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Chapter 19: Distinguishing profit and capital distributions

A case for reform

Whether a distribution is from profit or capital is at the discretion of the entity. The ability of an entity to choose the source of funds creates potential for tax avoidance. That potential is addressed through anti-avoidance provisions which are inherently complex, unreliable and uncertain in effect.

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A strategy for reform

To provide a more structured solution by means of a more objective test and reduce reliance on anti-avoidance provisions. Generally, distributions would be taken to be from profits, and only from contributed capital once profits are exhausted — hence a ‘profits first’ rule would apply. Distributions related to the extinguishment of an ownership interest in an entity would be taken to be from the slice of contributed capital and taxed and untaxed profits attributable to that interest — hence a ‘slice’ approach would apply.

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Key policy issues

Profits first rule

Slice approach

How would a profits first rule operate? How would contributed capital be determined? What exceptions would there be from
a profits first rule?
What treatment would apply to distributions of contributed capital? When would the slice approach apply? How would the components of the slice be calculated?
Option
Define distributable profits on market value basis.
Option
- Generic definition as much as possible with suggested options for companies
- Specific rules for existing trusts and testamentary trusts
Under the slice approach:

distributions arising from the extinguishment of ownership interests in entities.

Under transitional arrangements for trusts:

as announced in A New Tax System.

 

Option
Cost base reduction.

(See Appendix A to this chapter.)

Option
When ownership interests in an entity are extinguished.
Option

By reference to the
- contributed capital and
- franking account balance

attributable to the extinguished interest.