The quirky interaction of the Corporations Act, an ASIC practice note and the tax law can create a nasty sting in the tail for ongoing shareholders following the redemption of preference shares by a company.
Section 254K of the Corporations Act 2001 provides that a company may only redeem redeemable preference shares out of profits or the proceeds of a new issue of shares made for the purpose of the redemption. A new issue of shares is often impractical.
Practice Note PN 68 issued by ASIC provides commentary on what is required when preference shares are redeemed out of profits. PN 68 requires an accounting entry to record the transfer of retained profits to the share capital account in order to preserve the capital of the company and to protect creditors.
The accounting entry required to complete a redemption of the preference shares will result in a "tainting" of the company's share capital account for taxation purposes. Tainting generally occurs when an amount is transferred to the share capital account from some other account.
The effect of tainting is to generate a franking debit for the company as though the transferred amount were a dividend. This loss of franking credits may restrict the company's ability to frank future dividends. Furthermore, the share capital account is no longer treated as share capital. Any distribution out of share capital could be treated as a dividend rather than a more tax effective capital distribution. Whilst it is possible to untaint a tainted share capital account, this can be an expensive exercise.
The ASIC stance on redemptions creates an anomaly because under a share buy back or a capital return, capital can be returned to shareholders without the need to transfer an amount from profits into the share capital account. Thus the adverse tax consequences associated with tainting a share capital account through a redemption can be avoided.
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