Edited version of your private ruling

Authorisation Number: 1012439721503

Ruling

Subject: Whether Part IVA of the Income Tax Assessment Act 1936 applies to a proposed loan

Question

Will the Commissioner apply the provisions contained in Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) to the proposed loan(s) by the joint venture company to the taxpayer during the operation of the project?

Answer

No.

This ruling applies for the following periods:

Income year ended 31 December 2012.

Income year ending 31 December 2013.

Income year ending 31 December 2014.

Income year ending 31 December 2015.

Income year ending 31 December 2016.

Income year ending 31 December 2017.

The scheme commences on:

Commencement date of the project.

Relevant facts and circumstances

The entities

The taxpayer and another entity established a 50:50 owned joint venture company.

A shareholders agreement between the two entities governs the relationship between the shareholders and establishes the terms on which the joint venture company is managed.

Both shareholders have each subscribed for and have been issued shares in the joint venture company. The shares have full voting rights, dividend entitlements and entitlements to a return of capital.

The business

The joint venture company owns and operates a business.

The business is expandable. A decision on the expansion is expected to occur within the first five years of the project's commencement.

There is no specific plan as to how the expansion will be funded.

Surplus funds

A clause of the shareholders agreement allows any surplus funds to be loaned back to the shareholders until the earlier of the project expansion or five years from the project's commencement.

Surplus funds is the amount of funds the board of the joint venture company has determined are available to loan to shareholders after taking into account the its need to pay operating expenses, service debt obligations, and meet any capital expenditure requirements specified in the business plan and budget.

The board must equally loan the surplus funds to each shareholder unless their contributions are unequal. In that case, the shareholders agreement specifies the formula to be used to calculate the amount of the loan for each shareholder.

The Maturity Date of the loan is one day less than 10 years and the interest rate is a commercial rate that is agreed between the parties.

Each shareholder must ensure that any arrangement or transaction between the joint venture company and that shareholder, or an affiliate of that shareholder is on commercial terms and on an arm's length basis.

If a shareholder disposes of its shares, the disposing shareholder must use its best endeavours to novate any loans it holds to the incoming party, or if it is unable to do so, then it must pay back the loan before it disposes of its shares.

Unsecured line of credit facility

The taxpayer obtained an unsecured line of credit facility to meet its commitments to its investment in the joint venture.

The unsecured credit facility was obtained at commercial rates.

Other relevant comments

The applicant has advised that:

In the absence of an expansion of the project, the expected rate of return on the business is expected to be low and is considered to be marginal from an investment perspective.

The project is likely to yield free cash flow in its early years of operation notwithstanding that the project is expected to incur an accounting loss in its first year and small accounting profits thereafter.

The shareholders have plans to expand the project if circumstances allow it to be expanded profitably. Such an expansion is dependent on factors which are currently uncertain.

During the first five years, or until a decision is made on the expansion of the project, any surplus funds is to be loaned to the shareholders unless the joint venture company and its shareholders agree otherwise. If the joint venture company and the shareholders agree not to lend any surplus funds to the shareholders during this period of time, then it is possible for the board to pay a dividend or to make a capital return. It is expected that some dividends will be paid during the first five years.

The taxpayer plans to use the funds that it is proposing to borrow from the joint venture company to repay the unsecured credit facility used by the taxpayer to subscribe for its investment in the joint venture company.

If a decision is made not to proceed with the expansion, which is expected in the first five years, the joint venture company together with its shareholders would aim to pay a dividend and make a return of capital to its shareholders to the extent of the loan with such entries being booked as an offset against these loans, thereby effecting a repayment of those loans.

If a decision is made to proceed with the expansion, the shareholders would make a voluntary early repayment of the loans, which the joint venture company will then contribute towards the cost of the expansion.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 section 177A

Income Tax Assessment Act 1936 section 177C

Income Tax Assessment Act 1936 section 177CA

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 177F

Reasons for decision

Summary

The Commissioner will not apply the provisions under Part IVA of the ITAA 1936 as it cannot reasonably be concluded that the taxpayer would enter into the proposed loan from the joint venture company with the dominant purpose of enabling the taxpayer to obtain a tax benefit in connection with the loan.

Detailed reasoning

Part IVA of the ITAA 1936 is a general anti-avoidance provision. Part IVA gives the Commissioner the discretion to cancel a tax benefit that has been obtained, or would but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies (paragraph 46 of Law Administration Practice Statement PS LA 2005/24).

Before the Commissioner can exercise the discretion in section 177F of the ITAA 1936, the requirements of Part IVA of the ITAA 1936 must be satisfied. Broadly, the requirements are:

(i). a scheme, as defined in section 177A of the ITAA 1936 was carried on by the taxpayer;

(ii). a tax benefit, as identified in section 177C, was or would, but for section 177F, have been obtained in connection with the scheme; and

(iii). having regard to section 177D of the ITAA 1936, the scheme is one to which Part IVA applies.

The term 'scheme' for the purposes of Part IVA of the ITAA 1936 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.

This definition of 'scheme' is very broad. It encompasses not only a series of steps but also the taking of one step (Federal Commissioner of Taxation v. Hart [2004] HCA 26; (2004) 217 CLR 216; 2004 ATC 4599: (2004) 55 ATR 712). A scheme, as defined, is wide enough to cover a series of interrelated acts by a person or persons over a period of time.

Whether a scheme is wider or narrower should not be relevant in determining if the test in section 177D of the ITAA 1936 is met with respect to the scheme, as long as the tax benefit in question is sufficiently connected with the scheme.

Subsection 177C(1) of the ITAA 1936 defines four kinds of tax benefit, relating broadly to:

(i). an amount not being included in the assessable income of the taxpayer of a year of income

(ii). a deduction being allowable to the taxpayer in relation to a year of income

(iii). a capital loss being incurred by the taxpayer during a year of income, or

(iv). a foreign tax credit being allowable to the taxpayer.

For the purposes of subsection 177C(1) of the ITAA 1936, a tax benefit is obtained in connection with a scheme where the relevant tax benefit:

· would not have been obtained if the scheme had not been entered into or carried out, or

· might reasonably be expected not to have been obtained if the scheme had not been entered into or carried out ('reasonable expectation test').

A tax benefit can also arise for the purpose of section 177CA of the ITAA 1936 if a taxpayer is not liable to pay withholding tax on an amount where, but for the scheme the taxpayer would have or could reasonably be expected to have been liable to pay. Section 177CA does not require that a withholding tax liability, in relation to an amount, is actually reduced. It is sufficient that there is a reasonable expectation that but for the scheme, the relevant amount would have been subject to withholding tax.

The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA of the ITAA 1936, of an 'alternative hypothesis' or 'alternative postulate' (hereinafter referred to as a counterfactual). This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out (paragraph 69 of PS LA 2005/24).

A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable (Federal Commissioner of Taxation v. Peabody (1994) 181 CLR 359; 94 ATC 4663; (1994) 28 ATR 344 (Peabody's Case)).

In applying the reasonable expectation test to identify the counterfactual(s), it may be useful to consider:

· the most straightforward and usual way of achieving the commercial and practical outcome of the scheme (disregarding the tax benefit)

· commercial norms, for example, standard industry behaviour

· social norms, for example, family obligations

· behaviour of relevant parties before/after the scheme compared with the period of operation of the scheme, and

· the actual cash flow.

If a tax benefit is obtained in connection with a scheme that also achieves a wider commercial objective (disregarding the tax benefit) then, it is reasonable to expect that in the absence of the scheme the wider objective would still have been pursued by the means of a transaction or dealing with a different form or shape (paragraph 76 of PS LA 2005/24).

The alternative counterfactual(s) also forms the background against which an objective conclusion can be drawn as to the purpose of a person in entering the scheme for the purposes of section 177D of the ITAA 1936.

For Part IVA of the ITAA 1936 to apply to a scheme in connection with which the taxpayer obtained a tax benefit, it is necessary to conclude, having regard to the eight factors in paragraph 177D(b) of the ITAA 1936, that the person who entered into or carried out the scheme, or any part of it, did so for the 'purpose' of enabling the taxpayer to obtain the tax benefit. Pursuant to subsection 177A(5) of the ITAA 1936, 'purpose' includes the dominant purpose where there are two or more purposes.

It is possible for Part IVA of the ITAA 1936 to apply notwithstanding that the dominant purpose of obtaining the tax benefit was consistent with the pursuit of commercial gain. The key issue is whether the particular scheme, or any part of it, was entered into or carried out by any person for the relevant purpose having regard to the factors in paragraph 177D(b) of the ITAA 1936.

The consideration of purpose or dominant purpose under paragraph 177D(b) of the ITAA 1936 requires an objective conclusion to be drawn. The conclusion required is the conclusion of a reasonable person based on all the facts and evidence that are relevant to considering the eight factors.

While the factors in paragraph 177D(b) of the ITAA 1936 will not be equally relevant in every case, each of the eight factors are taken into account and weighed together in arriving at a conclusion as to dominant purpose. Consideration of the factors will involve a comparison of the scheme with the alternative counterfactual(s).

The scheme

For present purposes, one or a series of the following steps constitute a scheme, as defined, in section 177A of the ITAA 1936.

The wider scheme:

A A joint venture between the taxpayer and another entity was entered into.

B The taxpayer borrowed funds from on commercial terms to enable it to invest in the joint venture.

C The project was developed and is run by the joint venture company.

D The joint venture is governed and conducted in accordance with a shareholders agreement between the joint venture partners.

E A decision on whether to expand the project is to be made within five years of the project's commencement.

The narrower scheme:

A Until the earlier of the commencement of the project expansion or five years from the execution of the shareholders agreement, any surplus funds generated by the joint venture company is to be loaned back to the shareholders by way of loans.

B The loans will have a maturity date of one day less than 10 years.

C The interest rate on the loans will be at commercial rates.

D The taxpayer will use the funds from the loans to repay the unsecured credit facility.

E If a decision is made to expand the project, the loans will be paid back early to enable the funding of the expansion.

In determining whether the taxpayer will obtain a tax benefit as defined in section 177C of the ITAA 1936, it is necessary to identify what might reasonably be expected to have occurred if the relevant scheme had not been entered into or carried out (Macquarie Finance v. FCT [2005] FCAFC 205; 2005 ATC 4829; (2005) 61 ATR 1). The expectation of the alternative counterfactuals must be reasonable, as distinct from a mere possibility (Peabody's Case; paragraph 71 of PS LA 2005/24).

Alternative counterfactuals

The applicant contends that the matters that need to be taken into account in determining what would have taken place, or might reasonably be expected to have taken place, if the narrower scheme is not entered into or carried out, include the following:

1. No loan and no distribution would be made, or

2. A distribution would be made instead of a loan, either in whole or part a dividend (franked or unfranked), or a return of capital.

The applicant submits that the joint venture partners understand that if there is an expansion, then cash loaned to the shareholders would need to be returned to fund the expansion. On this basis, it is not the intention of the joint venture company to liberate the funds on a distribution basis either by way of dividend or return of capital while the decision concerning the expansion is still pending.

The applicant further contends that counterfactual (1) would be the most likely because it would enable the joint venture company to retain funds that it could use to fund the future expansion in the event that it proceeds. The applicant contends that there would be no tax benefit under counterfactual (1) for two reasons:

1. There would be no assessable income as there would be no distribution, and

2. If the taxpayer borrowed funds from the joint venture company as an interest bearing loan, then it would use those funds to pay an interest bearing unsecured credit facility obligation. There would be a tax deduction on the interest payable to the joint venture company, but a similar deduction would have been obtainable on the interest payable on the inter-company borrowing and therefore there would be no tax benefit.

If the Commissioner concludes that counterfactual (2) is the most likely, the applicant contends that the proposed loans would not be a scheme to which Part IVA of the ITAA 1936 would apply because the entering of the scheme did not have the dominant purpose of obtaining a tax benefit.

Dominant purpose

Each of the factors under paragraph 177(D)(b) of the ITAA 1936 have been considered by the applicant. The applicant contends that when taking into consideration all of the eight factors, it should not be concluded that the dominant purpose of any party to the scheme(s) was to obtain a tax benefit.

(i). The manner in which the scheme was carried out

The applicant contends that the making of a loan to shareholders is a transaction with a low level of complexity. There is nothing artificial or unusual about a company lending its free cash to its shareholders until such time as it is needed for another purpose by the company. Further, the repayment terms and the commercial rate of interest in the shareholders agreement, and reinforced by other clauses in the shareholders agreement supports the conclusion that the obtaining of a tax benefit was not the dominant purpose of the taxpayer entering the scheme.

Accordingly, as contended by the applicant, it is accepted that the manner in which the narrower scheme is entered into is a factor that points away from any conclusion that the dominant purpose of any party to either scheme was to achieve a tax benefit.

(ii). The form and substance of the scheme

The applicant contends that the making of the loans on commercial terms supports the conclusion that the form and substance of the scheme are essentially the same and therefore this factor does not point to the taxpayer having the dominant purpose required for the purposes of Part IVA of the ITAA 1936.

The form and substance of the narrower scheme are the same. Accordingly, as contended by the applicant, it is accepted that this points away from any conclusion that the dominant purpose of any party to either scheme was to obtain a tax benefit.

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

The applicant contends that the narrower scheme, consisting of proposed loans, is not expected to last for much longer than five years. Given that the ordinary repayment period for the loans is one day less than 10 years, the likely course of action will result in the early repayment of the loans. The plans to repay the loans once a decision is made on whether the expansion should proceed, supports the conclusion that the obtaining of a tax benefit was not the dominant purpose for the taxpayer entering the scheme.

The applicant contends, and it is accepted that, the timing of the entering of either scheme and the length of the period of the narrower scheme, is not for the dominant purpose of obtaining a tax benefit given that the loans would be repaid once a decision on the expansion of the project is made. The third factor in paragraph 177D(b) of the ITAA 1936 therefore, points away from any conclusion that the dominant purpose of entry into the scheme was to obtain a tax benefit.

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

The applicant contends that the mere fact that there might be a tax benefit under factor (iv) does not of itself lead to a conclusion that this was the purpose of the scheme when the commercial features of the scheme suggest otherwise. Those commercial features are:

(a) Two independent and unrelated parties have come together to undertake the project.

(b) The parties have entered into a shareholders agreement which reflects the commercial negotiation between the parties on how they will act over the life of the project.

(c) The shareholders agreement reflects commercial arm's length arrangements about how to deal with the surplus funds, which requires them to be loaned to the shareholders during the first five years of the project or until a decision is made to expand the project.

(d) The shareholders agreement establishes protocols for the effective and efficient operation of the project.

Whilst there are different tax implications under the scheme compared to those arising under counterfactual (2), these are a result of different types of transactions with different commercial consequences (Federal Commissioner of Taxation v. Ashwick (Qld) No 127 Pty Ltd [2011] FCAFC 49; 2011 ATC 20-255).

Accordingly, it is accepted that this factor cannot weigh in favour of a conclusion that the dominant purpose of any party to either scheme was to obtain a tax benefit.

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

The applicant contends that the taxpayer's financial position under the scheme is different to what it would have been under counterfactual (2). Although it is possible that the joint venture company may pay a dividend (including an unfranked dividend) during the first five years, the applicant contends that it is unlikely that the joint venture company would pay a dividend during this period due to the following uncertainties:

· the payment of an unfranked dividend is subject to the directors of the joint venture company agreeing to the payment of a dividend - this is not fully within the control of the taxpayer as it does not control a majority of the directors of the joint venture company, and

· the payment of a dividend is subject to the legal and accounting restrictions on the payment of dividends.

On the basis that the joint venture company does not pay a dividend under the scheme, the taxpayer's financial position would be different to what it would have been had an unfranked dividend and return of capital been paid to it. Specifically:

(a) the taxpayer would have an obligation to pay interest and repay the principal on the loans made to it under the scheme, but would not have the same obligations under counterfactual (2).

(b) The taxpayer would not be liable for income tax on any unfranked dividend as no unfranked dividend would be paid.

(c) The net book value of the taxpayer's investment in the joint venture company would be larger under the scheme, as under counterfactual (2), the joint venture company would be paying dividends and making returns of capital.

However, the mere fact that there might be a tax benefit associated with the change in the taxpayer's financial position, does not necessarily support the conclusion that this was the dominant purpose for entering the scheme, particularly in light of the various factors, including the commercial features of the scheme(s).

(vi). Any change in the financial position of any person connected with the taxpayer being a change that will result from the scheme

The applicant contends that if the narrower scheme were implemented, the joint venture company will have an additional asset (loan) and increased income (interest) as compared to its position if it paid dividends or returned capital to shareholders. That is, the joint venture company will have an improved financial position (shareholders' equity) as compared with the situation under counterfactual (2). This improved financial position should increase the joint venture company's capacity to self fund (or reduce further capital commitments), the project expansion if a decision to proceed with the expansion is made.

The applicant contends that the narrower scheme improves the financial position of the joint venture company to assist in the proposed expansion while also allowing shareholders to maximise commercial usage of the surplus funds. Lending the surplus funds to shareholders is economically equivalent to depositing the funds in a bank.

The applicant also contends that it would be questionable as to whether the joint venture company would choose to pay a dividend in the early stages of the project (notwithstanding recent changes to the Corporations Act 2001 in relation to the payment of dividends).

In addition, the narrower scheme will allow the taxpayer to repay some, or its entire unsecured credit facility. Effectively it will mean that the loan (or part of it) will be transferred to the joint venture company. As the unsecured credit facility the taxpayer has is at a commercial interest rate, and the proposed loan is also at a commercial interest rate, it is considered that any difference there may be in interest payments (tax deduction), would be negligible.

It is accepted that this factor points away from any conclusion that the dominant purpose of any party to either scheme was to obtain a tax benefit.

(vii). Any other consequence for the taxpayer of the scheme having been entered into or carried out

Other than the commercial consequences of the scheme, the applicant is not aware of any other consequences.

The applicant contends, and it is accepted, that this factor points away from any conclusion that the dominant purpose of any party to either scheme was to obtain a tax benefit as no other consequences can be identified for the taxpayer entering the scheme(s).

(viii). The nature of the connection between the taxpayer and any person referred to in (vi)

The applicant contends that the proposed loans represent an arm's length dealing and therefore there is nothing to support the dominant purpose of entering of the scheme being to obtain a tax benefit.

The parties to either scheme are at arm's length. Accordingly, this factor is neutral.

Tax benefit

A tax benefit or benefits must be identified in the context of the scheme. In the present circumstances, paragraphs 177C(1)(a) and 177C(1)(b) of the ITAA 1936 are relevant.

When comparing the facts under the scheme with counterfactual (2), the following items require examination:

an amount not being included in the assessable income of the taxpayer for the distribution of dividend income (paragraph 177C(1)(a) of the ITAA 1936), and

a deduction being allowable for the interest expense under the proposed loan (paragraph 177C(1)(b) of the ITAA 1936).

The applicant submits that if counterfactual (2) is implemented in place of the scheme(s), then:

It is unlikely that the joint venture company will distribute a dividend or return of capital while the decision regarding the expansion of the project is pending.

It is questionable whether the joint venture company will distribute a dividend in the early stages of the project.

Lending cash to shareholders on commercial terms is equivalent to depositing money in the bank.

Consequently, it is doubtful that counterfactual (2) would likely be implemented prior to a decision being made on the expansion of the project as this counterfactual would reduce the funds available to the joint venture company to implement the expansion if it is decided that the expansion is to proceed.

Conclusion

In summary, it is reasonable to accept that the taxpayer would have entered into the wider scheme whether or not the narrower scheme was available to it. The narrower scheme is intended to be used to facilitate the use of the surplus funds by the shareholders, and to also provide a return to the joint venture company, until a decision is made on whether the expansion to the project is to proceed.

It is accepted that the narrower scheme is designed on a commercial basis to provide the joint venture company with access to funds to implement the expansion of the project if the decision to proceed with that expansion is made, rather than requiring it to raise further capital should the need arise.

Accordingly, on an objective consideration of the relevant facts and circumstances, there is nothing elaborate or contrived that would indicate that the scheme was tax driven and that the narrower scheme was entered into for the dominant purpose of obtaining a tax benefit. It is therefore reasonable to conclude that counterfactual (1) would be the most likely alternative to the scheme(s). As counterfactual (1) has no tax benefit, then Part IVA of the ITAA 1936 has no application as there is no evidence that the scheme(s) were entered into to obtain a tax benefit.

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