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Ruling

Subject: Issue of redeemable preference shares (RPS)

Question 1

Will the proposed transaction give rise to the direct value shifting rules (DVS) under Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) applying and as such cause CGT event K8 (section 104-250 of the ITAA 1997) to occur?

Answer

No.

Question 2

Will the proposed transaction give rise to the indirect value shifting rules under Division 727 of the ITAA 1997 applying?

Answer

No.

Question 3

Will any payment of fully franked dividends to the holders of the proposed RPS be considered dividend streaming under Subdivision 204-D of the ITAA 1997?

Answer

No.

Question 4

(a) Will any distribution to the holders of the proposed RPS be considered part of a dividend stripping operation under section 207-155 of the ITAA 1997; or

(b) a scheme for the stripping of company profits within the meaning of paragraph 177E(1)(a) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

Question 5

Will section 45 of the ITAA 1936 apply to any distribution of fully franked dividends to the holders of the proposed RPS?

Answer

No.

Question 6

Will section 45A of the ITAA 1936 apply to the proposed issue of the RPS?

Answer

No.

Question 7

Will section 45B of the ITAA 1936 apply to the proposed issue of the RPS?

Answer

No.

Question 8

Will section 177EA of the ITAA 1936 apply to any distribution of fully franked dividends to the holders of the proposed RPS?

Answer

No.

Question 9

Will Part IVA of the ITAA 1936 apply to the proposed transaction?

Answer

No.

This ruling applies for the following period/s:

1 July 2010 to 30 June 2011

The scheme commences on:

During the year ended 30 June 2011.

Relevant facts and circumstances

A company (the IssuerCo) proposes to issue RPS to other companies (RPS's holder) within the same group of companies. The shares will initially be issued at market value with fixed dividend entitlements. The rights to the dividend of the RPS will be varied at any time after the issue for a discretionary dividend entitlement.

If the dividend entitlement is varied in such a way, a condition contained in the terms of the RPS stipulates that, by the earlier of a director's resolution or 3 years from the issue of the RPS, the rights of the RPS with respect to dividends will be automatically varied such that the RPS dividend entitlement will revert back to the original fixed dividend entitlement.

The IssuerCo has one class of ordinary shares (with rights to all voting, dividend and capital) which were 100% owned by a discretionary trust. All of the shares were issued post-CGT. The existing tax cost base of the equity interest held by the trust in the IssuerCo is nominal.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-250.

Income Tax Assessment Act 1997 section 202-5.

Income Tax Assessment Act 1997 Subdivision 204-D.

Income Tax Assessment Act 1997 section 204-30.

Income Tax Assessment Act 1997 subsection 204-30(1).

Income Tax Assessment Act 1997 paragraph 204-30(1)(a).

Income Tax Assessment Act 1997 paragraph 204-30(1)(b).

Income Tax Assessment Act 1997 paragraph 204-30(1)(c).

Income Tax Assessment Act 1997 subsection 204-30(3).

Income Tax Assessment Act 1997 subsection 204-30(6).

Income Tax Assessment Act 1997 subsection 204-30(8).

Income Tax Assessment Act 1997 Division 207.

Income Tax Assessment Act 1997 section 207-35.

Income Tax Assessment Act 1997 section 207-155.

Income Tax Assessment Act 1997 section 208-60.

Income Tax Assessment Act 1997 section 210-170.

Income Tax Assessment Act 1997 section 215-10.

Income Tax Assessment Act 1997 Division 725.

Income Tax Assessment Act 1997 section 725-50.

Income Tax Assessment Act 1997 paragraph 725-50(a).

Income Tax Assessment Act 1997 paragraph 725-50(b).

Income Tax Assessment Act 1997 paragraph 725-50(c).

Income Tax Assessment Act 1997 paragraph 725-50(d).

Income Tax Assessment Act 1997 paragraph 725-50(e).

Income Tax Assessment Act 1997 section 725-55.

Income Tax Assessment Act 1997 section 725-65.

Income Tax Assessment Act 1997 section 725-70.

Income Tax Assessment Act 1997 subsection 725-70(1).

Income Tax Assessment Act 1997 section 725-90.

Income Tax Assessment Act 1997 subsection 725-90(1).

Income Tax Assessment Act 1997 paragraph 725-90(1)(a).

Income Tax Assessment Act 1997 paragraph 725-90(1)(b).

Income Tax Assessment Act 1997 subsection 725-90(2).

Income Tax Assessment Act 1997 paragraph 725-90(2)(a).

Income Tax Assessment Act 1997 paragraph 725-90(2)(b).

Income Tax Assessment Act 1997 subsection 725-90(3).

Income Tax Assessment Act 1997 section 725-95.

Income Tax Assessment Act 1997 section 725-145.

Income Tax Assessment Act 1997 subsection 725-145(1).

Income Tax Assessment Act 1997 paragraph 725-145(1)(b).

Income Tax Assessment Act 1997 subsection 725-145(2).

Income Tax Assessment Act 1997 subsection 725-145(3).

Income Tax Assessment Act 1997 subsection 725-155(1).

Income Tax Assessment Act 1997 subsection 725-155(2).

Income Tax Assessment Act 1997 Division 727.

Income Tax Assessment Act 1997 subsection 727-150(3).

Income Tax Assessment Act 1997 section 727-460.

Income Tax Assessment Act 1997 section 727-465.

Income Tax Assessment Act 1997 subsection 960-130(1).

Income Tax Assessment Act 1997 subsection 960-130(3).

Income Tax Assessment Act 1997 section 960-135.

Income Tax Assessment Act 1997 section 995.

Income Tax Assessment Act 1997 subsection 995-1(1).

Income Tax Assessment Act 1936 subsection 6BA(5).

Income Tax Assessment Act 1936 section 45.

Income Tax Assessment Act 1936 section 45A.

Income Tax Assessment Act 1936 subsection 45A(1).

Income Tax Assessment Act 1936 paragraph 45A(3)(a).

Income Tax Assessment Act 1936 subsection 45A(5).

Income Tax Assessment Act 1936 section 45B.

Income Tax Assessment Act 1936 subsection 45B(1).

Income Tax Assessment Act 1936 subsection 45B(2).

Income Tax Assessment Act 1936 paragraph 45B(2)(a).

Income Tax Assessment Act 1936 paragraph 45B(2)(b).

Income Tax Assessment Act 1936 subsection 45B(4).

Income Tax Assessment Act 1936 paragraph 128B(3)(ga).

Income Tax Assessment Act 1936 subparagraph 177D(b)(i).

Income Tax Assessment Act 1936 subparagraph 177D(b)(ii).

Income Tax Assessment Act 1936 subparagraph 177D(b)(iii).

Income Tax Assessment Act 1936 subparagraph 177D(b)(iv).

Income Tax Assessment Act 1936 subparagraph 177D(b)(v).

Income Tax Assessment Act 1936 subparagraph 177D(b)(vi).

Income Tax Assessment Act 1936 subparagraph 177D(b)(vii).

Income Tax Assessment Act 1936 subparagraph 177D(b)(viii).

Income Tax Assessment Act 1936 section 177E.

Income Tax Assessment Act 1936 subsection 177E(1).

Income Tax Assessment Act 1936 paragraph 177E(1)(a).

Income Tax Assessment Act 1936 section 177EA.

Income Tax Assessment Act 1936 subsection 177EA(3).

Income Tax Assessment Act 1936 paragraph 177EA(3)(a).

Income Tax Assessment Act 1936 paragraph 177EA(3)(b).

Income Tax Assessment Act 1936 paragraph 177EA(3)(c).

Income Tax Assessment Act 1936 paragraph 177EA(3)(d).

Income Tax Assessment Act 1936 paragraph 177EA(3)(e).

Income Tax Assessment Act 1936 subsection 177EA(5).

Income Tax Assessment Act 1936 paragraph 177EA(14)(a).

Income Tax Assessment Act 1936 subsection 177EA(17).

Income Tax Assessment Act 1936 paragraph 177EA(17)(a).

Income Tax Assessment Act 1936 paragraph 177EA(17)(b).

Income Tax Assessment Act 1936 paragraph 177EA(17)(c).

Income Tax Assessment Act 1936 paragraph 177EA(17)(d).

Income Tax Assessment Act 1936 paragraph 177EA(17)(e).

Income Tax Assessment Act 1936 paragraph 177EA(17)(f).

Income Tax Assessment Act 1936 paragraph 177EA(17)(g).

Income Tax Assessment Act 1936 paragraph 177EA(17)(ga).

Income Tax Assessment Act 1936 paragraph 177EA(17)(h).

Income Tax Assessment Act 1936 paragraph 177EA(17)(i).

Income Tax Assessment Act 1936 paragraph 177EA(17)(j).

Income Tax Assessment Act 1936 Part IVA.

Reasons for decision

Question 1

Detailed reasoning

The essence of determining the issue of direct value shifting (DVS) is the application of reversal exception under section 725-90 of the ITAA 1997. However, it is important to first identify the direct value shift to which the exception is to be applied.

A direct value shift: section 725-50 of the ITAA 1997

Direct value shift is defined in section 725-145 of the ITAA 1997.

Subsection 725-145(1) of the ITAA 1997 states:

There is a direct value shift under a scheme involving equity or loan interests in an entity (the target entity) if:

(a) there is a decrease in the market value of one or more equity or loan interests in the target entity; and

(b) the decrease is reasonably attributable to one or more things done under the scheme, and occurs at or after the time when that thing, or the first of those things, is done; and

(c) either or both of subsections (2) or (3) are satisfied.

Subsections 725-145(2) and 725-145(3) of the ITAA 1997 continue that:

One or more ^*equity or loan interests in the target entity must be issued at a ^*discount. The issue must be, or must be reasonably attributable to, the thing, or one or more of the things, referred to in paragraph (1)(b). It must also occur at or after the time referred to in that paragraph.

Or, there must be an increase in the *market value of one or more ^*equity or loan interests in the target entity. The increase must be reasonably attributable to the thing, or to one or more of the things, referred to in paragraph (1)(b). It must also occur at or after the time referred to in that paragraph.

'Scheme' is defined broadly in section 995 of the ITAA 1997 to mean any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

Under the scheme, there will be a decrease in the market value of the equity interests in the IssuerCo; and the decrease is reasonably attributable to one or more of the things done under the scheme. The decrease occurs at the time when the first of those things just mentioned is done; and there is an increase in the market value of the equity interests in the IssuerCo held by the RPS's holders. The increase is reasonably attributable to the things mentioned above and occurs at or after the time as referred to above.

Thus, there is a direct value shift under the scheme in accordance with section 725-145 of the ITAA 1997.

Consequences for a direct value shift: section 725-50 of the ITAA 1997

There can be consequences for a direct value shift where the conditions in section 725-50 of the ITAA 1997 are met. The section states:

A direct value shift under a scheme involving equity or loan interests in an entity (the target entity) has consequences for you under this Division if, and only if:

(a) the target entity is a company or trust at some time during the *scheme period; and

(b) section 725-55 (Controlling entity test) is satisfied; and

(c) section 725-65 (Cause of the value shift) is satisfied; and

(d) you are an *affected owner of a *down interest, or an *affected owner of an *up interest, or both; and

(e) neither of sections 725-90 and 725-95 (about direct value shifts that are reversed) applies.

Note: For a down interest of which you are an affected owner, the direct value shift has consequences under this Division only if section 725-70 (about material decrease in market value) is satisfied.

The requirements in paragraphs 725-50(a), 725-50(b), 725-50(c) and 725-50(d) of the ITAA 1997 would be met under the current scheme. However, there will be no consequences of a direct value shift if either of the reversal provisions applies (paragraph 725-50(e) of the ITAA 1997).

The reversal exception is to be considered in light of the broader legislative context of the DVS rules and the General Value Shifting Rules, and the other income tax laws. The exception is explained in the Explanatory Memorandum (EM) to the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002:

8.46 The concept of reversal is based on the state of affairs that arises because of the thing, or things, done under the scheme to which the decrease in value of equity or loan interests is reasonable attributable. It must be the case that without the state of affairs the direct value shift would not have happened. A reversal happens where the state of affairs ceases to exist.

8.47 The state of affairs can include the effects and consequences of the things done, as well as the circumstances brought about by those things. A state of affairs can cease to exist partially or gradually over a period of time. If the state of affairs has not fully ceased to exist by the end of the 4 year period, the exception will stop applying.

The purpose of the reversal exception is to provide relief for temporary value shifts. As there is no other specific rule about what a temporary value shift is, the exception is to be interpreted in accordance with its terms as explained in the extrinsic materials.

One key term is 'state of affairs' in paragraph 725-90(1)(a) of the ITAA 1997. The 'state of affairs' is to be distinguished from the thing or things done under the scheme. The state of affairs does not equate to the market value impacts (i.e. decreases or increases) which those things cause.

The state of affairs includes the effects, consequences and circumstances brought about by the thing or things done under the scheme where, but for those effects, consequences and circumstances the direct value shift would not have happened. What is a state of affairs will depend on the facts of a particular case.

Another key term is 'cease to exist' in paragraph 725-90(1)(b) and subsection 725-90(2) of the ITAA 1997. The EM indicates that 'a state of affairs can cease to exist partially or gradually over a period of time'. In considering whether a state of affairs has ceased to exist it is important to recall that what is being considered is 'a state of affairs, but for which the direct value shift would not have happened'. Within these parameters, the question of whether a state of affairs has ceased to exist is a question of fact in the circumstances.

There are three structural questions for the reversal exception on the facts of this case.

Firstly, for the purposes of paragraph 725-90(1)(a) of the ITAA 1997, what are the 'one or more thing's referred to in paragraph 725-145(1)(b) [that] brought about a state of affairs, but for which the direct value shift would not have happened?

Secondly, what is the 'state of affairs' referred to in paragraph 725-90(1)(a) of the ITAA 1997 that is brought about by these things?

Thirdly, will this state of affairs cease to exist under the terms of the scheme in the manner described in paragraphs 725-90(1)(b) and subsection 725-90(2) of the ITAA 1997?

In the present case, the things done under the scheme are the company's decision to:

· vary the dividend rights attaching to the RPS; and

· alter dividend policy so that profits (including retained profits) will be distributed rather than retained during the period when the preferential dividend right are on foot.

The relevant 'state of affairs' is that the IssuerCo proposes to issue the shares will make substantial distributions of profits to the RPS holders.

The removal of the preferential dividend rights, which is planned to happen within three years of the earliest of the change of dividend policy and commencement of those rights will satisfy the requirements in paragraph 725-90(1)(b) and section 725-90(2) of the ITAA 1997.

Conclusion

Since the direct value shift has no consequences in this case as shown above, there is no CGT event K8.

Question 2

Detailed reasoning

The rulee would be a gaining entity (as defined in subsection 727-150(3) of the ITAA 1997) but not an owner of affected interests in either the gaining or the losing entities (under sections 727-460 and 727-465 of the ITAA 1997) thus the indirect value shifting rules in Division 727 of the ITAA 1997 does not apply to it.

Question 3

Detailed reasoning

Section 204-30 in Subdivision 204-D of the ITAA 1997 applies where an entity streams one or more distributions (or one or more distributions and the giving of other benefits), whether in a single franking period or in a number of franking periods, in such a way that:

a) an imputation benefit is, or apart from this section would be, received by a member of the entity as a result of the distribution or distributions (paragraph 204-30(1)(a) of the ITAA 1997);

b)  the member would derive a greater benefit from franking credits (favoured member) than another member of the entity (paragraph 204-30(1)(b) of the ITAA 1997); and

c)  the other member of the entity will receive lesser imputation benefits (disadvantaged member), or will not receive any imputation benefits, whether or not the other member receives other benefits (paragraph 204-30(1)(c) of the ITAA 1997).

Subsection 204-30(8) of the ITAA 1997 sets out the circumstances where one shareholder will be taken to have received a greater benefit than another shareholder.

An 'imputation benefit' is defined in subsection 204-30(6) of the ITAA 1997 as follows:

A *member of an entity receives an imputation benefit as a result of a distribution if:

(a) the member is entitled to a *tax offset under Division 207 as a result of the distribution; or

(b) an amount would be included in the member's assessable income as a result of the distribution because of the operation of section 207-35; or

(c) a *franking credit would arise in the *franking account of the member as a result of the distribution; or

(d) an *exempting credit would arise in the *exempting account of the member as a result of the distribution; or

(e) the member would not be liable to pay *withholding tax on the distribution, because of the operation of paragraph 128B(3)(ga) of the Income Tax Assessment Act 1936; or

(f) the member is entitled to a *tax offset under section 210-170 as a result of the distribution.

If all the conditions in subsection 204-30(1) of the ITAA 1997 are satisfied the Commissioner may make one or more determinations under subsection 204-30(3) of the ITAA 1997 as follows:

(a) that a specified *franking debit arises in the *franking account of the entity, for a specified *distribution or other benefit to a disadvantaged member;

(b) that a specified *exempting debit arises in the *exempting account of the entity, for a specified *distribution or other benefit to a disadvantaged member;

(c) that no *imputation benefit is to arise in respect of a distribution that is made to a favoured member and specified in the determination.

The word 'stream' is not defined and therefore takes on its ordinary meaning. The Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 (Imputation EM), which introduced Subdivision 204-D of the ITAA 1997 provides that:

3.28 Streaming is selectively directing the flow of franked distributions to those members who can most benefit from imputation credits.

3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming.

The Imputation EM notes that it is common for dividend rights to be discretionary, such that shareholders do not have a definite interest in the profits of the corporate entity. Paragraphs 3.36 to 3.38 of the Imputation EM state:

3.36 In most cases, the members less able to benefit from imputation credits have a real interest in the undistributed profits of the corporate tax entity, although the entity may not have yet allocated those profits to the members. However, some corporate tax entities have membership interests where the rights of the members holding those interests are effectively discretionary, since the entity can make distributions to some members to the exclusion of other members at its discretion. In these entities, which are usually family companies or trusts, the members do not have anything, in a sense relevant for streaming purposes, resembling a definite interest in the profits of the corporate tax entity, they have only a possibility of being considered as a possible recipient of distributions.

3.37 In these cases, the receipt of a franked distribution by one class of members does not imply that the other classes of members who have not received a franked distribution have deferred distribution of their share in the profits. More commonly it is reasonable to assume that they have simply missed out on any share in the profits. This is not streaming; all members with an actual share of the profits have appropriately received franked distributions.

3.38 In general, therefore, the distribution of franked and unfranked distributions by a closely-held family company or trust among family members is unlikely to be streaming.

Given that the company is issuing a single class of proposed RPS to the other companies, where a dividend is paid to all holders of the proposed RPS, the dividend streaming rules will not apply. In the present case:

· The 'other member' is the ordinary shareholder of the company. The payment of dividends to the other companies will not result in them receiving a greater benefit from franking credits than the ordinary shareholder would.

· No streaming is occurring. As noted in paragraph 3.37 of the Imputation EM above, the payment of franked dividends to one class of shareholder and no dividends to another is not streaming.

· If a discretionary dividend is declared it will be paid to all of the holders of the proposed RPS.

Consequently, on the basis of the above analysis, the payment of fully franked dividends to the holders of the proposed RPS will not be considered the 'streaming' of imputation benefits under Subdivision 204-D of the ITAA 1997.

Question 4(a) and (b)

Detailed reasoning

Section 207-155 of the ITAA 1997 states:

A distribution made to a *member of a *corporate tax entity is taken to be made as part of a dividend stripping operation if, and only if, the making of the distribution arose out of or was made in the course of, a *scheme that:

(a) was by way of, or in the nature of, dividend stripping; or

(b) had substantially the effect of a scheme by way of, or in the nature of, dividend stripping.

Subsection 177E(1) of the ITAA 1936, whilst more expansive, is couched in similar terms. The following discussion is considered relevant in determining the outcome for each of the legislative provisions.

The term dividend stripping is not defined. However, Taxation Ruling IT 2627 provides, at paragraphs 9 and 10, a general description rather than an exhaustive definition:

9. However, it can be said that in its traditional sense a dividend stripping scheme would include one where a vehicle entity (the stripper) purchases shares in a target company that has accumulated or current years' profits that are represented by cash or other readily-realisable assets. The stripper pays the vendor shareholders a capital sum that reflects those profits and then draws off the profits by having paid to it a dividend (or a liquidation distribution) from the target company.

10. No exhaustive list of other examples can be given of what might constitute a dividend stripping scheme for the purposes of section 177E. Having regard to the overall scope and purpose of the section, an important element to be looked at will be any release of profits of a company to its shareholders in a non-taxable form, regardless of the different methods that might be used to achieve this result.

Under the proposed scheme, there is no payment between the existing shareholder and the proposed RPS holders reflecting the profits retained in the company. Furthermore, there will be no release of profit to shareholders in a non-taxable form. That is, the fundamental elements of a dividend stripping operation are absent.

Accordingly, the distributions to the proposed RPS holders will not be considered part of a dividend stripping operation or scheme under either section 207-155 of the ITAA 1997 or paragraph 177E(1)(a) of the ITAA 1936.

Question 5

Detailed reasoning

Section 45 of the ITAA 1936 states:

Application of section

(1) This section applies in respect of a company that, whether in the same year of income or in different years of income, streams the provision of shares (other than shares to which subsection 6BA(5) applies) and the payment of minimally franked dividends to its shareholders in such a way that:

(a) the shares are received by some shareholders but not all shareholders; and

(b) some or all of the shareholders who do not receive the shares receive or will receive minimally franked dividends.

(2) The value of the share at the time that the shareholder is provided with the share is taken, for the purposes of this Act, to be a dividend that is unfrankable (within the meaning of subsection 995-1(1) of the Income Tax Assessment Act 1997) and that is paid by the company, out of profits of the company, to the shareholder at that time.

(3) A dividend is minimally franked if it is not franked, or is franked to less than 10%, in accordance with section 202-5 or 208-60 of the Income Tax Assessment Act 1997.

Section 45 of the ITAA 1936 applies where a company streams the provision of shares and the payment of minimally franked dividends to its shareholders in such a way that the shares are received by some shareholders and minimally franked dividends are received by other shareholders. Minimally franked dividends are dividends which are not franked or are franked to less than 10%.

The IssuerCo is not providing shares to existing shareholders (the proposed RPS are issued for their paid up value to new shareholders) and there is no concurrent distribution of minimally franked dividends to other shareholders. Accordingly, section 45 of the ITAA 1936 will not apply to any distribution of fully franked dividends to the holders of the proposed RPS.

Question 6

Detailed reasoning

Subsection 45A(1) of the ITAA 1936 states:

This section applies in respect of a company that, whether in the same year of income or in different years of income, streams the provision of capital benefits and the payment of dividends to its shareholders in such a way that:

(a) the capital benefits are, or apart from this section would be, received by shareholders (the advantaged shareholders) who would, in the year of income in which the capital benefits are provided, derive a greater benefit from the capital benefits than other shareholders; and

(b) it is reasonable to assume that the other shareholders (the disadvantaged shareholders) have received, or will receive, dividends.

However, it does not apply if section 45 applies in relation to the streaming or in the circumstances set out in subsection (5).

The provision of a capital benefit is defined, to the extent relevant, in paragraph 45A(3)(a) of the ITAA 1936 to include 'the provision to the shareholder of shares in the company'.

This subsection will only apply if a company streams the provision of capital benefits and dividends to its shareholders. That is, 'the shareholder' referred to in paragraph 45A(3)(a) of the ITAA 1936 must already hold membership interests in the company before it can be provided with a capital benefit.

Under the proposed scheme as described, the RPS holders do not currently hold shares in the IssuerCo. They will not be provided with a capital benefit; rather they will acquire the RPS for consideration.

Section 45A of the ITAA 1936 will not apply to the proposed issue of RPS.

Question 7

Detailed reasoning

The purpose of section 45B of the ITAA 1936, as stated in subsection 45B(1) of the ITAA 1936, is to ensure that relevant amounts are treated as dividends if a payment, allocation or distribution is made in substitution for dividends. To the extent relevant, subsection 45B(2) of the ITAA 1936 provides that the section will apply if:

(a) there is a scheme under which a person is provided with a capital benefit by a company; and

(b) under the scheme, a taxpayer obtains a tax benefit; and

(c) having regard to the relevant circumstances of the scheme, it would be concluded that a person entered into or carried out the scheme for a more than incidental purpose of enabling the taxpayer referred to in paragraph (b) to obtain a tax benefit.

The proposed issue of the RPS would constitute a scheme for the purposes of paragraph 45B(2)(a) of the ITAA 1936. In order for the section to apply, it is a requirement that under the scheme, a person is provided with a capital benefit. The provision of a capital benefit is defined in subsection 45B(4) of the ITAA 1936 as a reference to the provision of ownership interests in a company.

The proposed issue of the RPS at their paid up value is not considered to represent the provision of a capital benefit. Nor can it be said that the proposed scheme as described is one involving dividend substitution to which section 45B of the ITAA 1936 is directed.

In the absence of the provision of a capital benefit, section 45B of the ITAA 1936 will not apply to the proposed issue of RPS.

Question 8

Detailed reasoning

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies where one of the purposes (other than an incidental purpose) of the scheme is to obtain an imputation benefit. In these circumstances, subsection 177EA(5) enables the Commissioner to make a determination with the effect of either:

· imposing franking debits or exempting debits on the distributing entity's franking account; or

· denying the imputation benefit on the distribution that flowed directly or indirectly to the relevant taxpayer.

Pursuant to subsection 177EA(3) of the ITAA 1936, the provision applies if the following conditions are satisfied:

(a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and

(c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d) except for this section, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

(e) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

Paragraphs 177EA(3)(a) to 177EA(3)(d) of the ITAA 1936

The conditions in paragraphs 177EA(3)(a) to 177EA(3)(d) of the ITAA 1936 are satisfied because:

(a) the issue of the proposed RPS will constitute a scheme for the disposition of a membership interest (paragraph 177EA(3)(a) of the ITAA 1936).

Pursuant to paragraph 177EA(14)(a) of the ITAA 1936, a 'scheme for the disposition of membership interests or an interest in membership interests' includes a scheme that involves the issuing of membership interests.

The term 'membership interests' is defined in section 960-135 of the ITAA 1997 as:

If you are a *member of an entity:

(a) each interest, or set of interests, in the entity; or

(b) each right, or set of rights, in relation to the entity;

by virtue of which you are a member of the entity is a membership interest of yours in the entity.

At item 1 of the table in subsection 960-130(1) of the ITAA 1997, a 'member' of an entity that is a company is 'a member of the company or a stockholder in the company.' However, subsection 960-130(3) of the ITAA 1997 provides that an entity is not a member of another entity just because the entity holds one or more interests or rights relating to the other entity that are *debt interests.

The issuance of the proposed RPS involves the issuing of membership interests because once a proposed RPS is issued, the holders become members in the company as the proposed RPS are not debt interests.

(b) frankable distributions are expected to be payable to the holders (paragraph 177EA(3)(b) of the ITAA 1936).

The dividends or any discretionary dividends to be paid in respect of each proposed RPS will be frankable distributions (refer Question 2 above).

(c) franked distributions are expected to be paid to the holders (paragraph 177EA(3)(c) of the ITAA 1936). The company has advised that it is expected that distributions will be paid and that those distributions will be fully franked to the extent franking credits are available in its franking account.

(d) it is reasonable to expect that an imputation benefit will be received by the relevant taxpayers (the proposed holders) as a result of distributions made to holders, given that the company expects to frank the dividends or any discretionary dividends on each proposed RPS (paragraph 177EA(3)(d) of the ITAA 1936).

An 'imputation benefit' is defined in subsection 204-30(6) of the ITAA 1997 as follows:

A *member of an entity receives an imputation benefit as a result of a distribution if:

(a) the member is entitled to a *tax offset under Division 207 as a result of the distribution; or

(b) an amount would be included in the member's assessable income as a result of the distribution because of the operation of section 207-35; or

(c) a *franking credit would arise in the *franking account of the member as a result of the distribution; or

(d) an *exempting credit would arise in the *exempting account of the member as a result of the distribution; or

(e) the member would not be liable to pay *withholding tax on the distribution, because of the operation of paragraph 128B(3)(ga) of the Income Tax Assessment Act 1936; or

(f) the member is entitled to a *tax offset under section 210-170 as a result of the distribution.

Each of the other companies (the proposed holders) are Australian residents for tax purposes, Therefore, in the present case, it is probable that imputation benefits will be received by the holders.

Accordingly, the issue is whether having regard to the relevant circumstances of the scheme, it would be concluded that a person, or one of the persons, who entered into or carried out the scheme, did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

Paragraph 177EA(3)(e) of the ITAA 1936

The term 'incidental purpose' is not defined in the income tax legislation and therefore takes its ordinary meaning. The Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 3) 1998 (EM No. 3) at paragraph 8.76 states the following in this regard:

A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with another purpose, or merely follows another purpose as its natural incident. For example, when a taxpayer holds shares in the ordinary way to obtain the benefit of any increase in their share price and the dividend income flowing from the shares, a franking credit benefit is generally no more than a natural incident of holding the shares, and generally the purpose of obtaining the benefit simply follows incidentally a purpose of obtaining the shares: it is therefore merely an incidental purpose.

The EM No. 3 also provides the following example (at paragraph 8.77):

…if a taxpayer, being a company, entered into a scheme involving the disposition of shares for the immediate purpose of obtaining a tax advantage for itself (for example, one deriving from an allowable deduction and the inter-corporate dividend rebate) and another, substantial, purpose of obtaining franking credits (which will ultimately benefit its shareholders), the fact that the taxpayer may regard the immediate benefit of the first tax advantage as more important than the deferred benefit of obtaining the franking credits does not mean that the second purpose is merely incidental to the first.

The test in terms of paragraph 177EA(3)(e) of the ITAA 1936 is an objective purpose. Circumstances which are relevant in determining whether any person has the requisite purpose include, but are not limited to, the factors listed in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed encompass a range of circumstances which taken individually or collectively could indicate the requisite purpose. Due to the diverse nature of these circumstances, some may or may not be present at any one time in any one scheme.

Having regard to the relevant objective circumstances of the scheme listed in subsection 177EA(17) of the ITAA 1936, it is considered the requisite purpose does not exist because the franking benefits received by the other companies will follow as an incident to the main purpose of the scheme ie the distribution of the retained profits from the company to the other companies. Accordingly, section 177EA of the ITAA 1936 will not apply to any distribution of fully franked dividends to the holders of the proposed RPS.

Question 9

Detailed reasoning

Part IVA of the ITAA 1936 applies to any scheme that has been carried out or is entered into for the dominant purpose of enabling a taxpayer to obtain a tax benefit in connection with the scheme. The application of Part IVA requires all of the following conditions to be present:

(i) a scheme has been carried out or entered into after 27 May 1981;

(ii) a taxpayer has or will obtain a tax benefit in connection with the scheme; and

(iii) the dominant purpose of the scheme was to enable the taxpayer to obtain a tax benefit.

Based on the information provided and the conditions required for Part IVA of the ITAA 1936 to apply, a conclusion cannot be formed that the scheme was entered into for the dominant purpose of obtaining a tax benefit. The proposed transaction is to be undertaken with the intention of succession planning. On this basis Part IVA will not have application to the proposed transaction.

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