Exotic share classes, such as redeemable preference shares and dividend only (dividend access [DA]), shares are a longstanding concern for a private company seeking to access the small business CGT concessions (the Concessions) in Division 152 of the Income Tax Assessment Act (ITAA) 1997. Exotic share classes can derail qualification as a significant individual and thence as a CGT concession stakeholder for all shareholders of the company. The consequences are that a private company, otherwise eligible for the Concessions:
- will not be eligible in some cases; and
- in more or all cases, where the company is eligible and can apply the Concessions, shareholders of the Company with an insufficient small business participation percentage (SBPP) won’t be able to individually participate in the Concessions along with the company.
Why does this happen?
It’s due to the structure of section 152-70 of the ITAA 1997 which, in the case of a company, determines SBPP based on the “the smaller or smallest”:
… percentage that the entity has because of holding the legal and equitable interests in shares in the company:
(a) the percentage of the voting power in the company; or
(b) the percentage of any dividend that the company may pay; or
(c) the percentage of any distribution of capital that the company may make;
or, if they are different, the smaller or smallest.
So a DA share may entitle a shareholder to dividends but not to voting rights or distributions of capital. Dividends of a company with DA shares can be declared on shares in the DA class only so other shareholders of the company, entitled to:
- voting rights and distributions of capital e.g. ordinary shareholders; but
- not to dividends as they are diverted to the DA share class;
leaves all shareholders with a zero SBPP. The SBPP is driven by the smallest of (a), (b) and (c) above and, in the case of the example ordinary shareholders, it is (b) that is zero. Zero is less than the 20% SBPP needed for a shareholder to be a significant individual: section 152-55.
What to do with dormant DA shares?
But what if a company on the verge of making a capital gain to which the Concessions can apply:
- has a DA shareholder who could receive dividends declared to the DA class; but
- desists from paying dividends on the DA class and all dividends are instead payable to ordinary shareholders?
Broadly this was what happened in Commissioner of Taxation v Devuba Pty Ltd  FCAFC 168. I have no first-hand knowledge of the background to the case but I imagine Devuba’s experienced tax lawyer, Gregory Ganz, was aware of and advised on section 152-70 in the years in the lead up to the profitable sale of shares in another company, Primacy Underwriting Agency Pty Ltd, for $4,381,645 by Devuba Pty. Ltd. on 19 May 2010.
The DA share dilemma
I can see he and Devuba faced a dilemma. If, by 19 May 2010:
- the DA shareholder still held the DA share then section 152-70 could apply to reduce the ordinary shareholders’ SBPPs to zero because Devuba “may pay” dividends on the DA class, This is the view that the Commissioner of Taxation was to take and contest in the case;
- Devuba had redeemed or cancelled the DA share so that dividends would no longer be paid on DA shares there would have been a CGT event, probably CGT event C2, on which the DA shareholder would be taxed with the value of the capital proceeds, based on the market value substitution rule, being attended by valuation uncertainty; or
- Devuba altered the rights of the DA shareholder so that dividends would no longer be paid on DA shares then CGT impacts and comparable valuation uncertainty would have arisen under the value shifting rules in Part 3-95 of the ITAA 1997 which had commenced to operate from 2002.
In the event Devuba went to the share sale on 19 May 2010 with the DA shareholder still holding the DA share. However, on 1 September 2008, the directors had passed a resolution in the accordance with Article 83 of the Memorandum and Articles of Association of Devuba that dividends were not to be paid on the DA share class until the directors passed a resolution to do so. Effectively this was a somewhat soft touch moratorium on DA class dividends probably insufficient or thought insufficient to trigger an alteration in rights which would have attracted value shifting CGT consequences.
Devuba figured dividends Devuba “may pay” on the DA class became zero as a matter of fact and likelihood because of this resolution. On the other hand the Commissioner took the view that Devuba could nonetheless legally pay dividends to the DA shareholder and so the ordinary shareholders had a SBPP of zero due to (b).
The Federal Court and the Full Federal Court agreed with Devuba. It was found that Devuba was unable to pay dividends immediately before 19 May 2010 to the DA shareholder with the moratorium in place. The courts found that the moratorium was valid and effective under the Memorandum and Articles of Association such that dividends that Devuba “may pay” on the DA class were zero. It followed that the percentage of dividends Devuba “may pay” to ordinary shareholders gave the ordinary shareholders sufficient SBPP to meet the relevant SBPP thresholds for the Concessions relevant in the case.
Exotic share class problem with the Concessions persists
This case shows the concern mentioned at the outset persists: Issued DA shares can still drive SBPP to zero and deprive ordinary shareholders of a company of the Concessions even where dividends are not paid to the DA class. Only with nuanced planning, an understanding of the constitution of a company and its interaction with the terms of the relevant exotic share class can help overcome a SBPP problem caused by an exotic share class with SBPP and the Concessions.
Even further income tax trouble
And income tax problems with exotic share classes like DA shares don’t end there. DA shares used for tax minimisation are considered aggressive tax planning and are the subject of the Commissioner’s:
Taxpayer Alert TA 2012/4 Accessing private company profits through a dividend access share arrangement attempting to circumvent taxation laws
which contains a lengthy list of bases on which the Commissioner can and will tax distributions on DA shares including treatment of DA share class distributions as dividend stripping under Part IVA of the ITAA 1936. Exotic share class can also have unexpected consequences under the debt equity rules in Division 974 of the ITAA 1997.
Although the outcome in Devuba was technical and based on its particular facts, it marks a divergent, realistic and perhaps reassuring approach to the enquiry into dividends a company may pay. That stands in comparison to the unrealistic and dogmatic approach taken particularly by Revenue NSW and under the Duties Act (NSW) 1997 (DA NSW) to the questions of:
- whether a trustee or trustees may become beneficiaries of a trust for the purposes of obtaining concessional duty on a change of trustee of a trust under sub-section 54(3) of the DA NSW; and
- whether foreign person or persons may become a beneficiaries of a trust for the purposes of foreign person stamp duty and land tax surcharges under section 104J of the DA NSW;
obliging substantial, sometimes legally unachievable and largely unnecessary trust deed amendments before it can be accepted that such persons will never take a percentage of a trust as a beneficiary of the trust oblivious to perceivable facts, likelihoods and evidence that such a beneficiary would ever take.