The taxation implications of company law reform
A discussion document
December 1993
CHAPTER 1: OVERVIEW
1.1 Purpose of the Discussion Document
1.4 Objective and Scope of this Review
1.5.1 Share Repurchases and Related Issues (Chapter 2)
1.5.2 Amalgamations (Chapter 3)
1.5.3 Tax Accounting Issues (Chapter 4)
Recovery of Excess Distributions
1.5.4 Miscellaneous Issues (Chapter 5)
1.1 Purpose of the Discussion Document
The Companies Bill was introduced into Parliament in 1990. After consideration by the Justice and Law Reform Select Committee the Bill was reported back to Parliament on 15 December 1992. The resulting Act, the Companies Act 1993, was enacted by Parliament in September 1993, and is scheduled to come into effect on 1 July 1994, together with other ancillary measures forming the company law reform package.
This discussion document assesses the implications of company law changes for income tax rules in the various Revenue Acts, in particular the Income Tax Act 1976.
The purpose of this document is to put the Government's perspective on the issues before the taxpaying community as part of the process of undertaking widespread consultation on tax policy changes. The Government seeks to ensure that the reasons for tax policy changes are well understood and that, before they become law, tax policy changes are properly worked through with those in the private sector who will operate under them.
1.2 Submissions
Submissions are invited on the various proposals. They should be addressed to:
The Director
Legislative Affairs
Inland Revenue Department
P O Box 2198
WELLINGTON
Submissions should be made by 21 February 1994. They should contain a brief summary of their major points and recommendations.
Following a full and thorough consideration of submissions by the Government, legislation to amend the various Revenue Acts to accommodate the new companies regime will be introduced into Parliament. The legislation will be considered by the Finance and Expenditure Select Committee of the House of Representatives. There will be a full opportunity for interested parties to make submissions on the legislation during the Select Committee process.
1.3 Background
The major income tax implications of recent company law reforms relate to:
- provisions in company law that allow a company to purchase its own shares;
- company amalgamations and their treatment for tax purposes;
- tax accounting procedures for existing companies when they register under the new companies regime;
- the implications of the repeal of the notions of "par value" and "nominal capital", and "share premium";
- miscellaneous changes to the Income Tax Act where existing concepts and terminology will be redundant or are to be modified by the new companies regime. (For example, the new Companies Act does not retain the current distinction between public and private companies.)
1.4 Objective and Scope of this Review
The objective of this review is to revise those aspects of taxation law that require amendment because of the linkages between company and taxation law. The review is not a complete revision of company taxation.
The Government desires to see taxation law integrate well with revised company law rules. While there is no desire to see taxation provisions inhibit the willingness of companies to take advantage of any increased flexibility that company law changes may confer, the need to maintain the integrity of the tax base must be given due weight. It is unrealistic to assume that because company law changes may increase the ability of companies to restructure or return funds to shareholders, tax imposts on such activities should be removed. Tax rules must be designed to achieve an appropriate balance between the competing considerations of maximising commercial activity and maintaining robust and fair taxation rules. Furthermore, the Government seeks rules that provide certainty and that impose as few as possible compliance costs on taxpayers in their day to day operations.
Existing tax rules which govern company distributions have also been reviewed. There are significant weaknesses in existing rules designed to prevent companies substituting tax-free distributions of subscribed capital for taxable distributions when shares are redeemed or cancelled by an on-going company. The current anti-dividend substitution rules are set out in section 4A(1)(c)(ii) of the Income Tax Act. Weaknesses include:
- The uncertain nature of existing rules. There is considerable uncertainty about the circumstances in which existing anti-dividend substitution rules apply and the exact meaning of the words used in the provisions. Consequently, the rules are difficult to apply in practice.
- Inadequate marshalling rules. Existing rules provide opportunities for companies to attribute the entire amount of a distribution to tax-free reserves even though taxable reserves remain in the company. This effectively allows tax-free reserves to be distributed first.
These weaknesses would be aggravated by the greater ease with which shareholders will be able to access the capital of a company under the new Companies Act.
In addition, existing rules aimed at preventing reserves that are taxable on distribution from being converted into tax-free reserves through share for share transactions are not completely effective. These rules include the restrictive definition of "qualifying share premium".
In order to address the weaknesses of the existing rules, this discussion document proposes new rules that:
- define clearly when distributions made by way of share repurchases, cancellations or redemptions are deemed to be dividends;
- modify the averaging formula that defines the portion of a distribution that is tax-free on the repurchase or redemption of shares, or liquidation of a company;
- define additions to subscribed capital where shares are issued either:
- directly or indirectly in consideration for the acquisition of shares in another company; or
- in circumstances where the subscription for that issue is funded by the payment of tax-free inter-corporate dividends by the issuing company.
The background to these proposals is described in more detail later in this report.
1.5 Outline of the Document
This document is set out in two parts. Part One comprises five chapters and details the major tax implications of company law changes and proposed tax policy responses. Part Two contains draft legislation and explanatory notes to the legislation.
An overview of the significant implications of proposed changes to companies legislation on current tax rules is outlined below. The issues are discussed in more depth in succeeding chapters.
1.5.1 Share Repurchases and Related Issues (Chapter 2)
From a tax perspective, proposed changes to company law will have their most significant impact on the tax treatment of company distributions. A key change is that companies will be able to purchase their own shares. Sections 58 to 67 of the new Companies Act provide that a company may purchase its own shares subject to:
- the company's constitution containing a power to repurchase;
- the solvency test;
- the repurchase being fair and reasonable to the company and its shareholders;
- no material information being withheld from shareholders;
- shareholders receiving advance advice of the repurchase (with an exception for small repurchases made on the stock exchange).
Repurchases can be initiated by the company only if the repurchase is made on:
- a pro rata basis, that is, an offer is made to all shareholders to acquire a proportion of the shares that would, if accepted, leave unaffected relative voting and distribution rights (section 60(1)(a) of the new Companies Act); or
- a selective basis, that is, an offer is made selectively to one or more shareholders to acquire shares (section 60(1)(b) of the new Companies Act); or
- a stock exchange, so giving all shareholders the same opportunity to sell some or all of their shares (sections 63 and 65 of the new Companies Act).
In all cases, shares are cancelled upon repurchase.
A company may repurchase on the stock exchange, without prior notice to its shareholders, up to 5 percent of its shares in any 12-month period. However, it must advise its shareholders of any such repurchase within 10 working days of the repurchase occurring.
A share repurchase may also be initiated by a shareholder under the buy-out of minority shareholder provisions in section 110 of the new Companies Act. A shareholder can require the company to repurchase his or her shares if:
- The shareholder casts all his or her votes against a resolution (passed by other shareholders) to:
- adopt or revoke the company's constitution;
- alter the company's constitution to impose or remove a restriction on the activities of the company;
- approve a major transaction (defined in section 129 of the new Companies Act);
- approve an amalgamation; or
- The shareholder does not sign a shareholders' resolution made in accordance with section 122 of the new Companies Act. Such a resolution must be signed by at least 75 percent of the company's shareholders representing at least 75 percent of votes entitled to be cast on that resolution.
A company may arrange for the shares it is required to repurchase to be acquired by another party.
The basic issues with respect to the tax treatment of share repurchases discussed in Chapter 2 are:
- determining the reserves from which tax-free distributions resulting from share repurchases can be funded (referred to as "tax-free reserves");
- determining when distributions by way of repurchases can be attributed to tax-free reserves;
- the mechanism for taxing the dividend component of share repurchases.
At present companies are able to cancel their own shares, subject to High Court approval, or, in the case of redeemable preference shares, redeem their own shares. However, the new Companies Act provides greater scope for companies to provide a cash return to shareholders in a form other than an ordinary dividend. This follows from the relaxation of the constraints on share repurchases or cancellations and the removal of the current company law requirement to distinguish between reserves that consist of subscribed capital and other reserves.
1.5.2 Amalgamations (Chapter 3)
The new Companies Act provides that two or more companies may amalgamate and continue as one company, which may be one of the amalgamating companies or a new company. Broadly, the procedure to amalgamate requires the consent of the boards and shareholders of each amalgamating company; there is no court involvement. The consent by shareholders must be by way of special resolution and the amalgamated company must satisfy the solvency test immediately after amalgamation.
A short-form amalgamation procedure is provided under section 222 of the new Companies Act for a wholly-owned subsidiary that amalgamates with a parent or two wholly-owned subsidiaries that amalgamate. Under the short-form procedure, an amalgamation may be approved solely by the boards of each amalgamating company agreeing to the amalgamation, provided that the solvency test is still met.
Following approvals, an amalgamation proposal is registered with the Registrar of Companies, who thereupon issues an amalgamation certificate. The certificate specifies the effective date of amalgamation.
The new Companies Act provides that all assets and liabilities of the amalgamating companies are vested in the amalgamated company. However, shareholders of amalgamating companies must agree to the terms of the amalgamation, and shares and rights of shareholders in amalgamating companies are not necessarily converted into shares and rights in the amalgamated company. Where one amalgamating company holds shares in another amalgamating company, those shares must be cancelled for no payment when amalgamation becomes effective.
Under current tax law, there are full tax consequences on the transfer of assets from the amalgamating company to the amalgamated company, and on the exchange of shares in the amalgamating companies for shares in the amalgamated company, where those are held on revenue account. Tax losses and imputation credits are generally extinguished. These consequences follow from an amalgamation being treated in substantially the same manner as a liquidation.
Under the new rules proposed in Chapter 3, amalgamating companies would be able to utilise tax-free asset transfer rules based on the existing consolidation regime. The tax losses and imputation credits of the amalgamating companies will be able to be retained, subject to shareholder continuity and commonality tests being met. Dispositions of shares occurring under an amalgamation would continue to be assessable to revenue account shareholders.
1.5.3 Tax Accounting Issues (Chapter 4)
Treatment of Reserves
Company law reform will remove the concepts of "par value", "nominal capital" and "share premium" on which existing tax law relies. As a result, it is proposed that tax rules be amended to focus on subscribed capital (consisting of the sum of what is now paid-up capital and qualifying share premium). When existing companies register under the new companies regime, it will be necessary to convert reserve accounts for tax purposes into a form appropriate to the new regime. The treatment in this context of paid-up capital, including bonus issues, share premium and capital redemption reserves, is covered in Chapter 4.
Also considered in Chapter 4 is the carry over into the amended dividend definition applying after the enactment of company law reform of an equivalent of the concept of "qualifying share premium". Existing rules limit the range of share premium eligible for tax-free distribution to "qualifying share premium". This limitation is aimed at preventing companies from creating, via share swaps, share premium reserves on take-overs or mergers from which tax-free distributions can be made.
Tax accounting issues relating to amalgamation are also addressed, as is the extent to which subscribed capital can be derived directly or indirectly from exempt inter-corporate dividends.
Recovery of Excess Distributions
The new Companies Act provides in section 56 for a company to recover distributions made to shareholders where such distributions breach the solvency test. The recovery of distributions from shareholders is likely to be a rare event, since repayment by the shareholder would not be required if the unauthorised dividend was received in good faith, and it would be unfair to require repayment having regard to the altered circumstances of the shareholder. The discussion document outlines how current income tax rules will need to be amended in order to cater for situations where taxable distributions are later returned to a company.
1.5.4 Miscellaneous Issues (Chapter 5)
In addition to the issues outlined above, there are also a number of consequential changes to the Income Tax Act resulting from terminology changes in company law. A number of the existing definitions, largely relating to defining a shareholder's interest in a company, rely on the concepts of nominal and paid-up capital that, as previously noted, will have no relevance under the new companies regime.
Also, the removal of the private/public company distinction means that changes will be necessary to those provisions of the Income Tax Act that rely on the definition of "private" and "public" companies.