House of Representatives

Explanatory Memorandum

Circulated by authority of the Treasurer, the Hon Wayne Swan MP

Chapter 1 - Shareholder and unitholder rights

Outline of chapter

1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to:

Call options

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ensure that no amount is included in the assessable income of a shareholder in a company as a result of acquiring certain rights issued by the company (issuing entity) to acquire further shares (relevant interests);

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ensure that no amount is included in the assessable income for a unitholder in a unit trust as a result of acquiring certain rights issued by the trustee of the unit trust (issuing entity) to acquire further units (relevant interests); and

Put options

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ensure that an amount that is included in the assessable income of a shareholder as a result of acquiring rights issued by the company to dispose of shares, is appropriately reflected in the cost base of the rights. As issue of rights to dispose of units is not possible for many trustees and is unlikely to arise in practice, rights to dispose of units are not dealt with by this Schedule.

Context of amendments

1.2 Companies and trustees of a unit trust may issue call options to their shareholders and unitholders. Companies may issue put options to their shareholders.

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Under a call option, a company issues its shareholders with rights to buy additional shares in the company. A trustee of a unit trust can also issue to its unitholders with rights to buy additional units in the trust.

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Under a put option, a company issues its shareholders with rights to sell their shares back to the company.

1.3 In Commissioner of Taxation v McNeil
[2007] HCA 5 ( McNeil's case), the High Court of Australia found that the market value of tradeable put options issued by a company to its shareholders was assessable as ordinary income at the time of issue of the options.

1.4 While the decision in McNeil's case related to the acquisition of put options, the analysis in the decision is considered capable of applying to call options. This would require a shareholder or unitholder issued with call options in some circumstances to include the value of the option in their assessable income at the time of receiving the option. Such an outcome would seriously affect the capital markets and have significant implications for companies and trustees of unit trusts wanting to use call options to raise capital.

1.5 These amendments restore the original tax treatment of rights issued by issuing entities to existing shareholders or unitholders to acquire additional relevant interests in those entities. As a result, a taxing point will not arise for the shareholders or unitholders in relation to the rights until a subsequent capital gains tax (CGT) event happens to the rights or to relevant interests as a result of exercising the rights.

1.6 These amendments affect rights issued by companies and trustees to existing shareholders and unitholders to acquire shares and units if those shareholders and unitholders would ordinarily be taxed on capital account.

Summary of new law

1.7 These amendments ensure that an amount equal to the market value of rights issued by an issuing entity to existing shareholders or unitholders to acquire relevant interests in the issuing entity is non-assessable non-exempt income at the time the rights are issued, provided that those shareholders or unitholders holds their original interests in the issuing entity on capital account. As a consequence, a capital gain or loss will generally arise for an affected taxpayer when a CGT event subsequently happens to the rights or to the relevant interests acquired as a result of the exercise of the rights

1.8 These amendments also ensure that, for rights issued by a company to dispose of shares, any amount that is assessable at the time the rights are issued will be reflected in the cost base of the rights or of the shares disposed of as a result of the exercise of the rights.

Comparison of key features of new law and current law

Detailed explanation of new law

Rights issued by an issuing entity to acquire relevant interests (call options )

No amount is included in assessable income at the time of issue

1.9 If an issuing entity issues rights to a taxpayer to acquire a relevant interest in the issuing entity, the market value of the rights, as at the time of issue, will be non-assessable non-exempt income at that time, provided certain conditions are satisfied. [ Schedule 1, items 1 and 2, section 11 - 55 and subsection 59 - 40(1 )]

1.10 The conditions are that:

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at the time of issue, the taxpayer must already own an interest in the issuing entity (known as original interests);

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the rights must be issued to the taxpayer because of their ownership of the original interests;

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the original interests and the rights must not be revenue assets or trading stock at the time the rights are issued;

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the rights must not have been acquired under an employee share scheme;

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the original interests and rights must not be traditional securities; and

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the original interests must not be convertible interests.

[ Schedule 1, item 2, subsection 59 - 40(2 )]

1.11 The conditions in paragraphs 59-40(2)(a) and (b) ensure that subsection 59-40(1) applies only if the rights are issued to a taxpayer who already owns original interests and they are issued because of their ownership of the original interests. Rights issued to an existing shareholder or unitholder because they choose to participate in a dividend or distribution reinvestment plan in relation to existing interests will generally be taken to be issued because of their ownership of the original interests. However, subsection 59-40(1) does not impact on the taxation of dividends or distributions reinvested under such plans.

1.12 The conditions in paragraphs 59-40(2)(c) to (e) ensure that subsection 59-40(1) only applies to shareholders or unitholders that would ordinarily be taxed on capital account in relation to the original interests and the rights. Consequently:

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if the original interests and the rights are revenue assets, then the shareholder will generally be taxed on the profit that is made on the disposal of the rights at the time of disposal;

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if the original interests and the rights are trading stock, then the trading stock provisions (Division 70) will apply to the rights;

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if the rights are acquired under an employee share scheme, then the employee share scheme provisions (Division 13A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936)) will apply to the rights; or

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if the original interests and rights are traditional securities, then sections 26BB and 70B of the ITAA 1936 will apply to the rights.

1.13 The condition in paragraph 59-40(2)(f) ensures that subsection 59-40(1) does not apply if the original interests are convertible interests. In this regard, the principles enunciated in McNeil's case are not easily applied to convertible interests.

1.14 In the event that the principles enunciated in McNeil's case do apply to include the market value of rights in a taxpayer's ordinary income at the time of issue, then where that amount is otherwise included in assessable income again, section 6-25 will apply to ensure that the amount that was included in the taxpayer's assessable income at the time of issue will not be included in the taxpayer's assessable income again at any other time.

Capital gain or loss arises when a CGT event happens to the rights

1.15 If a company or trustee issues rights to a taxpayer to acquire shares in the company or units in the trust and the conditions in subsection 59-40(2) are satisfied, then a capital gain or capital loss will arise only when a CGT event happens to the rights or to the shares acquired as a result of the exercise of the rights. For example, if the taxpayer disposes of the rights, the taxpayer may make a capital gain or capital loss because CGT event A1 happens.

Example 1.1

Kylie is an existing shareholder of Co A. Co A issues existing shareholders with rights to acquire additional shares on 1 February 2009. The market value of the rights at that time is $130. Kylie disposes of the rights on 15 March 2009 and receives $150 and incurs transaction costs of $15.

Section 59-40 operates to ensure that the market value of the rights at the time of issue ($130) is non-assessable non-exempt income at that time. However, Kylie will make a capital gain of $135 on the disposal of the rights. The capital gain is included in Kylie's assessable income for the 2008-09 income year.

Other CGT consequences

1.16 A capital gain that is made from a CGT event is currently reduced to the extent that, among other things, an amount of ordinary income that arises from the event is non-assessable non-exempt income. For the avoidance of doubt, a modification is made to ensure that the amount of a capital gain is not reduced by the amount that is non-assessable non-exempt income because of the operation of section 59-40. [ Schedule 1, item 8, subsection 118 - 20(4 )]

1.17 CGT event E4 happens if, broadly, a trustee makes a payment to the taxpayer in respect of a unit where some or all of the payment (the non-assessable part) is not included in assessable income. The non-assessable part is worked out disregarding various components, including any part that is 'non-assessable non-exempt income' (see paragraph 104-71(1)(a)), so that part does not include the value of a right to acquire units to which proposed section 59-40 applies.

1.18 CGT event G1 happens if, broadly, a company makes a payment to the taxpayer in respect of a share where some or all of the payment (the non-assessable part) is not a dividend or an amount taken to be a dividend. A capital gain arises if the non-assessable part is more than the share's cost base. To ensure that CGT event G1 does not happen at the time the rights to acquire shares are issued, CGT event G1 will be modified so that:

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CGT event G1 does not apply to any amount that is included in the taxpayer's assessable income; and

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in working out the non-assessable part, any amount that is non-assessable non-exempt income is disregarded.

[Schedule 1, items 3 and 4, paragraphs 104-135(1)(c) and 104-135(1A)(aa)]

Rights issued by a company to dispose of shares (put options )

CGT event H2 does not apply

1.19 CGT event H2 happens if, broadly, an act, transaction or event occurs in relation to a CGT asset owned by the taxpayer that does not result in an adjustment to the asset's cost base or reduced cost base. However, certain acts, transactions and events are specifically excluded from the scope of CGT event H2. A modification is made to ensure that CGT event H2 does not happen if a company grants an option to dispose of shares in the company, to the company. [ Schedule 1, item 5, paragraph 104 - 155(5 )( ea )]

The market value substitution rule does not apply

1.20 The market value substitution rule can currently apply to rights to dispose of shares regardless of whether or not the right is subsequently exercised. The rule is appropriate if the rights are not exercised as it ensures symmetry between the grantee's cost base for the rights and the capital proceeds that the company is taken to receive in relation to the grant of the rights for the purposes of calculating their capital gain or loss under CGT event D2 (which happens when an option is granted).

1.21 However, the market value substitution rule results in a lack of symmetry between the company that issues the rights and the shareholder who acquires the rights if the rights are exercised, as Division 134 only requires the company to reduce the cost base of the acquired shares by any actual payment they received for the grant of the option. However, Division 134 also allows the shareholder to include the market value of the option in the cost base of the shares sold because of the effect of section 112-20.

1.22 Therefore, the market value substitution rule will no longer apply in relation to a CGT asset that is a right to dispose of a share in a company if the right was issued by the company and the right was exercised either by the shareholder or by another entity who became the owner of the right. [ Schedule 1, item 6, subsection 112 - 20(3 )]

Cost base of put options

1.23 If a company issues tradeable put options to a shareholder, McNeil's case applies to ensure that the market value of the options at the time of issue is included in the shareholder's assessable income.

1.24 To ensure that this amount is not taxed again when the shareholder makes a capital gain or capital loss when a subsequent CGT event happens to the rights or to the shares disposed of as a result of the exercise of the rights, the first element of the cost base and reduced cost base of a right to dispose of a share in a company that a taxpayer acquires as a result of CGT event D2 happening is the sum of:

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the amount included in the taxpayer's assessable income as ordinary income as a result of acquiring the right; and

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the amount, if any, paid by the taxpayer to acquire the right.

[ Schedule 1, item 7, section 112 - 37 ]

Application and transitional provisions

1.25 The amendments will apply to rights issued on or after 1 July 2001. [ Schedule 1, item 9 ]

1.26 The amendments are beneficial to taxpayers because:

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the taxing point in relation to rights issued by a company to acquire shares or by a trustee to acquire units will be deferred from the time that the rights are issued until the time that a subsequent CGT event happens to the rights or to the shares or units acquired as a result of the exercise of the rights; and

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the cost base of shares disposed of on the exercise of a put option will more accurately reflect the effect of the assessment of the value of the put option on acquisition of the option.

1.27 Business and professional groups sought retrospective application of the amendments to prevent taxpayers from being disadvantaged by the reopening of past assessments.