Edited version of your private ruling

Authorisation Number: 1012434377885

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Ruling

Subject: Debt/equity interest, franking redeemable preference shares.

Question 1

Are the redeemable preference shares transferred to G Pty Ltd equity interests under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the dividend paid to G Pty Ltd in relation to its holdings of the redeemable preferences shares capable of being franked under section 202-40 of the ITAA 1997?

Answer

Yes

Question 3

Will section 204-30 of the ITAA 1997 apply to deny the provision of imputation benefits to G Co Pty Ltd upon receipt of franked dividends from F Pty Ltd?

Answer

No

Question 4

Are distributions made to G Pty Ltd in relation to its holding of redeemable preference shares in F Pty Ltd considered to be part of a dividend stripping operation under section 207-155 of the ITAA 1997 or a dividend stripping scheme for the purposes of paragraph 177E(1)(a) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 5

Will section 45 of the ITAA 1936 apply to the payment of fully franked dividends to G Pty Ltd, as a holder of the redeemable preference shares?

Answer

No

Question 6

Will section 45A and section 45B of the ITAA 1936 apply in relation to the transfer of redeemable preferences shares or the subsequent payment of a dividend to G Pty Ltd in respect of that shareholding?

Answer

No

Question h

Will section 177EA of the ITAA 1936 apply in relation to the payment of a fully franked dividend to G Pty Ltd?

Answer

Yes

Question i

Does section 177D of the ITAA 1936 deem the arrangement, or any part of it, to be a scheme to which Part IVA applies? If so will the Commissioner make a determination under section 177F to cancel any tax benefit that may be obtained under the arrangement, or part thereof?

Answer

Yes

This ruling applies for the following period:

Financial year ended 30 June 2013

Financial year ended 30 June 2014.

The scheme commenced on:

1 July 2012.

Relevant facts and circumstances

F Pty Ltd

1. The shareholdings in F Pty Ltd are as follows:

S has pre-CGT A class, C class, and redeemable preference shares (RPS). They also have post issue A, B, and C class shares.

T, U, and V have pre-CGT A and C class shares in the company.

2. There are four classes of shares that F Pty Ltd has on issue. The dividend and voting rights attaching to these shares are as follows:

	A Class Shares	B Class Shares	C Class Shares	Redeemable Preference Shares
Right to attend and vote at meetings	Yes	No	Yes	No
Right to receive notices of meetings	Yes	No	Yes	No
Right to participate in dividends	No	Yes	Yes	Yes
On winding up, right to repayment of capital paid on share	Yes	Yes	Yes	Yes - in priority to all other shares
On winding up, right to participate in the division of surplus assets or profits	No	No	Yes	No

Table 1: Rights attaching to F Pty Ltd shares.

3. There is no obligation on the part of F Pty Ltd to redeem the RPS or pay a dividend on the RPS or any other class of shares.

Paid up capital on shares involved in the transactions

4. The amount of the paid up capital on the RPS is $X per share.

Payment of and ability to pay dividends

5. F Pty Ltd's ability to pay dividends on the RPS and its other shares is determined by reference to whether it has profits. F Pty Ltd can, to the extent it has available profits, choose to pay a dividend on any class of shares it chooses to in preference to any other class. However dividends must be proportionately distributed amongst the shareholders of a particular class in accordance with their shareholdings.

The intended Scheme

6. S is proposing to undertake the scheme described below. This scheme has two primary aims:

1. The first and most important aim of the scheme is to enable S to gift money to T so that they can make purchases.

2. The second is to setup a structure that can be used to facilitate:

(i) The distribution of income from F Pty Ltd amongst S, their children and grandchildren. The grandchildren currently have no interest or ability to receive income from F Pty Ltd other than as a gift from S. A further aspect of this is the ability to facilitate the distribution of dividends from F Pty Ltd to S's children in proportions different to their current rights to receive income from the company.

(ii) The holding of future family investments.

(iii) S's estate succession plans.

7. It is stated that this represents the first step in executing S's succession and estate planning.

8. The rulees are seeking a PBR on a scheme designed to give effect to these objectives. Under the proposed scheme the following steps will take place:

9. S will borrow money from F Pty Ltd prior to 30 June 20YY.

10. S will then gift this money to T.

11. At or around the same time, the following entities will be created

(i) A discretionary trust (New Trust)

(ii) Two companies (G Pty Ltd and G Pty Ltd 2)

12. New Trust

(i) Will own 100% of the shares in G Pty Ltd

(ii) S, their children and grandchildren will be objects of the trust.

13. G Pty Ltd 2

(i) S will be the sole shareholder/director.

(ii) This company will be the trustee of New Trust.

(iii) Will own 100% of the shares in G Pty Ltd.

14. S will enter into a contract with G Pty Ltd under which:

(i) G Pty Ltd will acquire the relevant shares from S:

· All S's RPS in F Pty Ltd (100% of the redeemable preference shares in F Pty Ltd) and

· between more than 30% of S's C class shareholding in F Pty Ltd.

(ii) G Pty Ltd agrees to pay S market value for the relevant shares, with the payment to be made at an indeterminate point in the future, albeit expected to be prior to the end of August 20YY.

15. F Pty Ltd will make a dividend payment out of its profits on its RPS to G Pty Ltd. The amount of this dividend will be equal to the amount of the loan F Pty Ltd made to S and will be paid on or prior to 31 August 20YY.

(i) In respect of the dividend:

i. G Pty Ltd will be entitled to a franking credit on this dividend under section 207-20 of the ITAA 1997, resulting in effectively no tax being payable on the dividend.

ii. A franking credit will arise in G Pty Ltd's franking account under Division 205 of the ITAA 1997.

(ii) The franked amount of the dividend will be equal to the debt G Pty Ltd owes S in respect of its acquisition of his shares in F Pty Ltd.

16. G Pty Ltd will use the dividend received to pay the debt owing to S on or prior to 31 August 20YY.

17. S will then use the payment for his shares from G Pty Ltd to repay the loan he received from F Pty Ltd on or prior to 31 August 20YY. (If the loan is not fully repaid by this date a complying loan agreement within the meaning of section 109N will be executed prior to the earlier of the date F Pty Ltd is required to lodge its income tax return or the day it lodges its income tax return.)

Other relevant facts:

18. G Pty Ltd intends to hold both the relevant shares it acquires indefinitely.

19. The amount of the loan made to S by F Pty Ltd, the number of shares to be sold by S to G Pty Ltd and the amount of the dividend to be paid by F Pty Ltd to G Pty Ltd will be the one amount as determined by reference to the money intended to be gifted to T and the amount of money S requires for other purposes.

20. The manner in which the loans, dividends and other payments to be made under the arrangement has not yet been determined.

21. The loans to S and dividend payable to G Pty Ltd will be paid out of F Pty Ltd's cash reserves. To the extent F Pty Ltd has insufficient cash it will liquidate assets to facilitate the payments.

22. There is no current intention to undertaken any further similar transactions in relation to S's interests in F Pty Ltd.

23. There are no immediate plans to transfer other assets, whether yet to be acquired or already owned, to New Trust.

24. G Pty Ltd is taxed at the corporate tax rate of 30%.

25. F Pty Ltd has not derived any profits from a Prescribed Territory.

26. F Pty Ltd will pay a dividend to S prior to the end of the financial year in which the scheme is commenced. The purpose of the dividend payment by F Pty Ltd to S will be to provide S will funds to enable S to make his minimum loan repayment prior to 30 June 20YY as required under Division 7A.

Assumptions

27. CGT event K6 does not apply to the disposal of S's pre CGT shares in F Pty Ltd. 

28. Division 7A will not apply to the loan made under the scheme by F Pty Ltd to S that would result in a deemed dividend to S.

29. It is not expected that any of the shareholders in F Pty Ltd (other than possibly U) will have a personal marginal rate of income tax of less than 30%.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-6

Income Tax Assessment Act 1997 subsection 104-10(5)

Income Tax Assessment Act 1997 section 104-230

Income Tax Assessment Act 1997 section 202-30

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 Division 203

Income Tax Assessment Act 1997 section 203-45

Income Tax Assessment Act 1997 section 204-30

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

Income Tax Assessment Act 1997 Division 205B

Income Tax Assessment Act 1997 section 205-15

Income Tax Assessment Act 1997 Division 207

Income Tax Assessment Act 1997 section 207-20

Income Tax Assessment Act 1997 Subdivision 207-B

Income Tax Assessment Act 1997 section 207-35

Income Tax Assessment Act 1997 subsection 207-35(3)

Income Tax Assessment Act 1997 section 207-45

Income Tax Assessment Act 1997 section 207-145

Income Tax Assessment Act 1997 paragraph 207-145(1)(d)

Income Tax Assessment Act 1997 paragraph 207-145(1)(e)

Income Tax Assessment Act 1997 paragraph 207-145(1)(f)

Income Tax Assessment Act 1997 paragraph 207-145(1)(g)

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 section 960-115

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 subsection 974-5(4)

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 Subdivision 974-C

Income Tax Assessment Act 1997 section 974-75

Income Tax Assessment Act 1997 paragraph 974-130(1)(a)

Income Tax Assessment Act 1997 section 974-135(6)

Income Tax Assessment Act 1997 section 995-1

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

Income Tax Assessment Act 1936 subsection 45A(1)

Income Tax Assessment Act 1936 subsection 44(1)

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 subsection 45A(3)

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 subsection 45B(2)

Income Tax Assessment Act 1936 subsection 45B(3)

Income Tax Assessment Act 1936 subsection 45B(5)

Income Tax Assessment Act 1936 section 45C

Income Tax Assessment Act 1936 subsection 177A(1)

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 subsection 177D(a)

Income Tax Assessment Act 1936 subsection 177D(b)

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

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

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

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

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

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

Income Tax Assessment Act 1936 paragraph 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 paragraph 177E(1)(d)

Income Tax Assessment Act 1936 paragraph 177E(1)(e)

Income Tax Assessment Act 1936 paragraph 177E(1)(f)

Income Tax Assessment Act 1936 paragraph 177E(1)(g)

Income Tax Assessment Act 1936 paragraph 177E(2)(a)

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 subsection 177EA(3)

Income Tax Assessment Act 1936 subsection 177EA(4)

Income Tax Assessment Act 1936 subsection 177EA(5)

Income Tax Assessment Act 1936 paragraph 177EA(5)(b)

Income Tax Assessment Act 1936 subsection 177EA(14)

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 subsection 177EA(18)

Income Tax Assessment Act 1936 subsection 177EA(19)

Income Tax Assessment Act 1936 section 177F

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

Income Tax Assessment Act 1936 section 318

Reasons for decision

Question 1

Are the redeemable preference shares transferred to G Co Pty Ltd equity interests under Division 974 of the ITAA 1997?

Summary

30. The redeemable preference share will be regarded as an equity interest under Division 974 of the ITAA 1997.

Detailed reasoning

31. The operation of the debt and equity rules in Division 974 of the ITAA 1997 are broadly outlined in the ATO publication, Debt and equity tests: guide to the debt and equity tests. As observed in the guide, the debt and equity tests are important for determining whether a return on an interest in an entity may be frankable and non-deductible (like a dividend) or may be deductible to the entity and not frankable (like interest).

32. The guide provides that the effective obligation of an issuer to return to the investor an amount at least equal to the amount invested is the principle that distinguishes debt interest from equity interests. For the purposes of distinguishing debt from equity interests, it is necessary to have regard to the substance of the particular arrangement. As noted in the guide, the substance of a particular arrangement may not necessarily reflect the arrangement's legal form.

33. The guide notes the following five elements that must be satisfied in order for the debt test to be satisfied. The elements are:

· there must be a scheme

· the scheme must be a financial arrangement

· there must be a financial benefit received

· the issuing entity must have an effectively non-contingent obligation to provide a future financial benefit and

· it must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received.

34. A further element to ensure that the debt test does not operate inappropriately requires that at least one of the financial benefits not be nil.

35. Preference shares are defined as shares that rank ahead of ordinary shares. Further detail in relation to the redeemable preference shares that are the subject of this matter can be obtained from the constitution of F Pty Limited.

36. Each of the elements of the debt - equity test will be considered below in light of the particular facts of this matter. It is noted that all elements of the debt test must be met for the debt test to be satisfied. As will be seen, this is not the case on the facts of this matter.

first element - there must be a scheme

37. The first element of the debt test that must be satisfied for the interest to be classified as debt is the existence of a scheme. A scheme is defined in section 995-1 of the ITAA 1997. A scheme is defined as any arrangement, or any scheme, plan, proposal, and action, course of action or course of conduct whether unilateral or otherwise.

38. In the Commissioner's view, the first element is satisfied on the basis that redeemable preference shares have been issued to the redeemable preference shareholder. This amounts to a scheme as defined at section 995-1 of the ITAA 1997.

second element - the scheme must be a financial arrangement

39. The second element of the debt test that must be satisfied for the interest to be classified as debt is the existence of a financial arrangement. Paragraph 974-130(1)(a) of the ITAA 1997 provides that a scheme is a financing arrangement if it is entered into to raise finance for the entity.

40. As noted in ATO Interpretative Decision ATO ID 2003/665, consideration of financial benefits that are received and provided on the issue of the redeemable preference shares is required for the purposes of the debt test at section 974-20 of the ITAA 1997.

41. On the facts, the company does not appear to have entered into a financial agreement. In particular, the shareholder does not appear to have contributed capital towards the corporation for the purposes of the second element of the debt test. Accordingly, the terms upon which the preference shares were issued does not amount to a financial arrangement.

third element - there must be a financial benefit received

42. The third element of the debt test that must be satisfied for the interest to be classified as debt is the receipt of a financial benefit by the issuing entity under the financing arrangement.

43. As noted above, the ATO is of the view that a financing arrangement does not exist on the facts of this case. On the facts of this matter, the ATO is not satisfied that the redeemable preference shareholder amounts to the receipt of a financial benefit for the purposes of the third element. A financial benefit is defined as anything of economic value. As noted in the Debt and equity tests: guide to the debt and equity tests, the definition of financial benefit on page 3 includes property and services.

44. The constitution provides a mechanism for a financial benefit to be conferred upon the redeemable preference share holder. To the extent that the financial benefit is conferred prior to 1 April in just over one hundred years time it is noted that it is not known when the financial benefit will be provided to the preference share holder or holders.

45. Further, it is not known whether a benefit will be provided to the preference share holder at all. The constitution of F Pty Ltd only goes so far as to provide that a financial benefit 'may' be provided. It does not go so far as to say that a financial benefit 'must' be provided.

46. Even though the constitution provides a mechanism for the return of amounts paid up, the constitution provides that such a benefit is at the discretion of the company. In the Commissioner's view this is not sufficient to satisfy the third element of the debt test. Accordingly, the third element has not been satisfied.

fourth element - the issuing entity (or connected entity) must have an effectively non-contingent obligation to provide a future financial benefit

47. For an interest to be regarded as debt, broadly speaking there must also be an obligation for the issuer to provide a financial benefit to the investor. The financial benefit to be provided could be a single amount, or involve a number of instalments over time. To determine whether an effectively non-contingent obligation exists, regard is to be had to the terms, conditions and pricing of the financial arrangement.

48. As noted above, the ATO is not satisfied that a financial arrangement exists on the facts of this matter. Nevertheless, the fourth element of the debt test will be considered briefly for completeness.

49. The ATO is of the view that an effectively non-contingent obligation to provide a future financial benefit does not exist on the facts of this matter. This is on the basis of:

· the constitution and

· the terms under which the redeemable preference shares were issued.

50. In particular, the constitution of F Pty Ltd provides that 'the company may at any time prior to the first day of April over one hundred years from now redeem all or from time to time redeem any one or more preference shares. Accordingly, the redeemable preference shares may be redeemed on or before 1 April in over one hundred years from now. However, as noted above, there is no obligation on the company to redeem preference shares. In particular, it may be the case the company does not redeem the redeemable preference shares. In this way, on the facts there is not an effectively non-contingent obligation for F Pty Ltd to provide a future financial benefit.

51. In some respects, the facts of this matter may be regarded as similar to those in ATO Interpretative Decision ATO ID 2003/873. In particular, the facts of ATO ID 2003/873 showed the following characteristics:

· the redeemable preference shares in ATO ID 2003/873 were undated

· the redeemable preferences shares in ATO ID 2003/873 were redeemable at the election of the holder and not the issuer

· the holder must first repay all outstanding financial accommodation and discharge all other obligations to the company

· there must be sufficient profits out of which to pay the redemption amount and

· the redemption amount must be permitted by APRA and must not result in the breach of APRA's capital adequacy requirements for the company

52. An important factor in ATO ID 2003/873 was that there was no compulsion for the directors of the issuing company to redeem the redeemable preference shares at a specified date or time. Given there was no certain point in time where the issuing company could be said to be under an obligation to redeem the redeemable preference shares, if the holders do not elect to do so, the redeemable preference shares may never be redeemed and no payment will ever eventuate.

53. ATO ID 2003/873 contains some useful guidance as to when an obligation is non-contingent. In particular, the interpretive decision provides as follows:

Subsection 974-135(3) of the ITAA 1997 provides that an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or its connected entity), other than the ability or willingness of that entity or its connected entity to meet the obligation. The dividend payments associated with the redeemable preference shares are not effectively non-contingent obligations of the issuer as they are contingent on the issuer having sufficient profits (economic performance). Where the form of dividend payment is by scrip (bonus) shares, subsection 974-30(1) of the ITAA 1997 provides that the issue of an equity interest in the entity (or connected entity) does not constitute the provision of a financial benefit.

54. Having regard to the guidance of the interpretive decisions outlined above, the Commissioner is not satisfied that F Pty Ltd as the issuer of the redeemable preference shares has an obligation to provide a future financial benefit to the redeemable preference shareholder.

fifth element - it must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received

55. Following on from the fourth element, the ATO is of the view that it is substantially more likely than not that the value of the financial benefit provided will be at least equal to the financial benefit received. This is on the basis that the redeemable preference shareholder, on the facts, is in a position in which he can exercise voting power collectively with his associates.

56. In this regard, it is noted that the constitution relevantly provides that redeemable preference share holders may receive a dividend from current or previous years' profits as declared by the company. Although a redeemable preference shareholder does not have voting rights, it is noted that voting rights are attached to the following shares:

· ordinary shares - one vote per share

· class A - one vote per share

· class B - no voting rights

· class C - one vote per share

· redeemable preference shares - no voting rights.

57. As discussed above, it is noted that all shareholders are associates of S. On this basis, the redeemable preference share holder would have a legitimate expectation that the relevant paragraph of the constitution would be exercised in his favour on either:

· an isolated occasion or

· from time to time.

58. In this regard, it is noted that, although S does not have a majority voting interest in their own right, with the agreement of any one of the other shareholders who are associates, S would obtain a majority voting interest. In the alternative, the ATO is of the view that there is an effectively non-contingent obligation to provide a financial benefit as a matter of substance, even if an effectively non-contingent obligation was held not to exist as a matter of form. In this regard, it is noted that the redeemable preference shareholder in the position of S would have a legitimate expectation that a financial benefit would be provided. In this regard, it is noted that S and his associates have a majority voting interest in F Pty Ltd.

59. An associate is defined at section 995-1 of the ITAA 1997 as having the meaning given by section 318 of the ITAA 1936. The definition of associate at this section includes relatives. In accordance with section 318, the company is effectively controlled by associates of the redeemable preference holder. This is because the majority voting interests in the company are held by:

· the redeemable preference shareholder as the holder of class C shares and

· associates of the shareholder as the holder of class C shares.

60. In this regard, it is noted that S as the holder of redeemable preference shares has been the only recipient of dividends from F Pty Ltd since more than four years ago. In the financial years since then dividends have been distributed to the redeemable preference shareholder.

61. However, it is noted that the payment of a dividend to a redeemable preference share holder is contingent on profit. Accordingly, the redeemable preference share holder does not have an effectively non-contingent obligation to provide a future financial benefit because the payment of a dividend is contingent on the profit.

62. As stated in ATO Interpretative Decision ATO ID 2003/200, if there are no profits, the issuing company will not have an effectively non-contingent obligation to pay a dividend. This remains the case notwithstanding amendments to the Corporations Act 2001 that came into effect in 2010. These amendments allow companies greater flexibility in the payment of dividends. In particular, it is expected that a close association between performance and the payment of dividends will remain. On the basis of experience and expectation, it is also expected that many companies will encounter periods where they are unable to pay dividends to their members.

63. In any case, on the facts of this matter the payment of dividends to redeemable preference share holders must come from current profits or profits held in reserve in accordance with the constitution. Accordingly, it cannot be said with certainty that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received. In particular, the contingency is not so artificial or contrived as to suggest that the occurrence of the contingency is immaterially remote or theoretical rather than a real possibility (section 974-135(6) of the ITAA 1997 as cited in ATO ID 2003/200).

64. In this way the facts are distinguishable from those set out in ATO Interpretative Decision ATO ID 2007/157. In particular, the facts in ATO ID 2007/157 involved the payment of a fixed rate of interest on preference shares.

65. Similarly, it cannot be known with certainty whether the company will have sufficient funds to redeem shares as provided by the constitution on or before 1 April in over one hundred years time. It is noted that the constitution does not provide for the mandatory exercise of redemption rights. Accordingly, it is possible that the company will not exercise redemption rights in respect to the redeemable preference shares.

66. Accordingly, the ATO cannot be satisfied that it is substantially more likely than not that the value of the financial benefit to be provided to the redeemable preference shareholder will at least be equal to or exceed the financial benefit received. The interest of a redeemable preference shareholder is not treated as a debt interest.

summary of the debt test

summary of debt test	Satisfied - not satisfied
element one	√
element two	×
element three	×
element four	×
element five	×
debt test satisfied?	×

67. As noted in the table above, the debt test has not been satisfied. Although the redeemable preference shares satisfy the first element, they do not satisfy the remaining four elements. As all the elements have not been satisfied, the debt test has not been passed. Accordingly, the redeemable preference shares do not amount to a debt interest.

equity test

68. The equity test is set out in Subdivision 974-C of the ITAA 1997. The equity test identifies those financing arrangements issued by an entity that may have frankable distributions (like dividends) rather than having returns that may be deductible (like interest). The law contains a table that lists schemes that are equity interest. A scheme satisfies the equity test if it gives rise to an interest listed at items 1 to 4 of the table at section 974-75 of the ITAA 1997. Each of these items will be considered below.

69. It is noted that only one item of the equity test need be satisfied in order for the test to be passed. That is, it is not necessary for all items to be satisfied. In this regard, the equity test is distinguishable from the debt test that was considered above.

item 1 - an interest as member or stockholder of a company

70. A member or stockholder is a person who holds an equity interest in respect of that company. As noted in the ATO publication, Debt and equity tests: guide to the debt and equity tests, a shareholder generally holds a number of rights that attach to the share, such as voting rights, the right to receive dividends, and the right to participate in the residual assets of the company when it is wound up.

71. The redeemable preference shares are shares in a legal form. As stated in ATO Interpretative Decision ATO ID 2003/898, a membership interest arises out of the legal form and satisfies the test at item 1. This test is described as the basic test for an equity interest in ATO Interpretative Decision ATO ID 2003/1021. It is further noted that the constitution of F Pty Ltd provides that redeemable preference share holders may receive dividends from time to time as declared by the company in respect of such preference shares. Accordingly, redeemable preference shareholders may receive dividends subject to the will of the company.

72. Further, the constitution provides that redeemable preference share holders have priority upon the winding up of the company or on a reduction of capital in the company. However, redeemable preference share holders do not have voting rights in accordance with the constitution.

73. On the facts, the ATO is satisfied that redeemable preference share holders have an interest as a member or stockholder of a company for the purposes of item 1. This is because holders of redeemable preference shares hold an interest as a member or stockholder in F Pty Ltd.

74. In particular, the constitution provides redeemable preference share holders with rights that are characteristic of membership interests. In this regard, redeemable preference shareholders are, at law, members of F Pty Ltd. Accordingly, in the Commissioner's view, item 1 of the equity test is satisfied. On this basis, the equity test is also satisfied. However, the other items of the equity test will also be considered below for completeness.

item 2 - an interest that carries a right to a return that is effectively contingent on economic performance

75. As noted in the Debt and equity tests: guide to the debt and equity tests, this item recognises an equity interest where the holder of such an interest has a right to a variable or fixed return that is dependent on the economic performance of the company. In accordance with the constitution, the holder of a redeemable preference share is entitled to dividends from current or past profits subject to declaration by the company in respect to such preference shares.

76. The text of the relevant paragraph of the constitution suggests that the payment of a dividend, if any, will be subject to the performance of the company. That is, if the company does not make a profit in a particular financial year, and there are no reserve fund representing the profits of previous years, it follows there will be no dividend to distribute to redeemable preference share holders.

77. However, the rights associated with the redeemable preference shares are entirely discretionary. In this regard, there is no right to a fixed or variable return, either in substance or effect. Accordingly, item 2 does not apply to the redeemable preference shares.

item 3 - an interest that carries a right to a return that is at the discretion of the company

78. Item 3 of the table recognises an equity interest where the holder of such an interest has a right to a return at the discretion of the company. An investor may, for example, have an interest in an entity that provides a set amount unless the directors determine otherwise: the interest is an equity interest.

79. The ATO notes that the right of redeemable preference shareholders to receive a dividend is at the discretion of the company. Notwithstanding that the shareholder may have a reasonable expectation that this discretion will be exercised favourably from time to time, the exercise of such discretion is necessarily subject to the will of the company. Indeed, the discretion may not be exercised in practice. As such, there is no right of return for the purposes of item 3.

item 4 - an interest that converts to, or provides a right to be issued with, an equity interest

80. Item 4 applies to a holder of an interest that carries a right to be issued with an equity interest. Similarly, an investor holds an equity interest in accordance with item 4 if the interest they hold is issued by the company, and it will or may convert into an equity interest.

81. The ATO is of the view that item 4 does not have application to the facts of this matter. This is because the redeemable preference shares are held outright and are not subject to future rights.

application of the equity test

82. As can be seen above, the redeemable preference shares satisfy the requirement of item 1 of the equity test. Having satisfied one of the items, the redeemable preference shares are taken to have satisfied the equity test.

application of the debt and equity tests

83. For the reasons outlined above, the ATO is of the view that the redeemable preference shares do not amount to a debt interest. In order for an interest to amount to a debt interest, all four elements must be satisfied. As this has not occurred, the relevant interest is not considered to be a debt interest.

84. Given that the ATO is of the view that the redeemable preference shares are equity in nature, there is no need to have regard to the tie breaker rule at subsection 974-5(4) of the ITAA 1997. This is because the tie breaker rule only has application where an interest meets both the equity and debt tests. While the ATO is of the view that the redeemable preference shares meet the equity test, the ATO is not of the view that the redeemable preference shares meet the debt test.

Question 2

Is the dividend paid to G Pty Ltd in relation to its holdings of the redeemable preferences shares a frankable dividend under section 202-40 of the ITAA 1997?

Summary

85. The dividends paid by F Pty Ltd on the RPS are frankable under section 202-40 of the ITAA 1997.

Detailed reasoning

86. As noted above, the ATO is of the view that the redeemable preference shares amount to an equity interest. Following from this, the ATO is of the view that dividends paid in respect of the redeemable preferences shares will be capable of being franked under Part 3-6 of the ITAA 1997.

87. On the basis of section 202-30 of the ITAA 1997, a distribution will be unfrankable in the event that the Commissioner considers it appropriate to issue a determination in accordance with section 45C of the ITAA 1936.

Conclusion

88. The operation of section 45C of the ITAA 1936 is considered in detail in response to question (f) below. However, it is noted that the Commissioner does not consider it appropriate to issue a determination in accordance with section 45C of the ITAA 1936. Accordingly, the distribution to G Pty Ltd will be frankable.

89. The facts of this matter are considered to be substantially similar to those in ATO Interpretative Decision ATO ID 2003/873. In this ATO ID the view was taken that redeemable preference shares issued by a company pursuant to its proposed constitution will be a frankable dividend. Consistent with the ATO ID, this ruling provides that:

· the issue of the redeemable preference shares is a scheme (as defined in subsection 995-1 of the ITAA 1997)

· the scheme falls within one of the items in the equity interest table in subsection 974-75(1) of the ITAA 1997 (principally the redeemable preference shares give rise to an interest as a member of the issuing company, item 1 of the equity interest table)

· as the redeemable preference shares satisfy item 1 of the equity interest table, pursuant to subsection 974-75(2) of the ITAA 1997, it does not have to satisfy the financing arrangement definition; and

· the redeemable preference shares are not characterised as, and do not form part of a larger interest that is characterised as, a debt interest (as defined in subsection 974-15(1) of the ITAA 1997) in the issuing company. (Although this ruling arrives at the same conclusion, it is noted that the facts are different and the reasons are distinguishable.)

90. For these reasons, the ATO is of the view that dividends paid in respect of the redeemable preferences shares to G Pty Ltd will be capable of being franked under Part 3-6 of the ITAA 1997.

Question 3

Will section 204-30 of the ITAA 1997 apply to deny the provision of imputation benefits to G Pty Ltd upon receipt of franked dividends from F Pty Ltd?

Summary

91. No, section 204-30 of the ITAA 1997 will not apply to deny the provision of imputation benefits to G Pty Ltd upon receipt of franked dividends from F Pty Ltd.

Detailed reasoning

92. In order for the Commissioner to make a determination under subsection 204-30(1) of the ITAA 1997, an entity must stream distributions over one or more franking periods in such a way that:

(i) An imputation benefit is, or apart from section 204-30, would be received by a member as a result of a distribution(s).

(ii) That member receives a greater benefit from franking credits than another member of the entity; and

(iii) The other member received lesser imputation benefits, or will not receive any imputation benefits.

93. The crux of the issue here is whether or not there is any streaming. Based on the terms of the scheme as disclosed, there would be no streaming, as merely electing to make a distribution on one class of shares rather than another is not sufficient to be classified as streaming. In Mills v. FCT (No.2) 2011 ATC 20-296 at paragraph 189 per Jessop J and paragraph 23 per Edmonds J, it was noted that in the absence of some other undisclosed transaction or fact, merely choosing to pay a dividend on one class of shares or frankable instruments would not amount to streaming. On the facts disclosed there is no basis for finding that streaming has taken place.

Question 4

Are distributions made to G Pty Ltd in relation to its holding of redeemable preference shares in F Pty Ltd considered to be part of a dividend stripping operation under section 207-155 of the ITAA 1997 and a dividend stripping scheme for the purposes of paragraph 177E(1)(a) of the ITAA 1936?

Summary

94. As all the elements are present, sections 207-155 and 177E apply.

Detailed reasoning

95. Section 177E of the ITAA 1936 deems Part IVA to apply to schemes that are by way of, or in the nature of dividend stripping, or a scheme that has substantially the effect of dividend stripping. Subsection 177E(1) states:

Where:

(a) as a result of a scheme that is, in relation to a company:

(i) scheme by way of or in the nature of dividend stripping; or

(ii) a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping;

any property of the company is disposed of;

(b) in the opinion of the Commissioner, the disposal of that property represents, in whole or in part, a distribution (whether to a shareholder or another person) of profits of the company (whether of the accounting period in which the disposal occurred or of any earlier or later accounting period);

(c) if, immediately before the scheme was entered into, the company had paid a dividend out of profits of an amount equal to the amount determined by the Commissioner to be the amount of profits the distribution of which is, in his or her opinion, represented by the disposal of the property referred to in paragraph (a), an amount (in this subsection referred to as the notional amount) would have been included, or might reasonably be expected to have been included, by reason of the payment of that dividend, in the assessable income of a taxpayer of a year of income; and

(d) the scheme has been or is entered into after 27 May 1981, whether in Australia or outside Australia;

the following provisions have effect:

(e) the scheme shall be taken to be a scheme to which this Part applies;

(f) for the purposes of section 177F, the taxpayer shall be taken to have obtained a tax benefit in connection with the scheme that is referable to the notional amount not being included in the assessable income of the taxpayer of the year of income; and
(g) the amount of that tax benefit shall be taken to be the notional amount.

(a) as a result of a scheme that is, in relation to a company, … a scheme by way of … dividend stripping; …any property of the company is disposed of;

Is there a scheme?

96. Scheme is defined in subsection 177A(1) of the ITAA 1936 to mean:

a. any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

b. any scheme, plan proposal, action, course of action or course of conduct.

97. The transactions outlined above, excluding the gift to S's children, clearly constitute a scheme as defined in subsection 177A(1) of the ITAA 1936. The Commissioner takes the view that the gift to S's children is not part of the scheme for the purposes of section 177E, as the use to which the vendor puts the moneys received is not an essential step of the scheme, and is not taken into consideration by the courts in determining whether a scheme is one by way of dividend stripping. See for example Lawrence v. FC of T 2008 ATC 20-052; 70 ATR 376; [2008] FCA 1497; Commissioner of Taxation v. Consolidated Press Holdings (No. 1) (1999) 91 FCR 524; (1999) 42 ATR 575; 99 ATC 4945.

Is the scheme one by way of dividend stripping?

98. In order for a scheme to be one by way of dividend stripping the following are elements that must be established (Lawrence v. FC of T 2008 ATC 20-052; 70 ATR 376; [2008] FCA 1497 at paragraph 62; Commissioner of Taxation v. Consolidated Press Holdings (No. 1) (1999) 91 FCR 524; (1999) 42 ATR 575; 99 ATC 4945 at paragraphs 136-137):

(i) The target company has substantial undistributed profits;

(ii) There is a sale or allotment of shares in that company;

(iii) There is a payment of a dividend to the purchaser of the shares;

(iv) The purchaser of the shares effectively escapes a liability to tax, by whatever means including the inclusion of the franking credit attached to the dividend in its assessable income and being entitled to a franking credit offset under Subdivision 207-B of the ITAA 1997;

(v) The vendor receives a capital sum for their shares the same as or equal to the amount of the dividend paid; and

(vi) The scheme is carefully planned for a dominant purpose of enabling the vendor to avoid paying tax on a distribution of dividends by the company.

99. It is not necessary for a scheme by way of dividend stripping to result in all the profits and assets of a company being distributed to the stripper (Lawrence v. FC of T 2008 ATC 20-052; 70 ATR 376; [2008] FCA 1497).

The target company has substantial undistributed profits.

100. The target company is F Pty Ltd. F Pty Ltd has substantial retained profits. Therefore this element is present.

101. There is a sale or allotment of shares in the target company.

102. Under the proposed scheme, there is a sale of 'C' Class and RPS shares in F Pty Ltd, the target company, from S to G Pty Ltd.

There is a payment of a dividend to the purchaser of the shares.

103. There is a payment of a dividend to G Pty Ltd, the purchaser of S's shares, equal to the price it has paid to purchase price the shares from S.

The purchaser of the shares effectively escapes a liability to tax by whatever means, including the inclusion of the franking credit attached to the dividend in its assessable income and being entitled to a franking credit offset under Subdivision 207-B of the ITAA 1997.

104. G Pty Ltd, a company which pays tax at the 30% corporate income tax rate, will effectively escape a liability to tax because of the inclusion of the franking credit in its assessable income and the franking offset it is entitled to under section 207-20 of the ITAA 1997.

The vendor receives a capital sum for their shares the same as or equal to the amount of the dividend paid.

105. The vendor, S, will receive a capital payment for their shares equal to their market value, which is equal to the dividend paid to the purchaser G Pty Ltd.

The scheme is carefully planned for a dominant purpose of enabling the vendor to avoid paying tax on a distribution of dividends by the company.

106. Whether a scheme is carefully planned for a dominant purpose of enabling the vendor to avoid paying tax on a distribution of dividends, is to be determined objectively from the perspective of a reasonable observer having regard to the characteristics of the scheme and the objective circumstances it was designed and undertaken and not by subjective statements of the participants in said scheme (Lawrence v. FC of T 2008 ATC 20-052; 70 ATR 376; [2008] FCA 1497 at paragraph 87; Commissioner of Taxation v. Consolidated Press Holdings (No. 1) (1999) 91 FCR 524; (1999) 42 ATR 575; 99 ATC 4945 at paragraphs 45 and 184).

107. When the effect, purpose, circumstances and form of the transactions undertaken are considered that it is open to a reasonable observer to conclude the dominant, if not sole purpose of the proposed scheme is to place the profits of F Pty Ltd in S's hands in a tax free form.

108. Merely because a scheme furthers a wider non-tax purpose, that wider non-tax purpose does not mean that the scheme cannot have a dominant purpose of obtaining a tax benefit (Hart v. FCT [2004] HCA 26). Here that means simply because the scheme has the wider effect of enabling S to make a gift to T and pay for other purposes, that fact alone does not require a conclusion that was the dominant purpose of the scheme. As noted above, the Commissioner takes the view it is not part of the scheme. It is still open to conclude, if the facts exist to support it, that the scheme was undertaken for a dominant purpose of obtaining a tax benefit.

109. For several reasons, in addition to those discussed below in relation to section 177EA and 177D of the ITAA 1936 it is reasonable to conclude that the dominant purpose of the scheme was for S to obtain a tax benefit.

110. Under the scheme, S not only maintains an interest in the shares he has disposed of to G Pty Ltd, being an object of New Trust which holds the F Pty Ltd shares through G Pty Ltd, but also in effect retains control over those shares and any distributions made on them as a result of them being the sole shareholder and director of the trustee of New Trust (G Pty Ltd 2) which owns G Pty Ltd.

111. There are two substantive non-tax related objectives of the scheme:

(i) A distribution of F Pty Ltd retained profits to S (so he can make a gift to T (and fund any other purpose)).

(ii) The disposal of shares from S to G Pty Ltd as part of the succession planning and broader scheme to enable the distribution of F Pty Ltd's profits to the children and grandchildren.

112. The scheme is more complicated than necessary to give effect to these objects and this complexity can only be explained by reference to the tax benefit that S was to obtain as a result of the scheme. In fact, several elements of the scheme are unnecessary to achieve either of these objectives. These are:

(i) the loan by F Pty Ltd to S

(ii) the sale of the shares by S to G Pty Ltd

(iii) the deferred consideration for sale of the share sale by G Pty Ltd to S

(iv) and the payment of a dividend to G Pty Ltd and the use of that dividend to pay S for his RPS, are entirely unnecessary.

113. The scheme and objects it aims to achieve could have been achieved in a much simpler way by:

114. F Pty Ltd paying S a dividend on the RPS in the same way it has over the past several years,

(i) S then using this dividend to make the gift to T [and fund any other purpose].

(ii) S gifting the relevant shares to G Pty Ltd.

115. The attainment of the substantive non-tax objectives does not require the 'round robin' of payments that will occur under the proposed scheme. That round robin being comprised of:

(i) the payment of a dividend to G Pty Ltd,

(ii) the use of that dividend by G Pty Ltd to pay S the debt they are owed in respect of the sale of relevant shares to G Pty Ltd, and

(iii) S passing that consideration received from G Pty Ltd back to F Pty Ltd in satisfaction of the loan they earlier obtained to fund the gift to T (and any other purpose).

116. The taxation consequence of the disposal of the relevant shares would remain the same under the simplified counterfactual (Which is reasonable to expect would have occurred for the reasons discussed below). The only difference between the taxation consequences of the scheme as proposed and the simplified counterfactual is the non inclusion of an assessable dividend in S's assessable income under the proposed scheme (subsection 44(1) of the ITAA 1936.). This is, because the relevant shares held by S are pre-CGT shares and therefore any capital gain he makes on their disposal to G Pty Ltd is disregarded - whether he does this by way of a gift or a sale (subsection 104-10(5) of the ITAA 1997). Nor does CGT event K6 apply to tax any part of the disposal process (section 104-230 of the ITAA 1997)

117. The scheme does have the additional effect of reducing the amount of the total dividend F Pty Ltd must pay in order that S receive sufficient cash so that he may fund his gift to T and any other purpose. However, this gain is made solely because of the tax benefit obtained by S. This merely supports the conclusion that the dominant purpose of the scheme was to obtain the tax benefit (British American Tobacco Australia Services Ltd v. FC of T 2010 ATC 20-222; 80 ATR 813).

118. It follows that the only discernable reason not to achieve the objectives of the scheme in the means of the simplified counterfactual, but in the manner proposed, is because of the tax benefit it obtains for S.

119. It follows that the scheme as proposed has a dominant purpose of obtaining a tax benefit for the vendor of the RPS shares, S.

Under that scheme is property of the company disposed of?

120. For the reasons discussed above there is a scheme by way of dividend stripping in relation to F Pty Ltd. Under that scheme, because a dividend is paid to G Pty Ltd, property of F Pty Ltd is disposed of (paragraph 177E(2)(a) of the ITAA 1997). Additionally it is noted that, the dividend will be paid to G Pty Ltd out of F Pty Ltd's cash reserves and, to the extent there are insufficient cash reserves, F Pty Ltd will liquidate assets, and then use the proceeds of that liquidation to pay the dividend to G Pty Ltd.

Conclusion


121. As all the elements are present the scheme is one by way of dividend stripping. It follows that paragraph 177E(1)(a) is satisfied.

177E(1)(b) - in the opinion of the Commissioner, the disposal of the property referred to in paragraph 177E(1)(a) of the ITAA 1936 represents, in whole or in part, a distribution (whether to a shareholder or another person) of profits of the company (whether of the accounting period in which the disposal occurred or of any earlier or later accounting period)


122. The relevant disposal of property under the scheme is the payment of a dividend by F Pty Ltd to G Pty Ltd. It is made directly to a shareholder - G Pty Ltd, that then uses it to pay S for the relevant shares. The capital sum that winds up in the hands of S can be directly traced through G Pty Ltd to the profits of F Pty Ltd. It follows that the disposal of property (through the payment of the dividend to G Pty Ltd), clearly represents a distribution of the profits of F Pty Ltd to a shareholder.

123. For these reasons the Commissioner is satisfied that the disposal of F Pty Ltd cash to G Pty Ltd represents, in whole, a distribution of F Pty Ltd's profits, to a shareholder.

124. Paragraph 177E(1)(b) is therefore satisfied.

177E(1)(c): if, immediately before the scheme was entered into, the company had paid a dividend out of profits of an amount equal to the amount determined by the Commissioner to be the amount of profits the distribution of which is, in his or her opinion, represented by the disposal of the property referred to in paragraph (a), an amount (in this subsection referred to as the notional amount) would have been included, or might reasonably be expected to have been included, by reason of the payment of that dividend, in the assessable income of a taxpayer of a year of income

125. If immediately prior to the execution of the proposed scheme, F Pty Ltd had paid a dividend out of profits equal to the amount of dividend paid to G Pty Ltd, that dividend would have been paid to S, and included in S's assessable income by virtue of subparagraph 44(1)(a)(i) of the ITAA 1936. He being:

(i) a shareholder by virtue of his owning the RPSs

(ii) an Australian resident at that time and

(iii) the dividend being sourced in the profits of the company.

126. For these reasons the Commissioner is satisfied that this requirement is satisfied.

177E(1)(d): The scheme has been or is entered into after 27 May 1981, whether in Australia or outside Australia

127. The final requirement that the scheme be carried out after 27 May 1981 is satisfied, it being proposed to be carried out sometime after March 20YY.

Conclusions - Application of 177E and exercise of his discretion under section 177F

128. Because all the criteria in paragraphs 177E(1)(a) to (d) are satisfied:

(i) The scheme is one to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e). of the ITAA 1936); and

(ii) S is taken to have obtained a tax benefit in connection with the scheme being an amount equal to the amount of the dividend paid to G Pty Ltd not being included in his assessable income for the year of income.(paragraphs 177E(1)(f) and (g) of the ITAA 1936).

129. In the circumstances where the taxpayer entered into the scheme the Commissioner would be entitled to exercise his discretion under paragraph 177F(1)(a) of the ITAA 1936 to make a determination including the tax benefit S has obtained in his assessable income for the year of income.

207-145 - Manipulated Distributions

130. Under section 207-145(1)(d) of the ITAA 1997, if a franked distribution is made to an entity as part of a dividend stripping operation, then for the purposes of the ITAA 1997 and ITAA 1936:

(i) The amount of the franking credit on the distribution is not included in the assessable income of the recipient entity (paragraph 207-145(1)(e) of the ITAA 1997)

(ii) The entity is not entitled to a tax offset under Division 207 of the ITAA 1997 because of the distribution; and

(iii) If the distribution flows indirectly through the entity to another entity - subsection 207-35(3) of the ITAA 1997 and section 207-45 of the ITAA 1997 do not apply to that other entity.

131. The relevant distribution for the purpose of applying paragraph 207-145(1)(d) of the ITAA 1997 is the dividend paid by F Pty Ltd to G Pty Ltd.

132. Under section 207-155 of the ITAA 1997 a distribution is made as part of a dividend stripping operation if the making of the distribution arose out of, or was made in the course of a scheme that was by way of, or in the nature of a dividend stripping operation. For the reasons set out above in relation to the application of section 177E, the dividend paid to G Pty Ltd was made in the course of a scheme that was by way of dividend stripping.

133. It follows that the dividend paid to G Pty Ltd was made as part of a dividend stripping operation.

134. It follows that G Pty Ltd will not:

(a) have the amount of the franking credit included in its assessable income under 207-20 of the ITAA 1997 (paragraph 207-145(1)(e) of the ITAA 1997); and

(b) be entitled to a tax offset under Division 207 of the ITAA 1997.(paragraph 207-145(1)(f) of the ITAA 1997)

135. Additionally any entity the distribution indirectly flows to will not be entitled to a tax offset under Division 207 of the ITAA 1997 (paragraph 207-145(1)(g) of the ITAA 1997).

Question 5

Will section 45 of the ITAA 1936 apply to the payment of fully franked dividends to G Pty Ltd, as a holder of the redeemable preference shares?

Summary

136. No, section 45 of the ITAA 1936 will not apply to the distribution of fully franked dividends to G Pty Ltd.

Detailed reasoning

137. The Commissioner is of the view that section 45 of the ITAA 1936 does not apply to the proposal as described in the application. In particular, section 45 of the ITAA 1936 relates to the provision of bonus shares and the minimally franked dividends. The Commissioner notes that the proposal arrangement does not involve the provision of bonus shares concurrently with the provision of minimally franked dividends. Accordingly, section 45 of the ITAA 1936 will not apply to the distribution of fully franked dividends.

Question 6

Will section 45A and section 45B of the ITAA 1936 apply in relation to the transfer of redeemable preferences shares or the subsequent payment of a dividend to G Pty Ltd in respect of that shareholding?

Summary

138. The Commissioner is of the view that these sections will not apply to the arrangement as proposed.

Detailed reasoning

Application of section 45A of the ITAA 1936

139. Section 45A of the ITAA 1936 is aimed at preventing companies from streaming capital benefits and the payment of dividends to shareholders in such a way that capital benefits are provided to shareholders who would derive a greater benefit from the capital benefit than other shareholders, with it being reasonable to assume that the other shareholders have received, or will receive, dividends.

140. 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).

141. Subsection 45A(3) of the ITAA 1936 states:

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 or share premium;

(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.

Provision of capital benefits

142. On the facts of this matter, the Commissioner cannot be satisfied that a capital benefit will be provided in accordance with the definition at subsection 45A(3) of the ITAA 1936 as outlined above. This is on the basis that:

· only existing shares will be made available to the shareholder. That is, it is not proposed that new shares in F Pty Ltd will not be created. Further, the applicant advises that the redeemable preference shares to be provided to F Pty Ltd will be transferred for market value consideration

· the proposal does not occasion the distribution of share capital or share premium

· the proposal will not have the effect of increasing the value of a share that is held by the redeemable preference shareholder or any other shareholder.

143. It is also understood that the company will continue to pay dividends on its issued capital as considered appropriate by the directors of F Pty Ltd.

144. Accordingly, as a capital benefit will not be provided, it is not necessary to consider the terms of section 45A of the ITAA 1936 further. However, the remainder of the section will be considered below for completeness.

Deriving a greater benefit

145. Section 45A of the ITAA 1936 only applies in circumstances where a company streams the provision of capital benefits and the payment of dividends to shareholders in such a way that:

(a) the capital benefits are or would be received by advantaged shareholders who would 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.

146. The expression 'streams the provision of capital benefits' is not defined in the legislation. However, it is generally understood to refer to a strategy of selectively directing capital payments to those shareholders who can most benefit from the receipt of capital as opposed to income in the form of dividends.

147. Capital streaming broadly describes a class of arrangements where capital is allocated to shareholders who have a preference for capital. In addition to this, capital streaming may involve the retention of imputation credits for distribution to shareholders who can most benefit from the receipt of franked dividends.

148. The Commissioner is not of the view that the proposed arrangement amounts to the allocation of capital to shareholders who have a preference for capital. Similarly, the Commissioner does not consider that other shareholders will receive dividends in accordance with the proposal.

149. By way of conclusion, it cannot be said that a shareholder would derive a greater benefit in accordance with the arrangement as proposed than other shareholders of the company within the terms of section 45A of the ITAA 1936. In the Commissioner's view, section 45A of the ITAA 1936 will not apply to the proposed arrangement.

Application of section 45B of the ITAA 1936

150. Section 45B of the ITAA 1936 is aimed at preventing companies from providing 'capital benefits' to shareholders in substitution for the payment of dividends, and having regard to the relevant circumstances of the scheme, it would be concluded that a person who entered into the scheme did so for a purpose (whether or not the dominant purpose, but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit.

151. In this way, the section is designed to ensure that certain payments that are paid in substitution for dividends are treated as assessable dividends for tax purposes. The operative provision appears at subsection 45B(2) of the ITAA 1936.

152. Where these conditions are met, the Commissioner is authorised to make a determination under subsection 45B(3) of the ITAA 1936. The effect of this determination is that the capital benefit that is provided to the shareholder is taken to be an unfranked dividend (section 45C of the ITAA 1936).

153. Each of the elements of section 45B of the ITAA 1936 is considered in more detail below.

Scheme

154. For the purposes of section 45B of the ITAA 1936, the term 'scheme' has the same meaning that it has for Part IVA of the ITAA 1936 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'.

155. In the Commissioner's view, the disposal of the redeemable preference shares falls within the definition of 'scheme' for the purposes of section 45B of the ITAA 1936.

Provided with a capital benefit

156. The meaning of 'provided with a capital benefit' is defined in subsection 45B(5) of the ITAA 1936 in identical terms to subsection 45A(3) of the ITAA 1936 as has been outlined above.

157. On the facts of this matter, the Commissioner cannot be satisfied that a capital benefit will be provided in accordance with the definition at subsection 45B(5) of the ITAA 1936 as outlined above. This is on the basis that:

· only existing shares will be made available to the shareholder. That is, it is not proposed that new shares in F Pty Ltd will not be created. Further, the applicant advises that the redeemable preference shares to be provided to G Pty Ltd will be transferred for market value consideration

· the proposal does not occasion the distribution of share capital or share premium

· the proposal will not have the effect of increasing the value of a share that is held by the redeemable preference shareholder or any other shareholder.

158. It is also understood that the company will continue to pay dividends on its issued capital as considered appropriate by the directors of F Pty Ltd.

159. Accordingly, as a capital benefit will not be provided, it is not necessary to consider the terms of section 45B of the ITAA 1936 further. The Commissioner is of the view that the section will not apply to the arrangement as proposed.

Question 7

Will section 177EA of the ITAA 1936 apply in relation to the payment of a fully franked dividend to G Pty Ltd?

Summary

160. As section 207-145 of the ITAA 1997 applies to deny G Pty Ltd, section 177EA of the ITAA 1936 would not apply. If section 177E of the ITAA 1936 does not apply then it is considered that 177EA will apply.

Detailed reasoning

161. Section 177EA is part of Part IVA of the ITAA 1936. Where it applies, it gives the Commissioner the discretion to make a determination creating a franking debit in the account of a company or denying a franking credit to an entity that would otherwise receive it (subsections 177EA(3) and (5) of the ITAA 1936).

162. Section 177EA of the ITAA 1936 applies where:

(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

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

(e) 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

(f) 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.

163. A corporate tax entity includes a company (section 960-115 and subsection 995-1(1) of the ITAA 1997).

(a) - is there a scheme for the disposition of membership interests in F Pty Ltd?

164. The first element that must be satisfied in order for section 177EA of the ITAA 1936 to apply is there must be a scheme for the disposition of membership interests in a corporate tax entity. Under subsection 177EA(14), a scheme for the disposition of membership interests relevantly includes entering into any contract, arrangement, transaction or dealing that changes or otherwise affects the legal or equitable ownership of the membership interest.

165. Under the scheme already described there is a contract under which S is disposing of their shares in F Pty Ltd, a corporate tax entity, to G Pty Ltd.

166. Therefore paragraph (a) is satisfied.

(b) & (c) - is a franked distribution paid, payable or expected to be paid to a person in respect of those membership interests?

167. Yes, under the scheme as set out in paragraph 11 above, a franked distribution (a fully franked dividend) will be paid to G Pty Ltd in respect of the relevant shares.

(d) - except for section 177EA of the ITAA 1936, would the relevant taxpayer (G Pty Ltd) receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution

168. An entity, who is a member of a franking entity, will receive imputation benefits as the result of a distribution from that entity if one or more of the following occurs:

a. they would be entitled to a tax offset under Division 207 of the ITAA 1997

b. a franking credit would arise in the entity's franking account

c. an amount would be included in their assessable income under section 207-35 of the ITAA 1997

169. Here, on the assumption that section 207-145 of the ITAA 1997 would not apply to deny imputation benefits to G Pty Ltd, it can reasonably be expected to receive all three of these imputation benefits as a result of the distribution (sections 205-15 and 207-20 of the ITAA 1997).

(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 it 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.

170. When analysing this factor, it is important to consider the recent decision of the High Court in Mills v. FCT 2012 ATC 20-360 (Mills' Case), where it considered what is meant by 'incidental purpose'. In Mills' Case the Commissioner argued the issue of membership interests was done for a more than incidental purpose of allowing the purchasers of those interests to obtain an imputation benefit. In that case, all the Justices of the High Court concurred with the judgement of Gageler J. Gageler J noted, at paragraph 63, that 'A purpose is a consequence intended by a person resulting from some action'. At paragraph 64 of his judgement, Gageler J, held that a purpose of a scheme will be 'incidental purpose' of a scheme if that purpose does no more than further some other purpose, or follows from some other purpose. He further noted at paragraph 66, that a purpose can be incidental even if it is central to the design of a scheme, where it is directed to achieving the primary outcome of the scheme. He ultimately concluded that in the circumstances of the case at hand, because the primary purpose of the scheme was to raise tier 1 capital for the issuer of the membership interests, the issuer's purpose of enabling the purchasers of those membership interests to obtain an imputation benefit was merely incidental to the purpose of raising capital. It being a natural consequence of issuing frankable membership interests.

171. It is the case that if the scheme is a mere acquisition of membership interests, it does not have a more than incidental purpose of enabling a taxpayer to obtain an imputation benefit (subsection 177EA(4) of the ITAA 1936). Here there is more to the scheme than the mere acquisition of shares, thus this exception does not apply.

172. Whether there is a more than incidental purpose of enabling a taxpayer to obtain an imputation benefit is to be determined by reference to the relevant circumstances of the scheme. These are non-exhaustively defined in subsection 177EA(17) of the ITAA 1936.

177EA(17)(a) - the extent and duration of the risks of loss, and the opportunities for profit or gain from holding the membership interests

173. Under the terms of the scheme, it is intended that the acquirer of the membership interests in F Pty Ltd, G Pty Ltd will hold those shares it acquires indefinitely. This tends to point against the existence of the relevant purpose.

177EA(17)(b) - Whether the relevant taxpayer obtains a greater benefit from franking credits than other members of the entity

174. All the members in F Pty Ltd, other than G Pty Ltd are:

(i) Australian resident individuals.

(ii) All bar one are expected to have marginal tax rates of greater than 30%.

175. Subsection 177EA(19) lists five circumstances in which an entity is deemed to have a greater benefit from franking credits than other members of the entity. Those circumstances are non-exhaustive (subsection 177EA(18) of the ITAA 1936).

176. None of those circumstances suggest that G Pty Ltd would obtain a greater franking benefit from the distribution than any other member of the company.

177. In the absence of some other relevant connected factor, this factor is neutral and does not support a conclusion as to the purpose.

177EA(17)(c) & (d) - whether apart from the scheme (F Pty Ltd) would have retained the franking credits or used them to frank a distribution to another and would a franked distribution would have flowed indirectly to another entity referred to in 177EA(17)(b)

178. For the reason discussed below, it is reasonable to expect that apart from the scheme F Pty Ltd would have paid a fully franked distribution (dividend) to S. When considered in conjunction with the fact that the former holder of the shares, S, ultimately receives the amount of the franked distribution in a tax free form (sale proceeds of pre-CGT shares), and G Pty Ltd has effectively no income tax liability as a result of receiving the imputation benefit this suggests there was a purpose of enabling G Pty Ltd to obtain an imputation benefit.

177EA(17)(e) - if the scheme involves the issue of a non-share equity interest…

179. This factor is irrelevant as the scheme does not involve the issue of non-share equity interests.

177EA(17)(f) - whether consideration under the scheme is calculated by reference to imputation benefits

180. No, the consideration payable for the sale of the RPS from S to G Pty Ltd is to be determined by reference to the market value of shares. This factor considered alone does not tend to support a conclusion as to whether the requisite purpose exists.

177EA(17)(g) - whether a deduction is allowable or a capital loss is incurred in connection with a distribution made under the scheme

181. The taxpayer has stated there are no deductions allowable or capital losses incurred in connection with the scheme. The facts as disclosed support this conclusion. This factor does not inform whether or not the requisite purpose exists.

177EA(17)(ga) - whether the distribution is sourced directly or indirectly from unrealised or untaxed profits

182. The dividend will be sourced from realised, taxed profits. F Pty Ltd has a significant franking account balance, which far exceeds the franking credits necessary to frank the distribution. This is strongly suggestive that the distribution is sourced from neither unrealised nor untaxed profits. Considered alone this does not support a conclusion as to the purpose of the scheme.

177EA(17)(h) - whether the distribution is in the nature of interest

183. The distribution is a dividend and is not calculated or payable by reference to a principal amount on terms similar to interest. Rather the amount of the franked distribution is calculated by reference to S's capital needs and takes into account the franking credit that is to be attached to it. Therefore it is proper to conclude that the distribution is not in the nature of interest (FC of T v. Century Yuasa Batteries Pty Ltd 38 ATR 442; 98 ATC 4380 at 4383; FC of T v. The Myer Emporium Ltd 18 ATR 693; 87 ATC 4363 at 4371). In the absence of some other relevant factor, this points neither towards nor against the conclusion that the relevant purpose exists.

177EA(17)(i) - the period for which the relevant taxpayer (G Pty Ltd) has held membership interests or an interest in membership interests in the corporate tax entity (F Pty Ltd)

184. G Pty Ltd will have held the interests in F Pty Ltd for no more than five months from the time they are acquired until the time it receives a dividend on them. It is then intended G Pty Ltd will hold those interests indefinitely. This neither points to or against the existence of the relevant purpose.

177EA(17)(j) - 177D(b)(i)-(ii) - manner in which the scheme was carried out/form and substance of the scheme/time at which/period over which the scheme was carried out


185. For the reasons discussed below, these factors disclose a distinct artifice to the scheme, with the form of the scheme not matching the underlying substance of the scheme. They strongly suggest that a dominant purpose for carrying out the scheme was to obtain the various tax and imputation benefits it will generate for S and G Pty Ltd.

177EA(17)(j) - 177D(b)(iv) and (v) - the result in relation to this act that, but for this part, would be achieved by the scheme and any change in the financial position of the relevant taxpayer (G Pty Ltd) that has resulted, will result, or may reasonably be expected to result from the scheme

186. Ignoring the potential application of Part IVA, the taxation consequences under the ITAA 1936 and ITAA 1997 as a result of the scheme are:

a. S receiving $1.5 to $6 million as a tax free loan from F Pty Ltd (Due to the non-application of Division 7A to tax it, and a loan being an otherwise non-taxable capital receipt ).

b. S receiving $1.5 to $6 million in tax free proceeds from disposing of his pre-CGT shares in F Pty Ltd (subsection 104-10(5)of the ITAA 1997).

c. G Pty Ltd, not having liability to tax on the dividend it receives from F Pty Ltd. This is a result of the inclusion of the franking credit in its assessable income and the franking offset it is entitled to under section 207-20 of the ITAA 1997 being equal to the amount of its tax liability on the dividend and grossed up amount that are included in its assessable income.

187. In other words, the scheme results in no tax being paid on any of the transactions involved by any entity, including the relevant taxpayer G Pty Ltd.

188. Under the scheme, the net change to G Pty Ltd's financial position is that it has obtained:

i. a franking credit (Division 205B of the ITAA 1997)

ii. an interest in the relevant shares.

177EA(17)(j) - 177D(b)(vi) and (viii) - 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 results from, will result or may reasonably be expected to result from the scheme and the nature of that connection

189. Here there are several entities with connections to G Pty Ltd whose financial position will be affected as a result of the scheme:

F Pty Ltd:

· distributed part of its accumulated profits equal to the amount gifted to T by S plus whatever is necessary to fund 'desirable purposes'

· a franking debit in its franking account equal to the amount of the franking credit on the distribution to G Pty Ltd made to its franking account.

T:

· is a shareholder in F Pty Ltd

· will receive, what is in substance, part of the profits of that company in a tax free form

· T is a person who has an interest in G Pty Ltd as a consequence of her being an object of the discretionary trust that owns G Pty Ltd.

S:

· will cease to hold all his RPS and some of his 'C' class shareholding in F Pty Ltd.

· S is effectively the controller of G Pty Ltd through their position as sole shareholder and director of the trustee of New Trust.

· S also has an interest in G Pty Ltd as a consequence of his being an object of the discretionary trust that owns G Pty Ltd.

177EA(17)(j) - 177D(b)(vii) - any other consequence for the relevant taxpayer or any other person referred to in subparagraph (vi) of the scheme having been entered into or carried out

190. Other than the consequences identified above, there are no other identifiable consequences of the arrangement.

Other relevant circumstances of the scheme


191. Another relevant circumstance of the scheme is that the amount of the fully franked dividend that F Pty Ltd pays to G Pty Ltd takes into account the amount of the imputation benefit that G Pty Ltd will receive and its effect on G Pty Ltd's tax liability. This is carefully worked out to ensure that G Pty Ltd has a specific amount of cash after tax. That after tax amount being precisely the amount it needs to discharge it's liability to S in respect of the acquisition of the relevant shares from them. This suggests that enabling F Pty Ltd to obtain imputation benefits was a substantive end of the scheme in itself and not something that merely followed as a result of some other step in the scheme.

Conclusion: Did a person who carried out the scheme or part of the scheme do so for a more than incidental purpose of enabling G Pty Ltd to obtain an imputation benefit?

192. At paragraph 63 in Mills' Case, Gageler noted that a purpose is '…a consequence intended by a person to result from some action..' Overall it is clear that the scheme had a purpose of enabling G Pty Ltd to obtain an imputation benefit, that being a clearly intended consequence of the scheme. The real question is whether this was more than merely an incidental purpose of those who carried out all or part of the scheme? Or to use the language from Mills' Case, from an objective standpoint does the purpose of enabling G Pty Ltd to obtain an imputation benefit do no more than further some other purpose, or merely follows from some other purpose of the scheme?

193. It is useful to start with an analysis of the underlying facts implicitly, but not expressly addressed in the judgement in the Mills' case. In Mills' Case, the primary driving purpose of the scheme was found to be the issue of tier 1 capital. Implicit in that finding are two important subsidiary points. The issue of tier 1 capital necessitated the issue of interests on which frankable distributions could be paid. The Benchmark franking rule would have necessitated that the distributions on those instruments be franked to the same level as other distributions that the Commonwealth Bank made (Division 203 of the ITAA 1997). Thus the ability to frank, and the level of franking of distributions on the issued equity interests, had to be determined in light of the Commonwealth Bank's broader franking policy and its capacity to frank distributions on all of its frankable distributions in any giving franking period (income year)( section 203-45 of the ITAA 1997). It follows that the purpose of enabling the purchasers of those interests to obtain an imputation benefit was merely a natural consequence of the Commonwealth Bank's purpose of raising tier 1 capital. The current case can be distinguished from Mills' Case. Here, the franking of the dividend payable to G Pty Ltd does not follow as a natural consequence of some wider dominant purpose of the scheme. In Mills' Case the dominant purpose was raising tier 1 capital for prudential purposes. Here, unlike Mills' Case the scheme was carefully constructed and will be carried out in a way designed to ensure specific taxation outcomes as a result of every step in the scheme, including ensuring that G Pty Ltd would receive a frankable distribution and thus obtain imputation benefits. While these steps were carried out to further a wider purpose that does not necessarily of itself mean the requisite purpose cannot exist (FCT v. Hart 2004 HCA 26; FCT v. Spotless Services Ltd 96 ATC 5201; (1996) 34 ATR 183). Particularly, where as is the case here, the carrying out of many of the steps in the scheme are entirely unnecessary to achieve those wider purposes and, for the reasons discussed below in the Part IVA analysis, were undertaken for a dominant, if not sole purpose of enabling the taxation and imputation benefits to be obtained by G Pty Ltd and S. It follows that in carrying out the scheme, it is apparent that F Pty Ltd's had a substantive, if not dominant, purpose in carrying out part of the scheme of enabling G Pty Ltd to obtain an imputation benefit.

194. Thus it cannot be said F Pty Ltd's purpose of enabling the imputation benefit to be obtained by G Pty Ltd merely furthers or necessarily follows as a natural incident of some other purpose of the scheme.

195. This element is present because the purpose of enabling G Pty Ltd to obtain an imputation benefit was a substantive, if not dominant purpose of F Pty Ltd's in carrying out the scheme, rather than a merely incidental purpose.

Conclusion

Because all the elements of section 177EA of the ITAA 1936 are satisfied, it applies to the scheme. It follows that the Commissioner is entitled to make either of the following determinations under subsection 177EA(5) of the ITAA 1936:

a. that a franking debit will arise in F Pty Ltd's franking account or

b. that G Pty Ltd will receive no imputation benefits as a result of receiving the distribution.

196. In these circumstances, where section 177E did not apply and the taxpayer entered into the arrangement, the Commissioner would exercise his discretion to make a determination that G Pty Ltd would not receive imputation benefits under paragraph 177EA(5)(b) of the ITAA 1936.

Question 8

Does section 177D of the ITAA 1936 deem the arrangement, or any part of it, to be a scheme to which Part IVA applies? If so will the Commissioner make a determination under section 177F to cancel any tax benefit that may be obtained under the arrangement, or part thereof?

Summary

197. As section 207-145 of the ITAA 1997 applies to deny G Pty Ltd, section 177D of the ITAA 1936 would not apply. If section 177E of the ITAA 1936 does not apply then it is considered that 177D would apply. In those circumstances, where the scheme was carried out and the taxpayer obtained a tax benefit, it is considered that the commissioner would be entitled to make a determination under section 177F.

Detailed reasoning

198. Subsection 177D(a) of the ITAA 1936 applies to deem a scheme to be one to which Part IVA applies if:

(a) A taxpayer (the relevant taxpayer) obtains a tax benefit in connection with a scheme (paragraph 177D(a) of the ITAA 1936); and

(b) Having regard to the eight factors listed in paragraph 177D(b), it would be concluded that any person who entered into carried out the whole or any part of the scheme did so for the sole or dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme, whether or not the person who entered into or carried out all or part of the scheme is the relevant taxpayer.

199. If section 177D of the ITAA 1936 applies to deem the scheme to be one to which Part IVA applies, the Commissioner is given a discretion under section 177F to make a determination to cancel all or part of the tax benefit that is obtained in connection with the scheme.

Is there a scheme?

200. Scheme is defined in subsection 177A(1) of the ITAA 1936 to mean:

(i) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(ii) any scheme, plan proposal, action, course of action or course of conduct.

201. There is a scheme within the meaning of subsection 177A(1) of the ITAA 1936 comprising the following steps and transactions:

(i) the making a loan from F Pty Ltd to S

(ii) the creation of G Pty Ltd, G Pty Ltd 2 and New Trust

(iii) the sale of pre-CGT RPS and 'C' class shares from S to G Pty Ltd for market value, with the consideration to be paid at a later date

(iv) the payment of a fully franked dividend payment to G Pty Ltd equal to the amount of the consideration G Pty Ltd must pay to S for the RPS and 'C' class shares it obtains from them

(v) G Pty Ltd using the dividend received from F Pty Ltd to pay the debt it owes S

(vi) S's use of the consideration for the sale of his 'C' class and RPS to repay the loan he has received from F Pty Ltd.

Does a taxpayer obtain a tax benefit in connection with the scheme?

202. Whether a tax benefit is obtained in connection with the scheme is determined by reference to the counterfactual (FCT v. Peabody 28 ATR 344; 94 ATC 4663 at 4671; FCT v. Spotless Services Ltd (1996) 34 ATR 183; 96 ATC 5201; FCT v. Hart 2004 HCA 26). That is what would reasonably be expected to have occurred had the scheme not been entered into (FCT v. Peabody 28 ATR 344; 94 ATC 4663 at 4671). Here there are a number of circumstances surrounding the scheme that are relevant to determining what would reasonably be expected to have happened had the scheme not been entered into or carried out. These include:

(i) the critical objectives of the scheme (FCT v. Axa Asia Pacific Holdings Ltd [2010] FCAFC 134; FCT v. Hart 2004 HCA 26)

(ii) what the taxpayer says they would have done had they not carried out the scheme (FCT v. Axa Asia Pacific Holdings Ltd [2010] FCAFC 134)

(iii) commercially realistic and simpler ways in which the critical outcomes of the scheme could have been achieved (FCT v. Hart 2004 HCA 26)

(iv) and the past patterns of behaviour of the entities involved in the scheme (FCT v. Hart 2004 HCA 26).

These factors manifest themselves in the following way described below.

203. The scheme has two end purposes:

(i) The first is that one of the purposes of the scheme is to get money into S's hands so that he can make a gift to T, and fund 'other desirable purposes'.

(ii) The second is that S is seeking to set up a structure that facilitates:

· their estate/succession planning

· the holding of future family investments

· allows income from part of his interests in F Pty Ltd to be distributed to themself, their children and grandchildren, without them necessarily being involved.

204. It has been indicated that in the absence of the scheme, the existing arrangement under which F Pty Ltd would pay a dividend to S, who would then on gift that amount to their children or grandchildren as currently occurs would continue. This outcome is also consistent with the past pattern of how profits of F Pty Ltd have been distributed to its shareholders and then on to S's children and grandchildren (FCT v. Axa Asia Pacific Holdings Ltd [2010] FCAFC 134).

205. The end position of S and all the entities involved, as a consequence of the scheme:

(i) S no longer holds an interest in the relevant shares

(ii) G Pty Ltd owns the relevant shares

(iii) S receives a net amount equal to the profit distributed by F Pty Ltd under the scheme, which he then uses to make a gift to T [and applies as necessary to other purposes as he in his sole discretion sees fit].

206. By having G Pty Ltd as a wholly owned entity of New Trust, distributions of F Pty Ltd profits can be retained within the trust structure without needing to be distributed to the objects of the trust and those objects becoming taxable on those profits in the financial year of distribution.

207. Whether S gifts or sells the relevant shares in F Pty Ltd to G Pty Ltd, the taxation consequences are identical.

208. F Pty Ltd has sufficient profits and franking credits necessary to pay S a dividend that after taking into account S's income liability will give a large net after tax cash figure.

209. Given the above, and the fact that it represents the simplest, and a realistic way in which all the objectives of the scheme can be achieved, it is reasonable to expect that in the absence of the scheme, the following would have occurred:

(i) G Pty Ltd, G Pty Ltd 2 and New Trust are created.

(ii) F Pty Ltd pays S a dividend of an amount, which, after his tax liability on it is taken into account, will give him sufficient cash to make the gift to T and fund other purposes (Assuming the only funds required by S is the money needed to make the gift to T, this would result in his needing to be paid a net dividend so that after having paid the tax liability on it, he would have a net cash figure. [This calculation assumes S's marginal tax rate is 45% and excludes Medicare Levy.]).

(iii) S gifts money to T and funds 'other purposes' using the dividend.

(iv) S gifts their RPS and the relevant number of 'C' class shares to G Pty Ltd.

210. This counterfactual achieves all the critical objectives of the scheme and puts, S, G Pty Ltd, and F Pty Ltd in the same financial position as they would be under the scheme, ignoring any tax consequences.

211. It is therefore reasonable to expect, that had the proposed scheme not been entered, the other scheme would have been executed.

212. When compared to the counterfactual, it can be seen the scheme allows S to obtain a tax benefit. That tax benefit being the amount of the dividend that he would otherwise reasonably be expected to receive, not being included in his assessable income under subparagraph 44(1)(a)(i) of the ITAA 1936.

Was the scheme undertaken for the sole or dominant purpose of enabling the relevant taxpayer to obtain the tax benefit in connection with the scheme?

213. Whether the scheme was entered into or carried out by any person, for the sole or dominant purpose of enabling the relevant taxpayer, here S, to obtain a tax benefit is determined by reference to the factors listed in paragraph 177D(b) of the ITAA 1936. Whether there is a sole or dominant purpose exists to be judged objectively from the standpoint of a reasonable person, by reference to the objective facts (FCT v. Spotless 28 ATR 344; 96 ATC 5201 at 5210) (FCT v. Spotless 28 ATR 344; 96 ATC 5201 at 5210).

214. Where a scheme has two or more purposes, a reference to the purpose of the scheme includes a reference to the dominant purpose for undertaking all or part of the scheme (subsection 177EA(5) of the ITAA 1936). Additionally the fact that the scheme may be consistent with achieving a wider commercial or private purpose, here making the $1.5 million gift to T and funding other purposes, does not of itself mean that Part IVA of the ITAA 1936 cannot apply to the scheme (FCT v. Spotless 28 ATR 344; 96 ATC 5201 at 5206; FCT v. Hart 2004 HCA 26 per Gleeson CJ and McHugh J).

177D(b)(i)-(ii) - manner in which the scheme was carried out/the form and substance of the scheme/the time at which the scheme was entered into or carried out and the length of the period over which the scheme was carried out

215. The scheme was not carried out in a way that reflects past patterns of how S would distribute profits from his interests in F Pty Ltd to their children and grandchildren as is occurring here. This was historically done, by them receiving a dividend from F Pty Ltd and then using that dividend to make gifts to their children and grandchildren as they saw fit.

216. The scheme is also, by time and by reference to its substantive results and surrounding circumstances, most closely correlated to S's desire to personally make a gift to T and fund other purposes rather than any other stated purpose. This gift and other purposes are in substance funded out of from the profits of F Pty Ltd, not the disposal of his shares to G Pty Ltd as part of the trust structure. While it also technically furthers its second purpose, which is to setup structures to facilitate:

(i) S's estate and succession planning

(ii) distribution of F Pty Ltd profits to their children and grandchildren without their involvement

(iii) facilitate the future holding of family investments

viewed objectively, these are not the immediate substantive objects achieved by what is proposed to be done. There is a lack of objective and temporal connection to these stated aims. Apart from the transfer of the relevant shares to G Pty Ltd, it is not being immediately used for any of these purposes, nor are there any further contemplated or identified plans for using it to further these purposes. Specifically, there are no identified concrete plans for other family investments that might be held within the structure, or identified further plans for how the structure will be used in facilitating S's estate and succession planning.

217. There are two key things that can be noted in relation to the form and substance of the scheme and the manner in which it is being carried out.

218. The first, as noted above, is the structure being setup under the scheme specifically to enable a distribution of profits from F Pty Ltd to S's children, including T, is not being used to make the distribution of F Pty Ltd's profits to T under the scheme. Rather that distribution is made in a manner inconsistent with the stated intent of the scheme, that is, it being routed through S. The scheme involves several entirely unnecessary steps to achieve this immediate purpose, specifically:

(i) F Pty Ltd making a loan to S

(ii) The sale of the relevant shares for market value and the deferred consideration until such time as F Pty Ltd pays a dividend on the RPS.

(iii) The round robin of funds involving:

· the payment of a dividend to G Pty Ltd

· the use of that dividend to settle the debt G Pty Ltd owes S

· finally S's use of that payment to repay the money F Pty Ltd loaned to him.

219. In substance, the only money that actually flows under the scheme is the initial loan of monies to S which are then gifted to T [and used for 'other purposes'].

220. Additionally these steps are also superfluous to achieving the second less connected purpose of setting up the structure to facilitate the ends identified.

221. In substance there are only two things that happen under the proposed scheme:

(i) there is a distribution of F Pty Ltd's profits to S, and S then on gifting that distribution to T and funding desirable purposes

(ii) the gifting of shares from S to G Pty Ltd under the umbrella of the New Trust discretionary trust.

222. That substance does not match the form of the scheme and illustrates the significant artifice and contrivance involved in how the objectives of the scheme are being achieved. The scheme in form results in S receiving a non-assessable capital payment for disposing of the relevant shares to G Pty Ltd, when in substance what he is receiving is a distribution of the profits of F Pty Ltd (paragraph 104-10(5)(a) of the ITAA 1997).

223. The only explicable reason for undertaking these unnecessary and contrived steps is to ensure that S will receive the tax benefit and prevent the distribution of profits from F Pty Ltd being included in his assessable income under subparagraph 44(1)(a)(i) of the ITAA 1936.

177D(b)(iv) and (v) - the result in relation to this act that, but for this part, would be achieved by the scheme and 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

224. Ignoring the potential application of Part IVA of the ITAA 1936, the taxation consequences under the ITAA 1936 and ITAA 1997 as a result of the scheme are:

a. S receiving money as a tax free loan from F Pty Ltd (due to the non-application of Division 7A to tax it, and a loan being an otherwise non-taxable capital receipt ).

b. S receiving money in tax free proceeds from disposing of their pre-CGT shares in F Pty Ltd (subsection 104-10(5) of the ITAA 1997.

c. G Pty Ltd, effectively not having liability to tax on the dividend it receives from F Pty Ltd. This is a result of the inclusion of the franking credit in its assessable income and the franking offset it is entitled to under section 207-20 of the ITAA 1997 being equal to the amount of its tax liability on the dividend and grossed up amount that are included in its assessable income.

225. In other words, the scheme results in no tax being paid on any of the transactions involved.

226. Under the scheme, the net change in S's financial position is that he has disposed of the relevant shares. However there are several more specific changes to his financial position that make up that net change that can be identified. S:

(i) Receives $1.5 to $6 million from F Pty Ltd.

(ii) Disposes of the relevant shares to G Pty Ltd

i. Although it is noted they retains an interest in the value of these shares being an object of the G Pty Ltd discretionary trust which hold G Pty Ltd and effectively being the controller of G Pty Ltd, them being the sole shareholder and director of that New Trust.

(iii) Pays money to T plus applies any additional amount receives to fund other purposes.

(iv) Receives money from G Pty Ltd.

(v) Pays F Pty Ltd money to repay the loan.

227. It follows that the net change to S's financial position, this being the relevant change for the purposes of Part IVA of the ITAA 1936, as a result of the scheme is limited to a reduction in his net worth equal to the amount of the gift they make to T and the amount of funds they have applied to other purposes (British American Tobacco Australia Services Ltd v. FC of T 2010 ATC 20-222; 80 ATR 813). It is however noted this does not take into account the fact they will retain an interest in the shares disposed of through his position as an object of New Trust and the fact they retain control over those shares being the sole shareholder and director of the trustee of New Trust.

177D(b)(vi) and (viii) - 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 results from, will result or may reasonably be expected to result from the scheme and the nature of that connection

228. There are several entities with connections to S whose financial position will be affected as a result of the scheme, F Pty Ltd, G Pty Ltd, and T.

F Pty Ltd

(i) distributed part of its accumulated profits equal to the amount gifted to T by S plus the amount required to fund other purposes, and

(ii) had a franking debit to its franking account equal to the amount of the franking credit on the distribution to G Pty Ltd made to its franking account.

(iii) S is a shareholder and controller of G Pty Ltd.

G Pty Ltd

(i) G Pty Ltd obtains an interest in shares in F Pty Ltd.

(ii) Obtains a franking credit equal to the amount of the franking credit on the dividend it receives from F Pty Ltd.

(iii) S is, by virtue of his position as sole shareholder and director of the G Pty Ltd 2 the trustee of New Trust, in a position to control G Pty Ltd. They are also an object of that discretionary trust.

T
Receives money from S.

229. Here there are only two changes to S's net financial position as a result of the scheme:

(i) A saving of tax on the dividend he would otherwise have received but for the scheme,

(ii) The disposal of the relevant shares.

230. These factors suggest, when considered in combination with the artifice and contrived nature of the scheme, with all its unnecessary steps that are undertaken for no other explicable purpose than to obtain the tax benefit that John receives as a result of the scheme, that the dominant, if not sole purpose for undertaking the scheme is to enable S to obtain the tax benefit.

231. The changes to the position of G Pty Ltd and F Pty Ltd are consistent with this view.

177D(b)(vii) - any other consequence for the relevant taxpayer or any other person referred to in subparagraph (vi) of the scheme having been entered into or carried out

232. Other than the consequences identified above, there are no other identifiable consequences of the arrangement.

Conclusions

233. Given the above analysis, it is open to a reasonable person to conclude that the dominant, if not sole, purpose for the scheme being entered into is to enable S to obtain the tax benefit. It follows that Part IVA of the ITAA 1936 applies to the scheme.

234. In the circumstances, where the taxpayer entered into the scheme and section 177E did not apply, the Commissioner would be entitled to exercise his discretion under paragraph 177F(1)(a) of the ITAA 1936 to make a determination including an amount in his assessable income equal to the amount of the dividend that would have been received by S but for the scheme.

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