Advance Tax
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.
2
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:
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
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.
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
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
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
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
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.
6
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,
7 Whiteford, Peter. 2010. “The Australian Tax-Transfer System: Architecture and Outcomes.” Economic
Record 86, no. 275: 528-544.
7
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
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.
8
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
11 Dempsey, Mike, and Graham Partington. 2008. “Cost of capital equations under the Australian
imputation tax system.”Accounting & Finance 48, no. 3: 439-460.
9
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
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.
10
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:
11
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.
12
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
13
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
14
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
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.
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.
16
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.
