Chapter 7 Varying Share Interest Notes
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Chapter 7 Varying Share Interest Revision
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MCL - Corporate Tax
Chapter 7 Varying Share Interest Abbreviation:
1. SH: Shareholder
2. GR: General Rule
3. De-m: De-merger
4. Co: corporation
5. MV: market value
1. Looks at scenario where there is in form a dealing in a share interest: a. Creation b. Transfer c. Termination
2. Before this dealing: the investor has a share interest of a particular quantum.
3. After the dealing: the investor still has a share interest of a particular quantum, but in a different form. Why? Because there is a change of share interest, but in substance there is not/ at least the share interest before the change can be identified with a share interest after the change. This is called variation of share interest (also known as "corporation reorganisation").
4. Issues of this chapter: a. Whether a shares interest has changed enough to justify the realisation of any gain/loss built into the interest. b. Whether the exchange should be recognised/ the replacement share interest should just be identified with the existing share interest. Concern with whether deferral/roll-over relief is available.
5. Options of variation of share interest: a. Investor may have a particular type of share interest before the event that is substituted for a different type of share interest by the event b. Investor may have one share interest before the event that is split into two or more interest by the event. c. Investor may have two/more share interest by the event.
6. If companies are recognised as artificial legal constructs, the argument for deferral/roll-over of variation of shares interests in the same co can be extended to a situation involving more than one co. So, a share interest in a co that is substituted into share interest/interests in one or more other companies may be sufficiently similar so as to justify non-recognition of realisation.
7. May be true where share interests in 2 companies are varied into share interests in a single corporation.
MCL - Corporate Tax
8. Variation of share interest involving: a. A single corporation - exchange (substitution), split, consolidate b. 2/more corporations - merging/ de-merging corporations B. WITHIN CORPORATION Substitution
1. Issue: Whether the substitution constitutes a realisation event such that a gain/loss may be realised by reason of the substitution.
2. Two factors: a. Factor 1: scope of the permitted substitution (what is being substituted for what) b. Factor 2: triggering the substitution and (done by agreement/option)
3. Factor 1: A country provides relief on the substitution of share interests must determine the type of share interests that qualify. a. Perhaps there is a stronger case for providing relief if the return on the existing share interest is the same as that which will be derived on the replacement share interest. b. If dividends are derived on each and the tax treatment is the same, perhaps there is reason to accept that nothing much has changed in substance and that deferral relief should be provided for the substitution realisation event. c. Unclear if tax treatment of the return on the investment changes by reason of the substitution event; this particularly the case where debt is substituted for equity (shares) or vice versa. d. Fundamental difference betw deductibility of interest and full taxation in the hands of the investor on the one hand and non-deductibility of dividends and potential dividend relief in the hands of the investor on the other. Country UK
Factor 1: A country provides relief on the substitution of share interests must determine the type of share interests that qualify.
Similar (US rules based), but more limited.
TCGA s. 127 "Subject to sections 128 to 130, a reorganisation shall not be treated as involving any disposal of the original shares or any acquisition of the new holding or any part of it, but the original shares (taken as a single asset) and the new holding (taken as a single asset) shall be treated as the same asset acquired as the original shares were acquired." (Explanation: Reorganisation - means reorganisation or reduction of a company's share capital'. The existing share interest must be 'shares'. Replacement share interest can be 'shares in and debentures of the company'. In US, the investor receives some consideration other than the new holding, a capital gain may be realised.)
TCGA s. 126(1) "For the purposes of this section and sections 127 to 131 "reorganisation" means a reorganisation or reduction of a company's share capital, and in relation to the reorganisationo "original shares" means shares held before and concerned in the reorganisation,
MCL - Corporate Tax
"new holding" means... the shares in and debentures of the company which as a result of the reorganisation represent the original shares... (2)... reorganisation of a company's share capital includesany case where persons are, whether for payment or not, allotted shares in or debentures of the company in respect of and in proportion to... their holdings of shares in the company or of any class of shares in the company..." (Explanation: UK reorganisation can involve the substitution of shares for debt, but do not expressly apply to substitute of debt for shares. This is remedied by a specific provision that extends the reorganisation rules to the 'conversion of securities' (include a conversion 'effected by a transaction or occurring in consequence of the operation of the terms of any security).
TCGA s. 132(1) "Sections 127 to 131 shall apply with any necessary adaptations in relation to the conversion of securities as they apply in relation to a reorganisation..."
Forgiveness o The conversion of debt into equity: Controllers of co are often required to 'retire' debt they are owed and replace it with shares, often of a lower face value to the debt that is replaced. Doing so involves forgiving an element of corporate debt, and an issue is whether the co may have to recognise income as a result of forgiveness. o
May not be treated as income if the release is in consideration for shares forming part of the ordinary share capital of the debtor corporation.
Board reorganisation rules- may provide relief in the substitution. ->
IRC s. 354(a)(1) "No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization." (Explanation: 'Reorganization' : includes 'recapitalisation' or Type E organisation.( IRC s. 368(a)(1)) 'Recapitalization': not defined, but has broadly been interpreted as the 'reshuffling of a capital structure within the framework of an existing corporation'. 'Stock or securities': means that US rule is broad enough to cover exchanges of shares, debentures for shares and shares for debentures. o If other property is received in the exchange, there may be partial recognition of a gain. o Outside of that, investor simply transfers the cost base of their existing share interest to the replacement share interest.
MCL - Corporate Tax
CTA 2010 s. 1000 The definition of distribution does not specifically include bonus shares and so Blott is applicable and the reorganisation provisions under TCGA s. 127 will spread the cost base.
An income tax liability may arise where capital is returned to shareholders within a certain time before or after a bonus issue; CTA 2010 S1022 and 1026.
Income tax may also be due where bonus shares are accepted in lieu of a cash dividend; CTA 2010 s. 1049 and ITTOIA s. 411. In this case the cost base of the shares is the amount treated as a dividend; TCGA s. 142.
IRC s. 305(a) "Except as otherwise provided in this section, gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock."
IRC s. 307 "The basis of the original shares is apportioned over those and the bonus shares."
Forgiveness Constitutes income if the amount of debt forgiven is more than market value of the replacement shares. Exchange of securities has been a taxing event.
General rules for disposal of share interest will apply. This includes the limited taxation on individuals, and for corporate investors, the participation exemption where the existing interest is shares.
A share acquired on the exercise of an option "has to be capitalised together with the option premium. Should the option right have been devalued since the purchase of the contract, the (lower) book value of the option right has to be entered in the calculation of the acquisition cost of the underlying asset... A realisation of profits can thus be avoided." The German Tax Guide p.
As to convertible notes - "With a view to classifying and valuing in the balance sheet, such compound instruments - due to their economic contents - are as a rule not valued as one entity, but must be stripped down to their basic components." The German Tax Guide p. 400.
German companies may also make a tax free distribution of bonus shares under the Stock Dividends Law of 10 October 1967 s. 1. The cost base of the old shares and the new shares is apportioned between them according to their par value; s.3
MCL - Corporate Tax
4. Factor 2: Triggering the substitution: Options and convertible notes: a. A share interest may be issued on terms tat specify the circumstances in which it converts into another share interest. (may be at the choice of one of the parties). b. Share interest may constitute nothing more than an option that may convert into a share interest. c. The option may be imbedded in another security (i.e convertible notes/debentures). d. If a share interest does not incorporate terms as to its conversion, then it is likely that the interest can only substituted for another share interest by agreement between the parties. Country
Factor 2: Triggering the substitution: Options and convertible notes:
General rule for options apply to options to acquire shares.
If exercise, then the granting and exercise of the option are treated as a single disposal when the option is exercise of the option are treated as a single disposal when the option is exercised. -> the acquirer's cost base of the shares includes any price paid for the option. For company, means that any price paid for the option is treated as paid in consideration for the shares and so need not be recognised.
If the option is not exercise, the company is taxable on any price paid for the option as a capital gain. The holder of an expired option is only permitted a capital loss on certain types of options, typically those listed on a stock exchange.
As for convertible notes, the treatment of the note holder is the same as debt converted into shares by agreement.
S415 CTA 2009 (UK)- a corporation issuing convertible notes typically bifurcates them into a debt instrument and an option for corporation tax purpose under the loan relationship rules. Different from Germany:
S1032(a) IRC Expressly provide that amounts received by a corporate in exchange for options to acquire its stock are not taxable, even if the option remains unexercised.
For acquirer, the cost of option is added to the cost of the shares if the option is exercised, but there is no attempt to tax any increase in the value of the option at the time of exercise.
S1273(c)(2): if the option is imbedded in a debt security, then there would be division between the option and the debt.
Corporation recognises no income in option part of convertible security. Security holder does not have to recognise any gain on conversion, but not clear in statute. The cost base of security is included in the cost base of the shares on conversion.
MCL - Corporate Tax
No express rules that cover conversion of convertible securities and exercise of share option. Such a conversion may trigger a realisation depends on how the exe is accounted for.
1) Share option: acquirer may capitalise the value of shares as the price paid +any option premium (at its deprecated value, if relevant). For the issuing co, the option premium would be recognised as income when the option is exercised or expires.
2) Convertible notes: instrument would be bifurcated into its option and debt components. It may give rise to tax consequences depends on whether the MV of the shares is more or less than the face value of debt.
Splitting: focus on bonus shares
1. Surrender of the existing share interest followed by the issue of 2/more new share interests.
2. Countries with par value shares, this variation could involve the splitting of a share with a par value: $10 in 2 shares with par value of $5.
3. Eg. Presume that a company with a market value of 100 has issued 10 shares. Each share is worth 10. If the corporation makes a one-for-one bonus issue, each shareholder will receive an additional share for each share. The total number of shares is now 20, but the value of the company has not increased. So each of the 20 shares is now worth 5, and the value of the existing shares has decreased: the value of the existing shares has been split or shifted between the original shares and bonus shares.
4. Management may feel that the company is undervalued, and the issue of bonus shares often sends a message to the market bout the confidence of management in company's outlook.
5. For listed company, a bonus share issue does not necessarily result in the devaluation of existing shares, at least not in proportion to the bonus share issue.
6. Issue of bonus shares can equal to a share split, but only if the bonus shares issue is proportionate to the holding of existing shares. If the bonus share issue is disproportionate, then the value that is shifted by the issue of the bonus shares is shifted unequally as between the existing SHs.
7. % interest in the company of a shareholder receives bonus shares will increase and of a SH that does not receive bonus shares will decrease.
Bonus shares and the capitalisation of profits
MCL - Corporate Tax
1. When a company issue bonus shares, it distributes additional shares to existing SH without considerations IF shares do not have a par value, the company usually has a choice as to whether to distribute bonus shares with or without a capitalisation of profits. It is also possible to capitalise profits without issuing bonus shares or directly affecting the rights attached to particular shares.
2. In par value jurisdiction, whenever bonus shares are issue, an amount = to the par value of the bonus shares must be transferred to co' share capital account (SCA). Such transferred from retained profits- "capitalisation of profits". Germany and UK- pay up an issue of bonus shares from the company's share premium account. In par value jurisd, it is impossible to increase the SCA without issuing new shares or increasing the par value of existing shares.
3. Distribution from profits-taxable as dividends; distribution from capital -NO.
4. IF no part of a bonus share that capitalises profits is treated as a dividend, then the co may be able to distribute those profits in the future as a return of capital subject to non-div treatment. If there is a substantial inconsistency between taxation of div and taxation of returns of capital, then the capitalisation of profits can give rise to tax arbitrage.
5. UK, Germany- treat certain returns of capital proximate to a capitalisation of profits as a div for tax purposes. (Involves recording capitalisations of profits for tax law purposes)
6. US- corporation distribution are taxable based on concept of E&P. Capitalisation of profits does not increase E&P. (involves a special record of all corporation profits for tax law purposes)
7. If the capitalisation of profits is taxed like a div then a subsequent return of the capitalised profits can be treated as return of capital without risk of tax arbitrage but streaming of return of capital might arise. If treating capitalisations of profits as div for tax purposes may facilitate consistency between records of share capital for corporate law and tax law purposes, but problem arise for countries adopt no par value shares. If a co capitalises profits without a bonus shares issue, who should be taxed on the deemed dividend?
1. This involves the disposal or surrender of 2/more shares in return for the issue of a single new share.
2. Happen when shares of a small par value are consolidated into a single share of a greater value. There is no issue of dividend treatment, but only exchange of an existing holding in return for a new holding of shares.
3. UK and US - Reorganisation rules apply C. MORE THAN ONE CORPORATION
1. 3 manners:
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