1012624543219 | Legal database

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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

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Edited version of private advice

Authorisation Number: 1012624543219

Ruling

Subject: Retirement Planning Proposal

Question 1

Is the franked distribution from A Pty Ltd (the Company) to the B Superannuation Fund (the Fund) made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is there a scheme to which Part IVA, and therefore section 177F, of the Income Tax Assessment Act 1936 (ITAA 1936) applies?

Answer

Yes

Question 3

Is there a scheme to which section 177EA of the ITAA 1936 applies?

Answer

Yes

This ruling applies for the following period

Year of income ended 30 June 2014

The scheme commences on

1 July 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Factual arrangement

1. Taxpayer 1 and Taxpayer 2 (together, 'the Taxpayers') are retired.

2. Before retiring, Taxpayer 1 ran a business through A Pty Ltd (the Company). The Company's directors are Taxpayer 1, Person 3 and Person 4.

3. The Company's shares are wholly owned by Company ZZ Pty Ltd as trustee (Company Z). Company Z holds half the shares in its capacity as trustee of the AA Trust; and half in its capacity as trustee of the BB Trust. The shares were purchased by Company Z in 1976 (and are therefore 'pre-CGT assets' of Company Z).

4. The Taxpayers are beneficiaries of both the AA Trust and the BB Trust (together, the "Trusts").

5. The Company's assets are comprised wholly of cash of $X. That cash is, broadly, represented by: pre-CGT capital reserves and retained earnings. There is a balance standing to the credit of the Company's franking account.

6. Taxpayer 1 says the market value of the shares in the Company is $X (i.e. there is no value being attributed to the franking credits).

7. Taxpayer 1 and the other directors consider that the Company is of no further use and want to deregister it.

8. The Taxpayers are the only members of the B Superannuation Fund (the Fund). The Taxpayers are the directors of the corporate trustee of the Fund.

9. The Fund owns a portfolio of listed shares and units, with the value of the Fund being approximately $Y as at 30 June 2013.

10. Taxpayer 1 has created a foundation (the Foundation) (which is a deductible gift recipient) and he has advised that he donates money to it each year.

11. It is intended that the following steps will be implemented:

(a) the Taxpayers will each make a non-concessional contribution to the Fund to be used to commence a new pension for each of them. These contributions will subsequently be used by the Fund to purchase from Company Z shares in the Company to the value of those two contributions;

(b) the Fund will purchase the balance of the shares in the Company from Company Z via a limited recourse borrowing arrangement (LRBA) described further below;

(c) the total purchase price of the shares in the Company will be $X and Company Z will receive a capital sum in that amount;

(d) the loan amount under the LRBA will be $X less the amount contributed to the Fund by the Taxpayers at paragraph 11(a) above;

(e) the shares will be held on trust (the LRBA holding trust) with the trustee of the LRBA holding trust acquiring the legal title and the trustee of the Fund acquiring a 'beneficial interest' in the shares (as referred to in paragraph 67A(1)(b) of the Superannuation Industry (Supervision) Act 1993 (SISA)).

(f) the key features of the LRBA will be as follows:

(i) the interest rate will be pegged to the interest rate offered by the major Australian banks for a similar product;

(ii) repayments will be due and payable on a monthly basis;

(iii) the repayments will comprise both principal and interest;

(iv) the LRBA will be fully repaid within 12 months;

(v) there will not be an amount outstanding under the LRBA at a time when the value of the shares in the Company is nil. The terms of the LRBA will require the Fund to repay the loan sufficiently to maintain the agreed loan to value ratio at a certain level being equivalent to that of a similar product offered by a major Australian bank; and

(vi) there will be no forgiveness of the loan amount;

(g) at least 45 days after the purchase of the shares, the Company will pay a franked distribution to the Fund;

(h) the franked distribution, including the franking credit, is said to be exempt from income tax on the basis that a proportion (as worked out under subsection 295-390(3) of the ITAA 1997) of the franked distribution, which would otherwise be assessable income of the Fund, will be exempt from income tax under subsection 295-390(1) of the ITAA 1997 (the relevant proportion is expected to be 100%);

(i) the Fund is also said to be entitled to a refund of the unused franking credit tax offset (which arises from the franking credit);

(j) part of the franked distribution and refunded franking credit tax offset (and any net earnings) will be used to pay pensions to the Taxpayers from the Fund. The balance of the franked distribution amount will be used to repay the loan under the LRBA;

(k) as a result of these steps, the Fund's assets increase;

(l) once the loan under the LRBA is repaid in full, the Company will be deregistered; and

(m) upon deregistration of the Company, the Fund will incur a capital loss of approximately $X.

12. Taxpayer 1 has advised that the purpose in taking these steps is to:

(a) increase the retirement benefits available to members of the Fund;

(b) avoid liquidation fees, and instead pay only a deregistration fee and costs associated with establishing the LRBA;

(c) simplify Taxpayer 1's wealth structure and protect his/her wealth by keeping it in the hands of other entities rather than in Taxpayer 1's own name.

13. As an alternative to this proposal, it is intended that:

(a) the Company will, until Taxpayer 1 turns 75, pay fully franked dividends to Company Z;

(b) Company Z will distribute the dividends to the beneficiaries of the Trusts including Taxpayer 1;

(c) Taxpayer 1 will use his/her distribution of the dividends to contribute to the Fund each year up to his/her concessional contribution limit, with the remaining amount of the dividend distribution being contributed to the Foundation;

(d) Taxpayer 1 will claim a franking credit tax offset arising from franking credits on the fully franked dividend distribution and it is said that this in turn will result in a refund to Taxpayer 1;

(e) once the retained earnings have been fully paid out the Company will be liquidated so as to distribute the pre-CGT capital reserves in a tax-effective manner; and

(f) Company Z will not recognise any capital gain or loss in respect of the cancellation or ending of the shares as they are pre-CGT assets.

Assumptions

14. There is a borrowing of money that would otherwise be prohibited under subsection 67(1) of the SISA but for the LRBA that complies with the requirements of section 67A of the SISA. (Note: Not all forms of financial accommodation give rise to a borrowing of money. See Self Managed Superannuation Funds Ruling SMSFR 2009/2 Self Managed Superannuation Funds: the meaning of 'borrow money' or 'maintain an existing borrowing of money' for the purposes of section 67 of the Superannuation Industry (Supervision) Act 1993.)

15. The Taxpayers each satisfy the work test under subregulation 7.04(1) of the Superannuation Industry (Supervision) Regulations 1994 (SISR) and are therefore permitted to make contributions to the Fund.

16. There will be no default on the loan under the LRBA.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1997 section 104-230

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 section 202-55

Income Tax Assessment Act 1997 section 202-60

Income Tax Assessment Act 1997 section 202-65

Income Tax Assessment Act 1997 section 207-20

Income Tax Assessment Act 1997 section 207-145

Income Tax Assessment Act 1997 section 207-155

Superannuation Industry (Supervision) Act 1993 subsection 67(1)

Superannuation Industry (Supervision) Act 1993 section 67A

Superannuation Industry (Supervision) Regulations 1994 subregulation 7.04(1)

Reasons for decision

Question 1

Summary

17. The franked distribution that flows from the Company to the Fund is made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the ITAA 1997. Consequently the amount of the franking credit on the distribution is not included in the assessable income of the Fund under section 207-20 or 207-35 of the ITAA 1997 and the Fund is not entitled to a tax offset under Subdivision 207-F because of the distribution (paragraphs 207-145(e), (f) and (g) of the ITAA 1997).

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997

18. Subsection 207-145(1) of the ITAA 1997 provides, relevantly, that where a franked distribution is made to an entity in circumstances where (in paragraph 207-145(1)(d)) 'the distribution is made as part of a dividend stripping operation', then, relevantly:

(a) (in paragraph 207-145(1)(e)) the amount of the franking credit on the distribution is not included in the assessable income of the entity under section 207-20 or 207-35 of the ITAA 1997;

(b) (in paragraph 207-145(1)(f)), the entity is not entitled to a tax offset under Subdivision 207-F because of the distribution; and

(c) (in paragraph 207-145(1)(g)) if the distribution flows indirectly through the entity to another entity - subsection 207-35(3) and section 207-45 of the ITAA 1997 do not apply to that other entity.

19. Section 207-155 of the ITAA 1997 defines when a distribution is made as part of a 'dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997 as follows:

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

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

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

20. If the franked distribution is made 'as part of a dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997, the relevant effect will be that the amount of any franking credit on the distribution will not be included in the assessable income of the Fund and the Fund will not be entitled to a tax offset under Subdivision 207-F or section 207-45 of the ITAA 1997.

Dividend stripping operations

21. A 'dividend stripping operation' has been recognised as involving the following characteristics:

(a) a company with substantial undistributed profits (target co);

(b) a sale or allotment of shares in target co to another party;

(d) the acquirer escaping Australian income tax on the dividend so declared;

(e) the vendor shareholder receiving a capital sum for their shares in an amount the same as or very close to the dividend paid out; and

(f) the transactions being carefully planned, with the parties acting in concert for the predominant purpose of avoiding tax on the distribution of dividends by target co.

See Commissioner of Taxation v. Consolidated Press Holdings Ltd [1999] FCA 1199; (1999) 91 FCR 524 (FCT v. CPH (FFC)) at [136] - [137] and [157]; Commissioner of Taxation v. Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 207 CLR 235 (FCT v. CPH (HC)) at [126] and [129]; and Lawrence v. Federal Commissioner of Taxation [2009] FCAFC 29; (2009) 175 FCR 277 (Lawrence v. FCT) at [42] - [43].

22. A scheme may still be a 'dividend stripping operation' because the making of a distribution was 'by way of or in the nature of dividend stripping' even if it contains features which vary from the paradigm case of dividend stripping, so long as it retains the central characteristics of a dividend stripping scheme: FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45].

23. A difference between a scheme 'by way of or in the nature of dividend stripping' and a scheme which has 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping' lies in the means adopted to distribute the profits of the target company. Where the means adopted do not involve a distribution, but some other step (such as the purchase by the target company of near worthless assets or assets later rendered near worthless by the target company) this involves a scheme having 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping': Lawrence v. FCT at [47] - [52].

Will the franked distribution be a distribution made as part of a dividend stripping operation?

24. The payment of the franked distribution that flows to the Fund will be made as part of a 'dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997 because each of the elements (identified in paragraph 21) of a scheme 'by way of, or in the nature of, dividend stripping' will be present.

25. First element: The Company has substantial undistributed profits as its sole asset is cash of $X (represented by retained earnings and pre-CGT capital reserves). This creates a potential tax liability for either Company Z, and/or a beneficiary, or beneficiaries, of the Trusts, at least in relation to the retained earnings (assuming, as is asserted, that the Company's pre-CGT capital reserves could be paid out on liquidation of the Company in a tax-free manner). If the franked distribution were paid to Company Z, under subparagraph 44(1)(a)(i) of the ITAA 1936, either Company Z and/or a beneficiary, or beneficiaries, of the Trusts would be assessed on an amount reflecting the retained earnings. Accordingly, the element of a dividend stripping operation identified in paragraph 21(a) above is satisfied.

26. Second element: There will be a sale or allotment of shares in the target co to another party. Company Z will sell its shares in the Company to the Fund and Company Z will receive a capital sum for those shares. There is nothing in the concept of a scheme by way of or in the nature of a dividend stripping operation which would require that the sale involve a share trader or be a company-to-company transaction attracting an inter-company dividend rebate. In FCT v. CPH (FFC) at [136], the Full Court referred to a dividend stripping operation involving a sale and allotment to individuals. Accordingly, the element of a dividend stripping operation in paragraph 21(b) above is satisfied.

27. Third element: The Company will pay a franked distribution which flows to the Fund equal to the value of the Company's cash assets. Accordingly, the element of a dividend stripping operation in paragraph 21(c) above is satisfied.

28. Fourth element: On the assumption that the franked distribution is not non-arm's length income of the Fund (within the meaning of section 295-550 of the ITAA 1997) the franked distribution is said to be exempt income of the Fund under section 295-390 of the ITAA 1997. In the result, absent the application of subsection 207-145(1) of the ITAA 1997 the Fund will obtain a refund of the unused franking credit tax offset (arising from a franking credit) in relation to the franked distribution. It does not detract from this conclusion that the shares are held under the LRBA. This is because the Fund holds the beneficial interest in the shares under the LRBA and the franked distribution flows to the Fund with the consequence that neither the LRBA holding trust nor the Fund is subject to tax on the franked distribution.

29. The reference in FCT v. CPH (FFC) at [136] to various different means by which tax can be escaped (including application of an inter-company dividend rebate) was not an exhaustive description of the means by which tax can relevantly be escaped on the dividend by a dividend stripping operation. Accordingly, the element of a dividend stripping operation in paragraph 21(d) above is satisfied.

30. Fifth element: Company Z will receive a capital sum of $X for the sale of its shares in the Company to the Fund. This amount equals the sum of the dividend of $X. Company Z's shares in the Company were acquired before 20 September 1985. Assuming CGT event K6 (section 104-230 of the ITAA 1997) happens in relation to the sale of the shares, Company Z would make neither a capital gain nor a capital loss. The element of a dividend stripping operation in paragraph 21(e) above is satisfied. It does not detract from this conclusion that the capital sum is, in part, initially recognised as a loan amount due to Company Z by the Fund, and that the loaned amount will not be paid to Company Z until the franked distribution has been paid by the Company.

31. Sixth element: The sixth element is satisfied for the following reasons:

(a) The arrangement proposed and described at paragraph 11 above is carefully planned. It involves all the parties acting in concert. The parties are all related, being the Taxpayers or companies or trusts controlled by them.

(b) From the point of view of the Fund, the principal or pre-dominant economic effect of the arrangement proposed and described at paragraph 11 above is obtaining a tax benefit: namely, the attraction of the exemption in subsection 295-390(1) of the ITAA 1997 to the franked distribution and generating a refund of the unused franking credit tax offset. That tax benefit overwhelmingly provides the explanation for the increase in the value of the Fund as a result of the arrangement (see paragraph 11(k) above). The balance of the franked distribution is used to repay the loan under the LRBA to Company Z (from whom the shares in the Company were purchased) and thus has no other economic effect.

(c) A further tax effect for the Fund (although of lesser significance while it remains entirely in 'pension phase') is the generation of a capital loss which might be used if the Fund ceases to be entirely in pension phase.

(d) From the point of view of the vendor shareholder (Company Z), the principal or predominant effect of the proposed arrangement is to liberate the retained earnings of the Company in a form substantially free from income tax consequences through the conversion to a capital sum being part of the $X received for the sale of the pre-CGT shares in the Company (see paragraph 30 above). If those retained earnings were paid as a franked distribution by the Company to the vendor shareholder, then Company Z (and/or a beneficiary, or beneficiaries, of the Trusts) could expect to incur a tax liability (see paragraph 25 above).

(e) It is no answer to say that the arrangement is undertaken for the purposes of retirement planning and to provide for the Taxpayers' better retirement rather than for the purpose of avoiding tax. This is because that poses a false dichotomy of the kind referred to in Commissioner of Taxation v. Spotless Services Limited (1996) 186 CLR 404 (FCT v. Spotless) at 415 - 416. On an objective assessment, the aspect of the arrangement that makes it desirable retirement planning for the Taxpayers is the tax benefit obtained through the channeling of the franked distribution through the Fund: namely, the exemption of the franked distribution and the refund of the franking credit tax offset referred to in paragraph 11(i) above.

(f) It is also no answer to say that the arrangement is undertaken for the purpose of simplifying Taxpayer 1's wealth structure or keeping Taxpayer 1's wealth in the hands of other entities rather than in his/her own name as an aspect of wealth protection. If those were the objectives, they could be more simply achieved by the Company distributing its assets to Company Z and then being deregistered. The relevant difference would be the tax effects achieved by the arrangement proposed and described at paragraph 11 above would not be achieved.

(g) The avoidance of liquidation by implementing the arrangement proposed and described at paragraph 11 above, but which would be involved in the alternative proposal described in paragraph 13 above is not of sufficient significance in comparison to the available tax benefit to provide the predominant explanation for the scheme.

(h) The fact that, in the alternative proposal described in paragraph 13 above, tax deductible contributions are made by Taxpayer 1 to the Foundation beyond the amounts Taxpayer 1 is able to contribute to the Fund as concessional contributions, is not relevant to an assessment of whether the arrangement proposed and described at paragraph 11 above has a predominant tax avoidance purpose. This is because, even if those contributions to the Foundation effectively result in the same refund of franking credit tax offset as the arrangement proposed and described at paragraph 11 above, it does not provide funds for the Taxpayers' retirement to the same extent. This is because the amounts contributed to the Foundation would not be available for the Taxpayers' retirement purposes.

32. For these reasons, the arrangement proposed and described at paragraph 11 above is a dividend stripping operation within the meaning of subsection 207-145(1) of the ITAA 1997.

Question 2

Summary

33. There is a scheme to which Part IVA and therefore section 177F of the ITAA 1936 applies. The Commissioner may make a determination under section 177F that has the effect of cancelling the tax benefit.

Detailed reasoning

Section 177E of Part IVA of the ITAA 1936

34. Where the conditions of subsection 177E(1) of Part IVA of the ITAA 1936 are satisfied, paragraph 177E(1)(e) provides that the relevant scheme 'shall be taken to be a scheme to which this Part applies'; and paragraph 177E(1)(f) provides that 'the taxpayer shall be taken to have obtained a tax benefit in connection with the scheme' with the result that the Commissioner is empowered to issue a determination cancelling the tax benefit under section 177F of the ITAA 1936.

35. The conditions in subsection 177E(1) of the ITAA 1936 are to the following effect:

(a) there is a 'scheme' of the kind defined in subsection 177A(1) of the ITAA 1936 that is in relation to the company (target co);

(b) the scheme is one:

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

(ii) having substantially the same effect as dividend stripping;

(d) the Commissioner forms the opinion that the disposal of property by the target co represents in whole or in part a distribution whether to a shareholder (called the vendor shareholder) or another person of profits of target co;

(e) had the target co, immediately before the scheme was entered into, paid a dividend out of profits equal to the amount of profits represented by the target co's disposal of property (the 'notional amount'), the notional amount would or might reasonably be expected to have been included by reason of the payment of the dividend in the assessable income of a taxpayer in a year of income; and

(f) the scheme was entered into after 27 May 1981.

See FCT v. CPH (FFC) at [118] - [123].

36. As noted above, if those conditions are satisfied, the scheme is taken to be one to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e)), and the taxpayer shall be taken to have obtained a tax benefit referable to the notional amount not being included in the assessable income of the taxpayer in the year of income: FCT v. CPH (FFC) at [124] - [127].

Are the conditions of subsection 177E(1) of the ITAA 1936 satisfied in relation to the franked distribution that flows from the Company to the Fund?

37. For the following reasons, each of the conditions in paragraphs 177E(1)(a) to (d) of the ITAA 1936 referred to in paragraph 35 above is satisfied.

38. First condition: The breadth of the definition of 'scheme' in section 177A of the ITAA 1936 has been judicially noted: British American Tobacco Australia Services Ltd v. Federal Commissioner of Taxation [2010] FCAFC 130; (2010) 189 FCR 151 at [30]. It includes any 'scheme, plan, proposal, action, course of conduct, or course of action'.

39. The steps in paragraph 11 above clearly constitute a scheme (the scheme) within the meaning of subsection 177A(1) of the ITAA 1936.

40. The Commissioner can identify and rely on alternative wider and narrower schemes: Commissioner of Taxation v. Peabody (1994) 181 CLR 359 at 382. Alternatively, the steps in paragraph 11 above so far as they are in pursuit of the payment of the franked distribution referable to the Company's retained earnings is a 'scheme' (the alternative scheme) within the meaning of section 177A of the ITAA 1936.

41. The scheme and the alternative scheme are each plainly a 'scheme that is in relation to a company'.

42. For this reason, the first condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 35(a) above is satisfied.

43. Second condition: For the reasons given above in paragraphs 24 to 31 the steps set out in paragraph 11 above involves a 'scheme' by way of or in the nature of dividend stripping.

44. As does the alternative scheme, which is limited to the taking of the steps in paragraph 11 above so far as they were in pursuit of the payment of a franked distribution referable to the Company's retained earnings (see paragraph 40 above). Relevantly, as to the fifth element of the concept of a dividend stripping operation set out in paragraph 30 above, Company Z will receive a capital sum referable to the transfer of shares in the Company to the Fund which, in turn, is referable to the cash assets of the Company attributable to retained earnings. That amount is, in turn, equal to the sum of the franked distribution referable to retained earnings.

45. For this reason, the second condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 35(b) is satisfied.

46. Third condition: Subsection 177E(2) of the ITAA 1936 provides as follows:

Without limiting the generality of subsection (1), a reference in that subsection to the disposal of property of a company shall be read as including a reference to:

(a) the payment of a dividend by the company;

(b) the making of a loan by the company (whether or not it is intended or likely that the loan will be repaid);

(d) any transaction having the effect, directly or indirectly, of diminishing the value of any property of the company.

47. The scheme, or the alternative scheme, involves the payment by the Company of the franked distribution to the Fund and thus is a scheme the result of which is the disposal of property of the Company within the meaning of paragraph 177E(2)(a) of the ITAA 1936 (see paragraph 11(g) above).

48. Accordingly, the third condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 35(c) above is satisfied.

49. Fourth condition: As noted above in paragraph 11(g), the franked distribution is to be paid in an amount including the Company's retained earnings and the pre-CGT capital reserves. Therefore, the Commissioner has formed the view that the franked distribution will represent, in whole or in part, a distribution of the profits of the Company. For this reason, the fourth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 35(d) above is satisfied.

50. Fifth condition: If, before the scheme, or the alternative scheme, was entered into, the Company paid a franked distribution out of profits to its then shareholder, it is reasonable to expect that either Company Z and/or a beneficiary, or beneficiaries, of the Trusts would be assessed on an amount reflecting the franked distribution. For this reason, the fifth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 35(e) above is satisfied

51. Sixth condition: The scheme, or the alternative scheme, is to be entered into after 27 May 1981. Therefore, the sixth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 35(f) above is satisfied.

52. For those reasons, if the steps in paragraph 11 above are entered into, there will be taken to be a scheme to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e) of the ITAA 1936). Further, Company Z and/or a beneficiary, or beneficiaries, of the Trusts, will be taken to have obtained a tax benefit in connection with the scheme (paragraph 177E(1)(f)), being the amount which, had the Company paid a franked distribution (at least equal to its retained earnings) prior to entering into the scheme, would have been assessed to Company Z or an amount reflecting the franked distribution would have been assessed to a beneficiary, or beneficiaries, of the Trusts.

Question 3

Summary

53. There is a scheme to which section 177EA of the ITAA 1936 applies. The Commissioner may therefore determine (under paragraph 177EA(5)(b)) that no imputation benefit arises for the Fund in respect of that distribution.

Detailed reasoning

Section 177EA of the ITAA 1936

54. Subsection 177EA(5) of the ITAA 1936 gives the Commissioner the power (relevantly, in paragraph 177EA(5)(b)) to determine that no imputation benefit is to arise in respect of a distribution or specified part of a distribution that is made or flows indirectly to a relevant taxpayer.

55. In Mills v. Federal Commissioner of Taxation [2012] HCA 51; (2012) 87 ALJR 53 (Mills v. FCT) at [59], it was pointed out that subsection 177EA(3) of the ITAA 1936 'is an exhaustive statement of the jurisdictional facts that are necessary and sufficient for s177EA to apply so as to found an exercise of power by the Commissioner to deny a franking credit under s177EA(5)(b)'.

56. The 'jurisdictional facts' can be relevantly identified as follows:

(a) there is a scheme for the distribution of membership interests, or interests in membership interests, in a corporate tax entity (paragraph 177EA(3)(a) of the ITAA 1936). This includes entering into a contract, arrangement, transaction or dealing that changes or otherwise affects the legal or equitable ownership of the membership interests or interests in membership interests (paragraph 177EA(14)(b));

(b) a frankable distribution has been paid, or is payable, or expected to be payable in respect of the membership interest or has flowed indirectly, or flows indirectly, or is expected to flow indirectly in respect of the interest in membership interests (paragraph 177EA(3)(b));

(d) except for section 177EA, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, an imputation benefit as a result of the distribution (paragraph 177EA(3)(d)). An 'imputation benefit' includes receipt by the taxpayer of a tax offset under Division 207 of the ITAA 1997 or, in the case of a corporate taxpayer, a franking credit arising in the franking account of the taxpayer (subsection 177EA(16));

(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' (paragraph 177EA(3)(e)).

57. The 'relevant circumstances' are defined in subsection 177EA(17) of the ITAA 1936 to include 11 matters, the last of which (in paragraph 177EA(17)(j)) includes the eight matters in paragraphs 177D(2)(a) to (h) of the ITAA 1936.

58. Section 177EA of the ITAA 1936 was considered by the High Court in Mills v. FCT. The following propositions emerge from the judgment of Gageler J (with whom the other members of the Court agreed):

(a) the relevance of the 'relevant circumstances' in subsection 177EA(17) lies in the extent to which they are probative of the ultimate question of purpose (at [61]);

(b) the circumstances referred to in subsection 177EA(17) are not exhaustive of the circumstances that might be probative of that ultimate question. They are nevertheless mandatory relevant considerations. Where they exist, they must be taken into account and their degree of relevance will vary according to the extent to which they are probative of the ultimate question (at [61]);

(c) the reference to purpose in paragraph 177EA(3)(e) may, but need not, be that of the issuer. A purpose is a consequence intended by a person to result from some action and, in this context, refers to a consequence intended by the person in entering into or carrying out a scheme for the disposition of relevant interests. A person will often intend a single action to have multiple consequences (at [63]);

(d) a purpose is an 'incidental purpose' within the meaning of paragraph 177EA(3)(e) if it does no more than follow from some other purpose. A purpose can be incidental even when it is central to the design of a scheme if the design is directed to the achievement of another purpose (at [64] and [66]);

(e) the reference to 'enabling' in paragraph 177EA(3)(e) refers to 'supplying with the requisite means or opportunities' to the end of obtaining an imputation benefit (at [65]);

(f) a relevant purpose within the scope of paragraph 177EA(3)(e) need not be a 'dominant purpose'; a 'dominant purpose' is sufficient but not necessary to supply the relevant jurisdictional fact. It does not follow that 'a purpose which does no more than further or follow from some dominant purpose is incidental' (at [66]);

(g) counterfactual analysis is not antithetical to the assessment of purpose in paragraph 177EA(3)(e). Consideration of alternatives may assist the drawing of conclusions in a particular case that a purpose of enabling a holder to obtain a franking credit does or does not exist and, if it does exist, whether it is incidental to some other purpose (at [66]);

(h) in the case of a capital raising, if the franking of distributions serves no purpose other than to facilitate the capital raising, then the purpose is an incidental purpose within the meaning of paragraph 177EA(3)(e) (at [67]); and

(i) in the assessment of purpose in subsection 177EA(3), each of the factors in subsection 177EA(17) need not be analysed individually, so long as they are all taken into account, where probative, in a global assessment of purpose (at [73]).

Application of paragraphs 177EA(3)(a) - (d) of the ITAA 1936

59. It is clear that the 'jurisdictional facts' in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 and described in paragraphs 56(a) to (d) above are satisfied. This is because:

(a) there is a 'scheme for the disposition of membership interests' as the relevant scheme involves the sale of shares in the Company by Company Z to the Fund (see subparagraphs 11(a) and (b) above). Accordingly, the jurisdictional fact in paragraph 177EA(3)(a) is satisfied;

(b) it is expected that the distribution flowing to the Fund will be a frankable distribution and it is expected to be a franked distribution (see subparagraph 11(g) above). Accordingly, the jurisdictional fact in subparagraph 177EA(3)(b)(i) or (ii) and paragraph 177EA(3)(c) is satisfied:

(c) except for section 177EA, the Fund could reasonably be expected to receive an imputation benefit as a result of the franked distribution which flows to it. Accordingly, the jurisdictional fact in paragraph 177EA(3)(d) is satisfied.

60. Accordingly, the question as to whether the Commissioner has the power to make a determination under subsection 177EA(5) of the ITAA 1936 then turns on whether the relevant purpose in paragraph 177EA(3)(e) is present.

Is it more than an incidental purpose of the scheme to enable the Fund to obtain an imputation benefit?

61. As was observed in Mills v. FCT, the relevance of each of the factors in subsection 177EA(17) of the ITAA 1936 and the probative weight they bear will differ in each case (at [61]).

62. Some of the 'relevant circumstances' in subsection 177EA(17) of the ITAA 1936 can be put aside as irrelevant. Because the Fund will (directly or via the LRBA holding trust) be the sole beneficial shareholder in the Company, there is no question of it deriving a 'greater benefit' than other persons who hold membership interests. Thus, the circumstances in paragraphs 177EA(17)(b), (c) and (d) can be put to one side. Equally, the scheme does not involve the issue of non-share equity and so the matter in paragraph 177EA(17)(e) can be put to one side. These matters are generally concerned with 'dividend streaming' arrangements: see Mills v. Federal Commissioner of Taxation [2011] FCAFC 158; 198 FCR 89 at [43].

63. Some of the 'relevant circumstances' in subsection 177EA(17) of the ITAA 1936 point, at least to some extent, against the existence of the relevant purpose:

(a) the consideration ($X) to be paid to Company Z for the shares in the Company does not appear to have been calculated by reference to any imputation benefits (it appears to have been calculated by reference to the sum of the value of the Company's pre-CGT capital reserves and the Company's retained earnings but not including the franking credits) (cf., paragraph 177EA(17)(f)). However, given the close relationship of all parties to the scheme, the fact that the scheme involves circular payments as between those related parties and the fact that the tax effect of the scheme is not dependent on the dividend being calculated by reference to the franking credits, the weight of this factor is slight;

(b) the franked distribution does not appear to be equivalent to receipt of an amount in the nature of interest (cf., paragraph 177EA(17)(h));

(c) the franked distribution, to the extent that it is paid from retained earnings, appears to be paid from taxed and not untaxed profits (cf., paragraph 177EA(17)(ga)).

These matters, to the extent that they bear probative weight, point against the relevant conclusion.

64. The following matters in subsection 177EA(17) of the ITAA 1936 point to the existence of the relevant purpose:

(a) the period of time the Fund will hold the shares in the Company prior to the payment of the franked distribution is short and following payment of the franked distribution the Company will be deregistered. It appears that the Company will conduct no trading activities in that period and its assets are wholly cash assets. The extent and duration of the risk of loss the Fund will bear as a result of its holding of the shares in the Company will be minimal. After payment of the franked distribution, the Company will be worthless. The Fund was not the economic owner of the shares when the Company generated the franking credits and will not bear any significant risk in the short period of its holding of the shares in the Company. This undermines the principles of the imputation system: Explanatory Memorandum to the Taxation Laws (Amendment) Bill (No 3) at [8.5] (cf., paragraphs 177EA(17)(a) and (i));

(b) the subsequent deregistration of the Company will give rise to a capital loss for the Fund thus incurring a capital loss in connection with the distribution (cf., paragraph 177EA(17)(g)). However, since it is not anticipated that this capital loss will be used while the Fund is entirely in pension phase, this factor is of limited weight.

65. Turning to the matters in paragraphs 177D(2)(a) to (h) of the ITAA 1936 which are picked up by paragraph 177EA(17)(j) of the ITAA 1936, the following are relevant:

(a) the scheme involves a carefully orchestrated and interlinked series of transactions (cf., paragraph 177D(2)(a)) between persons who are, or who are all connected with, the Taxpayers (cf., paragraph 177D(2)(h));

(b) the scheme's form involves a sale of the shares in the Company to the Fund and payment of a franked distribution to it. The substance of the scheme (that is, 'what in fact [the relevant person] may achieve by carrying it out': Mills v. FCT at [71]) is the channelling of the distribution of the profits and the franking credits of the Company to its ultimate economic owners (the Taxpayers) through the Fund in order to generate a refund of the franking credits (see paragraph 31(b) above) (cf., paragraph 177D(2)(b));

(c) the scheme is to be implemented over a short period of time. The length of the scheme is no longer than is necessary to cause the Company to pay the franked distribution to the Fund and to thereby enable the Fund to repay the loan from Company Z under the LRBA and permit the Company to be put in a position to be deregistered (cf., paragraph 177D(2)(c));

(d) the effects of the scheme (that is, the financial position of the relevant persons with and without the scheme: Mills v. FCT at [70]) will be as follows(cf., paragraphs 177D(2)(d) - (f)):

(i) the Fund will receive the franked distribution as well as a refund of the franking credit tax offset on the basis that the franked distribution is exempt income pursuant to section 295-390 of the ITAA 1997; and a capital loss on the Company's deregistration. The Fund will incur a liability under the LRBA, and will utilize an amount equivalent to earlier contributions, to acquire the shares with the amount paid for the shares equal to the quantum of the franked distribution. The difference in the economic position of the Fund with and without the scheme is overwhelmingly due to the effect of the refund of the franking credit tax offset (paragraph 31(b) above). The existence of circular or 'round robin' payments is a matter which has been accepted as pointing towards a tax avoidance purpose: Commissioner of Taxation v. Sleight [2004] FCAFC 94; (2004) 136 FCR 211 at [77] per Hill J (cf., paragraph 177D(2)(d));

(ii) Company Z will receive a capital amount equal to the value of the capital reserves and retained earnings of the Company in a tax-free form (see paragraph 31(d) above). In the absence of the scheme Company Z would otherwise reasonably expect to receive a franked distribution from the Company and either Company Z and/or a beneficiary, or beneficiaries, of the Trusts could reasonably expect to incur a taxation liability in respect of that income (see paragraph 25 above) (cf., paragraph 177D(2)(d)); and

(iii) the Taxpayers will receive the benefit of pensions in a tax free form from the Fund - supported by the franked distribution (to the extent it is not used to pay the loan under the LRBA) and the refund of the franking credit tax offset received by the Fund. In the absence of the scheme Company Z would otherwise reasonably expect to receive a franked distribution from the Company and either Company Z and/or a beneficiary, or beneficiaries, of the Trusts could reasonably expect to incur a taxation liability in respect of that income (see paragraph 25 above). Any intention of the Taxpayers to make contributions to the Foundation in the event the scheme is not implemented is not relevant or probative for the reasons given in paragraph 31(h) above (cf., paragraph 177D(2)(e)).

66. Overall, the balance of matters points towards a conclusion that a more than incidental purpose of the scheme is to enable the Fund to gain an imputation benefit. The critical factor in an assessment of purpose is the absence of any substantial explanation for the implementation of the scheme other than to ensure that the Company's franking credits are channeled to their ultimate economic owners (the Taxpayers) through the Fund with the benefit of the exemption in section 295-390 of the ITAA 1997. This has the effect of converting the franking account of the Company to cash which is then used to support the Taxpayers' retirement income. A further taxation benefit is the conversion of the Company's funds on which Company Z or the beneficiaries of the Trust could reasonably expect to incur a taxation liability to a capital sum free of taxation liability.

67. It is no answer to say that the main purpose of the scheme is the maximising of the Taxpayer 1's wealth in retirement. That draws the same false dichotomy as was rejected in FCT v. Spotless. This is because it is the tax effect referred to above which achieves the maximisation of wealth in retirement over that which would otherwise be achieved. The suggested explanations of avoiding liquidation fees and simplifying the Taxpayers' wealth structure have inadequate probative weight for the reasons given in paragraph 31(f) and (g) above.

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