The taxation implications of company law reform
A discussion document
Chapter 4: Tax Accounting Issues
This chapter covers tax accounting questions associated with the transition between the existing and the new companies regime, as well as issues relating to company distributions made other than by way of share repurchases. The following areas, in particular, are discussed in this chapter:
- treatment of the existing capital reserves of companies registering under the new companies regime;
- revision of the current qualifying share premium rules;
- determining the subscribed capital of an amalgamated company;
- tax rules where distributions made to shareholders breach the company law solvency test and are subsequently recovered.
4.2 Treatment of Company Accounting Reserves for Tax Purposes
The current tax treatment of company reserves generally requires only minor changes to respond to the reform of company law. The only significant change will be the proposed revision of the current qualifying share premium rules.
4.2.1 Existing Capital Reserves
The new Companies Act makes no distinction between reserves arising from shareholder contributions and other reserves. However, this distinction is important for tax purposes, as reserves contributed by shareholders can be distributed tax-free. Therefore, the existing tax concepts of paid-up capital and share premium will be supplanted by the single concept of "subscribed capital".
Subscribed capital will, like paid-up capital and share premium, be available for tax-free distribution on liquidation, or on the redemption or repurchase of shares, subject to the proposed rules regarding share repurchases detailed in Chapter 2. Where shares are "partly paid" on subscription, only the amount paid on subscription is included in subscribed capital. For tax purposes, existing paid-up capital and qualifying share premium reserves will be included in subscribed capital.
The subscribed capital of new companies registering under the new Companies Act will include all sums paid to the company in return for shares in the company and the net value of subsequent taxable bonus issues.
For three years after the new Companies Act comes into force, some companies will have re-registered while others will remain under the old regime. Consequently, some companies will distinguish in their capital reserves between share premium and paid-up capital, while other companies will record only subscribed capital. Several sections of the Income Tax Act, including sections 4 and 4A, will be redrafted to accommodate both situations.
4.2.2 Capital Redemption Reserves
The Companies Act 1955 provides that where redeemable preference shares are redeemed otherwise than from the proceeds of a fresh issue of shares, a company must transfer a sum equal to the nominal amount of the shares redeemed to a "capital redemption reserve fund", sourced from funds available for distribution as a dividend.
Capital redemption reserves are not currently treated as paid-up capital for tax purposes. This treatment will be preserved for companies registering under the new companies legislation - capital redemption reserves will not be subscribed capital for tax purposes.
4.2.3 Existing Bonus Issues
Under the Companies Act 1955, bonus issues represent a transfer of retained earnings to paid-up capital effected by way of the creation of additional "bonus" shares which are issued to shareholders for no consideration, or in lieu of a dividend.
For tax purposes, there are currently three types of bonus issues, namely taxable, non-taxable and 10-year bonus issues. A different tax treatment applies to each of these.
Where non-taxable bonus issues are made, the bonus issue is tax-free, and the transfer to paid-up capital is ignored for tax purposes. It is proposed that amounts of paid-up capital resulting from non-taxable bonus issues will be taxable on distribution, with the exception of amounts bonus issued out of capital gain or qualifying share premium reserves and distributed during a liquidation or cancellation of shares.
In the case of taxable bonus issues, the value of the issue, less any attached imputation or RWT credits, is transferred from taxable reserves to paid-up capital at the time the issue occurs. It is proposed that on transition to the new companies regime, amounts of paid-up capital that have arisen from capitalised taxable bonus issues will be subscribed capital for tax purposes.
A 10-year bonus issue is a bonus issue made between 1 April 1982 and 1 October 1988. These bonus shares were non-taxable at the time of issue, with the capitalisation not being recognised for tax purposes until the tenth anniversary of the bonus issue. In effect, companies are permitted to make a tax-free transfer to paid-up capital 10-years after the bonus issue.
It is proposed that upon registration under the new Companies Act, amounts capitalised from 10-year bonus issues that have reached their tenth anniversary will be subscribed capital for tax purposes, while amounts capitalised in 10-year bonus issues that are less than 10 years old will not qualify as subscribed capital until the tenth anniversary of the issue. The exception to this is where the bonus issue was sourced from capital gain amounts or qualifying share premium. Other amounts capitalised by way of 10-year bonus issues would continue to be taxable if distributed before the 10-year period has elapsed.
4.2.4 Future Bonus Issues
With the elimination of company law distinctions between capital reserves and retained earnings, there is no need to maintain a tax distinction between share splits and non-taxable bonus issues. Therefore, Income Tax Act references to non-taxable bonus issues will also be applicable to share splits.
It is proposed that for taxable bonus issues other than those made in lieu of a dividend, the issuing company will be free to elect the amount transferred to subscribed capital per bonus share issued.
While the new Companies Act does not explicitly authorise bonus issues, section 42 provides a general authorisation for a company to issue shares as it sees fit. Consequently, it is not intended at this stage to develop tax rules that provide an alternative to taxable bonus issues.
It may be appropriate, however, to consider developing a mechanism that would enable companies to distribute imputation credits without creating additional shares or paying out cash. In particular, it may be appropriate to develop notional distribution rules similar to those applicable for co-operative companies, with appropriate anti-streaming rules. Submissions on this matter are welcomed.
4.2.5 Tax-Exempt Taxable Bonus Issues and Dividends
At present, if a taxable bonus issue is exempt from tax under section 63 of the Income Tax Act (for instance, a bonus issue made between members of a consolidated group) a tax-free transfer from that company's taxable to tax-free reserves may be achieved without any tax being paid. Similarly, a tax-free transfer from taxable reserves to subscribed capital may occur when tax-exempt dividends are paid out, and the funds are then re-subscribed in the dividend paying company. This is inconsistent with other tax rules that aim to tax, either at the time of the transfer or upon distribution to shareholders, amounts transferred from potentially taxable reserves to subscribed capital.
Accordingly, it is proposed that special rules apply to such a dividend that is either:
- used to directly or indirectly fund a subscription of capital in the company paying the dividends or in an associated company; or
- a taxable bonus issue.
The amount of the above subscription will be ineligible to be included in subscribed capital for tax purposes, to the extent that the dividend from which the subscription was sourced was:
- exempt from tax under section 63 of the Income Tax Act; and
- less than fully imputed, in which case an allocation rule will determine the portion of the dividend that is fully imputed.
For example, assume a company pays an exempt dividend of $800, attaching imputation credits of $200. The shareholder then subscribes $1,500 to the company. The attached imputation credits are sufficient to fully credit $406 of the dividend, with the remaining $394 being uncredited. The first $406 of the capital subscription would be subscribed capital for tax purposes, the next $394 would not be subscribed capital, while the remaining $700 would also be subscribed capital.
4.2.6 Qualifying Share Premium Rules
Subscribed capital (including qualifying share premium) can be returned tax-free to shareholders, unless it is distributed in lieu of a dividend. This is in contrast to retained earnings, which are generally taxed on distribution. Therefore, in the absence of effective tax rules to the contrary, taxpayers face an incentive to recharacterise retained earnings as subscribed capital.
Under current law, qualifying share premium does not include share premium arising with respect to the issue of shares in one company for shares in another company. This limitation on qualifying share premium is designed to prevent a tax advantage resulting from share swaps on capital restructuring occurring either as part of a genuine commercial transaction or motivated entirely by tax considerations.
The current rule is somewhat arbitrary and poorly targeted, in that the application of the rule to shares issued in the exchange is determined by the relationship between the par value and issue price of the shares (the difference being the share premium), rather than the relationship between paid-up capital plus qualifying share premium and the issue price of the shares acquired in the exchange.
Accordingly, it is proposed to revise the existing qualifying share premium rule to take account of company law changes, to better reflect the tax policy underlying the current rule, and to provide a rule suitable for application to both share swaps made in the course of an amalgamation, and other share swaps. Where a transaction or series of transactions has the effect of the issuing of shares by a company in exchange for shares in another company, the subscribed capital attributable to the issued shares shall be the lesser of the subscribed capital or market value of the shares acquired in consideration for the issued shares. This would include a transaction where the acquiring company pays cash for the acquired shares, on condition that the cash is then re-subscribed in the issuing company.
This rule might be defeated by inflating the subscribed capital of the acquired company in anticipation of the share swap. Therefore it is proposed to include an anti-avoidance provision that would prevent the limitation on subscribed capital being defeated in this way.
Existing amounts of non-qualifying share premium resulting from the application of the existing qualifying share premium definition will continue to be taxable on distribution. Share premium that currently qualifies for tax-free distribution will retain that status.
Amalgamations would be subject to the general rules limiting subscribed capital attributable to shares issued in return for other shares.
In addition, it is proposed that the subscribed capital of any amalgamating company represented by shares held by or on behalf of any other amalgamating company immediately prior to the amalgamation would not qualify as subscribed capital in the amalgamated company. This prevents double counting of subscribed capital, eliminates a tax planning opportunity, and is consistent with the new Companies Act. The new Companies Act requires that shares in any amalgamating company held by or on behalf of another amalgamating company be cancelled without payment or the provision of other consideration (sections 220(3) and 222(2)(b)(i) refer).
The example in Annex 4.1 demonstrates both this rule and the general subscribed capital limiting rule applicable to shares issued in exchange for other shares.
Other aspects of amalgamations are discussed in Chapter 3.
4.4 Excess Distributions
4.4.1 General Approach
Under the new Companies Act, the board of a company may authorise a distribution (including a repurchase of shares) only if it is satisfied that the company will be solvent after the distribution. Where the company does not satisfy the solvency test after the distribution, the dividend may be recovered by the company from the shareholder. There are three exceptions to this right of recovery:
- where the shareholder received the distribution in good faith and without knowledge of the company's failure to satisfy the solvency test;
- where the shareholder has altered its position relying on the validity of the distribution;
- if it would be unfair to require repayment.
It is anticipated that use of the recovery provisions is likely to be a rare occurrence. However, the Income Tax Act has to be amended to provide for this.
An amendment to unwind the distribution for tax purposes is complicated by the fact that some dividends will have been fully imputed, some will have had resident withholding tax deducted and others will carry neither imputation nor RWT credits. In addition, where imputed dividends are paid to a company the attached credits will have been credited to the recipient's ICA.
It is proposed to amend section 4 of the Income Tax Act to provide that where a shareholder repays a dividend to the company pursuant to the new Companies Act, the shareholder shall be deemed not to have received that dividend or any imputation credits attached to it. The Commissioner will reassess the shareholder's return for the year in which the dividend was received.
The company that recovered the distribution will credit its ICA as at the date of recovery for the amount of imputation credit attached to the dividend.
It is proposed that the Commissioner be required to refund any RWT or NRWT previously deducted on payment of the dividend.
4.4.2 Corporate Recipient
A corporate recipient will have credited to its ICA any RWT or imputation credits attached to the dividend. It is proposed that an offsetting debit to the corporate shareholder's ICA arise on repayment of the dividend.
4.5 Summary of Proposals
The following tax rules are proposed for companies registering under the new Companies Act:
- That the following amounts be "subscribed capital" for tax purposes:
- existing paid-up capital reserves, being:
- amounts subscribed by shareholders;
- where shares are "partly-paid" on subscription, the amount paid on subscription;
- amounts that have arisen from taxable bonus issues;
- amounts represented by 10-year bonus issues that have reached their tenth anniversary;
- amounts represented by both unexpired 10-year bonus issues, and non-taxable bonus issues, that were sourced from either capital gain amounts or qualifying share premium;
- existing qualifying share premium reserves.
- existing paid-up capital reserves, being:
- In respect of future transactions, including amalgamations, having the effect of the issuing of shares by a company in exchange for shares in another company:
- The subscribed capital of the issued shares will be the lesser of the subscribed capital or market value of the shares received in exchange for the issued shares.
- For the purposes of paragraph (b)(i) an anti-avoidance rule would apply, so that the subscribed capital of the acquired company will not include capital resulting from subscriptions in that company made in anticipation of the share swap, to the extent that some or all of that capital is returned to the subscribing shareholders in some form other than as shares in the amalgamated company. This removes any tax advantage that would otherwise result from inflating the subscribed capital of a target company prior to acquisition.
- Subscribed capital represented by shares held by amalgamating companies in each other would not be credited to the subscribed capital of the amalgamated company.
- Subscriptions be excluded from subscribed capital for tax purposes to the extent that they are attributable to dividends that were:
- exempt from tax under section 63 of the Income Tax Act; and
- were not fully imputed (in which case an allocation rule will apply to determine the non-imputed amount).
- In the case of a company recovering a distribution from shareholders:
- A credit to the value of imputation credits attached to the recovered dividend would arise in the imputation credit account of the company that recovers the dividend. The ICA credit would arise on the date of dividend recovery.
- The shareholder would be deemed not to have received that dividend, or any imputation credits attached to it, and would be reassessed accordingly.
- The Commissioner would be required to refund any RWT or NRWT that had previously been deducted from the refunded dividend.
- Where the recipient of the dividend was a corporate, the repaying company would debit its imputation credit account with an amount equal to the value of any resident withholding tax or imputation credits attached to the recovered dividend.