The taxation implications of company law reform
A discussion document
Annex 2.3: Examples of Mechanisms for Taxing the Dividend Component
Example 1: Repurchase from resident shareholder
Company A has reserves comprising:
$20,000 subscribed capital
$10,000 realised capital gain
$10,000 revenue reserves
There are 2,000 shares on issue, all of the same class, held by 10 shareholders. The market value of each share is $20.
B owns 500 shares. Company A purchases those shares for $20 per share. B receives $10,000. As all of B's shares are sold, the distribution is not deemed to be in lieu of a dividend and the slice rule applies. The subscribed capital and capital gains attributable to the repurchased shares will be tax-free and are calculated in the following way:
$20,000 = $10.00 per share
$10,000 = $5.00 per share
The balance, being the dividend component, is therefore $5 per share ($2,500 in total). The company attaches the maximum imputation credits to the dividend ($1,231.34) which is the benchmark ratio for the year. As the dividend is fully imputed, no RWT is deducted. B returns $3,731.34 as assessable income and claims $1,231.34 as a credit of tax. (If B was a resident company it would also credit its ICA with $1,231.34, being the imputation credit attached to the dividend).
Where the repurchasing company is distributing tax-paid income (and assuming that the company is able to fully impute the dividend) no premium above market price need be paid to attract shareholders to sell to the company. However, where the company does or cannot fully impute the dividend component, the cost to the company of the repurchase may be greater than the market value of the shares. This is because, where there is a market for the shares, the shareholder will look for an after-tax return that is not less than what the shares could be sold for on-market.
In practice, however, it is difficult to understand why a company would prefer to pay a premium on the market value and deduct resident withholding tax rather than make a payment of tax (which it could use to offset a future tax liability) and fully impute the dividend to the shareholder.
If the shares were repurchased on-market the slice rule would automatically apply. The dividend component would also be $5 per share. A debit would arise to company A's imputation credit account as follows:
0.33 x $2,500 = $1,231.34
Example 2: Off-market repurchase from vendor who is taxable on share profits
Assume in the above example that B is a trader who purchased the shares for $15 each (and subsequently sold them to the company for $20). B receives taxable income of $5 per share, totalling $2,500 for 500 shares. In addition, (assuming the company is paying the distribution from tax-paid profits) B will receive a fully credited gross dividend of $3,731.34, comprising a dividend component of $2,500 and imputation credits of $1,231.34. This transaction has therefore been taxed twice - once as a dividend and then again as a profit on sale. To avoid this double taxation, B would be assessed only on the dividend component of the share repurchase.
If B had purchased the shares for $5 per share so that the profit on the transaction was $7,500, $5,000 ($7,500 - $2,500) would be taxable as a profit on sale.