A new Draft Taxation Ruling on the income tax treatment of excess bookbuild proceeds in accelerated renounceable entitlement offers (or "retail premiums") has been released for public comment. The ATO controversially concludes that it will treat retail premiums as unfrankable dividends or (in the alternative) ordinary income rather than a capital gain.
While the ATO takes this view in relation to retail premiums, there are a number of analogous structures which lead to different tax outcomes. Issuers will need to be mindful of these issues when preparing entitlement offers which are renounceable.
Submissions on the draft Ruling are due on 10 February 2011. Please let us know if we can assist if you want to have input.
What are retail premiums?
One of the options for a company seeking to raise equity funds is to undertake an accelerated rights issue (or entitlement issue) which involves a pro rata offer of new shares, first to institutional shareholders, and then to retail shareholders. The offer price is typically set at a discount to the current market price. Such offers may be "renounceable" or "non-renounceable".
In the case of a renounceable rights issue, where shareholders elect not to participate in the offer, or are not entitled to participate (for example, certain non-resident shareholders), the company will engage a manager to conduct a "bookbuild" of the shares not taken up by non-participating shareholders. (A bookbuild is just a prosaic word for auction.)
To the extent that the sale price in the bookbuild is higher than the rights issue offer price, the difference (the retail premium) is paid to the non-participating shareholders in the proportions to which they were granted rights by the company. The remaining rights issue offer price element is paid to the company for the shares.
The ATO position
The ATO's view in the draft Ruling is that where moneys are paid to the manager for shares, the account into which those moneys are paid constitutes a share capital account for income tax purposes (because the manager is acting on trust for the company). It follows from this view that the payment of the retail premium to the non-participating shareholder is a payment from a share capital account.
The ATO states that such a payment of a retail premium is a dividend under section 6(4) of the Income Tax Assessment Act 1936 (which treats amounts paid into the share capital account by one person and then paid out by the company to another person as a dividend).
A section 6(4) dividend is unfrankable (that is, the company cannot attach franking credits to it). The effect therefore is that non-participating shareholders who are Australian residents are treated as receiving an unfranked dividend.
Further, where the retail premium is paid to non-resident non-participating shareholders, the payer (for example, the Manager) may be required to withhold dividend withholding tax (with the rate depending on whether the non-resident is resident in a country which has a bilateral double tax agreement with Australia).
The alternative view
The alternative view, which is preferred by many advisers on capital raisings, is that retail premiums should be treated as capital gains for the non-participating shareholders.
Problems with the ATO position
From a technical perspective, the ATO's assumption that the manager acts as an agent or nominee for the company (being the basis for the view that the amounts received by the manager constitute share capital) is problematic. The fact that proceeds of a share sale flow through an account and are then paid to the company does not in our view necessarily cause that account to be a share capital account, especially as it is unlikely that the company would have control over the account. It is not clear whether, once the account constitutes a share capital account, it can ever erase that status or how the tainting and untainting rules would apply to such an account.
It is also unclear whether, for the purposes of Chapter 2J of the Corporations Act 2001, the retail premium paid to shareholders would be treated as distributed from share capital. If so, there may be a question mark over whether shareholder approval would be required for such a distribution as a reduction of capital.
Further, the ATO position leads to inequitable results for shareholders depending on whether they exercise their rights or not. For example, shareholder X (who holds shares as an investment, not on trading account) exercises his rights and is issued shares in the company, which he then sells, making a profit of $10 per share. Shareholder X's profit on the shares is likely to be on capital account. This may give rise to a CGT discount, or might be capital proceeds that could be offset against capital losses.
In contrast, shareholder Y is an ineligible non-resident who is not entitled to exercise rights (or lacks sufficient funds to do so) and instead receives a retail premium in respect of shares, to which shareholder Y would have been entitled, being sold by the manager at the same price as the sale by shareholder X. Shareholder Y would be treated as having received assessable income from which tax is withheld.
Finally, the ATO analysis leads to different tax consequences for structures with similar commercial consequences. This is best demonstrated through the examples below, each of which are capital raisings through renounceable rights issues.
Accelerated renounceable rights issue example:
Company A is a listed company whose shares are trading at $100. Company A carries out a capital raising by accelerated renounceable rights issue to its shareholders. Each right entitles the shareholder to acquire a share at $90 (a discount of $10). Company A engages the manager to conduct a bookbuild of the shares not taken up by non-participating and ineligible non-resident shareholders. Ninety dollars of the bookbuild price is paid to Company A. To the extent that the amount received for each share exceeds $90, the manager pays that retail premium to the non-participating or non-resident shareholder.
According to the ATO position, dividend withholding tax will need to be withheld from the retail premium paid to the non-resident shareholder. However, Divisions 12 and 16 Schedule 1 of the Taxation Administration Act 1953 do not contemplate a situation where a dividend is paid by an entity other than the company and who would is responsible for dividend withholding tax in such a circumstance. This will need to be clarified to avoid any confusion.
Vanilla renounceable rights issue example:
As in Example 1, Company A carries out a capital raising by rights issue. However, the rights issued by Company A are tradeable on the ASX, unlike in Example 1. Company A arranges for a manager to sell the rights that cannot be issued to the ineligible non-resident shareholders as a nominee of those shareholders. The proceeds are paid to the non-resident shareholders as required under ASX Listing Rule 7.7.
The issue of the rights is treated as non-assessable non-exempt income under section 59-40 of the Income Tax Assessment Act 1997 (ITAA97) and the sale of the rights should be treated as on capital account. For a non-resident shareholder, any capital gain is likely to be disregarded under Division 855 ITAA97.
Nominee foreign sale process example:
As in Example 1, Company A carries out a capital raising through an accelerated renounceable rights issue. The Company issues the rights to the manager as nominee of the ineligible non-resident shareholders (for example, in accordance with the procedure in section 615(c) of the Corporations Act). The manager exercises the rights by paying $90 per share to Company A, and then sells the newly issued shares on-market. The difference between the $90 discount price and the on-market price is paid to the non-resident shareholders.
The amount paid to the shareholders is not a distribution by Company A, let alone a distribution from Company A's share capital account. It may constitute a capital gain for the shareholder, which is likely to be disregarded under Division 855 ITAA97.