Share Buy Backs

A company has the power the buy-back its shares under section 257 of the Corporations Act 2001. Here we will only consider the tax implications of an off-market buy-back.

One way to facilitate an exit or to reduce the value of an entity is to undertake a share buy-back. A share buy-back can reduce the value of an entity allowing for a less costly buy-in by a prospective purchaser. It can also facilitate the taking over of a company by an existing shareholder through the use of the company’s own money.

Example

Dormi Pty Limited is currently valued at $3million and has $1million in retained profits that are partly represented by cash reserves of $300,000. A potential purchaser is interested in acquiring a 33% stake in the company, but does not want to pay $1million. A share buy-back could be undertaken using some of the available cash, effectively reducing the overall value of the company, and reducing the buy-in price for the potential purchaser.

A buy-back will generally be seen to be of benefit when the person receiving the buy-back amount is in a better position than they would have been had there been a sale of their shares. In all instances, whether or not there is a benefit will need to be determined with reference to the tax profile of the shares held and the shareholder. In general however, a company shareholder will prefer a buy-back to the extent that there is a franked dividend component, as the tax payable on such a dividend would be less than tax payable on a capital gain.

In the above example the reduction in the value of the entity that occurs is the same as would occur if a dividend had been paid prior to the potential purchaser buying in. There are however two fundamental differences between a share buy-back and the payment of a dividend:

• Dividends usually need to be paid to all shareholders that own the same class of shares whereas buy-backs can target individual shareholders; and
• While a dividend can consist of a franked and an unfranked portion, a share buy back will also usually contain a return of capital that is not treated as a dividend.

Where shares are bought back by a company, stamp duty does not generally apply, but specialist advice should be obtained, especially where the company is land rich.

For taxation purposes a buy back is treated as a repayment of capital to the extent that the payment is debited to the amount shown as a credit in the share capital account.

In Practice Statement PS LA 2007/9, the ATO has outlined the methodology that the Commissioner considers to be the most appropriate in determining the appropriate amount to debit to the share capital account of a company in an off-market buy back, this being the average capital per share approach. This approach requires that the ordinary issued share capital of the company be divided by the number of shares on issue in order to determine the amount to be debited to the share capital account per share.

To the extent that the buy-back price exceeds the capital component (up to the market value of the share) it will be a frankable dividend. If the payment exceeds the market value, the excess is an unfranked dividend.

If the amount paid is less than market value, the amount of the buy-back price is deemed to be market value for tax purposes.

There are four anti-avoidance provisions relevant to a share buy-back:

• Section 45A of ITAA 1936;
• Section 45B of ITAA 1936;
• Section 204-30 of ITAA1997; and
• Section 177EA of ITAA1936.

Legal advice is needed to ensure these anti-avoidance provisions are not breached.

Shareholders with pre-CGT shares

Prima facie, the tax position in an off-market buy-back should be less favourable for shareholders whose shares were acquired pre 20 September 1985. This is because a portion of the accrued tax-free gains on those shares would be converted to a taxable dividend under section 159GZZZP(1) of the 1936 Act and any capital loss would not be recognised for tax purposes. Nevertheless, with the availability of refunds for surplus imputation credits, pre-CGT shareholders may prefer the franked dividend to a tax-free capital gain.

Position of the Company buying its own shares

The position of the company is discussed in section 159GZZZN of the 1936 Act. It is to the effect that the company should have no income tax or capital gains tax liability or benefit flowing from the on-market or off-market buy-back.

Interposing companies as shareholders

It may be necessary to take dividends from a company as part of planning for an exit. This may be done to reduce the value of the entity to allow a purchaser to buy-in at a lower price. A dividend may also be paid prior to selling an entity as it is not cost effective for someone to acquire shares, with the intention of holding them long term, if part of the acquisition price will be returned as taxable dividends.

One of the barriers to taking dividends from a company is the tax that is payable by the recipient of the dividend. While an individual shareholder on the top marginal tax rate will pay top up tax on a fully franked dividend they receive, where a corporate entity is the ultimate beneficiary of the same dividend no further tax is payable. A company would be the ultimate beneficiary of the dividend if the company were the shareholder or where the company were the beneficiary of a trust under which the shares were held.

Natural persons that own shares in a company have the opportunity to restructure their shareholdings so that any dividends that may be received will ultimately be received by a company. In such a restructure there are ordinarily two transaction costs, stamp duty and capital gains tax. If the shares are dutiable property, their transfer will result in duty being payable. In addition, if the capital proceeds received (or deemed to be received) under the restructuring are more than the cost base of the shares, a taxable capital gain will arise.

On the creation of a trust over the shares so that any dividends that may be received will flow to a company through a trust, CGT event E2 will occur, and a capital gain may result.

Where the shares are transferred directly to a company, a CGT rollover is available under Subdivision 122A. The shares held in the original entity would be disposed of for shares in the interposed company and any capital gain or loss would be disregarded as a result of the rollover.

An example is where Fred owns all of the shares in Barney Pty Limited. The company has $2million in retained earnings, which is matched by sufficient franking credits to fully frank the distribution.

Barney is currently valued at $5million and Fred wants to sell a 25% stake in the company.

The purchaser does not want to pay $1.25million as they recognise that some of that amount is represented by retained taxable profits. They ask that Fred take a dividend of $2million prior to them buying in, to reduce the buy-in price to $750,000.

Fred decides that he will transfer his shares in Barney Pty Limited to Barney Investments Pty Limited, in consideration for shares in that company.

Following the transfer he will take a $2million fully franked dividend from Barney Pty Limited, and as it will be received by a corporate entity, no top-up tax will be immediately payable.

In deciding to restructure shareholdings in this manner, regard needs to be had to whether the arrangement:

• Will be a scheme for the purposes of Part IVA;
• Will be a scheme by way of or in the nature of dividend stripping under subparagraph 177E(1)(a)(i) of ITAA 1936;
• Will be a scheme having substantially the effect of a scheme by way of or in the nature of  dividend stripping for the purposes of subparagraph 177E(1)(a)(ii) of the ITAA 1936; or
• Will result in the claim for franking credits in the interposed company being denied under section 207-145 as the distribution has been made as part of a dividend stripping operation.