The Income Tax Implications of the Transactions
Order Instructions:
Required:
Assuming that all entities involved in these arrangements are Australian residents, discuss the income tax consequences to Xena, Lawless, Gabrielle and Gaby of each of the following alternatives.
Option A: Xena issues 500 convertible notes with a face value of $1000 that will convert to 10 ordinary shares in Xena in seven years. The coupon rate is 5% per annum.
Option B: Xena will issue the lender 5,000 preference shares with a face value of $100 each and a dividend rate of 5%. In 7 years they will revert to ordinary shares.
Option C: Lawless is not satisfied with Xena acquiring a minority interest and initiates a takeover bid for Gabrielle. It makes an offer to purchase all shares in Gabrielle, issuing a $10 share in Lawless plus $10 cash for each share in Gabrielle. It succeeds in acquiring 85% of the shares in Gabrielle. Gaby accepts the offer.
SAMPLE ANSWER
The Income Tax Implications of the Transactions
In Australia, income tax is the most important revenue to the government within the boundaries of the Australian taxation system. Usually, it is levied on three sources in the individual citizens, including personal earnings, capital gains, and business income. It is recorded that the three elements of tax levy amount to approximately 67% of the federal government revenue. The system of taxation in this country is designed in a way that those who earn more pay more, while those who earn less remit relatively lower levies.[1] However, company taxes are calculated at a flat rate of 30%, as opposed to individual incomes, which are subjected to various progressive rates.[2] In this regard, the tax system ensures that each and every individual or entity is justly taxed, depending on prevailing circumstances. The following analysis focuses on presented case studies to calculate the taxes that can be levied in each case, and the subsequent income tax implications.
Duncan
The decision by Duncan to take the share offer and exercise his right to a full allocation was a wise decision. At the time of the offer, Duncan was on an income of $75,000, thus, his tax bill was as follows:
| 0 – 18,200 | 0 |
| 18,201 – 37,000 | 3,571.81 |
| 37,001 – 80,000 | 15,921.675 |
| 19,493.485 |
By choosing to exercise the share purchase via the Employee Share Trust Duncan was able to spread his income tax liability and avoid it altogether. This was not done illegally, but legally. The Employee Share Trust allows Duncan to purchase the shares but have the purchase allowed in tax since contributions. By using the Employee Share Trust, Duncan is influenced by the tax system that allows him to save and for that is able to invest both for his own good and for the community. He has managed to find a balance between work, investment and savings. This has allowed him to develop since by the time he cashes his options, he will make a tidy sum. By increasing the overall level of resources available to the Employee Trust Fund, Duncan has ensured he does not have to pay for any gains the share makes. Technically, the shares do belong to the trust fund, thus for Duncan, his income tax bill remains the same. This allows for efficiency in the Australian economy. Proper reporting encourages and promotes investments that reduce inefficiencies in resource consumption.[3] It could be argued that taxation does affect savings negatively. This argument is based on the assumption that both savings and taxation compete for the same finite pool of individual resources. However, this is not the case. Contributions which are the repayments and regular contribution to the Employee Trust fund attract tax deductions, while any interest is not taxed. However, withdrawals are taxed fully.
When Duncan finally cashes in his options at $1.00 above the market price, he will have to pay the full tax on this transaction. This strategy allows Duncan to postpone the tax liability to when he exercises his option. Duncan is able to postpone income by choosing to have the option exercised via the Employee Trust Fund. It allows Duncan to defer some of his income. Were he to exercise his options personally, it would mean taking his taxable income to a higher tax bracket. Furthermore, it could lower his income making it easy to meet the 2 percent floor required for taking certain deductions. When considering miscellaneous itemized deductions, Duncan could easily meet the 2 percent floor required for taking certain deductions. This is because the miscellaneous itemized deductions will allow Duncan to adjust gross income (AGI) when amalgamated. Duncan has managed to postpone income in order to delay the payment of his tax liability for as long as possible. With the anticipated change of employer, Duncan choice of year to exercise his option makes him lower his tax burden. On the year he cashes his options, there is no salary to swell up the income. This works to reduce the tax bracket.[4] This allows Duncan to derive the greatest advantage from his deductions.
Debbie
Debbie has been enjoying benefits that allow her to pay her taxes in a progressive manner. She only gets to pay for taxes on what she has used. For example, when she does not drive, she does not to pay for it. Additionally, the company parking offered by the company is not a direct cost to Debbie. Thus given the tax – her taxes have morphed to consumption tax in their nature; she is able to operate on a level playing ground. With the current income tax system being referred to as a progressive tax system, it will allow Debbie to operate on a level playing field. Debbie is not a low income earner. As a high-income earner, Debbie will pay tax at a rate of 15 percent as opposed to 25 – 30 percent that is applicable to other Australians.[5] Though it may seem unprogressive, the strategy allows for necessities to be exempt of have their tax levied at a lower rate. On the face of it, it would seem Debbie is not saving. However, a closer focus at Debbie reveals one who understands that taxation will only apply to her when she spends. For Debbie, the tax code performs a very important function; that of modifying her behavior. It was governments’ foresight of the future of IRA – that there was going to be Social Security System death, that it took the initiative to encourage individual savings secondary to the system. It is the consumption tax that would carry on the build-in-form encouragement. It should be evident that Debbie will not like all the tax decisions taken. She may feel that the government was been against her position, but she must remember that the government only makes decisions that will benefit the masses. Thus, it has been presuppose that if consumers only paid tax on what they had consumed as opposed to what they had earned. This way, even earnings that are not declared get captured when the earnings are used to purchase goods and services. This way, loopholes stop being major influencers. For Debbie, she will gain great benefits by paying her taxes as they fall due. When this is not achieved, it becomes very crazy when they must prepare quarterly estimated tax payments. When tax liabilities cease to become a burden on Debbie, the she, together with a large percent of the population would avoid tax troubles and live within their means.[6] For Debbie, compliance will allow her to enjoy the privacy and freedom – the tenets of a free society. The Tax man need not come and confirm Debbie’s individual and itemized consumption as captured in her bank account statement. With the need for federal withholding eradicated, there would be a net growth in net pay. This extra income that Debbie would have at her disposal would then be used to pay for goods and services. For Debbie, instead of having to estimate the tax payments and having to withhold at the source, will now increase the amount of tax payable on account of additional products and services sold.
As with any system of taxation, there is always the potential for abuse.[7] Levying a consumption tax in lieu of the income tax would give the responsibility to business owners and Debbie to collect and turn over the taxes. That is a lot of money to be entrusted to our nation’s companies. For Debbie, there is a very good answer to this quandary: She could embrace the use of a merchant branded card. When used for making purchases, the tax is paid directly without having to recalculate it item by item. That way the Debbie never has access to the funds and cannot abuse her position.
EW
EW’s choice of a share option plan as an incentive for employees is a cost-efficient and helps improve its overall business performance. When EW introduced the Employee share scheme, it was seeking to give valued employees an opportunity to own a part of the organization. To EW, the employee share scheme was an excellent commercial tool, that when applied assists in maximizing the intrinsic value of the organization.
EW granted each employee 1,000 ordinary shares at a discount of $1 per share below market value. Given the market value of the share was $5.30 at the time of implementing the strategy, each employee who took up the share option purchased the share at $4.30. With each employee having a choice between outright purchase or financing by EW Employee Share Trust, it is anticipated that the trust will recover the shares full price for the financed employees from the dividends received. To ensure that the share price is not vulnerable to speculative attacks, employees will be expected not to dispose the shares before three years have lapsed.[8] In exercising their option, Capital Gains Tax may be payable in gains exceed the employee’s annual tax free allowances. EW will be eligible for Corporation Tax Relief for the costs of establishing and administering the CSOP and the cost of providing the shares under the scheme.[9]
Practical Issues
To ensure the successful introduction and management of the employee share scheme, some critical issues will have to be addressed and laws adhered to in order to ensure that the distribution of shares abides by specific rules as spelt out with in the EW’s constitution and relevant legislation. These include the company’s Act 2006, the Financial Services and Markets Act and the listing rules of the Stock market, employees will be have restricted ability to dispose off their shares for three years if still employed o until they leave EW.[10] EW will also have to seek approval from the regulators to operate a tax-advantaged scheme as the one designed for EW. To ensure employees reap the maxim benefits from this strategy, there will have to be precise and specific communication with regards to the risks and benefits of the employee share ownership system. Adherence and fidelity to financial services regulations since the share schemes are financial and there are clear guidelines with regards to appropriate exclusions for scheme trustees and exemptions for their promotional materials. Finally, depending on the circumstances prevailing presently, there might be a need for a prospectus to be issued.
Addressing the tax issues
The Australian Taxation Office (ATO) does considers that there are a number of acceptable methodologies for ascertaining the capital/dividend split, although not all have equal applicability in every case. Each share buy-back is unique and must be well thought-out to establish the most ideal methodology to address each cases. The ATO appreciates that there exists many methods of determining the capita component of a particular buy-back for tax purposes.[11] The Average Capital per Share method has emerged as ideally suited to the task. The suitability of this method is premised on its ability to identify the average capital for each share the company has on issue. It is this average amount that is the basis of determining the capital component for each of the shares bought back.
To get the average capital amount, the amount held in the company’s share capital account is divided by the number of shares on issue. When applying the formula for determining the average capital amount, some adjustment will have to be undertaken in response to the environment under which it operates. These adjustments will address the number of different share classes on issue, the number of partly paid up shares of issue and whether there has been a recent injection of capital in the organization.[12] When an organization does not consider the buy-back for market value consideration, it could very possible result in additional amounts being assessable to the exiting shareholder.
When implemented properly, a share buy-back allows the organization to effectively exit particular shareholders or reinvest surplus funds to a particular shareholder group.[13] Despite the tax bill that could be accrued, it can be petered over through application of methodologies that are recommended by ATO when determining the capital/dividend split.
Option A:
Xena issues 500 convertible notes with a face value of $1000 that will convert to 10 ordinary shares in Xena in seven years. The coupon rate is 5% per annum. Xena will have to generate enough resources to meet the interest obligations when they fall due. By choosing the convertible note, Xena is positioning itself for a productive future and wants the partner coming in to buy into the future of Xena. Despite it being a subsidiary of Lawless, it operates autonomously. The new debt will have an effect on the dividends payable to Lawless, which in turn will have an effect of the tax declared by Lawless. Gabrielle will have get a strong partner coming into its operations. The convertible notes will not only guarantee Xena can lock in the future dividends should Gabrielle continue on the current growth trajectory. Gaby should expect the transaction to result in value of the Gabrielle shares. From the current cost of $5, there should be significant shift. This will have to be captured in Gaby’s computation of her income tax.
Initial Recognition
The following accounting entries must be recorded upon initial recognition:
| Dr – Cash/Bank | $500,000 (Total Proceeds) | |
| Dr – Share Option (Premium) | $144,622 (Balancing Figure) |
| Cr – Liability | $664,622 (Note 1) |
Note 1:
Present value of future interest payments and principal using 5%:
| Year1: | $50,000 (interest) | x | [1/1.05] | = | $47,619.0 |
| Year2: | $50,000 (interest) | x | [1/1.05^2] | = | $45,351.5 |
| Year3: | $50,000 (interest) | x | [1/1.05^3] | = | $43,191.1 |
| Year4: | $50,000 (interest) | x | [1/1.05^4] | = | $41,135.1 |
| Year5: | $50,000 (interest) | X | [1/1.05^5] | = | $39,176.3 |
| Year6: | $50,000 (interest) | X | [1/1.05^6] | = | $37,310.8 |
| Year7: | $50,000 (interest) | X | [1/1.05^7] | = | $35,534.1 |
| Year7: | $500,000 (principal) | x | [1/1.05^7] | = | $ 355,340.5 |
| Total | $ 644,622.0 |
Subsequent Measurement
Interest expense will be charged using 5%. The difference between interest paid and interest charged will be added to the liability component as follows:
| Interest Expense | Liability | |||
| $ | $ | |||
| Year1: | [664,622 x 5%] | 33,231 | [664,662 + 33,231 – 50,000*] | 647,853 |
| Year2: | [647,853x 5%] | 32,392 | [647,853 + 32,392 – 50,000] | 630,245 |
| Year3: | [630,245 x 5%] | 31,512 | [630,245 + 31,512 – 50,000] | 611,757 |
| Year4: | [611,757 x 5%] | 30,588 | [611,757 + 30,588 – 50,000] | 592,354 |
| Year5: | [592,345 x 5%] | 29,617 | [592,345 + 29,617 – 50,000] | 571,962 |
| Year6: | [571,962 x 5%] | 28,599 | [571,962 + 28,599 – 50,000] | 550,561 |
| Year 7 | [550,561 x 5%] | 27,528 | [550,561 + 27,528 – 50,000] | 528,089 |
*$50,000 is the 10% nominal interest.
Maturity
Following accounting entry will be required to account for the conversion of bonds into shares after three years:
| Dr – Liability | $500,000 | |
| Dr – Share Options (equity) | $144,622 |
| Cr – Share Capital | $500,000 | ||
| Cr – Share Premium | $144,622 |
Option B:
Xena will issue the lender 5,000 preference shares with a face value of $100 each and a dividend rate of 5%. In 7 years, they will revert to ordinary shares.
The preference shares the best debt vehicle for a lender since the debt is secured and payment is preferred over other debts. Xena will secure the necessary funding needed to purchase a minority stake in Gabrielle. Xena must consider the loan and interest repayment when capturing its operational expenses. This will mean a reduction in the profitability of Xena, and by extension, reduced profitability to Lawless. Lawless as stated before will experience reduced profitability in the short run. In the long run, the investment will result in additional profitability and thus additional tax liability. Gaby will have their debt secured and preferred over any other debt in the organization. For Gaby, the periodic interest to paid out represent a regular income. This will have to be captured in order to determine the appropriate income tax liability. The
Initial Recognition
The following accounting entries must be recorded upon initial recognition:
| Dr – Cash/Bank | $500,000 (Total Proceeds) | |
| Dr – Share Option (Premium) | $144,622 (Balancing Figure) |
| Cr – Liability | $664,622 (Note 1) |
Note 1:
Present value of future interest payments and principal using 5%:
| Year1: | $50,000 (interest) | x | [1/1.05] | = | $47,619.0 |
| Year2: | $50,000 (interest) | x | [1/1.05^2] | = | $45,351.5 |
| Year3: | $50,000 (interest) | x | [1/1.05^3] | = | $43,191.1 |
| Year4: | $50,000 (interest) | x | [1/1.05^4] | = | $41,135.1 |
| Year5: | $50,000 (interest) | X | [1/1.05^5] | = | $39,176.3 |
| Year6: | $50,000 (interest) | X | [1/1.05^6] | = | $37,310.8 |
| Year7: | $50,000 (interest) | X | [1/1.05^7] | = | $35,534.1 |
| Year7: | $500,000 (principal) | x | [1/1.05^7] | = | $ 355,340.5 |
| Total | $ 644,622.0 |
Subsequent Measurement
Interest expense will be charged using 5%. The difference between interest paid and interest charged will be added to the liability component as follows:
| Interest Expense | Liability | |||
| $ | $ | |||
| Year1: | [664,622 x 5%] | 33,231 | [664,662 + 33,231 – 50,000*] | 647,853 |
| Year2: | [647,853x 5%] | 32,392 | [647,853 + 32,392 – 50,000] | 630,245 |
| Year3: | [630,245 x 5%] | 31,512 | [630,245 + 31,512 – 50,000] | 611,757 |
| Year4: | [611,757 x 5%] | 30,588 | [611,757 + 30,588 – 50,000] | 592,354 |
| Year5: | [592,345 x 5%] | 29,617 | [592,345 + 29,617 – 50,000] | 571,962 |
| Year6: | [571,962 x 5%] | 28,599 | [571,962 + 28,599 – 50,000] | 550,561 |
| Year 7 | [550,561 x 5%] | 27,528 | [550,561 + 27,528 – 50,000] | 528,089 |
*$50,000 is the 10% nominal interest.
Maturity
The following accounting entry will be required to account for the conversion of bonds into shares after three years:
| Dr – Liability | $500,000 | |
| Dr – Share Options (equity) | $144,622 |
| Cr – Share Capital | $500,000 | ||
| Cr – Share Premium | $144,622 |
Option C:
Lawless is not satisfied with Xena acquiring a minority interest and initiates a takeover bid for Gabrielle. It makes an offer to purchase all shares in Gabrielle, issuing a $10 share in Lawless plus $10 cash for each share in Gabrielle. Lawless managed in acquiring 85% in Gabrielle. Gaby accepts the offer. Gaby will have to account for the new income that constitutes the offer price. This being a one off-payment will make the income tax bill to be big. Gaby can chose to declare the income in the next financial year thus reducing its tax burden. Gabrielle will have acquired a bigger partner. This strategy, however, has the risk of not determining whether the new owner will change things or leave operations as currently secured.[14] Lawless on its part will have to report on more income tax, since all the dividends declared by Gabrielle now belong to Lawless, its income tax will grow exponentially.
In order to reduce the influence of Tax consideration on how financial arrangements are structured, the organization will embrace Taxation of Financial Arrangements (TOFA). In its implementation, TOFA aims to align even closer the taxation recognition of gains and losses on financial arrangements with the resultant gains or losses being commercially recognized.[15]
Despite TOFA providing an overarching and comprehensive framework aimed at addressing directly the economic substance of arrangement, it does not exemplify a code so exclusive that covers taxation of gains and losses from financial arrangements. Consequently, TOFA will provide Xena with the basic framework that is principle-based and ideal for the taxation of gain and losses from financial arrangement based on their economic substance rather that legal form. These will more often than not be included in assessable income or allowed as a deduction on revenue account.
Bibliography
Balachandran, Balasingham, Dean Hanlon, and Hanghang Tu. 2013. “Tax-induced earnings management within a dividend imputation system.” Australian Tax Forum 28, no. 3: 555-582.
Dempsey, Mike, and Graham Partington. 2008. “Cost of capital equations under the Australian imputation tax system.”Accounting & Finance 48, no. 3: 439-460.
Eccleston, Richard. 2013. “The Tax Reform Agenda in Australia.” Australian Journal Of Public Administration 72, no. 2: 103-113.
Evans, Chris, and Jason Kerr. 2012. “Tax reform and ‘rough justice’: is it time for simplicity to shine?.” Australian Tax Forum 27, no. 2: 387-410.
Handley, John C., and Krishnan Maheswaran. 2008. “A Measure of the Efficacy of the Australian Imputation Tax System.” Economic Record 84, no. 264: 82-94.
Ikin, Catherine, and Alfred Tran. “Corporate tax strategy in the Australian dividend imputation system.” Australian Tax Forum 28, no. 3 (July 2013): 523-553.
Kalb, Guyonne, Hsein Kew, and Rosanna Scutella. 2005. “Effects of the Australian New Tax System on Income Tax and Benefits with and without Labour Supply Responses.” Australian Economic Review 38, no. 2: 137-158.
Lavermicocca, Catriona, and Margaret McKerchar. 2013. “The impact of managing tax risk on the tax compliance behaviour of large Australian companies.” Australian Tax Forum 28, no. 4: 707-723.
Thompson, William D. 2010. “Taxation Law: A Long-term Plan for Australian Tax Reform – the Henry Report and the Government’s Response.” Keeping Good Companies 62, no. 5: 305.d
Whiteford, Peter. 2010. “The Australian Tax-Transfer System: Architecture and Outcomes.” Economic Record 86, no. 275: 528-544.
[1] [1] Handley, John C., and Krishnan Maheswaran. 2008. “A Measure of the Efficacy of the Australian Imputation Tax System.” Economic Record 84, no. 264: 82-94.
[2] Balachandran, Balasingham, Dean Hanlon, and Hanghang Tu. 2013. “Tax-induced earnings management within a dividend imputation system.” Australian Tax Forum 28, no. 3: 555-582.
[3] Ikin, Catherine, and Alfred Tran. “Corporate tax strategy in the Australian dividend imputation system.” Australian Tax Forum 28, no. 3 (July 2013): 523-553.
[4] Lavermicocca, Catriona, and Margaret McKerchar. 2013. “The impact of managing tax risk on the tax compliance behaviour of large Australian companies.” Australian Tax Forum 28, no. 4: 707-723.
[5] Handley, John C., and Krishnan Maheswaran. 2008. “A Measure of the Efficacy of the Australian Imputation Tax System.” Economic Record 84, no. 264: 82-94.
[6] Balachandran, Balasingham, Dean Hanlon, and Hanghang Tu. 2013. “Tax-induced earnings management within a dividend imputation system.” Australian Tax Forum 28, no. 3: 555-582.
[7] Whiteford, Peter. 2010. “The Australian Tax-Transfer System: Architecture and Outcomes.” Economic Record 86, no. 275: 528-544.
[8] Kalb, Guyonne, Hsein Kew, and Rosanna Scutella. 2005. “Effects of the Australian New Tax System on Income Tax and Benefits with and without Labour Supply Responses.” Australian Economic Review 38, no. 2: 137-158.
[9] Evans, Chris, and Jason Kerr. 2012. “Tax reform and ‘rough justice’: is it time for simplicity to shine?.” Australian Tax Forum 27, no. 2: 387-410.
[10] Thompson, William D. 2010. “Taxation Law: A Long-term Plan for Australian Tax Reform – the Henry Report and the Government’s Response.” Keeping Good Companies 62, no. 5: 305.
[11] Dempsey, Mike, and Graham Partington. 2008. “Cost of capital equations under the Australian imputation tax system.”Accounting & Finance 48, no. 3: 439-460.
[12] Evans, Chris, and Jason Kerr. 2012. “Tax reform and ‘rough justice’: is it time for simplicity to shine?.” Australian Tax Forum 27, no. 2: 387-410.
[13] Eccleston, Richard. 2013. “The Tax Reform Agenda in Australia.” Australian Journal Of Public Administration 72, no. 2: 103-113.
[14] Balachandran, Balasingham, Dean Hanlon, and Hanghang Tu. 2013. “Tax-induced earnings management within a dividend imputation system.” Australian Tax Forum 28, no. 3: 555-582.
[15] Eccleston, Richard. 2013. “The Tax Reform Agenda in Australia.” Australian Journal Of Public Administration 72, no. 2: 103-113. https://doi.org/10.1111/1467-8500.12019
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