December 3, 2017

Is my Company Constitution tax effective?

Tax

Many will think of the Constitution of their company as a predominantly commercial document setting out the powers and procedures for the making of decisions by directors and shareholders, and the rights attaching to shares in respect of dividends, voting and winding up.

As far as tax is concerned the main focus is to allow for different classes of shares.

However, the content of the Constitution has an impact on the tax results in at least three important ways:

  1. Super contributions for directors;
  2. Differential dividends;
  3. Issue of shares of a different class.

Super Contributions for Company Directors

A tax deduction is generally available for contributions made by an employer for the benefit of an employee.

For a number of years the general view has been that deductions also apply for contributions for directors. A basis for this was that the income tax legislation allowed a deductions for superannuation contributions for persons employed by a company, and the legislation deemed directors to be employed by the company (the additional requirements that they be engaged in producing assessable income or in the business of the company would ordinarily be satisfied in a trading business).

However, were substantially changed in 2007 with the Simpler Super Regime.

The revised requirements for employer contributions run as follows:

  1. A deduction is available for contributions for employees (directors do not fall within the ordinary meaning of employee);
  2. Employees are deemed to include those falling within the extended meaning in the Superannuation Guarantee legislation;
  3. There are also the conditions that the employee be engaged in producing the company’s assessable income or its business, that the fund is a complying fund and the employee satisfies certain age conditions.

The Super Guarantee legislation does not deem any director to be an employee. Rather, it deems a director “who is entitled to payment for the performance of duties as a member of the executive body”.

This means is that a director is not deemed to be an employee unless they are entitled to payment for the performance of duties. The simplest way to provide that entitlement is an appropriate provision in the Company Constitution, for example providing an entitlement of say $1000 per annum. Alternatively, a binding arrangement (preferably, in writing) for the payment of directors fees is required.

Doubts of the correctness of the above analysis were put to rest by the decision in Kelly v FCT (No 2) [2012] FCA 689. A deduction for a superannuation contribution in favour of a director was denied. The court rejected the argument that actual payment of an amount was sufficient. It held that payment and entitlement to payment are different concepts, and entitlement to payment can be provided by the company’s constitution or approval by shareholders in accordance with the Corporations Act 2001.

Differential Dividends

It is quite common for a company to have various classes of shares (although readers should be mindful that the issue a different class of shares can result in the small business CGT concessions not being available on a sale of the business or shares in the company).

The issue of a different class of shares is common where it is desirable to pay dividends to certain shareholders to the exclusion of other shareholders, or at a different rate.

To do so, simply having different class of shares is not enough. If you only have different classes of shares, then all shareholders will be entitled to a share of any dividend declared in accordance with the rights attaching to those shares.

What is necessary is that the Constitution gives the directors the power to pay dividends on a differential basis. A provision of this kind is as follows:

Where there is more than one class of shares on issue, the Directors can declare a dividend so that the dividend:

(a) is made to the holders of shares of any one or more class or classes of shares;

(b) made at a higher, lower or the same rate as the dividend declared on any other class; and

(c) excludes the holders of shares of any other class or classes;

provided that the shares in each class will participate equally in any dividend declared. The resolution which declares a dividend is valid, even if the resolution is passed by virtue of the votes of persons who receive the higher rate of dividend.

Issue of shares of a different class

The issue of shares of a different class may have a number of tax effects including loss of the small business CGT concessions and impact on the utilisation of the losses. In addition, whenever there is an issue of shares the value shifting provisions, debt/equity rules and dividends streaming provisions must be considered.

In respect of the small business CGT concessions, the existence of a Significant Individual is required for the 15 year exemption, retirement exemption and to apply the concessions on a disposal of shares. For there to be a Significant Individual, it must be the case that the relevant shareholder has rights in respect of voting and, importantly, any dividend or distribution of capital.

The reference to the word ‘any’ has the effect that where a shareholder owns shares of one class, but there is another class of shares on issue, a dividend could be paid on the other class with the result that the shareholder does not have rights in respect of any dividend. However, this special rule does not apply to redeemable shares (the ATO accepts this point in Taxation Determination TD 2006/77).

If you are looking to issue shares simply to enable dividends to be paid to a different person, it is preferable for those shares to be issued as redeemable shares. It is also preferable for the rights attaching to those shares to be such that they can be cancelled without tax effect.

Key Points

Special provisions are required for a Company Constitution to be tax effective and to support implementation of tax planning strategies.

Before implementing any of the above arrangements, specific advice should be obtained.

As part of general tax administration, we recommend all accountants undertake a review of their client’s Company Constitutions to ensure their tax planning is not frustrated.

Need advice? Talk to the Tax & Superannuation Team at Rouse Lawyers. Contact us today!

NOTE: This article is for general information only and should not be relied upon without first seeking advice from one of our specialist solicitors.