What happens when there is a change in majority underlying shareholding interests?
As many readers may be aware, a solvent members voluntary liquidation (MVL) can allow the distribution of pre-CGT capital profits from a company to retain its pre-CGT status in the hands of the shareholders. This occurs in certain circumstances where it is distributed as ordinary or capital income and taxed accordingly. This is known as the Archer Bros Principle, which arose from Archer Bros Pty Ltd (In Vol Liq) v FCT (1952-53) 90 CLR 140.
Essentially, the principle sets out that where the liquidator can accurately determine the origin of the funds that the liquidator’s distribution is made from, those distributed assets retain their character for any of that amount distributed. Therefore, if the distribution is made from capital profits that have been realised and retained from a pre-CGT property, the distribution would retain its CGT exempt status in the hands of the shareholder rather than being distributed and taxed as ordinary income.
Many will also be aware that Division 149 of the Income Tax Assessment Act 1997 (ITAA 97) provides that where there is a change in the majority underlying shareholding interest in a pre-CGT asset, it may lose its pre-CGT status. A change in the majority underlying interest in a CGT asset is a change in:
More than 50% of the beneficial interest in the asset[1]; or
More than 50% of the beneficial interest in any ordinary income derived from the asset[2].
If there is a change to the above, the asset stops being a pre-CGT asset[3]. The exemptions to this are if the shares were transferred as part of a deceased estate or if there is a marital separation[4].
One of the common issues that people may not be aware of is that the change in majority underlying shareholder interests also affects a distribution in a solvent MVL. The asset in the company is no longer considered a pre-CGT asset and therefore any distribution of the capital profits from the realisation of that asset also does not retain any pre-CGT exempt status in the hands of the shareholders.
The ATO (Australian Taxation Office) notes that the role and purpose of the change in majority underlying interest provisions is aimed at preventing the circumvention of the limitation of the tax on capital gains to assets acquired after 1985[5]. Essentially, the purpose of the provisions is to avoid duplicating the pre-CGT benefit that would otherwise be available.
When developing a strategy for winding up a company’s affairs and there are pre-CGT assets or profits available, advisors should be aware of the following:
The distribution may no longer be pre-CGT exempt if there has been a change in the majority underlying interest.
Where there has been a change in the majority underlying shareholder interest, the distribution no longer retains its pre-CGT exempt status. However, the distribution of any capital profits by a liquidator may still be considered capital proceeds from the cancellation of the shares of the company[6]. Therefore, there may still be a tax benefit in winding up the company’s affairs via a solvent MVL process to receive the funds as capital income rather than ordinary income.
Although the pre-CGT asset in the company will lose its pre-CGT status if the majority underlying interests change, any shareholding interests which have been held since 1985 and are themselves pre-CGT may still retain their pre-CGT exempt status. In that situation, if wound up via an MVL:
In respect to the pre-CGT shareholders, the portion of the distribution which represents the capital profits retained in the company may be considered capital proceeds from the cancellation of the pre-CGT shares[7]. Therefore, the capital portion of the distribution may retain their pre-CGT exempt status.
In respect to the post-CGT shareholders, the capital portion of their distribution in an MVL would be received and taxed as capital proceeds in their individual capacities.
As with a lot of things in respect to tax, the timing of events and transactions can be material and critical to the amount of tax that may have to be paid. As an example, the pre-CGT asset in a company might be realised prior to any change in the underlying shareholding interest. In this way, the realisation of the pre-CGT asset would be exempt in the company. The capital profit would be carried in its equity accounts and may potentially be distributed to shareholders at a future date whilst retaining its pre-CGT status, even if there is a subsequent change in majority underlying shareholding interest. Thus, careful tax planning and strategising is essential in advance when considering the winding up of a company’s affairs.
The above is provided for general information purposes only. Eligibility criteria and certain conditions must be met to qualify for any potential tax benefits. We are the experts in the liquidation aspects of company winding ups, we will leave the tax advisory aspects to the experts in that field. We recommend that individuals first obtain specialised tax advice for their specific circumstances before proceeding with any liquidation appointment. If there are any queries regarding solvent members voluntary liquidations, feel free to reach out to your local Worrells Principal.
[1] s149.15(1)(a) of the ITAA97
[2] s149.15(1)(b) of the ITAA 97
[3] s149 .30(1) of the ITAA 97
[4] s149.30(3) and (4) of the ITAA 97
[5] See Taxation Ruling IT 2340.
[6] s104.25 and s104.135(6) of the ITAA97
[7] s104.25 and s104.135(6) of the ITAA97