposing this buyback to increase the value of shares and if it is having cash flow problems to show the market a false uplift of the share prices to realise capital loss as

decreasing the number of shares owned by Unlisted will ultimately increase the value of each share. It could still be argued that this also increases the value of all other shareholders shares and therefore this condition does not apply as no one gets a greater benefit. Furthermore there is a need

to show that there is more than an incidental purpose of the tax benefit and that there is a scheme. The distribution of share capital to Unlisted constitutes a scheme for the purposes of s45B__. The interest of Unlisted would ____ if there was only dividend paid instead of the share capital. In this case the share capital is calculated using the method outlined by the Commissioner in PS LA 2007/9 therefore it can be argued that Listed did not divide the dividend and capital component of this buyback in any way to give an unfair tax advantage to Unlisted. However it is for the tax officers to

determine with regard to all circumstances whether or not the scheme is entered into to confer a tax benefit to Unlisted. The circumstances are listed in s45B(8).

Section 45C ITAA1936: This section deals with the consequences if the Commissioner makes determination under Section 45A or 45B(8). The result is that the entire or part of the capital benefits out in the form of share capital or the 80% profits that Unlisted would receive will become undrinkable dividends (class C franking debit).

Capital reduction and s45B: From the facts of the question there is cancellation of shares at the end of the buy-back. Capital reduction is governed under Division 1 and 3 Corporations Act while the share-buy back is governed by Division 2 of Part 2J1 Corporations Act. PS LA 2008/10 governs situations where there is cancellation of shares. Where shares are cancelled there is a CGT event C2

that arises which will give Unlisted a tax benefit at the time of the cancellation. The result will depend upon the cost base or reduced cost base of the shares and capital proceeds which Unlisted will receive. If the cost base is lower than the capital proceeds Unlisted will make a capital loss or if the cost base is more than the capital proceeds then Unlisted will make a capital gain. Under s6(1)

the 80M which is debited against Listed’s capital account is not a dividend and as seen above in s45C can be determined by the Commissioner to become unfrankable dividends therefore

preventing Unlisted to get tax benefits. The application of s45B to capital reductions is governed by PS LA 2008/10. The relevant circumstances for the application of s45B are the same as described above. This present case can be distinguished from capital reductions as Unlisted has the choice to decide whether or not to sell the shares and therefore will be governed by s159GZZK ___ as opposed to share capital reduction rules.

Application of anti-avoidance rules to franking credits

It is for the Commissioner to determine whether to apply subdivision 204-D ITAA1997 and/or s177EA ITAA1936 both of which operate to either impose a franking debit or deny any imputation benefit to Unlisted.

s204-D ITAA1997: This is a selective buy-back and therefore naturally only Unlisted will receive imputation benefits and and not other shareholders. As a result Unlisted is a ‘favoured member’ for this purposes of this section and it will apply to it. This is because Unlisted will receive imputation benefits in the form of dividend tax offsets as well as franking credits which attach to it and will be streamed from Listed (s204-30). s204-30(3) does not give a definition of ‘streaming’ and therefore there is a need to look into the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 (Taylor and Richardson 2014. P.14). in paragraph 3.29 of the EM the Commissioner’s starting principles are stated which include classifying shareholders in their ability to use the franking credits. It could be

argued that Unlisted would benefit from selling its shares off-market as it could make the most use off the credits since this is a selective buy-back and there could be an assumption that Listed chose Unlisted from the conclusion that other investors will not be interested in the terms of the buy-back.

This will endow Unlisted with a large portion of Listed’s profits which will otherwise not be available for distribution. If the commissioner makes a determination then the result of it will be that franking debit will arise for Listed in its franking account on the in respect of the ‘disadvantaged’ shareholders or Unlisted will not receive any imputation benefit. The amount of franking debit will be ___(s204-40(1)(a)). The ATO has a general view that off-market share buybacks are structured to provide benefits of credit streaming to resident shareholders. Since there is no information on whether other shareholders of Listed are residents or not, this view of could possibly be disadvantageous to Unlisted. It is also a possibility that if the other shareholders are

non-residents then they will not benefit from withholding tax which Unlisted as a resident will be entitled to (s128B(3)(ga) ITAA1936. It is to be noted that the Commissioner will usually only exercise his discretion in either s204 ITAA1997 or s177EA ITAA1936.

s177EA ITAA1936: This section universally applies to most off-market share buy-backs. It relates

to $264M which will be the fully franked divided for the purposes of this buy-back. There is also a need for the presence of a scheme to obtain an imputation benefit in order for this section to apply. With these dividends there will be credits attached to it which will provide an imputation benefit by giving Unlisted dividend imputation. Listed has created a scheme for a disposition which will allow

Unlisted to get tax benefits in relation to ‘franking credit benefit’. The key here is to have ‘more than an incidental purpose’ of obtaining an imputation benefit. The EM provides an objective test which states that there is a need to look into the terms of the scheme. It could be argued that since Unlisted is not the ‘true economic owner’ of those credits, it should not benefit from them. It could also be argued that Unlisted is trying to obtain franking credits in order to get tax refund.

Conversely since Listed has excess franking credits it could be an indication that the purpose or object of the buy back is to avoid "wastage" of those credits. If the commissioner finds that the buyback uses unacceptable amount of discount he will apply s177EA(5)(b) ITAA1936. In order to assess whether this section applies the Commissioner will have regard to the circumstances listed in 177EA(17). All that is required to satisfy the application of this section is one circumstance to be

present. It could be argued that Unlisted as a resident shareholder will obtain greater benefits from the fully franked dividends and it would avoid the wastage of franking credits than a non-resident shareholders (in this case there is no information on whether or not the other shareholders are residents). Since there is no information on whether the other shareholders of Listed are individuals or corporations, it could be said that Unlisted would benefit from the lower tax rate of 30% than individuals (45%). If the Commissioner makes a determination under this section s177EA(5) has to bee looked into. The effect is that he can deny the imputation benefit received by Unlisted

(177EA(5)(b)) as he can not reduce the amount of franking credits in Listed’s account as per(s177EA(5)(a) (this is because the buy-back discount of 14% is an acceptable amount and has been calculated using the 5-day VWAP of shares).

Value shifting: Since the transaction in this case is not occurring at the market value of the shares

value shifting applies. Division 725 contains provisions which apply where value is shifted from anequity interest in a company to other equity interest in the same company. From the facts of thepresent case there is equity interest at a discount to market value. Unlisted satisfies the ‘controllingentity test’ under s725-65 as Listed is its ‘controller’ and under s725-65 as the value shift is causedby the controlling company.However since in this case the value is shifted between ‘up interest’that are of the same character that are owned by Unlisted, cost base adjustments occur rather than ataxing event. Following TD 2004/22 the market value substitution rule is applied where the price ofthe shares is taken to be the market value in the event that the buy back was never supposed tooccur (s159GZZZQ(2) ITAA1936).

SHOULD UNLISTED ENTER INTO THIS BUY-BACK?

It is not necessary that a share buy-back indicates that Listed does not have enough growth opportunities or having financial difficulties. Considering that Unlisted will continue to own 15%shares in Listed after the buyback, it is in the interest of Unlisted that it enter this buy-back as it will allow Listed to utilise its capital in a productive way and coupled with future growth opportunities for Listed if any will only be beneficial for Unlisted as the value of the remaining shares will increase. Either way even if Listed was having a financial crises, lowering the number of shares

that Unlisted owns will only help Unlisted by reducing future loses in its investments. The biggest advantage of this buy-back is that Unlisted will receive finance from its investment in Listed in the form of dividends. Although Unlisted will not receive a lump sum out of its investment the tax benefits it derives from share capital are numerous as seen from above. One of the reasons listed for the repurchase is that there is a share price overhang. The other big advantage of this arrangement is that it is more tax efficient that Unlisted not receive cash immediately as the taxes would not be paid

in advance and lower transaction costs. Overall the key constituents of a successful share buybackare the existence of franking credit surplus and the tax loss which in this case is present but thedecision to participate in this buy-back would depend on all other economic considerations and the

level of confidence Unlisted has in Listed in terms of the belief that any loses will be balanced byfuture investments.

TENDER AGREEMENT - AN ALTERNATIVE?

These agreements allow shareholders to sell their shares at a range of discrete price points set by thelisted company. This gives shareholders the option to ‘tender’ any number of shares starting at thelowest price point until the company has repurchased its desired number of shares. This process willresult in capital losses since the purchase price will be low. There is also the option to extend theperiod of buyback if Listed does not meet its capital management aspirations and Unlisted will reapmore out of its remaining investments in Listed.

CONCLUSION

The reported work has been done on the Tax Law for the company Unlisted incorporated in the Listed Company. The share of the Listed is incorporated under the Australian Security Exchange (ASX). Listed has decided to sell its share to the Enlisted. The next section discusses the impact of division 16K ITAA1936. This Division signifies that the Company Listed is going to enjoy the advantage of those shares which are undervalued by buying back its shares at the price stated above. The tax consequences for Unlisted have been discussed. This section includes some subsections like an application of anti-avoidance rules. Division of 202 ITAA 1997 has been discussed. Also, the impact of Division 207 ITAA 1997 has been discussed. Section 45A, 45B, 45C of ITAA 1936 has been discussed. The discussion also contained whether Unlisted should enter into BUY-BACK POLICY. The advantages and disadvantages of this decision have been discussed. Finally, the discussion ended with the tender agreement as an alternative way.