Shareholder continuity: Directors' knowledge provision

Section YC 15 of the Income Tax Act 2007; and section OD 8(5) of the Income Tax Act 2004 

Amendments have been made to the directors' knowledge provision under the shareholder continuity tax rules (section YC 15 of the Income Tax Act 2007 and section OD 8(5) of the Income Tax Act 2004). The amendments exclude minor "off-market" transactions from the scope of the provision in order to provide more certainty and clarity when applying the provision.

Background

The shareholder continuity and tracing rules govern the carry forward of tax losses and imputation credits to ensure that the benefits from these are enjoyed, in general, by the same persons who were shareholders when the benefits were incurred or derived. The standard tracing rules require tracing the ownership of shares in a company through to the ultimate natural person shareholders.

There are a number of concessions that simplify the standard tracing rules, in particular, with respect to listed companies. These concessionary rules are subject to section YC 15, under which shareholder continuity is deemed to be breached when the directors of a company know or could reasonably be expected to know, that the requirements of any continuity provision would not have been satisfied.

While there is uncertainty as to the interpretation of the current section, on its plain words, it seems that directors are presumed to be aware of all "off-market" transactions.

The frequency with which some minor "off-market" transactions occur (eg, employee share schemes) means that the application of section YC 15 may limit access to the tracing concessions for at least some listed companies. In such cases, the effect is that these companies may then be required to undertake full tracing, which may be onerous.

In addition, it is considered that, given section YC 15 is an anti-avoidance rule, when applying the provision, companies should only have to include in their continuity calculation those transactions which their directors would know of or which it is reasonable to expect the directors to know of. It is unlikely that company directors will have either actual or constructive knowledge of minor "off-market" transactions. Therefore, these transactions should not be taken into account in applying the section.

Key features

Section YC 15 is amended to exclude from its scope minor "off-market" transactions, ie, share transactions occurring outside of a recognised stock exchange (examples are employee share schemes, dividend reinvestment plans and small private sales between shareholders).

More specifically, the Act amends section YC 15 to exclude the following transactions from its scope:

• "off-market" transactions between less than 5 percent shareholders in a company in the income year; and
• "off-market" transactions between a company and its shareholders which in aggregate are less than 5 percent of the shareholding in a company in the income year.

This is in order to remove current uncertainty about how the section should apply with respect to "off-market" transactions and to reduce compliance costs.

Application date

The amendments apply retrospectively, for income years beginning on or after 1 April 2005.

Detailed analysis

The rationale for excluding the above transactions is that, when applying the provision, companies should only have to include in their continuity calculation those transactions of which their directors have knowledge or of which it is reasonable for their directors to have knowledge. Furthermore, given that the purpose of the directors' knowledge provision is to target share transactions intended to take advantage of the tracing concessions, companies should not have to count minor transactions which are unlikely to be mischievous in nature.

Accordingly, in line with the existing approach under the directors' knowledge provision, on-market trading between minor shareholders should be excluded. This is consistent with the tracing concession under the shareholder continuity rules which provides that persons having a less than 10 percent direct interest in a company are treated as a "notional single person" - thereby preventing the need for companies to trace ownership changes in relation to their minor shareholders.

New paragraph (iv)

"Off-market" transactions between shareholders with less than 5 percent holdings, eg, small private sales, should be excluded because companies are unlikely to be aware of such transactions. The proposed 5 percent threshold aligns with the threshold that exists under securities law for triggering disclosure by shareholders of their interests in a New Zealand-listed company to that company. The 5 percent holding test applies both before and after any transaction (ie, the holding must be less than 5% both before and after the transaction).

New paragraph (v)

With respect to off-market trading where the company is a party, a de minimis of 5 percent is appropriate in order to exclude minor "off-market" transactions which are undertaken in the company's ordinary course of business, eg, employee share schemes and dividend reinvestment plans. This is measured on an income year basis (ie, pro rating of the 5 percent threshold is not required if the continuity period is less than an income year).

The wording is also intended to cover the common scenario under an employee share scheme where a company transfers shares to a trustee who holds the shares on trust for the benefit of company employees and then subsequently transfers the shares to those employees.