Focus: Draft ruling on rights issues Retail Premiums
20 December 2010
In brief: Australian issuer companies should be aware of a recent Australian Taxation Office draft ruling that states Retail Premiums paid in respect of certain accelerated rights issues will be regarded as unfranked dividends for tax purposes, and therefore taxed as such in the hands of Australian resident shareholders, and subject to withholding tax where paid to non-Australian resident shareholders. Partner Martin Fry (view CV), Senior Associate Rory O'Brien and Lawyer Kai Fu report.
How does it affect you?
- The draft ruling states that it is to apply both to future and past accelerated rights issues. Issuer companies that have not adopted this 'unfranked dividend' treatment for past rights issues will need to consider their position.
- The Australian Taxation Office's (the ATO) position will affect the Australian issuer company in relation to both its Australian shareholders and its foreign shareholders.
- In relation to foreign shareholders, it will be necessary to comply with the dividend withholding tax rules in relation to the Retail Premium. The rate of withholding will depend on the location of the foreign shareholder. Where the rights issue and payment of the Retail Premium is managed by a bank or other third party, the Australian issuer company will want to ensure that it (and if necessary the third party) has records sufficient to fully discharge the withholding obligation.
- The Australian issuer company will also need to consider how to communicate the ATO's
treatment to its Australian resident shareholders.
(i) The Australian shareholders may well be surprised to find that the Retail Premium is to be taxed in their hands as an unfranked dividend. Australian shareholders are likely to have expected that the Retail Premium would be subject to the CGT rules and would potentially benefit from the CGT discount.
(ii) Also, the Australian issuer company may need to consider whether it has a TFN withholding obligation in relation to the Retail Premium.
- The fact that the Retail Premium is treated as an unfranked dividend should not adversely affect the Australian issuer company under the benchmark franking rules or the franking disclosure rules.
- Also, the Australian issuer company should not have an obligation under the tax laws to provide relevant shareholders with a distribution statement for this deemed unfranked dividend.
The draft ruling is open for comment until 10 February 2011.
This style of rights issue has generally been an accelerated issuance under which institutional investors are invited to take up entitlements that are not otherwise taken up by the existing shareholders of the issuer company. The institutions may pay a premium to the issue price and, if so, this premium is paid to the shareholders who have not taken up their entitlements. (The ATO issued TR 2010/D8, which deals with this style of rights issue, on 8 December 2010). The process is generally as follows:
- An issuer company grants entitlements to its existing shareholders that allow them to take up an allotment of new shares in the company at a certain offer price, which is often at a discount to the current market value of the shares.
- For different reasons some of the entitlements may not be taken up. Some otherwise eligible shareholders may choose to not exercise some or all of their entitlements, some shareholders may not be eligible to receive entitlements, or some shareholders may not be permitted to take up entitlements (for example as a consequence of foreign laws).
- The issuer company issues new shares to new investors (usually to institutional investors under a bookbuild process) in an amount matching the shares that would have been issued under the unexercised entitlements, at the clearing price offered by those new investors.
- Where the clearing price is higher than the original offer price, an amount is paid to the shareholders who did not exercise their entitlements, being the Retail Premium. Often the Retail Premium is the full difference between the clearing price and the offer price.
The taxation treatment of rights issued by companies to shareholders has been a controversial area since the High Court held in Commissioner of Taxation v McNeil  HCA 5 that the market value of rights issued by St.George to its shareholders (under which St.George shareholders were entitled to sell their shares into a buyback at an attractive price) should be included in shareholder's assessable income.
In response to McNeil, section 59-40 of the Income Tax Assessment Act 1997 (Cth) was introduced to provide that rights to acquire shares in a company issued by the company to its shareholders would generally not be regarded as assessable income of shareholders. Where the rights to acquire shares were exercised, there would be no taxing event. Where the rights were disposed of for consideration, a capital gains tax event would occur and if the underlying shares had been acquired more than 12 months before, the CGT discount (50 per cent for individuals and trusts, 33 1/3 per cent for superannuation entities) may apply to reduce the capital gain. Foreign shareholders would generally not be subject to Australian tax.
However, on 19 May 2009, the ATO issued Taxpayer Alert 2009/11 in which it stated that the ATO was considering whether the payment of a Retail Premium should be treated as an unfrankable dividend for tax purposes. Consistently with this, on 17 September 2010, the ATO stated in a Fact Sheet for Shareholders that the payment of a Retail Premium should be treated as an unfranked dividend for tax purposes, and on 8 December 2010 the ATO issued TR 2010/D8, which sets out in detail the ATO's reasoning supporting this position. In summary:
- The ATO states that the Retail Premium is an amount paid to non-participating shareholders in their capacity as shareholders (according to TR 2010/D8, it does not matter whether the Retail Premium is actually paid by the company, or by an investment bank or other entity, under an arrangement with the company).
- The ATO states that amounts paid to shareholders in their capacity as shareholders are generally dividends as defined by s6(1) of the Income Tax Assessment Act 1936 (Cth) unless they are debited to share capital by the company.
- Section 6(4) provides that the exception to the 'dividend' definition for amounts paid from share capital does not apply where there is an arrangement under which the amount credited to share capital is then paid to the shareholder. In this respect, TR 2010/D8 states in effect that the clearing price paid under the bookbuild process would be credited to share capital and the Retail Premium would be debited to share capital for tax purposes, even if it is not debited to share capital for accounting purposes.
- Therefore, the ATO view is that the Retail Premium is a dividend as defined by s6(1).
On this basis, TR 2010/D8 states that the Retail Premium:
- would not be frankable because of s202-45(e) of the Income Tax Assessment Act 1997;
- should be included in the assessable income of Australian resident shareholders, because s44(1B) provides that dividends debited to share capital are deemed to be dividends paid out of profits and s44(1) provides that dividends paid out of profits received by Australian resident shareholders should be included in their assessable income;
- even if it is not a dividend, the Retail Premium should be included in the assessable income of Australian resident recipients as ordinary income under s6-5 of the Income Tax Assessment Act 1997;
- would be subject to withholding tax under s128B of the Income Tax Assessment Act 1936 to the extent it is paid to foreign resident shareholders;
- to the extent that a shareholder made a capital gain as a result of the expiry of entitlements and the receipt of the Retail Premium in the way discussed above, this would be reduced under the anti-overlap rule in s118-20 of the Income Tax Assessment Act 1997.
However, the Fact Sheet for Shareholders issued on 17 September 2010 states:
If you sell your rights before the right or entitlement offer end date, you will be subject to the rules about taxing rights at the time that you sell your rights.
This statement raises the prospect of undertaking an accelerated rights issue in a manner that would not attract the 'unfranked dividend' treatment; in particular, a rights issue under which it is clear that the non-participating shareholders are taken to have sold their entitlements to the institutions or other third-party investors.
- Martin FryPartner, Practice Leader, Tax,
Ph: +61 3 9613 8610
- Larry MagidConsultant,
Ph: +61 2 9230 4918
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