What becomes of COVID cash when a company winds up?
Grants given tax-free to a business pose a dilemma when distributed to shareholders.
When a company is being wound up, there is a popular view that cash flow boost amounts and other tax-free government grants relating to COVID – which are treated as non-assessable, non-exempt income in the hands of a company – can be distributed to shareholders as a tax-free or concessionally taxed capital gain.
It’s an issue that has been brewing for few years.
A recent ATO private ruling indicates that cash flow boost amounts distributed to shareholders of a company by a liquidator in connection with winding up the company should be taxed as dividends.
Presumably, similar treatment would apply to the distribution of many state government grants that qualify for tax-free treatment in the hands of the company.
While legislation was passed to ensure that cash flow boost amounts are treated as non-assessable, non-exempt income in the hands of the recipient (including a company), there is nothing in the tax legislation that specifically enables these amounts to be paid out of an entity tax-free.
The ATO previously issued guidance indicating that cash flow boost amounts received by a trust could be distributed to beneficiaries tax-free, but distributions of cash flow boost amount to shareholders of a company would generally be treated as a taxable dividend.
However, there has been a lack of clear guidance on whether these amounts could be paid out as capital distributions in connection with winding up a company to potentially access more favourable tax treatment.
Section 47 ITAA 1936 can sometimes enable distributions made by a liquidator on winding up a company to be treated as capital amounts in the hands of the shareholders rather than being taxed as dividends. The key issue is whether the amount being distributed represents income derived by the company.
Section 47(1A) ensures that amounts are treated as income for this purpose if:
- They are income under ordinary concepts.
- They have been included in the assessable income of the company (except net capital gains).
- They relate to a net capital gain that would be included in the company’s assessable income if the net capital gain was calculated in a specific way.
When it comes to cash flow boost amounts (and other state government grants that are classified as non-assessable non-exempt income) the position really depends on whether they are classified as income under ordinary concepts.
While cash flow boost amounts and other COVID grants, etc, are sometimes classified as non-assessable non-exempt income and are not assessable income for tax purposes, this doesn’t necessarily mean that they are not classified as income under ordinary concepts.
Our concern has been that payments like this could potentially be treated as ordinary income if they are received in connection with the company’s business activities (see the approach taken by the ATO in TR 2006/3).
The recent private ruling published on the ATO legal database concludes that the cash flow boost amount received by the company in question should be treated as income under ordinary concepts.
This means that distributions sourced from this amount should be taxed as dividends in the hands of the shareholders, even though the amounts have been distributed by a liquidator in connection with winding up the company and the cash flow boost amount was tax-free in the hands of the company.
We hope that the ATO will provide clear public guidance on this issue given this is likely to impact a large number of taxpayers.
Michael Carruthers is the tax director of Knowledge Shop, a resource service for accountants and financial advisers.
