Edited version of your private ruling

Authorisation Number: 1012588825030

Ruling

Subject: Franking credits and franking tax offset

Question 1

For the purposes of subsection 207-145(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997), would the trust be a 'qualified person' under former section 160APHO of the Income Tax Assessment Act 1936 (ITAA 1936) in relation to franked dividends it receives from shares in respect of which it has entered into a single name short?

Answer

Yes, where the shares are continuously held for at least 45 days (not counting the day of acquisition or disposal) around the ex-dividend date and the total level of hedging of market exposure does not exceed 70%.

Question 2

In determining whether the trust has materially diminished risks of loss or opportunities for gain (under former section 160APHM of the ITAA 1936) in respect of the shares it holds, can the trust decompose any Share Price Index (SPI) Futures contracts in order to determine the 'net position' in relation to the shares?

Answer

Yes.

Question 3

Would the anti-avoidance rule in section 177EA of the ITAA 1936 apply to deny the trust 'imputation benefits' in relation to franked dividend distributions on the shares in respect of which the trust has entered into a single name short?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

The investment objective of the trust is to achieve superior risk adjusted returns with an emphasis on capital preservation over the medium to long term utilising various quantitative trading processes.

The trust will utilise two core investment strategies operated in parallel.

One of these strategies involves investing in a portfolio of high dividend yielding securities around their ex-dividend dates. The distributions from the portfolio will comprise a mix of franked, partially franked and unfranked dividends. In addition to generating a stable dividend yield, the strategy also seeks to capture opportunistic gains from the out-performance of dividend yielding securities during the period leading up to the security's ex-dividend date.

The strategy is designed to take advantage of inefficiencies or pricing opportunities in the market associated with yield. The investment rationale of the strategy is that securities can be expected to outperform in the lead up to their ex dividend dates and that the price drop offs experienced by securities after the ex-dividend date are on average, less than the associated gross dividend.

The trust may invest in stocks paying fully franked, partially franked or unfranked dividends.

The trust will typically hold shares for between 0-3 months in order to capture these effects that pervade the market in the period running up to the ex-dividend date, earn the dividend and where applicable the franking credit, and then liquidate the holding to free up capital in order to make other investments.

As part of the strategy, the trust will typically seek to (partially) hedge its investment portfolio to reduce exposure, to generate a stable return across its portfolio and increase returns via inefficient market price reactions to dividend announcements. The trust may hedge specific stocks within its investment portfolio using a combination of the following hedges:

· Single name shorts, borrowed from offshore lenders (subject to availability) where the short relates to the same security and borrowed from domestic and/or offshore lenders where the short does not relate to the same security

· Index shorts, borrowed from domestic and/or offshore lenders

· Futures over index or single name securities

· Options over index or single name securities

In addition to specific stock hedges, the trust may utilise an SPI future short contract to hedge between 0 and 50% (nominally 30%) of the net market exposure of the trust.

The total level of hedging for each parcel of shares comprising the investment portfolio will be up to 70% for shares paying franked dividends and up to 100% for shares paying unfranked dividends. The exact level of hedging for each parcel of shares will depend upon the risk profile of the investment.

Description of single name shorts

Short selling of a stock involves the selling of stock that has been borrowed from a third party, with the intention of buying the stock back at a later date to return to that third party.

This stock lending describes the common market practice by which securities are transferred temporarily from one party (the lender) to another (the borrower), with the borrower obliged to return them (or equivalent securities) at the end of a period.

It is possible to hedge a security by short selling that same security or by short selling a different security that is expected to have a similar performance.

The borrower will not receive dividends and franking credits in relation to the borrowed stock as these will be received by the buyers in the market who purchased the stock from the borrower. However, under the agreement with the lender, the borrower (the trust) will be obliged to make equivalent payments (that is, payments equivalent to the amount of dividends and franking credits on the borrowed stock in the case of Australian resident lenders and payments equivalent to the amount of dividends (excluding franking credits) on the borrowed stock in the case of foreign resident lenders) back to the lender.

Assumptions

· The shares acquired by the trust are all ordinary shares;

· All shares are held directly by the trust;

· There are no associates of the trust that will invest in any of the same shares as the trust under an arrangement with the trust;

· For the purposes of Question 1 in relation to single name shorts, the trust will not have a 'short position' in relation to the shares during the relevant qualification period other than the single name short;

· The trust is a unit trust that is a fixed trust for income tax purposes and therefore, as provided by subsection 160APHL(10), unit holders will have a delta of 1 in relation to the shares held by the trust prior to the trust entering into any hedge position in relation to the shares.

· The unit holders that will hold units in the trust will remain constant. Accordingly, the analysis in the private ruling application has been performed at the trust level.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 207-145(1)(a)

Income Tax Assessment Act 1936 subsection 160APHJ(5)

Income Tax Assessment Act 1936 section 160APHM

Income Tax Assessment Act 1936 section 160APHO

Income Tax Assessment Act 1936 section 177EA

Reasons for decision

Question 1

To be eligible for franking benefits under the imputation system, paragraph 207-145(1)(a) of the ITAA 1997 states that the entity receiving the franked distribution must be a 'qualified person' for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.

For an entity to be qualified person, the entity must satisfy the holding period requirement with respect to the relevant qualification period.

Where the entity has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend, the secondary qualification period is the relevant period (subsection 160APHO(1) of the ITAA 1936).

For franked dividends that the trust receives from shares in respect of which it has entered into a single name short, it is required to make a related payment as it is under an obligation to make an equivalent payment to the lender of the borrowed stock. Therefore, the secondary qualification period is applicable.

The secondary qualification period for ordinary shares means the period beginning on the 45^th day before, and ending on the 45^th day after, the day on which the shares became ex dividend.

The holding period requirement will be met if the entity holds the shares 'at risk' for a continuous period (not counting the day of acquisition or disposal) of at least 45 days (for ordinary shares) during the relevant qualification period (subsections 160APHO(2) and (3) of ITAA 1936).

Shares will be held 'at risk' on a particular day if the taxpayer's net position on that day in relation to the shares has at least 30% of the risks and opportunities associated with holding the shares (subsection 160APHM(2) of the ITAA 1936).

The taxpayer's net position is determined using the financial concept known as 'delta' (subsection 160APHM(3) of the ITAA 1936). Briefly, delta measures the percentage change in the price of one security relative to the percentage change in the price of another. A net position is defined in subsection 160APHJ(5) of the ITAA 1936 as the sum of the taxpayer's long and short positions in the shares, calculated on the basis of their deltas. For example, where shares have been hedged to a level of 70%, the delta will be 0.3 (30% risk).

Therefore, in this case the trust will be a 'qualified person' in relation to franked dividends it receives from shares in respect of which it has entered into a single name short, where the shares are continuously held for at least 45 days (not counting the day of acquisition or disposal) around the ex-dividend date and the total level of hedging of market exposure does not exceed 70%.

Question 2

It is considered that ATO Interpretative Decision 2012/24 is directly on point with regards to Question 2. Applying the principles in the ATO Interpretative Decision, it is concluded that in determining whether the trust has materially diminished risks of loss or opportunities for gain in respect of the shares it holds, the trust can decompose any SPI Futures contracts in order to determine the 'net position' in relation to the shares.

Question 3

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies to a wide range of schemes seeking to obtain a tax advantage in relation to imputation benefits.

Subsection 177EA(3) of the ITAA 1936 provides that section 177EA of the ITAA 1936 applies if:

(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 membership interests, as the case may be;

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

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

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

If section 177EA of the ITAA 1936 applies, the Commissioner may make a determination under subsection 177EA(5) of the ITAA 1936 that either a franking debit arises to the company in respect of each distribution paid to the relevant taxpayer (paragraph 177EA(5)(a) of the ITAA 1936) or, in the alternative, that no franking credit benefit arises in respect of a distribution paid to the relevant taxpayer (paragraph 177EA(5)(b) of the ITAA 1936).

Subsection 177EA(14) of the ITAA 1936 states that 'a scheme for a disposition of membership interests, or an interest in membership interests' includes a scheme that involves 'substantially altering any of the risks of loss, or opportunities for profit or gain, involved in holding or owning the membership interests or having the interest in membership interests'. In relation to this case it is considered that entering into single name shorts gives rise to a scheme within the meaning of paragraph 177EA(3)(a) of the ITAA 1936.

The application of section 177EA of the ITAA 1936 in this case turns on whether, after consideration of all the relevant circumstances, it would be concluded that the trust entered into the scheme for a more than incidental purpose of obtaining an imputation benefit.

In arriving at a conclusion the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed there encompass a range of circumstances which taken individually or collectively could indicate the requisite purpose. Due to the diverse nature of these circumstances, some may not be present at any one time in any one scheme.

Considering the relevant circumstances in this case, it is noted that:

· Limiting exposure to the risks of loss and the opportunity for gain that attach to shares is consistent with a purpose of obtaining an imputation benefit. However, the level of hedging on the stocks in the trust's portfolio will vary significantly according to the risk profile of the investments and the stocks invested in may be franked, partially franked and unfranked. These facts support the applicant's statement that the hedging is undertaken to generate a stable return across its portfolio rather than for a purpose of obtaining an imputation benefit and that any franking credits obtained are simply a natural incident of investing in the shares.

· A short holding period is generally a relevant circumstance that weighs in favour of there being a more than incidental purpose of obtaining an imputation benefit. However, in this case the holding periods of the shares must be considered in light of the trust's investment strategy of investing in stocks expected to outperform in the lead up to their ex dividend dates with price drop offs after the ex-dividend date less than the dividend paid out. This strategy requires a short holding period.

Having regard to all the relevant circumstances, it is concluded that section 177EA of the ITAA 1936 would not apply to deny the trust imputation benefits in relation to franked dividend distributions it receives on shares in respect of which it has entered into a single name short.

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