Income Tax Amendment Act (No 3) 1985

This commentary item was published in Public Information Bulletin Volume 136, May 1985

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Introduction

The Income Tax Amendment Act (No 3) 1985 was enacted on 20 August 1985.

It removes, with some exceptions, the exemption from income tax, in the hands of shareholders, of capital distributions made by companies on or after 21 August 1985. The basis of the amendment is that distributions from capital reserves and share premium reserves will, if made to shareholders on or after 21 August 1985, be subject to tax in the hands of the recipient, irrespective of whether the capital gain was made before or after that date. The only exemption for distributions made on or after 21 August 1985 will be in respect of those distributions made on the winding-up of a company (irrespective of when the capital gain arose) and even then only where the distribution is made to shareholders who are not "related companies" as defined.

As announced by the Minister of Finance the taxation of capital dividends in the hands of shareholders will apply as an interim measure until a full imputation system of company/shareholder income is implemented with effect from the 1988/89 income year.

Section 1 - Short Title and Commencement

This section provides that the Amendment Act is to be read together with the Income Tax Act 1976 and that it forms part of that Act.

It further provides that the Amendment Act is to come into force on 21 August 1985. This means that, within the boundaries specified in the Amendment Act, the removal of the capital distributions exemption applies to such distributions made on or after that date.

Section 2 - Meaning of the Term Dividend

A. Subsection (1) is a machinery amendment arising from amendments made to section 4(1) of the principal Act by section 4(1) of the Income Tax Amendment Act (No 2) 1985.

Under the 1985 "No 2 Act" amendment, section 4(1)(b) of the principal Act (which deems certain distributions of property, to a shareholder, to be dividends) was stated as NOT applying to the distribution of property to which section 4(1)(c) applied.

Section 4(1)(c), which deemed certain distributions to a shareholder on the winding up of the company to be a dividend, was in turn stated (in the proviso) as NOT applying to specified "in specie" distributions of assets made on winding up.

The overall effect was that when the "in specie distribution" exemption applied in accordance with the proviso to section 4(1)(c), it was nevertheless subject to section 4(1)(b) and the "in specie" distribution could, in theory, become a divided in terms of that section.

That inadvertent circularity has now been remedied.

Section 2(1) of the Amendment Act also provides that if section 4(5) as now amended (distributions of realised capital gains) of the principal Act applies, section 4(1)(b) of that Act will not apply. This amendment is designed to make it quite clear that section 4(1)(b) cannot be applied to winding-up distributions of capital gains where they are otherwise exempted by the provisions of the amended section 4(5).

B. Subsections (2) - (5) - Capital Dividends

1. Tax Treatment of Capital Dividends Distributed Prior to 21 August 1985 - Prior to the coming into force of this Amendment Act, section 4 of the principal Act provided that, with three exceptions, all distributions to a shareholder, in excess of the amount paid up on shares were deemed dividends. The effect of the three exceptions was that the following distributions were tax free in the shareholders' hands:
   1. The capital gain content of an "in specie" distribution of an asset in the course of the winding up of a company. (Proviso to section 4(1)(c).)
   2. Premiums, paid to the company by shareholders, where:
      1. The premium arose from a cash payment made by a shareholder to the company for the purchase of shares issued at a premium, and
      2. The premium did not arise with respect to the issue of shares in one company as consideration for the purchase of shares in another company. (Second proviso to section 4 of the principal Act.)
      3. The premiums were credited to a share premium reserve in the company's account.
   3. The profit arising from the realisation of a company asset, in excess of the cost of that asset to the company, and any other capital gains (section 4(5) of the principal Act). However, certain profits arising from realisations of assets between related parties are excluded from this exemption, except in the case of a private company where the asset is sold on winding-up to a related person, not being a company, by section 4(5A).

• Although the amendment repeals the existing section 4(5) of the principal Act, the exemption for capital distributions made prior to 21 August 1985 is preserved by the new sections 4(5)(a)(i) and 4(5)(b)(i) of the principal Act.

2. Tax Treatment of Capital Distributions Subsequent to 20 August 1985
   • With the exception of certain distributions upon the winding-up of a company (see paragraph (3) below) all company distributions on or after 21 August 1985 are taxable in the shareholders' hands.

3. Tax Treatment of Capital Distributions on Winding-up Subsequent to 20 August 1985
   • In specie Distributions Subsection (2) of the Amendment Act relates to "in specie" distributions. It provides that the capital gain content of "in specie" distributions on winding up will continue to be tax exempt except when the distribution is made by a "specified company" within the meaning of section 4(5A) to any related company.
   • Share Premium Reserves Subsection (3) limits the application, of the second proviso to section 4(1) of the principal Act (share premium reserves), to distributions, to individuals or non-related companies, made upon the winding up of a company. Such distributions from share premium reserves, upon winding up, will be tax exempt.
   • Realised Capital Profits and Other Capital Gains Subsection (4) repeals the existing subsection (5) of the principal Act and replaces it with a new subsection (5). The new section 4(5) contains the following provisions relating to distributions on or after 21 August 1985. Subsection (5)(a)(ii) of the principal Act relates to distributions made from realised capital profits of a company. It restricts the exemption of such distributions in the hands of shareholders to those made by companies upon winding-up (section 4(1)(c) of the principal Act) and then excludes from this exemption such distributions if they are made to related companies. Subsection (5)(b)(ii) of the principal Act relates to distributions from capital profits or gains derived by a company other than by way of realisation of an asset. This provision restricts the exemption, so that it applies only to such distributions made by companies upon winding-up. (Section 4(1)(c) of the principal Act.) Here again, the exemption does not apply to a distribution made to a related company.

4. Meaning of the Term "Related Company" Distributions during winding up will not be tax exempt in the shareholders' hands where the distribution is made to a company which:
   1. Owns, or has the power to control, or the right to acquire 20 percent or more of the ordinary shares of the company which makes the distribution. (Section 4(5B)(a)(i).)
   2. Owns, or has the power to control, or the right to acquire 20 percent or more of the voting rights of the company which makes the distribution. (Section 4(5B)(a)(ii).)
   3. Is a company of which:
      • The shares are owned to the extent of 20 percent or more by any shareholders who own or control or have the right to acquire 20 percent or more of the shares or the voting rights of the company which makes the distribution, or
      • The voting rights are able to be controlled to the extent of 20 percent or more by shareholders who own, control, or have the right to acquire 20 percent or more of the shares or the voting rights of the company which makes the distribution. (Paragraph (c) could apply where a company held less than 20 percent of the shares in the company making the distribution but the companies also had common shareholders.) (Section 4(5B)(a)(v).)

5. The Taxable Status of Distributions to Shareholders that are Related Companies
   • As already explained, distributions made on or after 21 August 1985 upon the winding up of a company, to shareholders that are related companies, are not exempt from income tax. This is designed to inhibit the "artificial" winding up of companies as a means of using the winding-up provisions in order to distribute capital reserves and thus avoid tax on dividends. When such a distribution is made to a shareholder that is a related company that distribution, received as a dividend, will (although it may be exempted by section 63 of the principal Act from income tax in the hands of the shareholder company) constitute a dividend when distributed subsequently to the shareholders of that related company. This will apply even if that latter distribution is made upon the winding-up of that related company.

6. Amendment to the Related Persons Test
   • Subsection (5) of the Amendment Act expands the application of subsection (5B) of section 4 of the principal Act which, for certain purposes within section 4, defines when a person is a "person related" to a company. Consequent upon this amendment subsection (5B) will, on or after 21 August 1985, apply for the purposes of each of the following:
     1. The proviso to section 4(1)(c) of the principal Act ("in specie" distributions on winding-up).
     2. The second proviso to section 4(1) of the principal Act (distributions, on winding-up, of qualifying share premium reserves).
     3. Section 4(5) of the principal Act (distributions, on winding-up, of realised capital gains).

• This expanded application of subsection (5B) is relevant to the amendment that is made by each of the subsections (2), (3) and (4) of this Amendment Act which insert in the appropriate places, in each of the provisions (of section 4) referred to at (a), (b) and (c) above, the following words: "(not being a shareholder that is a company that, where the company first mentioned in this subsection is a specified company within the meaning of subsection (5A) of this section, is a person related thereto or that, if the said first-mentioned company were a specified company within the said meaning, would be a person related thereto)." See also, in this regard, paragraph 4 above.

C. Subsections (6) and (7) - Bonus Share Issues

Subsections (6) and (7) of this Amendment Act make amendments to section 3 of the principal Act ("meaning of term bonus issue"). Bonus share issues made after 20 August 1985 from capital gains or from share premium reserves will constitute "bonus issues" for income tax purposes. The effect will be that if a reduction or repayment of capital occurs within 10 years after the making of such a bonus issue, the bonus issue will be treated as a dividend in terms of section 4(1)(ca).

D. Subsection (8)

Subsection (8) of this Amendment Act consequently repeals previous amendments that, on the enactment of this Amendment Act, became spent.

E. Non-Resident Withholding Tax

As a result of this amendment distributions to non-resident shareholders from capital reserves and share premium reserves are subject to non-resident withholding tax as from the date on which the exemption was removed.

Summary

The treatment of various distributions upon the winding up of a company in terms of the Amendment Act is summarised as follows:

The Income Tax Position in Relation to Distributions Made on or After 21 August 1985

The following gives a guide to the income tax status of such distributions, in the hands of shareholders.

1. "In specie" distributions to individuals and non-related companies:
   • Not taxable (proviso to section 4(1)(c)).
2. "In specie" distributions to related companies:
   • Taxable (section 4(1) (c)).
3. Distributions to individuals and non-related companies from profits resulting from arms-length realisations of assets:
   • Not taxable (section 4(5)(a)(ii)).
4. Distributions to related companies from profits resulting from arms-length realisations of assets:
   • Taxable (section 4(1)(c)).
5. Distributions from qualifying share premium reserves to individuals or non-related companies:
   • Not taxable (second proviso to section 4(1)).
6. Distributions from share premium reserves to related companies:
   • Taxable (section 4(1)(c)).
7. Distributions, whether to individuals or to related or non-related companies, from profits arising from realisations of assets to related persons:
   • Taxable (section 4(1)(c)). However, note that under the proviso to section 4(5A), distributions by private companies are not taxable where made to individuals or non-related companies from profits arising from a realisation of an asset to a related person, other than to a related person that is a company.
8. Distributions by private companies to related companies from profits arising from realisation of assets to related persons:
   • Taxable (section 4(1)(c)).