- The tax impacts of IFRS need to be considered now, particularly as they affect the share capital account and disqualifying account rules.
All Australian entities preparing financial reports under the Corporations Act 2001 must comply with the Australian equivalents to the International Financial Reporting Standards ("IFRS") for financial years commencing on or after 1 January 2005. Although most tax managers are already aware of this, they might not understand the full implications of IFRS for their entities’ share capital account. In this article, we’ll tease out some of those implications and also see its effects on the disqualifying account rules.
Reclassification of shares
On transition into IFRS, companies are required to prepare an opening IFRS compliant balance sheet. The preparation of this balance sheet will require companies to examine whether any shares on issue that are currently treated as equity should be treated as a financial liability and, if so, at what value. If such reclassification is required, changes will be required to various of the company's accounts, with possible tax ramifications.
The share capital account, specifically defined, plays an important role in the tax distinction drawn between corporate dividends and distributions of capital. The tax rules seek to ensure that tax advantages of distributing capital are restricted to distributions of contributed share capital (rather than amounts that have been transferred to the share capital account from other accounts of the company). This is achieved by share capital tainting rules that provide that a company's share capital account is "tainted" if amounts such as profits are transferred to the account. The tainting of the share capital account means that subsequent distributions made from the account are treated as unfranked dividends.
Another set of rules (known as disqualifying account rules) ensures that franking benefits are restricted to dividends paid from realised profits. In brief, dividends paid from "disqualifying accounts" (including a share capital account and a profit reserve to the extent it consists of profits from the revaluation of assets) cannot be franked. If amounts are transferred from such an account to a non-disqualifying account (essentially liability accounts and profit accounts to the extent they consist of realised profits), a notional disqualifying account is created. Subsequent dividends will be deemed to be paid from this notional account and not be frankable.
Under IFRS, certain shares that under previous accounting rules were treated as equity will need to be classified as a financial liability. This applies particularly to converting and convertible preference shares. A consequence of such reclassification is that the share capital associated with those shares needs to be removed from the share capital account of the company and transferred to a liability account. The amount of the liability should be its fair value, which may differ from the amount of share capital that relates to the shares.
What rules apply to tainting?
In relation to tainting, the first problem is working out what rules apply. The share capital tainting rules are contained in the former Division 7B of Part IIIA of the Income Tax Assessment Act 1936 ("1936 Act"). These provisions ceased to have effect from 1 July 2002 when new dividend imputation provisions were introduced into the Income Tax Assessment Act 1997 ("1997 Act"). However, the Commonwealth Treasury is working on a replacement set of rules that will have retrospective application from 1 July 2002.
The operative provision of the old rules is section 160ARDM(1) which provides that: "A company's share capital account is tainted if the company transfers an amount to its share capital account from any of its other accounts." We have to assume that the new legislation will be in similar terms.
We assume that a new liability account would be created for the reclassified share. What would be the nature of such an account for tax purposes? It seems that it will be a share capital account. Section 6D of the 1936 Act defines a share capital account as.
6D(1) [Definition] A share capital account is:
(a) an account which the company keeps of its share capital; or
(b) any other account (whether or not called a share capital account)
created on or after 1 July 1998, where the first amount credited to the
account was an amount of share capital.
Share capital is not specifically defined, although shares are. They are "shares in the capital of the company". It seems that share capital is any capital raised by the issue of shares (irrespective of their classification as debt or equity for accounting or tax purposes). Therefore the account is defined by reference to its contents. So long as its contents are comprised of capital raised by the issue of shares, it will be a share capital account despite the fact that the account sits in a different part of the balance sheet of the company and is no longer described as a share capital account.
Section 160ARDM applies to a transfer to a share capital account from any other account, even, it seems, another share capital account. Therefore it would seem to apply even to a transfer between share capital accounts. Section 6D(2) comes to our aid. It provides as follows:
6D(2) [More than one account]If a company has more than one account
covered by subsection (1), the accounts are taken, for the purposes of
this Act, to be a single account.
It seems that, on the basis of this provision, transfers between share capital accounts can be ignored. Therefore no tainting arises from a transfer of share capital from an existing share capital account to a new liability account that is created for the reclassified shares.
In the relation to the disqualifying account rules, is there a transfer from a disqualifying account (ie. the share capital account ) to a non-disqualifying account (such as a liability account)? It seems not. On the basis that the liability account created for the reclassified shares is a share capital account for tax purposes, the transfer is between disqualifying accounts. In fact, as the two accounts are deemed to be one for tax purposes, there is probably no transfer at all for tax purposes.
A further issue that arises is the treatment of any difference between the amount removed from the share capital account and the fair value of the liability relating to the reclassified shares. If the fair value of the liability exceeds the amount of share capital that was contributed in relation to the shares, the difference will need to be sourced from the retained earnings account of the company.
A transfer from the retained earnings account to a share capital account will clearly result in tainting the share capital account unless the redrafted tainting rules allow for such a transfer (which seems to us to be unlikely). This will cause problems in relation to any future use of the share capital account.
Under IFRS, the issuing of equity in return for services needs to be recognised as an expense with a corresponding increase in the company's equity. The most common example is equity-based remuneration of employees that previously was not required to be recognised in this manner.
Where the relevant services are to be provided over time, the expense and the increase in equity are also recorded over time. For instance, if options are issued subject to vesting conditions, the expense and increase in equity are recognised over the vesting period. The value of the equity is established at the time of the grant.
A concern has been raised that the company's share capital account would be tainted as a result of these accounting entries. However, we do not believe that this is the case. Share capital tainting only arises if there is a transfer from one of the company's accounts to the share capital account. There would be no transfer if all that occurs is a debit to an expense account and a credit to the share capital account.
Tax assets and tainting under IFRS
A further change required by IFRS is in relation to tax assets. The value of these assets will often need to be credited to the equity account of the company. For instance, if a tax deduction is available for equity based remuneration that exceeds the accounting expense in relation to that remuneration, the value of the tax deduction for the excess is credited to equity rather than to tax expense.
Another example of a tax asset is in relation to equity raising costs. Under IFRS, the equity account needs to be credited with the net amount of cash that has been raised plus the value of any tax benefit. For instance, if $1,000 of equity is raised and equity raising costs of $100 are incurred, the equity account of the company would be credited with $930 comprising a net amount of cash raised of $900 plus $30 for the value of the tax deduction associated with the equity raising costs.
No share capital tainting issue would seem to be raised by crediting the equity account with the value of the tax deduction. There is no transfer by the company to its share capital account from any of its other accounts. The fact that there is a debit to one of the company's accounts (in this case, a tax asset account) to correspond to the credit to the share capital account does not mean that there is a transfer between the accounts.
Revaluation of assets
It seems that IFRS would require more assets to be valued at market value, with the potential that more unrealised gains will be included in a company's profit.
Under section 46H of the 1936 Act, a disqualifying account includes a reserve to the extent that it consists of profits from the revaluation of assets that have not been disposed of by the company. The effect of including unrealised gains in a company's retained earnings account is that the account becomes a disqualifying account to the extent of the unrealised gains. Dividends debited against a disqualifying account of the company are not frankable.
It seems the companies may need to have a separate retained earnings account for profits on the revaluation of assets that are not being disposed of. This will allow any dividends to be paid out of realised profits.
We await with interest the new share capital tainting rules that Treasury is currently drafting. However it seems, at least from our research, that the advent of IFRS does not require any change to those rules. While the tax impact will need to be considered in making any necessary accounting changes to comply with IFRS, in our experience, there are ways to avoid any adverse tax consequences within the existing share capital tainting rules.
On the other hand, the impact of the adoption of IFRS on the disqualifying account rules would seem to present more of a challenge. The example mentioned above is in relation to companies that will have unrealised gains in their profits as a result of IFRS. We understand that there are other examples.
The Australian Taxation Office has established a committee to look into the tax effects of the adoption of IFRS. It is hoped that recommendations will be made to amend the law with respect to disqualifying accounts and in any other areas where the adoption of IFRS presents tax problems.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.