Edited version of private advice

Authorisation Number: 1012636211264

Ruling

Subject: Dividend access share arrangement

Question 1a

Answer

No

Question 1b

Answer

Not necessary to answer this question

Question 1c

Answer

Not necessary to answer this question

Question 2

Will the proposed transaction give rise to the indirect value shifting rules under Division 727 of the ITAA 1997 applying?  

Answer

No

Question 3

Will any payment of fully franked dividends to the holder of the proposed RPS be considered dividend streaming under Subdivision 204-D of the ITAA 1997?

Answer

No

Question 4(a) and (b)

(a) Will any distribution to the holders of the proposed RPS be considered part of a dividend stripping operation under section 207-155 of the ITAA 1997; or

(b) a scheme for the stripping of company profits within the meaning of paragraph 177E(1)(a) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes to (a) and (b)

Question 5

Will section 45 of the ITAA 1936 apply to any distribution of fully franked dividends to the holder of the proposed RPS?

Answer

No

Question 6

Will Division 7A of the ITAA 1936 have application?

Answer

No

Question 7

Will the RPS be considered to be an Equity Interest for the purposes of Division 974 of the 1997 Act?

Answer

Yes

Question 8

Will section 177EA of the ITAA 1936 apply to any distribution of fully franked dividends to the holders of the proposed RPS?

Answer

Yes

Question 9

Will Part IVA of the ITAA 1936 apply to the proposed transaction?

Answer

Yes

This ruling applies for the following periods:

1 July 2013 to 30 June 2017

The scheme commences:

During the year ended 30 June 2014

Relevant facts and circumstances

The scheme is based on the following documents provided by the Applicant:

• Private ruling application

• Further information provided by the tax agent

The entity is incorporated. It has operated a business in an industry. It is owned by A, B and the trustee for FT (FT).

The related entity is incorporated. It is owned by FT, the trustee for OPT, and the trustee for PT.

The rights attached to the various classes of shares in the related entity are different.

The entity and the related entity are members of the same group of entities, which comprises companies, non-fixed trusts and a unit trust. The related entity operates "to a large degree as the financier for the group of entities."

A wishes to pass on the operation and ownership of the business conducted by the entity to C. Owing to the business ties with the entity, consideration is being given to the sale of the shares in the entity to C. The application does not indicate how many shares would be acquired.

The retained earnings in the entity provides an impediment to the acquisition by C of the shares in the entity. For this reason, it is proposed to issue a RPS to the related entity and in turn pay out the retained earnings of the entity via this share.

The terms of the RPS would include:

1. The right to such fully franked dividends as the Directors in their absolute discretion from time to time declare.

2. No right to vote at a general meeting of the Company or to participate in a distribution of the surplus assets of the profits on the winding up of the Company.

3. A right by the Company to redeem the new share within 4 years of the issue date.

4. A right by the Company to abolish dividend entitlements on the new share within 4 years of the shares' (sic) issue date.

The RPS will be issued at a nominal value.

Reasons for decision

Question 1(a)

The essence of determining the issue of direct value shifting is the application of the reversal exception under section 725-90 of the ITAA 1997. However, it is important to first identify the direct value shift to which the exception is to be applied.

A direct value shift is defined in section 725-145 of the ITAA 1997.

Subsection 725-145(1) of the ITAA 1997 states:

There is a direct value shift under a scheme involving equity or loan interests in an entity (the target entity) if:

(a) there is a decrease in the market value of one or more equity or loan interests in the target entity; and

(b) the decrease is reasonably attributable to one or more things done under the scheme, and occurs at or after the time when that thing, or the first of those things, is done; and

(c) either or both of subsections (2) or (3) are satisfied.

Subsections 725-145(2) and 725-145(3) of the ITAA 1997 continue that:

One or more ^*equity or loan interests in the target entity must be issued at a ^*discount. The issue must be, or must be reasonably attributable to, the thing, or one or more of the things, referred to in paragraph (1)(b). It must also occur at or after the time referred to in that paragraph.

Or, there must be an increase in the *market value of one or more ^*equity or loan interests in the target entity. The increase must be reasonably attributable to the thing, or to one or more of the things, referred to in paragraph (1)(b). It must also occur at or after the time referred to in that paragraph.

'Scheme' is defined broadly in section 995 of the ITAA 1997 to mean any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

The foundation of the scheme is that the entity will issue to the related entity a redeemable preference share (RPS) which has rights to income (dividends) only. It is stated that the share would be redeemed within 4 years of its issue.

Conclusion

You advised the RPS will issue for market value; that is the consideration for the RPS will be equivalent to the market value of the RPS. On this basis Division 725 does not apply.

Question 2

Indirect value shift

Under section 727-100 of the ITAA 1997 an indirect value shift has consequences if four conditions are satisfied:

• the losing entity is a company or a trust (paragraph 727-100(a)),

• the losing entity and the gaining entity exchange economic benefits at non- arm's length (paragraph 727-100(b)),

• either or both the ultimate controller test and the common-ownership nexus test are satisfied (paragraph 727-100(c)),

• none of the exclusions in Subdivision 727-C applies (paragraph 727-100(d)).

There can only be consequences for an indirect value shift if the entities between which the value is shifted (the losing entity and the gaining entity) satisfy an ultimate controller test under section 727-105 and/or a common ownership nexus test under section 727-727-110 at some time during the indirect value shift period as required by paragraph 727-100(c).

Conclusion

As the RPS will be issued at market value there is no value shift under Division 727.

Question 3

Dividend Streaming

Streaming is not a defined term, but the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 at paragraph 3.28 describes streaming as selectively directing the flow of franked distributions to those members who could most benefit from imputation credits to the exclusion of any other members.

Division 204 of the ITAA 1997 contains some specific anti streaming rules. Subdivision 204-D contains provisions which aim to prevent the streaming of franking credits to one member of a corporate tax entity in preference to another by either imposing a franking debit or denying an imputation benefit.

Paragraph 204-30(3)(c) of the ITAA 1997 allows the Commissioner to make a determination that no imputation benefit is to arise for a receiving entity because distributions have been streamed in a certain way.

Subsection 204-30(8) of the ITAA 1997 sets out the circumstances where one shareholder will be taken to have received a greater benefit than another shareholder.

These are where the other shareholder:

a) is not an Australian resident;

b) is not entitled to use the tax offset under Division 207;

c) incurs a tax liability as a result of the distribution that is less than the benefit associated with the tax offset attributable to the distributions;

d) is a corporate tax entity at the time the distribution is made, but no franking credit arises for the entity as a result of the distribution;

e) is a corporate tax entity at the time the distribution is made, but cannot use the franking credits to frank a distribution to its own members because it is not a franking entity or is unable to make a frankable distribution; and

f) is an exempting entity.

The entity is issuing a RPS to the related entity. The proposal is that the entity will pay fully franked dividends on its ordinary shares and to the RPS Shareholder. All participants in the proposal are Australian resident taxpayers. The right to receive dividends under the RPS is at the discretion of the directors of the entity. If a discretionary dividend is declared it will be paid to the holder of the proposed RPS.

There will be no streaming for the purposes of subdivision 204-D as all shareholders will be Australian resident taxpayers and there is no evidence that any shareholder or class of shareholder in the proposal will obtain a greater benefit from franking credits than any other shareholder or class of shareholder.

Provided the arrangement is carried out in accordance with the principles outlined in the facts, it is accepted that the payment of fully franked dividends to the holder of the proposed RPS will not be considered the 'streaming' of imputation benefits under Subdivision 204-D of the ITAA 1997.

Consequently, the Commissioner will not make a determination under paragraph 204-30(3)(c) of the ITAA 1997.

Question 4(a) and (b)

Section 207-155 of the ITAA 1997 states:

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.

Subsection 177E(1) of the ITAA 1936, whilst more expansive, is couched in similar terms. The following discussion is considered relevant in determining the outcome for each of the legislative provisions.

The decisions in Lawrence v FCT 2008 ATC 20-052 (Jessup J) and Lawrence v FCT 2009 ATC 20-096 (Ryan, Stone and Edmonds JJ) are relevant to this ruling application. The Full Court affirmed Jessup J's decision. All references to Lawrence are to Jessup J's decision.

Section 177E contains two limbs. The first limb covers schemes by way of or in the nature of dividend stripping (abbreviated to "by way of dividend stripping" below). The second limb covers schemes having substantially the effect of a scheme by way of dividend stripping.

Jessup J decided the scheme in Lawrence was a second limb scheme.

The elements of section 177E are examined below.

As a result of a scheme (s177E(1)(a))

The disposal of property must be a result of the scheme, but the scheme is not limited to the events by which the disposal occurs. The scheme consists of:

1. The issue by the entity of one RPS to the related entity.

2. The declaration of fully franked dividends payable to the RPS holder.

3. The discharge of the resulting debt due by the entity to the related entity

By way of or in the nature of dividend stripping (s177E(1)(a)(i))

The common characteristics of a scheme by way of dividend stripping include:

1. a target company with substantial undistributed profits creating a potential tax liability either for the company or its shareholders.

The entity has undistributed profits which, if distributed, would be included in the assessable income of its shareholders.

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

One RPS would be allotted by the entity to the related entity.

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

It is proposed that the entity pay a dividend(s) to the related entity.

4. the purchaser escaping Australian income tax on the dividend

The related entity (an Australian company) would not pay tax on the dividend because it would be fully franked.

5. the vendor shareholders receiving a capital sum for their shares in an amount the same as or very close to the dividends paid to the purchasers.

This characteristic refers to "vendor shareholders". A literal reading would require the shareholders to sell their shares; in which case, a scheme involving the issue (rather than sale) of shares could not be a scheme by way of dividend stripping. Therefore, a literal reading should be rejected.

A literal reading might also require the shareholders to receive the capital sum (benefit). The ATO rejects this view. It is sufficient that the benefit be received by the shareholders and/or their associates.

Support for a non-literal interpretation is found in the Full Court's decision in FCT v Consolidated Press Holdings Limited (No 1) 99 ATC 4945 (CPH). At [156], the Full Court said:

The terms of the first limb of s 177E(1)(a) suggest that a scheme may fall within its scope, even though not all the elements of a dividend standard dividend stripping scheme are present. The use of the words "by way of or in the nature of" suggests that variations from the paradigm will not necessarily result in the scheme being excluded from the first limb, provided it retains the central characteristics of a dividend stripping scheme.

The facts in CPH illustrate the application of this principle to the fifth characteristic. The taxpayer (CPH) submitted that the scheme did not satisfy the first limb of s 177E(1)(a) because, among other things, the shareholders received an allotment of shares, rather than cash, as consideration for their shares. At [159], the Full Court said:

… the fact that the consideration takes a different form is not a significant departure from the paradigm. The critical point is that the vendor shareholders receive a consideration which is in a tax-free or largely tax-free form.

In the proposed scheme, the form of the capital benefit would be an increase in the value of shares held by trusts in the related entity. The capital benefit in Lawrence took the same form i.e. an accretion to capital attributable to an increase in the value of shares held by family trusts.

The accretion to capital in Lawrence was attributable to a change in the rights attached to shares held by the trusts, whereas the accretion to capital in the proposed scheme would be attributable to dividends from the target company.

The question arises as to whether the capital benefit in the proposed scheme is in a tax-free or largely tax-free form. On one view, the capital benefit is in a tax-free form - the trusts would not be taxable on the increase in value of their shares in the related entity. Arguably, you should look no further. This contention finds some support in the judgement of Jessup J at [85]:

85. It is convenient at this point to return to the identification and limits of the schemes which I have held to exist. Having considered the matter of dividend stripping, I have concluded that the schemes had substantially the effect of a scheme by way of or in the nature of dividend stripping. To reach that conclusion, I did not need to look beyond the increase in value in the shareholding of Clearmink in Netscar and Windainty. At that point the value - to use a neutral term - that started out as undistributed profits in Plaster Plus and Zinkris had become accretions to the capital of the Clearmink trusts. Subject only to the discretionary nature of those trusts, the applicant and his associates were beneficially entitled to that capital. To reach the conclusion that the scheme substantially had the effect of dividend stripping, it is sufficient that associates of the applicant had derived the benefit, as capital, of the profits stripped out of Plaster Plus and Zinkris. In the circumstances, the question whether the scheme went no further than the resolutions altering the participation rights of the "B" Class shareholders was, in my view, moot.

In contrast with the proposed scheme, Jessup J did not have to consider the possibility that Lawrence (as a beneficiary of the Clearmink trusts) would ultimately receive the profits of the target company in the form of a dividend from the new shareholder, because the profits of the target companies were not distributed as a dividend. Strictly speaking, the profits of the target companies were eliminated by the value shifts. In contrast, the profits of the entity would be distributed to the related entity and would be available (hypothetically) for distribution to FT. This raises the possibility that the profits of the target company (the entity) might, at some future time, be received in a taxable form by the shareholders and their associates (i.e. as dividends assessable at personal tax rates with franking credits). This might give rise to the same tax implications that would arise if the scheme was not entered into and the profits of the entity were distributed directly to its current shareholders.

Based on Jessup J's reliance on the scheme alone (and nothing beyond the scheme), the Commissioner favours the view that the capital benefit - an accretion to the capital of the trusts - has been received in a tax-free form. Otherwise, the section would turn on speculation about possible future events and circumstances. For example, you would need to make assumptions about a range of matters, such as whether and, if so, to whom the related entity would distribute the dividend and whether, alternatively, the trusts would realise the benefit of the entity's profits by selling their shares in the related entity before the dividends were distributed by the related entity.

Having substantially the effect of a scheme by way of or in the nature of dividend stripping (s177E(1)(a)(ii))

If the scheme is not a scheme by way of dividend stripping, it may be a scheme having substantially the effect of a scheme by way of dividend stripping.

Before you can determine whether a scheme has substantially the effect of a scheme by way of dividend stripping, you need to determine the effect of a scheme by way of dividend stripping. This requires you to formulate a notional scheme having the effect of a scheme by way of dividend stripping.

Under a notional scheme, the three shareholders would have sold their shares in the entity to the related entity in consideration for a capital sum and the related entity would have received dividends in a tax free form (owing to the effect of franking credits).

Under the proposed scheme, one of the three shareholders and two associates would obtain a capital benefit in the form of an increase in the value of their shares in the related entity as a result of the distribution of the entity's profits to the related entity.

The notional and proposed schemes are different in two respects: firstly, the nature of the capital benefits and, secondly, the entities to which the capital benefits accrue. These differences were present in Lawrence. Jessup J (with the Full Court concurring), found that the second limb applied notwithstanding that the capital benefit was an accretion to the capital of family trusts:

To reach the conclusion that the scheme substantially had the effect of dividend stripping, it is sufficient that associates of the applicant had derived the benefit, as capital, of the profits stripped out of Plaster Plus ….

Provided the scheme did not constitute a scheme by way of dividend stripping, and subject to the sixth characteristic below, the scheme would have substantially the effect of a scheme by way of dividend stripping.

Dominant purpose

The sixth characteristic is common to the first and second limbs of s 177E(1)(a).

6. the dominant purpose of, in particular, the vendor shareholders, avoiding tax on a distribution of dividends by the target company.

To constitute dividend stripping, a scheme must have as its dominant purpose the avoidance of tax on the distribution of dividends by the target company.

The objective purpose of the scheme is to be assessed from the perspective of the reasonable observer, having regard to the characteristics of the scheme and the objective circumstances in which the scheme was designed and operated.

The purpose is ordinarily examined from the perspective of the vendor shareholders (or existing shareholders in the case of share allotment).

In the ruling application, the applicants state that the proposed transactions would provide the following benefits:

1. Facilitate the transfer of shares in the entity at a value commensurate with the value of the business.

2. Assist in ensuring the retained earnings of the entity are no longer exposed to on-going risks associated with the business.

3. Enable the business to continue through its current structure and avoid the associated costs and complications of establishing a new company.

4. Assist the related entity in its capacity as financier of the group.

5. Would not result in a considerable transfer duty liability.

The first benefit

The ruling application states that the entity operates a business in an industry. We do not have financial statements, but the assets of the entity included assets which you might expect a business to own. The majority of the assets, however, were non-industry business assets.

From the information available, it is apparent that the entity's accumulated profits have not been reinvested in its business; rather, they have been used to fund the activities of other entities in the group.

If the prospective new owner of the entity (C) does not wish to acquire non-industry business assets, it is reasonable to reduce the value of the entity by distributing such assets. However, this could be easily achieved by the entity declaring a dividend payable to the current shareholders and assigning the loan receivables to satisfy the resulting debt.

The second benefit

There is no objective evidence that the entity is subject to any impending threats to its business which would erode its profits. In any event, the entity could more easily reduce its assets at risk by declaring a dividend.

The third benefit

The proposed scheme would not, of itself, enable the business to continue in its current form. The scheme simply makes this option more attractive financially by reducing the stamp duty costs of transferring the ownership of the current structure to the new owner.

The fourth benefit

It is not clear how the scheme would assist the related entity in its capacity as financier of the group.

The applicants have not provided financial statements, so we cannot verify the claim that the related entity is the financier of the group, nor the manner in which it carries out this function. More importantly, it is not clear how the scheme would assist the related entity in capacity as financier. The dividends to the related entity would be satisfied by the assignment of intra-group receivables.

The fifth benefit

The benefit is attributable to a reduction in the assets of the entity. This could be more easily achieved by declaring a dividend.

Other considerations

The scheme itself contains features which appear to be designed to avoid specific Tax Act integrity measures, namely, the value shifting rules in Division 725 by taking advantage of the exclusion in section 725-90 for value shifts that are reversed within 4 years.

The scheme is complex. As indicted above there would appear to be a more straightforward and obvious means to achieve the purported commercial benefits, namely, the declaration of dividends to existing shareholders.

Property of the company is disposed of (s177E(1)(a))

The company is the entity. The payment of a dividend constitutes the disposal of property by the company: s 177E(2).

In the opinion of the Commissioner, the disposal represents, in whole or in part, a distribution of profits of the company (s177E(1)(b))

It is proposed that the whole of the retained earnings be distributed to the RPS holder.

If, immediately before the scheme was entered into, the company had paid a dividend equal to the amount determined by the Commissioner to be a distribution of profits, an amount would have been included in the assessable income of the taxpayer (s177E(1)(c))

The dividend would have been included in the assessable income of the following taxpayers:

1. FT

2. A

3. B

The Commissioner may make s177F(1) determinations in respect of, and issue assessments to, both the trustee and the beneficiaries of FT. The Act, however, does not authorise double taxation of the same income, so tax could only be collected from the taxpayer(s) ultimately held to be liable.

The scheme has been entered into after 27 May 1981

The scheme is proposed to be entered into in the future.

The effect of satisfying the conditions in s 177E(1)(a)-(d)

(e) the scheme is taken to be a scheme to which Part IVA applies

(f) the taxpayer(s) shall be taken to have obtained a tax benefit

(g) the tax benefit shall be taken to equal to the amount of dividends distributed by the entity to the related entity

Question 5

Section 45 of the ITAA 1936 states:

Application of section

(1) 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 shares (other than shares to which subsection 6BA(5) applies) and the payment of minimally franked dividends to its shareholders in such a way that:

(a) the shares are received by some shareholders but not all shareholders; and

(b) some or all of the shareholders who do not receive the shares receive or will receive minimally franked dividends.

(2) The value of the share at the time that the shareholder is provided with the share is taken, for the purposes of this Act, to be a dividend that is unfrankable (within the meaning of subsection 995-1(1) of the Income Tax Assessment Act 1997) and that is paid by the company, out of profits of the company, to the shareholder at that time.

(3) A dividend is minimally franked if it is not franked, or is franked to less than 10%, in accordance with section 202-5 or 208-60 of the Income Tax Assessment Act 1997.

Section 45 of the ITAA 1936 applies where a company streams the provision of shares and the payment of minimally franked dividends to its shareholders in such a way that the shares are received by some shareholders and minimally franked dividends are received by other shareholders.

On the facts as given, there is no evidence of a plan or intention on the part of the company to ensure that unfranked or minimally franked dividends are received by shareholders who are not in receipt of the RPS. Therefore section 45 of the ITAA 1936 will not apply to the proposed distribution.

Question 6

Generally, Division 7A of Part III of the ITAA 1936 (Division 7A) applies where a private company has made a payment or loan to, or forgiven the debt of, an entity in an income year and in that income year either:

• The entity was a shareholder or shareholder's associate of the private company at the time the payment, loan or debt forgiveness was made, or

• A reasonable person would conclude that the loan, payment or debt forgiveness was made because the entity had been a shareholder or shareholder's associate at some time.

An entity includes an individual (section 109ZD and paragraph 960-100(1)(a) of the ITAA 1936).

An associate includes a relative of an entity (section 109ZD of the ITAA 1936 and section 318 of the ITAA 1936).

The general rule is that a private company is taken to pay a dividend to an entity at the end of the income year in which the payment (including the transfer of property) or loan is made or the debt is forgiven (refer to sections 109C, 109D and 109F of the ITAA 1936). Such dividends are included in the assessable income of the shareholder or associate under section 44 of the ITAA 1936.

The issue of a RPS will not result in the application of Division 7A as the payment of a dividend is not a loan.

Question 7

Division 974 of the ITAA 1997 sets out the rules for defining what constitutes an equity interest in a company or a debt interest [GL1]. The debt and equity rules are designed to treat returns on debt interests in the same way as interest on debt and returns on non-share equity interests in the same way as distributions on a share. The characterization as debt or equity is intended to be based on the economic substance of the right regardless of its legal form.

The main operative provisions for the debt test are found in sections 974-15 and 974-20 of the ITAA 1997 and the main operative provisions for the equity test are found in sections 974-70 and 974-75 of the ITAA 1997. If an interest satisfies both the debt and the equity tests there is a tiebreaker rule in subsection 974-70(1) of the ITAA 1997 which will make the interest a debt interest.

The Debt Test

The debt test will be satisfied if all of the following preconditions set out in subsection 974-20(1) of the ITAA 1997 are satisfied:

A scheme satisfies the debt test in this subsection in relation to an entity if:

(a) the scheme is a financing arrangement for the entity; and

(b) the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme; and

(c) the entity has, or the entity and a connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when:

(i) the financial benefit referred to in paragraph (b) is received if there is only one; or

(ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and

(d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

The scheme does not need to satisfy paragraph (a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company).

Is there a 'scheme'?

A 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a) any arrangement; or

(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

The issue of the RPS by the entity to the related entity falls within the ambit of a scheme.

Is the scheme a financing arrangement?

As the RPS is a class of shares representing an interest as a member or stockholder of the entity it is covered by item 1 of the table in subsection 974-75(1) of the ITAA 1997. Therefore, the RPS do not need to satisfy the financing arrangement requirement in subsection 974-20(1) of the ITAA 1997.

Does the entity receive, or will receive, a financial benefit or benefits under the scheme?

Section 974-160 of the ITAA 1997 defines 'financial benefit' as anything of economic value, including property or services.

It is proposed that the RPS will be issued to the related entity at a nominal value. Thus the proceeds received by the related entity from the issue of the RPS will constitute a financial benefit as they will have an economic value, despite this economic value only being a nominal amount.

Does the entity have an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits?

Subsection 974-135(1) of the ITAA 1997 defines an effectively non-contingent obligation (ENCO) in the following way:

There is an effectively non-contingent obligation to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation …. to take that action.

Subsection 974-135(3) of the ITAA 1997 specifies that:

An obligation will be non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity) other than the ability or willingness of that entity or connected entity to meet the obligation.

Paragraph 2.175 of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (the Debt Equity Bill) describes an effectively non-contingent obligation (ENCO) in the following way:

The debt test therefore uses the concept of an effectively non-contingent obligation as opposed to a legally (or formally) non-contingent obligation. Thus a scheme under which an entity has a right but not a legal obligation to provide a financial benefit could nevertheless be debt if, having regard to the pricing, terms and conditions of the scheme, the entity is in substance or effect inevitably bound, to exercise that right . This would occur where not to exercise the right would result in the entity having to sustain a greater loss (in present value terms) from the scheme than if it exercised the right. A simple example of this would be where the issuer of a financing instrument has a right to redeem it after a certain period but is compelled to provide accelerating returns on the instrument if it does not exercise that right: the accelerating returns would make it uneconomic for the issuer not to redeem the instrument so that it is under an effectively non-contingent obligation to do so.

(Emphasis added)

Thus, an ENCO may exist where a party has a right that it may exercise to provide a financial benefit, without a legal obligation, and upon consideration of the pricing, terms and conditions of the scheme, the party is in substance or effect inevitably bound to exercise that right.

The characteristics of the proposed RPS include:

• issue at a nominal value,

• the right to fully franked dividends at the sole discretion of the Directors of the entity,

• no voting rights,

• no right to participate in distributions of surplus assets or profits upon windup of the entity, and

• a right for the entity to redeem the RPS within 4 years of the date of issue, and

• a right for the entity to abolish dividend entitlements within 4 years of their issue.

Based on their pricing, terms and conditions there are no obligations, legal or otherwise, whereby the entity has an ENCO to provide a financial benefit in relation to the RPS.

Subsections 974-20(1) (d) & (e) of the ITAA 1997

As paragraph 974-20(1)(c) of the ITAA 1997 is not satisfied it is not necessary for the other conditions in subsection 974-20(1) of the ITAA 1997 to be considered.

Conclusion debt test

Based on the above it is concluded that the issue of the RPS will not satisfy the requirements of the debt test in subsection 974-20(1) of the ITAA 1997.

The Equity Test

The meaning of equity interest is found in subsection 974-20(1) of the ITAA 1997, which states that:

A scheme gives rise to an equity interest in a company if:

(a) the scheme, when it comes into existence, satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest; and

(b) the interest is not characterised as, and does not form part of a larger interest that is characterised as, a debt interest in the company or a connected entity of the company under Subdivision 974-B.

Of relevance subsection 974-75(1) states that:

A scheme satisfies the equity test in this subsection in relation to a company if it gives rise to an interest set out in the following table:

Equity interests
Item	Interest
1	An interest in the company as a member or stockholder of the company.
….

This subsection has effect subject to subsection (2) (requirement for financing arrangement)

Subsection 974-75(2) of the ITAA 1997 states that:

A scheme that would otherwise give rise to an equity interest in a company because of an item in the table in subsection (1) (other than item 1) does not give rise to an equity interest in the company unless the scheme is a financing arrangement for the company.

The proposed RPS, as shares, would constitute an interest in the entity as a member or stockholder covered by item 1 of the above table. As subsection 974-75(2) exempts interests covered by item 1 of the above table from the financing arrangement requirement. The proposed RPS would satisfy the equity test.

The tie breaker rule

As considered above under the heading 'The Debt Test' heading, the RPS is not a debt interest.

Conclusion

As the proposed RPS is an equity interest that does not pass the debt test, it will be considered to be an equity interest for the purposes of Division 974.

Question 8

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies where one of the purposes (other than an incidental purpose) of a scheme is to obtain an imputation benefit. In these circumstances, subsection 177EA(5) enables the Commissioner to make a determination with the effect of either:

• imposing franking debits or exempting debits on the distributing entity's franking account; or

• denying the imputation benefit on the distribution that flowed directly or indirectly to the relevant taxpayer.

Pursuant to subsection 177EA(3) of the ITAA 1936, the provision applies if the following conditions are satisfied:

(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

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

(d) 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

(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.

The "imputation benefit" is defined to be simply the availability of a tax off-set pursuant to Division 207 of the ITAA 1997. (Subsection 177EA(16)).

The "relevant circumstances" of the scheme are set out in subsection 177EA(17) in an inclusive manner.

In the event that a distribution was made on the RPS and franking credits were available, that distribution would be franked and the RPS holder would get the benefit of the franking credits. This "imputation benefit" would be no more than an incidental benefit of the scheme.

Having regard to those relevant circumstances in the context of the facts of this proposal, it cannot be concluded that any person who proposes to enter into the scheme or carry it out, are doing so for the more than incidental purpose of entitling the RPS shareholder to a tax off-set.

Question 9

Part IVA of the ITAA 1936 applies to any scheme that has been carried out or is entered into for the dominant purpose of enabling a taxpayer to obtain a tax benefit in connection with the scheme. The application of Part IVA requires all of the following conditions to be present:

(i) a scheme has been carried out or entered into after 27 May 1981;

(ii) a taxpayer has or will obtain a tax benefit in connection with the scheme; and

(iii) the dominant purpose of the scheme was to enable the taxpayer to obtain a tax benefit

The scheme

The scheme would consist of:

1. The entity would issue one RPS to the related entity.

2. The entity would fully distribute its retained earnings to the related entity. The dividends would be fully franked.

3. The entity would assign loans receivable to the related entity to discharge the dividend debt.

The taxpayers

The taxpayers are the persons who obtain a tax benefit in connection with the scheme.

We consider the taxpayers to be the registered shareholders of the entity.

The Full Federal Court decided in Grollo Nominees Pty Ltd & Ors v FCT 97 ATC 4585 that the trustee of a trust may be a "taxpayer" for the purposes of Part IVA. The relevant trustee was a company named Grofam Pty Limited (Grofam). The Commissioner made determinations under s 177F of the ITAA 1936 that amounts which had been omitted from the assessable income of Grofam shall be included in its assessable income as a trustee.

Grofam submitted that "a trustee cannot be caught by Part IVA of the Act at least unless the trustee is properly to be regarded as a taxpayer in respect of the trust income."

Grofam contended that it received no tax benefit because it was not itself liable to pay income tax upon the net income of the trust. The Court accepted that ss. 96 and 97 of the ITAA 1936 would operate to make the beneficiaries of the trust and not the trustee (Grofam) liable to pay income tax upon the income earned by the trust.

The Court, however, rejected Grofam's submission. At 4623, the Court analysed the definition of "taxpayer":

"An initial difficulty we have with the submission arises from the terms of the definition of ``taxpayer'' in s. 177A. As mentioned, ``taxpayer'' includes a taxpayer in the capacity of a trustee. So, when one considers the words of subsec. 177F(1) to which we have referred, one needs to read ``taxpayer'' therein as including a taxpayer in the capacity of a trustee."

The Court also noted at 4623 that Grofam's submission would lead to an unintended outcome:

"… the submissions made on behalf of Grofam would lead to an extraordinary result. ... If the trustee is not a taxpayer for the purposes of the provisions, there can be no tax benefit, no occasion for the carrying out of the exercise required by s. 177D if there be a tax benefit, and no work for s. 177F to do".

The alternative postulate

The alternative postulate may be based on events which would have occurred or might reasonably be expected to have occurred. We have considered both options below.

A tax effect that would have occurred

In determining the tax effect that would have occurred if the scheme had not been entered into, the postulate comprises only events that actually happened (other than those that form part of the scheme). Accordingly, the postulate comprises the sales by the shareholders of all of their shares in the entity to C. The profits of the entity would not be distributed prior to the sales.

A tax effect that might reasonably be expected to have occurred

In determining the tax effect that might reasonably be expected to have occurred if the scheme had not been entered into, you must have particular regard to the substance of the scheme and any result for the taxpayer that is or would be achieved by the scheme (other than a result in relation to the operation of this Act).

The substance of the scheme would be the transfer of substantial assets from the entity to the related entity in a tax-free form (fully franked dividends) for nominal consideration. The result for the taxpayers of the entity would be a substantial reduction in the value of their shares in the entity.

Having regard to the substance of the scheme and the result for the taxpayers, the reasonable alternative postulate comprises the distribution of all of the retained earnings of the entity to the current shareholders, followed by the transfer of the intragroup loans receivable to the related entity for nil consideration. In deciding whether this postulate is a reasonable alternative, any tax consequences under the Act for any person must be disregarded.

The tax benefits

A tax effect that would have occurred

CGT event A1 would happen when the shareholders of the applicant entity sell their shares to C.

i Individual shareholders

A and B acquired their shares in the entity post-CGT. The applicants have not supplied details of the cost base of the shares, however, having regard to the time at which the shares were acquired and the book value of the applicant entity's major assets and liabilities, it is likely that the cost base is relatively small. Therefore, it is likely that A and B would each make a capital gain on the sale of their shares. Provided the capital gains were worked out using a cost base calculated without reference to indexation, 50 per cent of the gains would be included in A and B's assessable income under s 102-5 of the ITAA 1997.

ii. The trustee

The FT acquired its shares in the entity pre-CGT. Accordingly, any capital gain or loss under CGT event A1 would be disregarded. However, CGT event K6 would happen if all of the following conditions were satisfied:

1. The FT owned shares that it acquired before 20 September 1985

2. CGT event A1 happened to the shares

3. There was no roll-over for the A1 event

4. Just before the A1 event:

a. the market value of property of the entity (excluding trading stock) that was acquired on or after 20 September 1985 was at least equal to 75% of the net value of the entity; or

b. the market value of interests of the entity owned through interposed companies or trusts in property (excluding trading stock) that was acquired on or after 20 September 1985 was at least equal to 75% of the net value of the entity.

The net value of an entity is defined in s 995-1(1) of the ITAA 1997 to mean the amount by which the sum of the market values of the assets of the entity exceeds the sum of its liabilities.

The applicants have not supplied details of the market values of the assets of the entity, however, if the book value of the assets (other than goodwill) approximates their market value

If all of the entity's property, other than goodwill, was acquired on or after 20 September 1985, the market value of such property would exceed 75% of the net value of the entity. Accordingly, CGT event K6 would happen when the FT sells its shares in the entity.

FT would make a capital gain equal to that part of the capital proceeds from the sale that is reasonably attributable to the amount by which the market value of the post-CGT property assets exceeds the sum of that property's cost bases.

A trust can make a discount capital gain under Division 115. There are rules in Subdivision 115-C for dealing with trusts with capital gains. The Subdivision applies if a trust estate has a net capital gain for an income year that is taken into account in working out the trust estate's net income (as defined in s 95). There are separate rules for assessing presently entitled beneficiaries, trustees under s 98 and trustees under s 99 or 99A.

As indicated above, the relevant taxpayer in relation to the capital gain would be the FT. Therefore, the amount of the capital gain may be calculated under s 115-220 (if s 98 applies) or s 115-222 (if s 99 or 99A applies). The purpose of these sections is to ensure that the trustee does not get the benefit of the CGT discount. Accordingly, the amount of the capital gain assessed to the trustee company would be the undiscounted capital gain.

In conclusion, if the scheme was entered into, the shareholders of the entity would sell their shares in the entity to C. The CGT events described above would occur, however, in comparison with the alternative postulate, the proceeds of the sale of the shares would be lower as a result of the distribution of the entity's retained earnings to the RPS holder.

The cost bases of the shares would, however, be the same. Accordingly, the capital gains made by the shareholders would be lower. The reduction in the amount of the capital gains represents a tax benefit for each of the taxpayers.

A tax effect that might reasonably be expected to have occurred

The dividends and associated franking credits might reasonably be expected to have been included in the assessable income each of the shareholders of the entity (i.e. the taxpayers).

If the scheme was entered into, the dividend income and franking credits would not have been included in the assessable income of the taxpayers.

The purpose of one or more persons who entered into the scheme (or any part thereof)

The scheme would be entered into by the entity, the related entity, A and B and FT.

We have considered the eight matters in s 177D(b) below.

a. The manner

The scheme would involve a transaction which is unconventional, namely, the purchase of a share for nominal consideration on the premise that you will receive fully franked dividends within 4 years. We do not consider this to be an ordinary commercial dealing.

It might be argued that the distribution to a related entity would be actuated by one or more of the following objectives:

i. To minimise the stamp duty payable on the transfers of the applicant entity shares to C.

The stamp duty reduction could be achieved equally well by distributing the entity's profits to existing shareholders. The return of surplus assets to existing shareholders (by, for example, dividends, a return of capital or share buy-back) is the conventional means by which the assets of a company are reduced.

ii. To assist the related entity in its role as group financier.

It is not entirely clear how the transfer of intragroup loans from the entity to the related entity would enhance the related entity's role as group financier. We have no evidence of the manner in which the related entity currently carries out its function as group financier.

There is no evidence that the intragroup loans would provide the related entity with additional liquid funds - it would seem reasonable to assume that the funds are already invested in the group's existing business assets.

There is no evidence that the related entity plans to borrow funds. In any event, it is arguable that the related entity could be equally effective in its role as financier by employing conventional borrowing practices, such as guarantees, e.g. other members of the group could guarantee future borrowings of the related entity.

There is no evidence that the related entity plans to use the funds to refinance existing debt; in fact, to our knowledge, the group has no external debt.

iii. To effect a gift of assets.

The scheme involves a transfer of substantial assets for nominal consideration between corporate members of a group. We consider this to be equivalent to a gift from one company to another.

A gift may be actuated by the connection between the relevant parties. The proposed arrangement would not, however, represent a gift of assets because A and B would retain the ultimate control over the distribution of the assets shifted from the entity to the related entity.

Furthermore, the current ownership structure, in particular, the existence of non-fixed trusts with broadly defined classes of beneficiaries, provides flexibility to distribute assets. In other words, the current structure would facilitate a gift of assets.

iv. To fully distribute the related entity's profits in a tax free form.

Due to franking credit offsets, there would be no tax liability for the related entity upon receipt of fully franked dividends.

Under the first postulate, the profits would have, in effect, been included in the proceeds of sale of the shares sold to C. Accordingly, the profits would have been included in the capital gains made by the taxpayers.

Under the second postulate, the franking credit offsets would not fully offset the taxpayers' tax liability on the dividend income.

In conclusion, the stamp duty savings could be achieved by conventional means and the benefits to the related entity as a financier are unsubstantiated. In light of the unconventional nature of the scheme, we consider this factor inclines towards a dominant purpose of obtaining a tax benefit.

b. The form and substance

The form and substance of the scheme are different in one important respect.

In form, the related entity would subscribe for one RPS share for a "nominal issue price" (our emphasis). In effect, however, the related entity would subscribe for a share which, from the related entity's standpoint, would be very valuable. The share would be issued on the premise that substantial, fully franked dividends would be paid to the related entity.

The discrepancy between the nominal subscription price and the value to the related entity of the fully franked dividends would facilitate the value shift from the entity to the related entity in a tax free form.

The applicants contend, correctly, that estimation of the market value involves a hypothetical inquiry. This may be appropriate in determining the form of the transaction, but the substance of the transaction is not based on a hypothetical inquiry. The substance should be determined by reference to the proposed transaction, including the objectively ascertainable intent to shift value from the entity to the related entity in a tax free form.

Owing to the nature of the difference between the form and substance of the scheme, this factor inclines towards a dominant purpose of obtaining a tax benefit.

c. The time and duration

The scheme would be entered into shortly before the transfer of ownership of shares in the applicant entity to C. The scheme would substantially reduce (or eliminate) the resulting capital gains without crystallising a tax liability for the existing shareholders upon the distribution of the entity's profits. Therefore, the proximity of the scheme to the share transfer inclines towards a dominant purpose of obtaining a tax benefit.

In light of the terms of the RPS, it is reasonable to expect that the scheme would be carried out over a period of up to 4 years. The terms of the RPS include:

• A right by the entity to redeem the new share within 4 years of the issue date; and/or

• A right by the entity to abolish dividend entitlements on the new share within 4 years of the shares' issue date.

The applicants have not provided any reasons for these terms.

The terms would seem to be explicable by the direct value shift rules in Division 725 of the ITAA 1997. A direct value shift happens if, as a result of the issue of shares at a discount by the target company, there is a decrease in the market value of one or more equity or loan interests in the target company.

The direct value shifting provisions in Division 725 contain a saving provision in s 725-90. It provides that a direct value shift does not have consequences if at the time the act which caused the value shift to occur, it is more likely than not that that state of affairs will cease to exist within 4 years after that time.

There is no apparent commercial reason for the above terms. Accordingly, this factor inclines towards a dominant purpose of obtaining a tax benefit.

d. The result achieved by the scheme but for Part IVA

The result achieved depends upon the postulate.

Under the first postulate, the capital gains to be made by the taxpayers on the sale of the applicant entity shares to C would be reduced by the scheme.

Under the second postulate, the dividend and franking credit (gross up) income of the taxpayers would be reduced by the scheme.

e. 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 shares held by the taxpayers in the entity would decrease in value owing to the distribution of the entity's retained earnings to the holder of the RPS. The shares held by the trustee company in the related entity would increase in value owing to the distribution of the applicant entity's retained earnings.

This factor does not significantly incline towards or away from a dominant purpose of obtaining a tax benefit.

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

The scheme would result in an increase in the assets of the related entity i.e. intragroup loans receivable.

The applicants contend that the scheme would assist the related entity in its capacity as financier. Our views in relation this contention are outlined under the first factor (The manner) above.

The increase in the value of the related entity would increase the total value of the shares issued by the related entity. However, due to the rights attached to the different classes of shares, the additional value would accrue to the ordinary shares.

This factor does not significantly incline towards or away from a dominant purpose of obtaining a tax benefit.

g. Any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out

None.

h. The nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f).

It might be argued that the relationships explain the issue of an RPS for nominal consideration, thereby facilitating a shift of value from the entity to the related entity. The scheme, however, does not effect a transfer of value between related members (see The manner above).

This factor does not significantly incline towards or away from a dominant purpose of obtaining a tax benefit.

Conclusion as to purpose

We have weighed up each of the eight factors and concluded that one of more of the persons who entered into the scheme did so for the dominant purpose of enabling the taxpayers to obtain a tax benefit in connection with the scheme.

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