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TAXA5013:  Assignment 2 – Semester 2, 2015

Case Study:Xena Pty Ltd

Xena Pty Ltd is a subsidiary member of the Lawless Group Ltd (Lawless).  The Group is consolidated for tax purposes.  The Balance sheet for Xena shows the following balances at the end of the current financial year:

                                                                                                                                             $ ,000

Assets

Cash                                                                                                                                            10

Loan to Lawless Ltd                                                                                                                 140

Financial Assets                                                                                                                    1,540         Note 1

Property                                                                                                                                 2,550         Note 2

Total Assets                                                                                                                          4,300

Liabilities

Loan from external bank                                                                                                       3,200

Total liabilities                                                                                                                      3,200

Net Assets                                                                                                                             1,100

Represented by:

Share Capital                                                                                                                              10

Retained Earnings                                                                                                                    790

Note 1:  Listed shares at current market value.  The cost base is $800,000

Note 2:  Current market value.  The cost base is $1,500,000.

Gabrielle Pty Ltd is an unrelated company that pays substantial dividends.  Xena has the opportunity to acquire a minority interest in Gabrielle, and is looking at methods to raise the necessary $500,000.

Required:
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:  Immediately prior to issuing the preference shares, Lawless repays $40,000 of the amount it owes to Xena.  This is used to reduce the bank debt.  Does this make any difference to your advice in relation to Option B?

Option D:  Lawless Ltd is not satisfied with Xena acquiring a minority interest and initiates a takeover bid for Gabrielle Ltd.  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 held 1,000 shares in Gabrielle Ltd., and her shares had a cost base of $5 each.

Option E:  When undertaking the due diligence inquiries Lawless discovers that Gaby has been living in an apartment owned by Gabrielle Pty Ltd for the whole of this financial year, carried on the balance sheet at $460,000.  She has been paying rent of $300 pw.  Another apartment in the same building has recently been leased for $500 pw.   Lawless also asks for advice on the consequences of this arrangement.

Assignment guidelines: 

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In the following case, Xena Pty Ltd was a subsidiary member of Lawless Group Ltd. The group was consolidated for the tax purpose. The company issue convertible bonds, so that the investors covert them in shares to earn more profit. Ordinary share represent equity ownership in the company and shareholders receive dividends after preferred shareholders and bondholders. Coupon rate is the yield paid by fixed security of income. Gabrielle was an unrelated company, which pays dividends, and Xena has opportunity for acquiring minority interest in the Gabrielle and looking methods to raise funds.  According to the Australian Taxation Law, the companies have the legal right of deducting dividends distributions while calculating the total taxable income of the company. The level of deduction that is legally allowed in these cases help in determining the source of income of the company.

Table of Contents

Summary. 1

Introduction. 3

Option A.. 3

Option B.. 5

Option C.. 6

Option D: 8

Option E.. 9

Conclusion. 10

Introduction

The company of Xena choose to rise fund by issuing convertible bonds, so that the investors covert them in shares to earn more profit. Bond is considered as debt investment for the company, which borrows funds for period of time at fixed or variable rate of interest[1]. Australian taxation office, convertible notes holder receives interest on the amount paid at the end of note’s expiry date. It is to be kept in mind that the in case of preference shares a fixed dividend would need to be paid. The residents of Australia area mainly taxed for their worldwide income coming from a variety of sources.

Option A

In the following case study, Xena issues five hundred convertible notes with face value $1000, which will convert into ten ordinary shares. The coupon rate is 5percent per annum. Issuing convertible notes is the way for company to minimise the negative interpretation of investors. The company choose for issuing convertible bonds, so that the investors covert them in shares to earn more profit Andrea Amatucci et al, International Tax Law. Bond is considered as debt investment for the company, which borrows funds for period of time at fixed or variable rate of interest[2]. Xena issues convertible notes to raise fund of amount $500,000 that would be converted to ten ordinary shares in seven years.  Ordinary share represent equity ownership in the company and shareholders receive dividends after preferred shareholders and bondholders. Coupon rate is the yield paid by fixed security of income. The amount for coupon rate is $25000. Therefore, investors would receive $25000 per annum. According to Australian taxation office, convertible notes holder receives interest on the amount paid at the end of note’s expiry date[3].  Convertible notes purchased after 10 May 1989 would not be subjected to capital gain tax if the notes are disposed or sold before they are converted into shares. The tax treatment on convertible notes depends on:

• When the convertible notes are acquired
• The type of note
• The conversion period of note
• The issue date of convertible notes

Shares acquired by conversion of the convertible notes after or on September 20, 1985 would subject to capital gain tax when they are disposed or sold off David Barker, Essential Australian Law. According to Australian taxation office convertible notes issued by an organization after May 14, 2002:

• Any gain an investor make when these notes are exchanged or converted for ordinary share would not be considered as ordinary income at time of exchange or conversion and any losses an investor makes would not be deductable Sadaf Aliuddin, ‘Capital Gains’ (2012) 42 CFA Digest[4].
• Any losses or gain an investor makes on disposal or sale of shares would subject to capital gain tax, if an individual is an ordinary investor or ordinary income if an individual is in business of share trading Tim Brighouse, ‘Capital Gains’ (2005) 2005 SecEd..

If Lawless Ltd, Gabriella and Gaby purchase convertible notes then, the company would be subjected to capital gain or capital losses at the time of sale of shares. If the notes are exchanged or converted for, ordinary share would not be considered as ordinary income at time of exchange or conversion and any losses an investor makes would not be deductable as per the Australian taxation law Johannes Becker and Clemens Fuest, ‘Tax Enforcement And Tax Havens Under Formula Apportionment’ (2009) 17 International Tax and Public Finance[5].

Option B

As per the case under consideration, Xena Ptv Ltd will be issuing the lender with 5,000 preference share having the $100 face value of each. The rate of dividend mentioned in this case is that of 5% per annum. A preference share can be defined as a particular share where the holder of the share has a fixed dividend and the payment of that dividend is of most priority and it needs to be done before the payment of any other ordinary share dividends. According to Section6 (1) ITAA36 Dividend is the money or property distribution or any particular amount that is credited to shareholder except for amount that is debited against company’s share capital[6]. It is to be kept in mind that the in case of preference shares a fixed dividend would need to be paid while this is not required in case of common stocks Robbie Burns, The Naked Trader. In case of buying common stocks, there is a very good chance of losing the money but they can be secured through the process of convertible preferred shares.

According to the Australian Taxation Law, the companies have the legal right of deducting dividends distributions while calculating the total taxable income of the company. The level of deduction that is legally allowed in these cases help in determining the substance of the system[7]. If it is a smaller deduction, then it would become a classical system Kimberly A. Clausing, ‘Multinational Firm Tax Avoidance And Tax Policy’ (2009) 62 National Tax Journal.. But one of the major problems relating to dividend deduction is that the foreign shareholders also can avail the relief from double taxation and thus they do not have to contribute in any way towards the domestic tax on the distributions. Regardless of whether a shareholder is domestic or foreign, a company has the right to deduct each and every dividend while calculating the taxable income F.M Gilders, Understanding Taxation Law 2012[8].

In this particular scenario, Xena Ptv Ltd is issuing the lender which is Lawless Ltd or bitterly known as Lawless 5,000 preference shares with $100 face value each and rate of dividend is 5%. Now since the time period up to which Xena Pty Ltd would have to pay Lawless is less than 10 years, therefore a nominal method would be used in order to calculate the total amount of dividend Mihir A Desai and William M Gentry, The Character And Determinants Of Corporate Capital Gain[9]s. Therefore, the total amount of money given by Xena Pty Ltd is $50,000 at the dividend rate of 5% for 7 years. Now since dividend forms a part of assessable income, therefore Lawless would have to pay taxes.

 Option C

Preference share are considered to be the preferred stock which comes before common stock which company utilise in case of bankruptcy or when there is a risk related to the solvency of the company. As per the Section 6(1) ITAA36 the definition of the dividend consists of the distribution of the profit or the property or any considerable amount to the shareholder except against the share capital of the company Louis Kaplow, An Optimal Tax System[10]. As soon as Xena issues preference share, Lawless group repays around $ 40000 of the total amount which it owes to the Xena due to the issuing of preference share which eventually decrease the level of the bank debt. According to the Income Tax Assessment Act 1997, Division 974 which helps to operates from July 2011 which states that payment are made which are associated with the debt interest or the interest payment on a loan are considered to be tax deductible which are on the other hand not frankable Craig M Elliffe and Emma Marr, Tax[11]. Secondly the payment which are made associated with the equity interest are not reduced or deducted but are considered as frankable. Bank debt decline is considered to be beneficial for the company as the solvency risk and liquidity risk related to the company is considered to be effective and the current ratio of the company plays a vital role in this scenario Laszlo Goerke, ‘Income Tax Buyouts And Income Tax Evasion’ (2014) 22 International Tax and Public Finance[12].

 The advice related to the option B where Xena will issue around 5000 share at the face value of 1000 dollar will help the company to reduce the bank debt as it will be levied by the lawless group Callie Harvey, Cornerstones Of Australian Law.  The dividend rate of the company will be around 5% which help to determine the conversion rate of the preference share to the ordinary share. Thus bank debt as per the Income Tax Assessment Act 1997, Division 974 helps to provide a clear and precise idea about the company act and rules which will help to provide as framework for the company to determine overall rules and regulation related tot eh debt and equity due to the issuance of the preference share. Private companies like Xena need to base their law and ruyle as per the Income Tax Assessment Act 1997, Division 974 which help to provide the platform for the calculation and guideline which eventually help to determine the debt and equity aspect of the companies[13]. Thus on the basis of the Income tax act is it clear and evident that it make difference in relation to the option b KimSungKyun, ‘Review Of Inheritance Tax System―Focused On Unrealized Capital Gain―’ (2007) 13 Seoul Tax Law Review..

Option D:

The residents of Australia area mainly taxed for their world wide income coming from a variety of sources.  It is a matter of fact that the temporary and the foreign residents are mainly taxed on the sources of income within Australia. Thus, this case study evaluates the fact that Lawless was not satisfied and initiated a takeover bid mainly for Gabrielle Ltd.   As per the act of income tax 1997 (ITAA 1997), there are some of the important tax treatment.  The cost of the particular registered emissions cans be deductible during the acquiring of the unit[14]. The selling of the registered emissions comes under the assessable incomes Tax Review, ‘Tax Review’ (2015) 12 Pittsburgh Tax Review.. As per the provided offer Lawless succeeded in making 85% of the desired shares in the Gabrielle.  The cost base of each shares were $5 and a total of 1000 shares were held by Gaby[15].  If the desired mutual shares were purchased within more than a date then the cost basis can be calculated related to the shares by various methods. There are three of the valuation methods for the respective registered emissions such as the FIFO, actual cost of the respective shares and the final market value Yoon Oh, ‘Consolidated Tax Return System And Corporate Tax Act’ (2010) 16 Seoul Tax Law Review..  Lawless ltd. initiated a takeover bid for Gabrielle LTD and in order to take over the Gabrielle Ltd the company want to buy the entire shares of Gabrielle LTD thus the Lawless group issue share @ $10/share to the Gabrielle LTD. Beside this the Lawless group pay $10/share for the Gabrielle LTD. Therefore, the lawless company pay total $20/share of Gabrielle LTD. The lawless company can be able to acquire 85% of the share of the Gabrielle LTD. Therefore, in order to acquire the 85% of share Gabrielle LTD, the Lawless group pay ($500,000*85%) = $425,000[16]. Thus the group acquire (425000/20) =21250 share. As the lawless company buy the shares so the lawless company has to pay sales tax on $ 425,000 for the 85% shares of Gabrielle LTD , for the buying as per the taxation law of the Australia the lawless group ,has to pay sale tax, however, the company can get the deduction for the amount as this amount is invest in income generating investment. The Gabrielle LTD has to pay GST in order to sale their share however, for the shares of Lawless group the Gabrielle LTD can claim deduction as it is investment which is income generate. Gaby has to pay GST for the shares, which she purchased @$5 and she bought 100 shares of  Gabrielle LTD thus for this she has to pay GST but at the same time she can claim deduction as she invest the amount in income generating asset Park Nosu and Hun Park, ‘Research On Unified Application Of Tax Laws Related Contractual Rescindment On Capital Gain Tax, Gift Tax And Acquisition Tax’ (2014) 20 Seoul Tax Law Review..

Option E

According to the case study, Lawless discovers Gaby was living in apartment of Gabrielle Pty Ltd for the year, which was carried on the balance sheet at $460,000 Trischa Mann, Australian Law Dictionary. Rent paid by Gaby was $300 pw. Gabrielle Pty Ltd also leased an apartment for $500 pw. According to Australian taxation office, income earned from rent would be considered as taxable income. Gabrielle Pty Ltd rent income has been carried on balance sheet and it would be considered as taxable income as per the Australian taxation law Rainer Niemann, ‘Tax Rate Uncertainty, Investment Decisions, And Tax Neutrality’ (2004) 11 International Tax and Public Finance[17].  Option ELawless Ltd, while undertaking the “due diligence” discovers the fact that Gaby is living in an apartment which is owned by Gabrielle Ltd. Gaby will live in the in this apartment for a whole financial year and this agreement was carried over the balance sheet of $460,000. According to the Australian taxation Office, there are some taxes that have to given by the Gabrielle Pty Ltd on the annual income. According to the case study, Gaby is paying $300pw for the rent. Gabrielle Ltd is subjected to pay income tax on the total amount of his annual income. In addition to that as per the case study, there is an apartment, which is being recently taken on lease for $500pw Park Nosu and Hun Park, ‘Research On Unified Application Of Tax Laws Related Contractual Rescindment On Capital Gain Tax, Gift Tax And Acquisition Tax’ (2014) 20 Seoul Tax Law Review.. Thus, the Gabrielle Ltd is earning a large amount of money and this is the reason why the concerned group is liable to pay the taxes that are being fixed by the Australian taxation law. Rental taxes are one of the most essential parts of Australian taxation Law. Thus, Gabrielle Pty Ltd is subjected pay the income taxes over the annual income. The consequences for giving in rent two apartments in the same building will result in paying a huge amount of tax[18]. It is very much important to know about the consequences before giving rent the two apartments in the same building. There are many ifs and buts regarding the rental taxes Michael Littlewood, Taxation Without Representation. Thus, according to Australian taxation law Gabrielle Pty Ltd have to pay taxes on the annual income that he earned at the end of the current year.

Conclusion

If Lawless Ltd, Gabriella and Gaby purchase convertible notes then, the company would be subjected to capital gain or capital losses at the time of sale of shares. If the notes are exchanged or converted for, ordinary share would not be considered as ordinary income at time of exchange or conversion and any losses an investor makes would not be deductable as per the Australian taxation law. Thus, according to Australian taxation law Gabrielle Pty Ltd have to pay taxes on the annual income that he earned at the end of the current year. The Gabrielle LTD has to pay GST in order to sale their share however, for the shares of Lawless group the Gabrielle LTD can claim deduction as it is investment, which is income, generate.