Edited version of private ruling

Authorisation Number: 1011507105774

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Share Capital Reduction

Question 1

In respect of the proposed payment of an amount to be debited against the share capital account of Investor Co Pty Ltd as part of the consideration for the cancellation of shares, will the Commissioner make a determination under subsection 45A(2) of the Income Tax Assessment Act 1936 (ITAA 1936) that section 45C of the ITAA 1936 applies in relation to the whole, or part, of the payment?

Answer

No.

Question 2

In respect of the proposed payment of an amount to be debited against the share capital account of Investor Co Pty Ltd as part of the consideration for the cancellation of shares, will the Commissioner make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole, or part, of the payment?

Answer

No.

Question 3

Will the Commissioner make a determination under paragraph 204-30(3)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) to deny the whole or part of the imputation benefit that would arise in respect of the proposed payment of a fully franked dividend as part of the consideration for the cancellation of shares?

Answer

No.

Question 4

Will the Commissioner make a determination under section 177F of the ITAA 1936 in relation to Investor Co Pty Ltd in connection with the proposed arrangement to cancel certain shares in both Operating Co Pty Ltd and Investor Co Pty Ltd?

Answer

No.

Question 5

Will section 177E of the ITAA 1936 apply to the proposed arrangement to cancel certain shares in Operating Co Pty Ltd such that, the Commissioner will make a determination that section 177F of the ITAA 1936 applies to determine that an amount should be included in the assessable income of Investor Co Pty Ltd?

Answer

No.

Question 6

Will the Commissioner make a determination under subsection 177EA(5) of the ITAA 1936 that a franking debit arises in the franking account of Investor Co Pty Ltd, or that no imputation benefit arises, in respect of the proposed payment of a fully franked dividend as part of the consideration for the cancellation of shares?

Answer

No.

This ruling applies for the following period:

1 July 2010 - 30 June 2011

Relevant facts and circumstances

Investor Co Pty Ltd is an investment company, and does not conduct any active business. Investor Co Pty Ltd's major asset is a parcel of shares it holds in Operating Co Pty Ltd.

Certain shareholders in Investor Co Pty Ltd have expressed a desire to liquidate all or a part of their shareholding in the company. To this end, Investor Co Pty Ltd is proposing to enter into a selective share capital reduction (SCR) with shareholders who have indicated a desire to liquidate all (or a portion) of their interest in Investor Co Pty Ltd. A shareholder who participates in the SCR is referred to in these reasons and explanation as a participating exiting shareholder (PES). The applicant has stated that Investor Co Pty Ltd is proposing to cancel some of its ordinary shares on issue that is, Investor Co Pty Ltd is cancelling approximately 16% of its issued ordinary share capital). In consideration of the PESs agreeing to have their shares cancelled, Investor Co Pty Ltd will pay those entities an amount of $XX.00 per share. That amount is stated to comprise $X.XX of share capital and $XX.XX of fully franked dividend. In other words, the total consideration paid by Investor Co Pty Ltd to the PESs will be approximately $X,XXX,XXX.

In order to fund the SCR, Investor Co Pty Ltd will utilise the proceeds received from the realisation of a portion of its interest in Operating Co Pty Ltd. This arrangement was considered the most appropriate as the remaining shareholders in Investor Co Pty Ltd do not wish to purchase the interests of the PESs.

The Investor Co Pty Ltd Share Cancellation

The proposed SCR will comply with the Corporations Act 2001 (the Corporations Act). In particular, with subsection 256B(2) of the Corporations Act. The applicant has provided a spreadsheet detailing the PESs. Of those entities participating in the SCR, only 2 will maintain any membership interest in Investor Co Pty Ltd after the completion of the transaction.

The start date for the SCR will be dependent on certain pre-conditions being satisfied, including obtaining funding on suitable terms and conditions, complying with the Corporations Act and having the shareholders pass a resolution approving the SCR. The transaction will commence during the income year ending 30 June 2011.

The applicant has stated that there have not been any transfers to Investor Co Pty Ltd's share capital account which would cause it to be tainted for the purposes of either Division 197 of the ITAA 1997 or Division 197 of the Income Tax (Transitional Provisions) Act 1997 (IT(TP)A 1997).

The applicant has advised that as of 30 June 2009, Investor Co Pty Ltd had a credit franking account balance. Upon receipt of the proceeds from the Operating Co Pty Ltd SCR it is expected that a credit will arise in the franking account. If the Investor Co Pty Ltd SCR proceeds as intended, then a franking debit should arise when the SCR occurs. It is expected that the franking account balance will remain in credit after the SCR.

Investor Co Pty Ltd has an informal dividend policy under which it pays out an amount (as a dividend) which approximates the company's net profit after tax.

The applicant has stated that the dividend paid to the PESs will not adversely affect the ability of Investor Co Pty Ltd to pay dividends to its remaining shareholders in the future, and Investor Co Pty Ltd intends to pay future dividends on a fully franked basis, in accordance with its informal dividend policy.

Relevant legislative provisions

Corporations Act 2001, section 256B

Corporations Act 2001, subsection 256B(2)

Corporations Act 2001, section 256C

Income Tax Assessment Act 1936, section 45A

Income Tax Assessment Act 1936, subsection 45A(2)

Income Tax Assessment Act 1936, subsection 45A(3)

Income Tax Assessment Act 1936, subsection 45A(4)

Income Tax Assessment Act 1936, paragraph 45A(4)(b)

Income Tax Assessment Act 1936, paragraph 45A(4)(e)

Income Tax Assessment Act 1936, paragraph 45A(4)(f)

Income Tax Assessment Act 1936, section 45B

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

Income Tax Assessment Act 1936, paragraph 45B(2)(c)

Income Tax Assessment Act 1936, subsection 45B(5)

Income Tax Assessment Act 1936, paragraph 45B(5)(b)

Income Tax Assessment Act 1936, subsection 45B(8)

Income Tax Assessment Act 1936, paragraph 45B(8)(a)

Income Tax Assessment Act 1936, 45B(8)(b)

Income Tax Assessment Act 1936, paragraph 45B(8)(c)

Income Tax Assessment Act 1936, paragraph 45B(8)(d)

Income Tax Assessment Act 1936, paragraph 45B(8)(e)

Income Tax Assessment Act 1936, paragraph 45B(8)(f)

Income Tax Assessment Act 1936, paragraph 45B(8)(h)

Income Tax Assessment Act 1936, paragraph 45B(8)(i)

Income Tax Assessment Act 1936, paragraph 45B(8)(j)

Income Tax Assessment Act 1936, paragraph 45B(8)(k)

Income Tax Assessment Act 1936, section 45C

Income Tax Assessment Act 1936, section 46F

Income Tax Assessment Act 1936, section 160ADA

Income Tax Assessment Act 1936, Part IVA

Income Tax Assessment Act 1936, section 177A

Income Tax Assessment Act 1936, section 177C

Income Tax Assessment Act 1936, section 177D

Income Tax Assessment Act 1936, paragraph 177D(b)

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, paragraph 177E(1)(a)

Income Tax Assessment Act 1936, paragraph 177E(1)(b)

Income Tax Assessment Act 1936, paragraph 177E(1)(c)

Income Tax Assessment Act 1936, section 177EA

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

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

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

Income Tax Assessment Act 1936, section 177F

Income Tax Assessment Act 1936, paragraph 177F(1)(a)

Income Tax Assessment Act 1997, subsection 4-10(3)

Income Tax Assessment Act 1997, section 4-15

Income Tax Assessment Act 1997, section 118-20

Income Tax Assessment Act 1997, subsection 118-20(2)

Income Tax Assessment Act 1997, Division 197

Income Tax Assessment Act 1997, section 204-30

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, paragraph 204-30(3)(a)

Income Tax Assessment Act 1997, paragraph 204-30(3)(c)

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

Income Tax Assessment Act 1997, subsection 204-30(7)

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

Income Tax Assessment Act 1997, paragraph 204-30(8)(a)

Income Tax Assessment Act 1997, paragraph 204-30(8)(b)

Income Tax Assessment Act 1997, paragraph 204-30(8)(c)

Income Tax Assessment Act 1997, paragraph 204-30(8)(d)

Income Tax Assessment Act 1997, paragraph 204-30(8)(e)

Income Tax Assessment Act 1997, paragraph 204-30(8)(f)

Income Tax Assessment Act 1997, subsection 204-30(9)

Reasons for decision

All legislative references are to the ITAA 1936, unless specified otherwise.

Question 1

Section 45A applies where a company streams the provision of a capital benefit to one shareholder (the advantaged shareholder), and the payment of a dividend to another shareholder (the disadvantaged shareholder) in such a way that:

1. the capital benefit is received by the shareholder (the advantaged shareholder) who would in the year of income derive a greater benefit from the capital benefit than any of the disadvantaged shareholders; and

2. it is reasonable to assume that the disadvantaged shareholders have received or will receive dividends.

In this private ruling application, the advantaged shareholders are the PESs, and the disadvantaged shareholders are all other shareholders identified on the Investor Co Pty Limited share register.

The applicant has stated that the PESs are having approximately 16% of Investor Co Pty Limited's 2,585,202 ordinary shares on issue cancelled. It should be noted that 2 of the PESs will continue to hold shares in Investor Co Pty Limited after the SCR. These 2 shareholders will be 'advantaged' in terms of that portion of shares which are subject to the SCR, and disadvantaged in respect of the balance.

Section 45A should be applied on an individual, rather than a class basis. As the 2 identified PESs are both 'advantaged' and 'disadvantaged' (depending on the actual share interest), the provision must be applied to the entity by analysing each share that it holds.

It should be noted that the disadvantaged shareholders will not be receiving any dividend payment that is associated with the SCR. Rather, they will continue to receive dividends paid in accordance with Investor Co Pty Limited's informal dividend policy.

To determine whether (or not) the Commissioner should apply section 45A, it is necessary to determine whether the capital benefit received by the PESs as a result of the SCR constitutes a greater benefit, as compared to any other benefit that may (or may not) be derived by other shareholders identified on the Investor Co Pty Limited share register. Subsection 45A(4) sets out 6 factors to have regard to when determining whether the advantaged shareholder is actually receiving a greater benefit. Those factors are:

(a) Whether the PESs hold pre-CGT shares:

The shares which are to be cancelled as a result of the SCR are potentially both pre and post-CGT shares. Both the advantaged shareholder and disadvantaged shareholders hold a mix of pre and post-CGT shares. Where post-CGT share are cancelled there will be no advantage to the PESs in terms of realising shares that have a pre-CGT status.

In the event pre-CGT shares are cancelled, the applicant states that there are other shareholders who are not participating in the SCR who also hold pre-CGT shares. The shareholders who hold pre-CGT shares in Investor Co Pty Limited, and who are not participating in the SCR are not disadvantaged in respect of those actual shares' pre-CGT status.

The applicant has also stated that if the advantaged shareholder disposes of pre-CGT shares, then it is likely CGT event K6 will occur. In other words, the applicant expects that due to increases in the market value of the property acquired by Investor Co Pty Limited between 20 September 1985 and the time of the actual SCR, shareholders who hold pre-CGT shares will loose the benefit of the pre-CGT status to the extent that the increase in value of the share is attributable to that increase in market value of the acquired property.

The Commissioner has not been asked to rule on CGT event K6, and expresses no opinion as to whether (or not) CGT event K6 happens.

In estimated terms, approximately 43% of the shares being cancelled have a potential pre-CGT status. Further, in approximate terms, the share register supplied by the applicant suggests that 7.3% of Investor Co Pty Limited's currently issued share capital that will be cancelled under the SCR may have a pre-CGT status. Based on the methodology adopted by the rulee (average capital per share), and the extent of the dividend component in the consideration amount, the Commissioner accepts the proposition that return of share capital in respect of the PESs pre-CGT shares does not confer a sufficient benefit, such that it would constitute a greater benefit.

(b) The PESs are Australian residents:

The applicant has stated that Investor Co Pty Limited has 2 non-resident shareholders, who hold 2.08% of Investor Co Pty Limited's issued share capital. Further, the applicant has also stated that all of the participating shareholders are Australian residents. On this basis the Commissioner is satisfied that paragraph 45A(4)(b) is not relevant in determining whether the advantaged shareholder gains a greater benefit.

(c) The PESs cost base of the share is not substantially less than the capital benefit:

The Commissioner accepts that Investor Co Pty Limited is not in a position to know the exact cost base of either the PESs shareholdings, or that of the remaining, potentially disadvantaged shareholders.

The applicant has submitted that should the dividend component of the payment exceed the capital gain made on cancellation of a share, then while subsection 118-20(2) of the ITAA 1997 reduces the capital gain to nil, it is not possible for the advantaged shareholder to make a capital loss (which would otherwise occur if the cost base of the share was greater than the capital benefit received).

In effect to the extent that the share's cost base exceeds the capital benefit, the PESs will be suffering a disadvantage. Accordingly, the Commissioner is satisfied that little weight can be given to this factor.

(d) The PESs do not have any capital losses for the income year in which the benefit is provided:

The applicant has stated that Investor Co Pty Limited is not in a position to know whether (or not) the PESs have any carried forward capital losses. The applicant has stated that this may be the case for some, and not for others. The Commissioner accepts that based on these circumstances, paragraph 45A(4)(d) is not relevant in determining whether the advantaged shareholder gains a greater benefit.

(e) The PESs are private companies that would have been entitled to the inter-corporate dividend rebate under the former section 46F:

On the information provided by the applicant, only 1 PES is a corporate entity, and the applicant has stated that this entity would have been entitled to a rebate under the former section 46F. The Commissioner accepts that this factor will not result in the PESs deriving a greater benefit under the proposed arrangement. Accordingly, the Commissioner accepts that based on these circumstances, paragraph 45A(4)(e) is not relevant in determining whether the advantaged shareholder gains a greater benefit.

(f) The PESs do not have any income tax losses:

The applicant has stated that Investor Co Pty Limited is not in a position to know whether (or not) the PESs have any carried forward income tax losses. The applicant has stated that this may be the case for some, and not for others. The Commissioner accepts that based on these circumstances, paragraph 45A(4)(d) is not relevant in determining whether the advantaged shareholder gains a greater benefit.

The Commissioner has formed the view that the SCR does not represent the streaming of capital to one class of shareholder and dividends to another, based on their ability to utilise the dividends or otherwise. Rather the purpose of the SCR is to facilitate the exit of the PESs from Investor Co Pty Limited. Given Investor Co Pty Limited's status as a private company, a targeted SCR is a commercially understandable method of facilitating the realisation and exit of those shareholders.

Question 2

Requirements of section 45B

The operative provision of section 45B is subsection 45B(2). Insofar as is relevant, that provision states:

This section applies 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 (the relevant taxpayer), who may or may not be the person provided with the capital benefit, obtains a tax benefit; and

(c) 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 a taxpayer (the relevant taxpayer) to obtain a tax benefit.

Where these conditions are met, the Commissioner is authorised to make a determination that any of the capital benefit provided to the shareholder is an assessable dividend.

Each of the elements of section 45B is considered in more detail below.

Scheme

The term 'scheme' takes on the same meaning that it has for Part IVA purposes. The Part IVA definition of scheme is very broad and includes any 'agreement, arrangement, understanding, promise or undertaking' or 'any scheme, plan, proposal, action, course of action or course of conduct.'

Accordingly, the capital reduction is a scheme for the purposes of section 45B.

Provided with a capital benefit

The meaning of 'provided with a capital benefit' is defined in subsection 45B(5) as follows:

A reference to the "provision of a capital benefit" to a shareholder in a company is a reference to any of the following:

(a) the provision to the shareholder of shares in the company;

(b) the distribution to the shareholder of share capital;

(c) something that is done in relation to a share that has the effect of increasing the value of a share (which may or may not be the same share) held by the shareholder.

As part of the SCR proceeds are regarded as capital, and to that extent will be fully debited against Investor Co Pty Limited's share capital account, those proceeds will represent a capital benefit in the hands of the PESs, pursuant to paragraph 45B(5)(b).

Obtaining a tax benefit

Under the scheme a person must obtain a tax benefit. A tax benefit is defined broadly as:

… if any amount of tax payable, or any other amount payable under the Tax Act, by the relevant taxpayer would, apart from the operation of Section 45B, be less than the amount that would have been payable, or would be payable at a later time than it would have been payable, if the capital benefit had been a dividend.

Accordingly, under a literal reading of the legislation, the SCR may provide a number of Investor Co Pty Limited's shareholders (the PESs), with a tax benefit (since small capital gains may be made). This is in contrast to the outcome that would result if the entire payment was characterised as a dividend.

Purpose of obtaining a tax benefit

The final element that has to be satisfied for section 45B to apply is contained in paragraph 45B(2)(c):

… having regard to the relevant circumstances of the scheme, it would be concluded that the person 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 a taxpayer to obtain a tax benefit.

Paragraph 1.31 of the Explanatory Memorandum that accompanied the Taxation Laws Amendment (Company Law Review) Bill 1998, which originally enacted section 45B explained what is meant by 'a purpose' of a scheme as follows:

Section 45B requires a 'purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit. The words in parentheses are inserted for more abundant caution; a reference to 'a purpose' of a scheme is usually understood to include any main or substantial purpose of the scheme, and the words in parentheses clarify that this is the intended meaning here. Thus while Section 45B does not require the purpose of obtaining a tax benefit to be the ruling, most influential or prevailing purpose, neither does it include any purpose which is not a significant purpose of the scheme.

A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with one of the main or substantial purposes of the scheme, or merely follows that purpose as its natural incident.

The application of section 45B to Investor Co Pty Limited therefore turns on whether, having regard to the relevant circumstances of the SCR, it may be concluded that it was undertaken for a purpose of enabling Investor Co Pty Limited's shareholders to obtain a tax benefit.

The meaning of the 'relevant circumstances of the scheme' is set out in subsection 45B(8). Listed in paragraphs (a)-(j) are the relevant circumstances that need to be considered. In paragraph (k), the matters referred to in sub-paragraphs 177D(b)(i)-(viii) are also required to be considered.

The relevant circumstances that need to be considered are as follows.

Whether the capital component of the Investor Co Pty Limited payment will be attributable to profits of Investor Co Pty Limited: paragraph 45B(8)(a).

The capital component of the payment that Investor Co Pty Limited will pay the PESs is entirely attributable to Investor Co Pty Limited's share capital account. The applicant has stated that Investor Co Pty Limited's share capital account is not tainted (within the meaning described in Division 197 of the ITAA 1997 and Division 197 of the IT(TP)A 1997). The capital component of the payment has been determined using the 'average capital per share' (ACPS) methodology. The Commissioner has issued Practice Statement PS LA 2008/10 to provide instruction and guidance to tax officers in regards to the application of section 45B in relation to SCRs. PS LA 2008/10 does not discuss a suitable methodology for attributing consideration between a capital payment and a dividend. However, drawing on the Commissioner's discussion in PS LA 2007/9 of the appropriate methodology to determine the split between share capital and dividend payments in a share buy-back, the Commissioner considers that the ACPS methodology is an appropriate one.

Accordingly, the Commissioner is satisfied that the capital component of the payment is not sourced from the profits of the company.

The pattern of distributions of dividends, bonus shares and returns of capital or share premium by the company or an associate of the company: paragraph 45B(8)(b).

Investor Co Pty Limited has a long history of paying dividends to its shareholders. These are generally proportionate to the net profit derived by the company. The applicant has not identified any loss years, or years where a dividend was not paid.

The applicant has confirmed Investor Co Pty Limited's intention to continue paying regular dividends to shareholders both in the year of income in which the SCR will take place, as well as in future income years. That is, the SCR will not alter the current and ongoing dividend policy of Investor Co Pty Limited. The provision of the capital benefit is not intended to replace or supplement the regular distributions made by Investor Co Pty Limited. Investor Co Pty Limited's pattern of distributions shows that there is no intention or motivation that could be regarded as inclining towards the requisite purpose that is required for the application of section 45C.

Further, Investor Co Pty Limited has not previously undertaken a SCR. It is only doing so now in order to facilitate the reduction of numerous shareholders' interests who no longer wishes to maintain either any share ownership, or the same proportion of share ownership in Investor Co Pty Limited. These circumstances combined tend against the existence of the requisite purpose.

Whether the relevant taxpayer has capital losses that, apart from the scheme would be carried forward to a later year of income: paragraph 45B(8)(c).

The Commissioner has previously indicated that where a company has a diverse range of shareholders, this factor in isolation will neither tend toward or against the existence of the requisite degree of purpose.

The applicant has advised that Investor Co Pty Limited has a diverse range of shareholders, including individuals, corporate entities, trusts and a superannuation fund. On this basis the applicant contends that no (or little) weight should be ascribed to this factor.

The Commissioner accepts the applicant's contentions, and accordingly this factor will tend neither toward nor against the requisite purpose.

Whether some or all of the ownership interests in the company or in an associate of the company were acquired or taken to have been acquired before 20 September 1985: paragraph 45B(8)(d).

Whilst Investor Co Pty Limited has identified the shareholders who wish to sell either a portion or the entirety of their interest in the company, the applicant has not stated whether the share cancelled will be a pre or post-CGT issue.

However, on the basis of information provided by the applicant it seems that of the shares to be cancelled, potentially some may have a pre-CGT status. The applicant has stated that the shareholders were not targeted on the basis of their share profile, rather they were determined on the basis of no longer wanting to be involved in the company.

In the event that the PESs have pre-CGT shares cancelled, then the applicant has stated that it is likely CGT event K6 will happen. The applicant further contends, that this will prevent the PESs from disregarding any capital gain. The Commissioner makes no statement as to the likelihood (or not) of CGT event K6 happening.

Finally, given the mix of participating and non-participating shareholders pre and post-CGT status profile, the Commissioner accepts the applicant's contentions, and accordingly this factor will tend neither toward nor against the requisite purpose.

Whether the relevant taxpayer is a non-resident: paragraph 45B(8)(e).

All of the PESs are Australian residents for taxation purposes. Therefore this factor is of no consequence to the Commissioner's consideration of whether or not to make a determination under section 45C.

Whether the cost base of the relevant ownership interest is not substantially less than the value of the applicable capital benefit: paragraph 45B(8)(f).

The applicant has stated that the PESs will have a range of cost bases for shares that they hold in Investor Co Pty Limited. As noted, Investor Co Pty Limited has not determined the exact shares it will be cancelling. The applicant has further stated that they expect the PESs will have shares cancelled with cost bases both above and below the value of the capital proceeds.

In circumstances where the cost base of the share exceeds the capital benefit, then as identified in paragraph 10 of PS LA 2008/10, there is no possibility of a capital loss being generated by the application of the anti-overlap rules in section 118-20 of the ITAA 1997 and the PESs would be disadvantaged by the receipt of the capital benefit.

The Commissioner accepts the applicant's submission that little weight should be given to this factor.

Whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital: paragraph 45B(8)(h).

Investor Co Pty Limited is cancelling its shares. Therefore, the ownership of the membership interest in Investor Co Pty Limited held after the SCR will be different in proportion and profile to that which would have been the case had the payment consisted entirely of a dividend, and had those shares not been cancelled. Therefore, this factor tends against the existence of the requisite purpose.

Paragraphs 45B(8)(i) and 45B(8)(j) are not relevant to the proposed Investor Co Pty Limited SCR as the scheme will not involve the provision of ownership interest and is not considered to be a demerger.

Paragraph 45B(8)(k) requires that regard be had to the matters contained in subparagraphs 177D(b)(i) to (viii), namely:

(i) the manner in which the scheme was entered into or carried out;

The commercial realities of the situation indicated that a number of shareholders in Investor Co Pty Limited (the PESs) have a desire to no longer be involved in the company. This meant that a selective SCR of the PESs' interest in Investor Co Pty Limited was the most appropriate method to facilitate the reduction of the PESs interests. The other option considered was a share buy-back, and the capital benefit provided there under would be identical in all respects. This tends to weigh against a finding of the requisite purpose.

Finally, the scheme is intended to be carried out in a simple, transparent and commercial matter. There are no artificial or contrived steps in the scheme.

(ii) the form and substance of the scheme;

The form and the substance of the scheme are congruent in all respects. This tends to weigh against a finding of the requisite purpose.

(iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

The applicant has stated that the SCR is entirely dependent on certain commercial objectives being met. These include obtaining a binding private ruling, complying with sections 256B and 256C of the Corporations Act, and receipt of proceeds from a related SCR to fund the Investor Co Pty Limited SCR and reaching a final negotiated outcome with the PESs. The SCR will proceed as soon as is practicable after meeting these commercial considerations. Neither the timing of the transaction, or the period which it is anticipated to take suggest that this factor is of any importance. Consequently, this factor weighs against a finding of the requisite purpose.

(iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

The applicant has stated that there is little practical difference in the PESs receiving either a return of capital or a franked dividend.

In the case of a return of capital, PESs may make a small capital gain, but it is not possible for them to make a capital loss unless the payment is less than the reduced cost base of the shares as a result of the SCR.

In the case of a fully franked dividend, the applicant suggests that the tax effect would be beneficial if the shareholder is on a 30% (or lower) marginal tax rate, or neutral if their marginal rate is greater.

The Commissioner accepts the applicant's contentions. Accordingly, no weight is placed upon this factor in evaluating the motives behind the requisite purpose.

(v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

The applicant has submitted that the net change in the financial position of the PESs will be nil. This is due to the simple fact that the PESs are liquidating an asset for its market value. That is, they are replacing one asset (a share) with another asset (cash) of the same value. This tends to weigh against a finding of the requisite purpose.

(vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

Investor Co Pty Limited will need to receive funds from the sale of its interest in Operating Co Pty Limited, the company will also be required to debit its share capital account and retained earnings to reflect the return of capital and profits to the PESs. This tends to weigh against a finding of the requisite purpose.

(vii) any other consequence for the relevant taxpayer, or for any person referred to in paragraph (vi), of the scheme having been entered into or carried out; and

There are no other consequences of the scheme having been entered into, or carried out.

(viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (vi);

The relevant relationship for the purposes of this factor is that which exists between Investor Co Pty Limited and the PESs (as shareholders in Investor Co Pty Limited who are desirous of liquidating their interests in the company). This tends to weigh against a finding of the requisite purpose.

Examining the totality of the relevant circumstances, the Commissioner considers that the conclusion required by paragraph 45B(2)(c) should not be drawn and the Commissioner will not make a determination under subsection 45B(3) that section 45C applies in relation to the whole, or part, of the payment.

Question 3

The applicant has stated that Investor Co Pty Limited intends to continue paying fully franked dividends to its remaining shareholders into the future. The applicant has further stated that as at 30 June 2009 Investor Co Pty Limited's franking account was in credit, and the franking debit that would result from the receipt of the Operating Co Pty Limited SCR is likely to result in a credit. Finally, after Investor Co Pty Limited has paid the PESs their fully franked dividend, a franking debit of should arise. This leaves an estimated franking account balance of $XXX,XXX.

Section 204-30 of the ITAA 1997 counters strategies that are designed and implemented to manipulate the imputation system. The section applies where a corporate tax entity streams the payment of dividends, or the payment of dividends and the giving of other benefits, to its members 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 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, 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).

If section 204-30 of the ITAA 1997 applies, the Commissioner is vested with discretion under subsection 204-30(3) of the ITAA 1997 to make a determination in writing either:

(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 (paragraph 204-30(3)(a) of the ITAA 1997); or

(b) that no imputation benefit is to arise in respect of any streamed distributions made to a favoured member and specified in the determination (paragraph 204-30(3)(c) of the ITAA 1997).

It is clear that the PESs are receiving an 'imputation benefit' for the purposes of subsection 204-30(6) of the ITAA 1997.

What must be determined, is whether (or not) the PESs will derive a greater benefit from the franking credits in accordance with subsections 204-30(7)-(10) of the ITAA 1997, as compared to what would be derived by the non-participating shareholders in Investor Co Pty Limited. Subsection 204-30(7) of the ITAA 1997 states that the list of cases in which a member of an entity derives a greater benefit from franking credits than another member, in subsection 204-30(8) of the ITAA 1997 is not an exhaustive list.

In determining whether the PESs derive a 'greater benefit from franking credits', subsection 204-30(8) of the ITAA 1997 directs the Commissioner to have regard to six factors set out in that provision. Namely, whether:

i. the non-participating shareholders are non-residents for Australian taxation purposes: paragraph 204-30(8)(a) of the ITAA 1997. The applicant has stated that Investor Co Pty Limited has 2 non-resident shareholders, who hold a total of 2.08% of Investor Co Pty Limited's issued shares. The applicant acknowledges that as some shareholders are trusts, the potential exists for the ultimate beneficiaries to be non-residents, however they do not expect that this is the case. The Commissioner is satisfied that this level of non-resident shareholding is not capable of motivating the transaction.

ii. the non-participating shareholders are entitled to a tax offset under Division 207: paragraph 204-30(8)(b) of the ITAA 1997. Whilst the non-participating shareholders will not be receiving a franked dividend that is associated with the SCR, the applicant has stated, with the exception of the non-resident shareholders discussed previously and the potential situation of a trust distributing to a non-resident beneficiary, that all other non-participating shareholders will be entitled to a tax offset. The Commissioner accepts these contentions, and is satisfied that little weight should be given to this consideration.

iii. the participating shareholder's amount of income tax payable as a consequence of the distribution paid under the SCR, is less than the tax payable (after taking into account the available tax offset) by the non-participating shareholders: paragraph 204-30(8)(c) of the ITAA 1997. The applicant contends that the tax offset is unlikely to be wasted in this way by the non-participating shareholders. This is due to the tax offset being refundable to individuals, and convertible into carry forward losses for corporate shareholders. The applicant has acknowledged that where the franking credits flow to a trust, the potential exists for a discrepancy to arise, but has submitted that even in these circumstances there is unlikely to be any franking credit wastage. The Commissioner accepts these contentions, and is satisfied that little weight should be given to this consideration.

iv. the non-participating shareholders are corporate tax entities who will not receive a franking credit if a distribution is made: paragraph 204-30(8)(d) of the ITAA 1997. The Commissioner accepts the applicant's contention that the rulee is not aware of any circumstances which would preclude a corporate shareholder of the company from receiving a franking credit in respect of a distribution.

v. the non-participating shareholders are corporate tax entities who will not be able to pass the benefit of the franking credits received on to its own members: paragraph 204-30(8)(e) of the ITAA 1997. All of the corporate shareholders in Investor Co Pty Limited are franking entities. The applicant has stated that Investor Co Pty Limited is not in a position to know whether these shareholders would be unable to make frankable distributions (for example they may have no profits out of which to declare dividends), however, the applicant has stated that Investor Co Pty Limited considers it unlikely that its corporate shareholders could not pass the benefit of the franking credits on. The Commissioner accepts the applicant's contention that Investor Co Pty Limited is not in a position to know the accounting and tax positions of its corporate shareholders.

vi. the non-participating shareholders are exempting entities: paragraph 204-30(8)(f) of the ITAA 1997. This consideration is not relevant as the applicant has stated that none of the corporate shareholders satisfy this condition.

The applicant has stated that the circumstances detailed in subsections 204-30(9) and (10) of the ITAA 1997 are not relevant. These provisions concern franking credits that flow from an exempting entity (or former exempting entity: subsection (9), and venture capital: subsection (10)). The Commissioner accepts the applicant's contentions that these provisions are not relevant.

In summary, the Commissioner accepts the applicant's contention that the SCR is not structured so as to 'stream' franking credits to those who are best able to use them.

The Commissioner will not make a determination under paragraph 204-30(3)(c) of the ITAA 1997 to deny imputation benefits that arise in respect of the dividend component of the SCR paid to the PESs.

Question 4

Part IVA has potential application to transactions if it is reasonable to conclude that a scheme (broadly defined) was entered into or carried out by a person for the dominant purpose of enabling a relevant taxpayer to obtain a tax benefit in connection with the scheme. In this context, a tax benefit may arise where;

i. an amount is not included in assessable income,

ii. a deduction is allowable,

iii. a capital loss is incurred, or

iv. a foreign income tax offset is allowable

in circumstances where that outcome would not have been reasonably expected if the scheme had not been entered into or carried out. Section 177F allows the Commissioner to cancel certain tax benefits which have been obtained, or would but for section 177F be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

For Part IVA to apply the following requirements must be satisfied:

i. a 'tax benefit', as identified in section 177C, was or would, but for subsection 177F(1), have been obtained;

ii. the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A;

iii. having regard to the criteria in section 177D, the scheme must be one to which Part IVA applies.

The scheme for the purposes of this ruling application will extend to the entire transaction, that is the 'scheme' which will encompass both Investor Co Pty Limited's and Operating Co Pty Limited's SCR.

Elements of the scheme

A 'scheme' is defined in wide terms (section 177A). A scheme is not to be identified so narrowly that '… the circumstances are incapable of standing on their own without being robbed of all practical meaning': FCT v. Peabody (1994) 181 CLR 359; 94 ATC 4663; (1994) 28 ATR 344 (Peabody). A narrower scheme can exist within a set of arrangements if that narrower scheme can stand on its own as a separate scheme : FCT v. Consolidated Press Holdings Ltd (2001) 207 CLR 235; 2001 ATC 4343; 47 ATR 229 (Consolidated Press).

In this case, whilst both Investor Co Pty Limited's and Operating Co Pty Limited's SCR may be characterised as a 'scheme' in themselves, the full and proper characterisation of the scheme encompasses the following elements:

i. The obtaining of debt financing by Operating Co Pty Limited

ii. The determination by Operating Co Pty Limited of the group of shareholders who will be invited to participate in the SCR

iii. The determination of the dividend / capital allocation in relation to the payments to be made under the Operating Co Pty Limited SCR

iv. The timing of the payments made by Operating Co Pty Limited

v. The use of the payments received by Investor Co Pty Limited

vi. The determination of the group of Investor Co Pty Limited's shareholders (PESs) who will participate in Investor Co Pty Limited's SCR

vii. The determination of the dividend / capital allocation in relation to the payments to be made under the Investor Co Pty Limited SCR

viii. The timing of the payments made by Investor Co Pty Limited

Tax Benefit

If Part IVA is to apply Investor Co Pty Limited must have obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme. It must be possible to say that the tax benefit would not have arisen if the scheme had not been entered into or carried out, or that it might reasonably be expected not to have been obtained. In Peabody, the High Court had earlier commented:

A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable to be regarded as reasonable: (1994) 181 CLR 359 at 385.

The applicant has submitted that in the context of this ruling application, section 177D can have no application, as this scheme is 'in respect of obtaining imputation benefits'. As such, there can be no 'tax benefit', as the definition of that term 'does not extend to an entity receiving franking credits'.

Where an entity receives franking credits, the benefit it will enjoy flows from the tax offset that those franking credits provide. The entity's taxable income is calculated prior to the application of that tax offset (section 4-15 of the ITAA 1997). Once the entity has determined its taxable income, it then determines its income tax liability, which is calculated by reference to the amount of any tax offset (subsection 4-10(3) of the ITAA 1997).

Accordingly, the receipt of franking credits is not:

i. an allowable deduction

ii. an amount that is included in assessable income

iii. a capital loss, or

iv. a foreign income tax offset.

On this basis, the applicant contends that a 'tax offset' cannot fall within the definition of a tax benefit under section 177C.

While the Commissioner accepts the applicant's contention in relation to the characterisation of a franking credit in terms of 'tax benefit' under section 177C, there still remains a possibility that a tax benefit of some description does exist.

However, having regard to the eight factors referred to in section 177D, the dominant purpose of the scheme appears to be the facilitation of a capital change in two entities for commercial reasons on commercial terms.

Accordingly, the Commissioner will not make a determination under section 177F of the ITAA 1936 in relation to Investor Co Pty Limited in connection with the proposed arrangement to cancel certain shares in Operating Co Pty Limited and Investor Co Pty Limited.

Question 5

Section 177E applies where there is:

i. a scheme in relation to a company, that is in the nature of (or has substantially the same effect) as a 'dividend stripping' scheme (paragraph 177E(1)(a)), and

ii. in the opinion of the Commissioner, the dividend stripping scheme results in disposal of property that represents the profits of the company (paragraph 177E(1)(b)), and

iii. by reason of the payment of a dividend, an amount would have been included, or might reasonably be expected to be included, in the assessable income of the taxpayer, then that amount is referred to as the notional amount under the dividend stripping scheme (paragraph 177E(1)(c)).

Then,

i. Part IVA will apply to that scheme, and

ii. The taxpayer will be taken to have obtained a tax benefit in connection with the scheme that is referrable to the notional amount not being included in their assessable income, and

iii. The amount of the tax benefit will be taken to equal the notional amount.

In terms of this private ruling application the question is whether the transaction undertaken by Operating Co Pty Limited is 'in the nature of a dividend strip'. In other words, is Operating Co Pty Limited's SCR a dividend stripping arrangement?

The term 'dividend stripping' was considered extensively by the full High Court in the decision of Consolidated Press. In the Federal Court decision of Lawrence v. FC of T [2008] FCA 1497; 2008 ATC 20-052; 70 ATR 376, Justice Jessup drew on the full Federal Court's reasoning in the subordinate decision of Consolidated Press when he stated that the term (at paragraph 61 of [2008] FCA 1497):

… "dividend stripping" was "applicable to a range of transactions provided certain essential characteristics are present" (91 FCR at 560 [132]). Specifically, their Honours relied upon the judgment of Gibbs J in Commissioner of Taxation (Cth) v Patcorp Investments Limited 76 ATC 4225; (1976) 140 CLR 247, and upon his Honour's identification of four previous judgments of the High Court in which dividend stripping operations had been involved. Their Honours in the Full Court continued (91 FCR at 561 [136]):

These four cases had the following 'characteristics in common':

§ a target company, which had substantial undistributed profits creating a potential tax liability either for the company or its shareholders;

§ the sale or allotment of shares in the target company to another party...;

§ the payment of a dividend to the purchaser or allottee of the shares out of the target company's profits;

§ the purchaser escaping Australian income tax on the dividend so declared (whether by reason of a s 46 rebate, an offsetting loss on the sale of the shares, or the fact that the shareholders were resident outside Australia); and

§ the vendor shareholders receiving a capital sum for their shares in an amount the same as or very close to the dividends paid to the purchasers (there being no capital gains tax at the relevant times)."

The Full Court identified "a further common characteristic" of the schemes in the four cases considered by Gibbs J in Patcorp, namely -

... that they were carefully planned, with all the parties acting in concert, for the predominant if not the sole purpose of the vendor shareholders, in particular, avoiding tax on a distribution of dividends by the target company. (91 FCR at 561 [137])

When regard is had to the 'characteristics in common' it is apparent that the Operating Co Pty Limited SCR has no resemblance to a 'dividend stripping' arrangement. The Commissioner accepts the applicant's submission that there is no release of profits from Operating Co Pty Limited in a tax advantaged form, and that the dividends paid under the SCR to Investor Co Pty Limited will form part of Investor Co Pty Limited's assessable income. Accordingly, section 177E will not apply to the proposed arrangement to cancel certain shares in Operating Co Pty Limited.

Question 6

Section 177EA is directed towards schemes involving franking credit trading and dividend streaming. The reason for its introduction was explained in the Explanatory Memorandum to the Taxation Laws Amendment Act (No.3) 1998 (Act No 47 of 1998) as follows:

One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them undermines this principle. Similarly, dividend streaming (i.e. the streaming of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings.

The preconditions to the application of section 177EA are:

i. a scheme for the disposition of shares or an interest in shares in a company;

ii. a frankable dividend or a distribution has been paid, is payable, or is expected to be payable in respect of the shares or interest in shares;

iii. the dividend or distribution was or is expected to be franked;

iv. but for the section, a person (the 'relevant taxpayer') would receive or could reasonably be expected to receive franking credit benefits from the dividend or distribution; and

v. 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 thereof did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain a franking credit benefit (subsection 177EA(3)).

One of the features of section 177EA is its purpose test. This is based on a non incidental purpose, whether or not the dominant purpose, of enabling the relevant taxpayer to obtain a franking credit.

The elements of this purpose test are that having regard to the 'relevant circumstances' it would be concluded that at least one of the persons who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a franking credit benefit. That purpose must not be an incidental purpose but may or may not be the dominant purpose.

An example of the need to apply section 177EA can be found in a scheme based on the greater attraction of a distribution to resident shareholders who can fully utilise franking credits than to non-resident shareholders who cannot. When dividends are streamed away from non-residents under such a scheme to avoid the 'wastage' of franking credits, section 177EA is attracted.

In the case of Investor Co Pty Limited's SCR, non-residents shareholders of Investor Co Pty Limited constitute only 2.08% of the company's issued share capital. As such, the quantum of any determination made under section 177EA would be correspondingly small.

Having regard to the relevant circumstances the Commissioner is satisfied that there can be no more than an incidental purpose of enabling the relevant taxpayer to obtain a franking credit benefit. Accordingly, the scheme does not satisfy paragraph 177EA(3)(e), and as such section 177EA has no application to the arrangement.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).