Corporate Actions have significant income tax ramifications. The Inland Revenue Act does not exist in a water tight compartment. The Companies Act has much influence on Income Tax laws of Sri Lanka.
Corporate Actions more often than not give rise to income tax including capital gains tax, excluding corporate actions such as a change of name of the company. Corporate actions also have a direct impact on Earnings per Share (EPS) and the shareholders.
Corporate Actions include issuance of equity and debt security, declaration of dividends on ordinary shares as well as preference shares, payment of coupons on debt securities, share splits, share consolidations, bonus issues, rights issues, buy back of shares, and redemption of preference shares. The list would also include reduction of capital following the procedure laid down under the Companies Act, reorganisation of capital structure, amalgamations, arrangements and compromises by companies, the restructure of companies by spin off of business units, etc.
Distinction between dividends in Companies Act and Income Tax Act
In practice, perhaps the single most significant Corporate Action that has ramifications attracting from the Income Tax Act is the incidence of declaration and payment of dividends. Thus it is essential that corporate decision makers are aware of the distinction.
The definition of dividend commencing from the 1932 Ordinance has not remained static in Inland Revenue Acts in Sri Lanka. Though the Companies Act 2007 defines the term “dividends”, the concept of dividends contained in the Inland Revenue Act is much broader than the dividends referred to in Companies Act. The impact of this would be that if the Corporate Action falls within the definition of dividends, the cost to the company is 14% by way of Dividend Tax which used to be mere 10% under the old Income Tax Act.
Not only has the quantum of the dividend tax, but the nature of the dividend too has undergone a significant change under the new tax regime where dividends tax is now considered part of the income tax liability of the shareholder as opposed to where it was considered part of income tax liability of the company.
Corporate decision makers should be well aware of the dividend definition, and what are the dividends that are not considered dividends for the Companies Act. Furthermore, if not dividends for Companies Act but only for income tax purposes, is there a requirement to fulfil the solvency test? The answer lies in the Companies Act itself.
Preference Dividends v Ordinary Dividends
As per the Companies Act a share in a company is a movable property. A share carries with it a single vote and right to participate in dividends equally. However a company has the right to issue different classes of shares. Therefore a company is empowered to issue shares that are redeemable, confer preferential rights to distributions, or confer special, limited or conditional voting rights or confer no voting rights.
Under SLAS 32 the substance of a financial instrument as opposed to the legal form determines the classification of an instrument. Though generally substance and legal form are consistent there are exceptions too.
Where a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is recorded as financial liability as per paragraph 18(a) of the SLAS 32. It follows that the return on such prefers shares to be recorded as interest rather than dividends.
Whether the new Inland Revenue Act treats such preference dividends as interest for tax purposes too is an interesting analysis.
Share buyback and the concept of realisation
The new Inland Revenue Act has introduced a new significant term to the approximately 85 year old income tax regime of Sri Lanka. “Realisation” is term of wide import and has been defined in the new Income Tax Act. Parting with ownership is a form of realisation though not the only form, as per the definition. Transfer of an asset thus is an incidence that would fall within the definition of realisation.
In this context the analysis of the school of thought that a share buyback by a company tantamount a realisation is an interesting proposition. How accurate is the proposition? The stakes are high as the proposition has the potential for saving of tax of the shareholders. The accurate interpretation and analysis calls for rules of interpretation of statutes.
Capitalisation of profits
The process of converting retained earnings into capital is termed capitalisation of profits. This may entail issuance of bonus shares to the existing shareholders or even increasing the paid up capital of existing shares.
“When a company capitalises its distributable reserves, it reduces at a stroke its accumulated realised profits available for dividend and issues in their place to existing ordinary shareholders in proportion to their holdings shares or loan stock credited as fully paid up. From an accounting viewpoint, the distributable reserves figure in the balance sheet is reduced and the share or loan capital accounts increased by an equivalent offsetting amount. As a result, other things being equal, the net effect on the value of an individual’s holding in the company remains unchanged.” (Charlesworth’s Company Law, 1987).
Lord Viscount Cave in the decided case The Commissioners of Inland Revenue v John Blott in deciding whether capitalisation of profits and issuance of bonus shares would amount to dividends, pointed out that “The transaction took nothing out of the Company’s coffers, and put nothing into the shareholders’ pockets; and the only result was that the Company, which before the resolution could have distributed the profit by way of dividend, carried it temporarily to reserve, came thenceforth under an obligation to retain it permanently as capital.
It is true that the shareholder could sell his bonus shares, but in that case he would be realising a capital asset producing income, and the proceeds would not be income in his hands.”
Even in the Sri Lanka decided case of Commissioner of Income Tax v. Macan Markar decided by the District Court, it was pointed out that capitalisation and issuance of shares does not entail distribution of profit. Hence this incidence should not be subjected to income tax on distribution. I.e. not dividends
Whilst the historical context with regard to the tax on capitalisation and issuance of shares is indicated in case law, what is the ramification from the perspective of income tax of capitalisation of profits under the new Inland Revenue Act?
Redemption of shares, reduction of capital and repurchase of shares
These are three distinct corporate actions addressed in the provisions in the Companies Act of 2007. The concept of redemption of shares is addressed at Sections 66 to 69 of the Companies Act. Repurchase of shares is a corporate action referred to at Section 64 and 65. Section 59 of the Act empowers a company by special resolution to reduce its stated capital as it thinks as appropriate, in accordance with the Companies Act. The impact of these incidences in the context of the Inland Revenue Act is not uniform.
The above are few of the many areas that will be deliberated at the seminar on ‘Company Law Principles intertwined with the Inland Revenue Act’ hosted by KPMG on 29 August at Ramada Hotel. In addition to the above the seminar will focus on key areas such as Income Tax impact on loans to and from directors and shareholders, branch vs. permanent establishment, directors’ liabilities, liquidation of companies, etc.
(The writer is Principal – Tax & Regulatory, KPMG.)