Tax Insight: Draft Share Buy-back Rules

By Ryan Leslie, Alistair Haskett and Graeme Cooper

Summary

One of the few tax surprises in the October 2022 Budget was the announcement that “the tax treatment of off-market share buy-backs undertaken by listed public companies" would be aligned "with the treatment of on-market share buy-backs.” Treasury has now released an Exposure Draft of the legislation to deliver this measure. The draft legislation contains a few surprises.

Background

Dedicated provisions about the tax treatment of share buy-backs were inserted into the tax legislation in 1990. The provisions dealt with the treatment of both the company and the shareholder, and, so far as the shareholder was concerned, differentiated between on-market transactions and off-market transactions. Because an “on-market purchase” could only be undertaken in respect of a share listed on a stock exchange, by implication, the regime differentiated between buy-backs undertaken by listed public companies and those done by other companies.

At the time the provisions were enacted, Treasury’s concern was to attach dividend treatment to part of the buy-back price received by shareholders in most companies, or to put it the other way, to prevent shareholders, where possible, from receiving only gain / loss treatment from participating in a buy-back. The lore at the time was that Treasury would have liked to attach dividend treatment to both on-market and off-market transactions, but it was considered impractical to do this for on-market transactions in listed public companies – sellers of shares in listed public companies simply could not know if their shares were being bought on-market by the company or by someone else. But Treasury did not give up without a fight: it insisted on dividend treatment, even for transactions in listed public companies, if the transaction was not “in the ordinary course of trading on [a] stock exchange.”

The proposal in the October 2022 Budget not only revises the original 1990 policy, it also rejects the recommendations of the Board of Taxation in 2008. The Board had recommended a so-called “slice approach” which divided the amount received by shareholders in an off-market buy-back between the return of capital and the amount deemed to be a dividend, based on the average capital per share (which approach has typically been used in practice in any event). The Board had also recommended aligning the tax treatment of off-market share buy-backs for listed and unlisted companies. In the 2009-10 Budget the government announced that it accepted the Board’s “slice” recommendation, praising the Board’s recommendation: it would “facilitate the optimal allocation of capital across the economy” and “increase certainty and flexibility for companies undertaking off-market share buy-backs and their shareholders.” As it turned out, no legislation was enacted during the next 4 years, and the measure was cancelled by the incoming government in 2013.

Shift forward 30 years from the original 1990 amendments and Treasury’s original theory has shifted markedly: the policy now is to prevent shareholders in listed public companies who participate in an off-market share buy-back receiving dividend treatment for part of the price they receive. The draft explanatory memorandum provides very little by way of explanation for the change in policy, stating only that “[c]hanges to the income tax laws since the commencement of Division 16K now makes the distinction between off-market and on-market buy-backs for listed public companies inappropriate.”

Proposed amendments

The proposed amendments will leave much of the existing legislative framework in place:

• the company undertaking the buy-back will still not trigger income, deduction, gain or loss,
• the tax treatment for shareholders in on-market transactions still generates only gain or loss, and not a dividend, and
• the tax treatment of shareholders in off-market transactions remains unaffected for companies that are not listed public companies. This turns out to be an important device: other provisions in the draft work on the assumption that buy-backs in some circumstances will still trigger a deemed dividend. The most obvious candidates for ongoing dividend treatment are buy-backs of shares by unlisted companies.

The main new provision in the draft proposes that none of the amount received by a shareholder in an off-market buy-back will be deemed to be a dividend if the buy-back is being undertaken by a listed public company. Since a buy-back by a listed public company does not give rise to a dividend for corporate law purposes, and is now not “taken to be a dividend” for tax purposes, the payment is not “distribution” and so is not frankable.

But there are two unannounced elements in the draft legislation.

First, there are two modifications to the franking rules:

• a new franking debit is inserted to require a listed public company in an off-market buy-back to debit to its franking account (even though none of the buy-back price is a frankable distribution). The operative provision works by saying, pretend the listed public company is not listed. The assumption behind this seems to be, once we assume the listed company is actually unlisted, the current provisions in the law, which will survive these changes unamended, will operate to trigger a franking debit. The amount of the debit is set at the company’s benchmark, or 100% if the company does not have a benchmark; and
• the debit to the franking account which currently happens when a company pays an amount under an on-market buy-back (even though none of the amount is a dividend) is re-written. The amount of the debit is currently set by reference to the debit that would happen in an off-market buy-back, but since off-market buy-backs by a listed public company will no longer be frankable, this comparison no longer makes sense. Again, the device is, just pretend the listed public company is not listed (which means the existing franking debit can continue to happen). While the amount of the debit is not set out with precision, if the existing practice for on-market buy-backs continues, the amount of the franking debit will be determined by the amount of the buy-back consideration that is not debited against the company’s share capital account. Under the existing rules for on-market buy-backs, the ATO accept this is a matter to be determined by the company. So, for example, a company with a significant amount of share capital may debit the entire buy-back proceeds against share capital to ensure no franking debit arises to prevent double taxation of the company’s profits. The relevant ATO guidance also makes clear that they generally won’t apply s.45B of the ITAA 1936 in this scenario, which is intended to prevent capital streaming in preference to assessable dividends. Given the intention to align the treatment of off-market and on-market buy-backs, it would be reasonable to expect the ATO will adopt the same approach under the amended rules, however this remains to be clarified.

Secondly, the legislation expands the scope of these rules from share buy-backs (and the accompanying cancellation of the share which happens under the Corporations Act), to include share cancellations occurring as part of a selective reduction of capital. A new provision will make unfrankable “a distribution by a listed public company that is consideration for the cancellation of a membership interest … as part of a selective reduction of capital.” The assumption behind this provision seems to be that a selective capital reduction does not meet the definition of a “buy-back”; the company is not buying a share in itself from the shareholder. The new provision is drafted to refer to situations where some of the company’s shares are cancelled; it does not explicitly refer to situations where a company returns an amount to shareholders but leaves the number of shares on foot. Even though the payment in a capital reduction is unfrankable, the payment will trigger a debit to the franking account. The amount of the debit is set at the company’s franking benchmark, or 100% if the company does not have a benchmark.

The new provisions will apply to buy-backs and share cancellations undertaken by listed public companies after 7:30pm on 25 October 2022. Share buy-backs and cancellations which were on foot on that date are protected if they were announced to the market operator and to the market before 25 October 2022.

The proposed amendments arise while we await the government response to consultation submissions on exposure draft legislation concerning franked distributions funded by equity raisings – see our previous article here.^[1] Suffice to say, the amendments collectively mean the old practices in regard to capital management activities will need to be re-evaluated (by taxpayers and the ATO) in the years ahead.

Next steps

The draft legislation is open for consultation until 9 December 2022.

^{[1] https://hsfnotes.com/taxaustralia/2022/09/20/tax-insight-draft-legislation-on-franking-and-capital-raising/}