WHEN SHAREHOLDERS CAN BE TAXED WITHOUT EARNING INCOME
In principle, a capital reduction is a return of the original investment of the shareholders of a company and should not be regarded as their income. For an investment in shares, the income earned by investors would normally be in the form of dividends, capital gains or the amount of liquidation proceeds that exceeds the cost of the investment.
If the investors did not receive any gains or value added from their investments, they have received no income and so do not expect to be taxed.
Nevertheless, the current tax law in Thailand treats a capital reduction as taxable income if the paying company at the time has undistributed earnings and reserves. The law states that there is assessable income to the extent that “the amount of the capital reduction does not exceed the sum of the company’s retained earnings and legal reserves”.
This provision was included in the law as an anti-avoidance measure to discourage companies with retained earnings from paying out available cash as a tax-free capital reduction instead of a taxable dividend.
The Revenue Department has applied a strict interpretation in this matter for many years, and it has sometimes led to unfair treatment where the same income has been taxed multiple times in the hands of the shareholder.
For example, a company may reduce its capital on two separate occasions (without distributing a dividend between each capital reduction) and subsequently distribute a dividend from the retained earnings, as the table illustrates.
In a literal application of the law, the “retained earnings and reserves” will be subject to tax three times: once at each time of the capital reduction and again when the dividend is declared or the company is liquidated. This has become one of the red flag areas for a company when considering a capital reduction.
A 2013 tax ruling issued by the Revenue Department stated that, even if the company was in a deficit position but its accounting books contained a legal reserve brought forward from preceding years, the capital reduction (to the extent of the legal reserve) was subject to tax — regardless of the fact that the company was in an overall deficit retained earnings position.
If we look closely at this case, the cash paid to the shareholders could only be a pure capital reduction because the company did not have enough distributable profits (legal reserves cannot be distributed as dividends). Clearly, in this case, the capital reduction could not have been a mechanism of tax avoidance as there were no distributable profits, but nevertheless the shareholder was penalised by being taxed on the return of capital.
A ruling last year by the Supreme Court in another case is also interesting. In this case, the company undertook a capital reduction when it still had retained earnings and a legal reserve. Later, it distributed a dividend from these retained earnings to its shareholders. Therefore, what the shareholders obtained in total were: (1) a partial return of capital, and (2) a dividend, but they were taxed twice because the capital reduction was made at a time when the company still had the retained earnings and a legal reserve.
In their defence, the shareholders claimed that the dividend received should not be taxed again because the same amount had already been taxed during the capital reduction process. Unfortunately, the Supreme Court was of the opinion that the capital reduction and subsequent dividend are different types of income under the law and are independent of each other. Therefore, double tax was unavoidable according to the wording of the law.
This example confirmed the strong position taken by Revenue Department on the tax treatment of a capital reduction, although it is not aligned with the concept of income tax collection. Starting with the intention to prevent tax avoidance, it turns into weapon for double-taxing distributions to shareholders.
As long as these tax issues remain unresolved, taxpayers must have a clear plan for every single step of the capital reduction process.
Hopefully, we will see guidance from the Revenue Department that will address the unintended consequences of economic double taxation of the same income. As a step in this direction, the department addressed one such adverse consequence of the regulation in a tax ruling it issued in 2016. In that case, the company undertook two capital reductions in favour of its shareholder in Singapore, and each time the amount reduced exceeded the sum of retained earnings and legal reserve.
During the first reduction, the tax was properly withheld and paid. The ruling confirmed that no withholding tax should be imposed on the second capital reduction because the retained earnings and legal reserve had already been taxed in the first capital reduction.
Nevertheless, the ruling was silent as to the tax treatment when these (oncetaxed) retained earnings are paid out as dividends at some time in the future. It did not address the issue of whether withholding tax would be imposed at the time of payment of the dividend.
The Revenue Department should do the right thing and issue guidance to its officers to avoid double or even multiple economic taxation of the same income in cases where there are multiple capital reductions or distributions of reserves that have already been taxed once during a capital-reduction process.