Snap Shot
- Complex tax rules apply to dealings with company shares.
- If a matter is not within your area of expertise seek specialist advice.
You acted for the family when Celia’s parents, Tom and Mary, brought her into the family business by making her a shareholder. They decided to issue enough shares to make her an equal shareholder and because they loved her, the shares were a gift. You duly prepared an application and directors’ resolution and, after signing, sent them off to the Company’s accountant. They didn’t want to transfer any of their existing shares, which they had held since the Company was set up in the early 1980s.
Celia’s partner, Geoff, worked in the business and they all got on very well. So, when Celia asked her parents a few months later if she could transfer half her shares to him, they were happy. Once again you fixed up the share transfer and directors’ resolution and sent them off to the Company’s accountant – about 10 months after the issue of shares to Celia.
Happiness didn’t last long. Geoff, who thought Tom and Mary were a bit old fashioned in the way they ran the business, persuaded them to give him a management role where he quickly demonstrated his unsuitability as a manager by bullying the staff and making some very bad business decisions.
Things got worse and worse, and finally they asked you to help sort things out. After a protracted and difficult negotiation, it was agreed that the Company would buy back Celia and Geoff’s shares at market value, and they would both find work elsewhere. You quickly prepared the documents and had them signed by all family members.
First sting
The first sting was the Company issuing new shares to Celia as a gift. Under section 112-20(3) Income Tax Assessment Act 1997 (‘ITAA 1997’), the shares had a nil cost base – so all increases in value as a result of sale or gift would be subject to CGT. It would have been better if Tom and Mary transferred Celia some of their shares. They were issued before the introduction of CGT in September 1985, so there was no CGT on the transfer (s 104-10(5) ITAA 1997) and Celia would have had a market value cost base (s 112-20(1) ITAA 1997).
Second sting
The second sting was that Celia didn’t wait for 12 months before she transferred shares to Geoff. If she had waited, that would have halved the CGT she had to pay, as she would have been entitled to the general 50 per cent discount (s 115-25 ITAA 1997). The shares had a nil cost base on issue and, because of the relationship between Celia and Geoff, the deemed market value rule applied. That meant Celia was liable to pay tax at marginal rates on 100 per cent of the then current market value (s 116-30 ITAA 1997).
Under section 112-20(3) Income Tax Assessment Act 1997 … the shares had a nil cost base so all increases in value as a result of sale or gift would be subject to CGT.
Third sting
The third sting was the Company buying back the shares instead of Tom and Mary personally. Under section 159GZZZP of the Income Tax Assessment Act 1936, the whole amount paid to Celia and Geoff (except possibly a very small amount debited to share capital) is assessable as a dividend. While it’s possible that it could have been franked, which would have helped a bit, there are time limits for this.
Also, there are CGT implications for both Celia and Geoff as a result of the shares they sold to the Company. However, that is not significant as section 118-20 ITAA 1997 provides that if one payment is both assessable income (as under the third sting) and a capital gain (as payment for Celia and Geoff’s shares), the capital gain is reduced (or, as here, extinguished) by the assessable income component.
Conclusion
In summary, if you assume the shares issued to Celia were worth $1 million on issue and there was no increase in value over the relevant period, Celia and Geoff would have no tax to pay if the family had followed the alternative courses of action. As things stand, they will have to pay tax on a collective $1.5 million because:
- Celia is liable for tax at her marginal rates on $500,000 when she transferred half her shares to Geoff because of the zero cost base. This contrasts with a market value cost base had there been a transfer from Tom and Mary (or $250,000 if she waited the full 12 months); and
- Celia is also liable for tax at her marginal rates on $500,000 when she sold the other half of her shares to the Company. This payment is taxed as a dividend under section 159GZZZP. In contrast, she would not have been liable to pay tax if Tom and Mary had given and bought back her shares, because her shares didn’t increase in value; and
- Geoff is also up for tax at his marginal rates on $500,000 as a dividend when he sold the shares back to the Company. He would not have been liable to pay tax if Tom and Mary had bought his shares because his shares didn’t increase in value after the transfer from Celia.
Author: Jim Main – Special Counsel