Distributing excess capital to shareholders – considerations and implications

Without doubt, the economy has changed quite substantially over the last few months. We now have an environment of tighter lending markets, volatile financial markets and a general reduction in the multiples paid for businesses. However, what remains constant is the fact that the cost of equity is more than the cost of debt.

While the changes bring new challenges, they also create opportunities, particularly for companies holding reasonable cash balances, especially where the market value of its shares fall below the net tangible asset backing. This scenario presents the chance buy-back shares now at a “discount”, with a view to reissue a similar number of shares after the market changes favourably and hence reduce the overall cost of financing the business.

Once a company decides to return excess capital to its shareholders, the next question is how best to do this. Should a company return earnings or capital? Alternatively, should the company buy-back shares which can return both earnings and capital? Should excess capital be returned selectively or across the board? There are many considerations to take into account. We explore some of them below.

Shareholder composition
The first order of business should be to look at the shareholders. The last thing that a board of directors would want, is to disadvantage their shareholders from a tax perspective. Suffice to say that this would be an easier process for closely-held companies.

Taking a look as some possible shareholders, it’s easy to conclude that Superfund shareholders would have a strong preference for franked dividends, meanwhile holders of pre-CGT shares would generally much prefer to receive capital as opposed to a dividend.

Likewise, foreign resident shareholders would have a preference for capital (so long as their investment is not ‘taxable Australian property’) or alternatively an unfranked dividend where they will be entitled to a foreign tax credit in their home country. Naturally, a shareholder with an unrealised capital loss on their investment would be loath to receive a taxable dividend.

The taxation impact on the shareholders of any return of excess capital can be summarised as follows:

Company’s equity composition
Following the examination of the shareholder base, it is then important to determine what the company actually has to pay out. Irrespective of the wishes of the shareholders’, if a company doesn’t have a lot of capital then it cannot return it. Likewise, a company with little or no retained profits cannot return dividends of any significance.

The availability of franking credits is also a significant issue, as only foreign resident shareholders generally lack the strong preference to receive franked dividends over unfranked dividends. Related to the issue of franking credits is the requirement to stick to the benchmark rule, that is, the extent to which dividends are franked within a franking period (either six or twelve months) is the same for all dividends.

Corporations law
By this stage, the structure of the ideal return of capital should be starting to form and the requirements under the Corporation Act need to be considered. In particular, the important points to note are that:

• directors are generally free to declare dividends;
• capital reductions require an ordinary resolution; while
• a share buyback may require an ordinary or even a special resolution (although in some circumstances no resolution is required).

In any event, regard must be had to the company’s solvency prior to returning cash to its shareholders.

Other considerations
A selective return of excess capital could be employed as a means of removing minority or even recalcitrant shareholders, particularly where a selective share buy-back is utilised.

Taxation considerations
In relation to off-market buybacks, generally the amount debited to an account other than share capital will represent a dividend, with the debit to share capital unsurprisingly representing capital. The manner in which a company can calculate the dividend/capital composition is constantly under debate, with the Commissioner of Taxation sighting his views in Practice Statement PS LA 2007/9.

In relation to on-market buybacks, while the shareholders merely receive capital, there is still a cost to the company (and ultimately continuing shareholders) in the form of a reduction in franking credits. In both situations the facts and circumstances need to be reviewed to gain a full understanding of the impact on both the company and its shareholders.

In addition to all of the above requirements, there are two further taxation considerations that must be taken into account. The first consideration relates to the distribution of capital, as the tax laws allow the Commissioner of Taxation to deem a distribution of capital to be an unfranked dividend. The circumstances with which the Commissioner can do this are where he feels capital is diverted to some shareholders at the expense of others to gain a tax advantage, or where he feels that there is an overriding scheme to distribute dividends as capital. The other taxation consideration relates to franking credits, as franked dividends can be deemed by the Commissioner to be unfranked where he feels that franking credits have been streamed to particular shareholders in order to obtain a tax benefit. A private ruling can be obtained by the Commissioner in relation to any proposed distribution of excess capital, whereby he can effectively “endorse” an arrangement by confirming that he won’t attempt to deem the distributions to be unfranked dividends.

As outlined above, the considerations and implications (particularly tax impacts) of distributing excess capital to shareholders can be significant for both the company in question and its shareholders. For this reason it is prudent to seek professional guidance before proceeding with any course of action.

Author: Peter Godber, Scott Treatt & Robert Campbell

Peter is the national leader of Grant Thornton’s Tax practice. Scott Treatt is an Associate in the Sydney Tax team, specialising in tax issues arising from corporate finance matters, and Robert Campbell is Grant Thornton’s national Tax technical resource.

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