Edited version of private advice

Authorisation Number: 1012659767116

Ruling

Subject: Proposed issue of redeemable preference shares

Question 1

Will the proposed redeemable preference shares (RPS) be treated as equity interests under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) upon issue?

Answer

Yes

Question 2

Will the existing ordinary shareholders continue to maintain a greater than 50% beneficial interest in the ordinary income of the company under subsection 149-15(1)(b) of the ITAA 1997 following the issue of the RPS?

Answer

Yes

Question 3

Will the proposed issue of the RPS, and subsequent payment of dividends to RPS holders, trigger tax consequences under Division 725 of the ITAA 1997, and cause a CGT event K8 (section 104-250 of the ITAA 1997) to occur?

Answer

No

Question 4

Will dividends declared in respect of the RPS be prevented from being frankable distributions, as defined in section 202-40 of the ITAA 1997, due to the operation of subsection 202-45 (d), (e) or (h) of the ITAA 1997?

Answer

No

Question 5

Will the future payment of dividends to the individual holders of the proposed RPS be considered dividend streaming under Subdivision 204-D of the ITAA 1997?

Answer

No

Question 6

Will the individual, Australian resident holders of the RPS, who are qualified persons, be entitled to franking credits under Division 207 of the ITAA 1997?

Answer

Yes

Question 7

Will section 207-155 of the ITAA 1997, or section 177E of the ITAA 1936, apply to the future payment of dividends to the individual holders of the RPS?

Answer

No

Question 8

Will section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the future payment of dividends to the individual holders of the RPS?

Answer

No

Question 9

Will the Commissioner make a determination under Part IVA of the ITAA 1936 to the whole, or part, of the proposed arrangement?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

Year ending 30 June 2019

Year ending 30 June 2020

The scheme commences on:

1 July 2014

Relevant facts and circumstances

1. The Company is a private company.

2. The ordinary shares on issue in The Company all have equal dividend and voting rights.

3. The directors of The Company have proposed to issue redeemable preference shares (RPS) to individuals associated with The Company.

4. Having canvassed a number of alternatives, the directors of The Company consider that the issue of RPS to the associated individuals will increase their connectivity, engagement and involvement in the business of The Company.

5. The directors of The Company propose that the RPS will be issued with the following features and conditions attached:

• The holder of an RPS will have the right to receive notices of all meetings of The Company, but have no right to attend and vote at any meeting;

• The holder of an RPS will have the right to receive discretionary dividends but not in preference to any other class of shares as nominated and declared by the directors;

• Dividends declared and received by RPS holders are non-cumulative;

• The holder of an RPS will have the right to receive capital as the directors may determine to pay, but this shall not exceed the amount paid up on subscription of each RPS;

• The RPS are redeemable at the option of The Company and upon death or bankruptcy of the holder;

• The holder of the RPS will have the right of return of unpaid capital and any unpaid declared dividends at the time of redemption by The Company;

• Right to participate and receive capital upon the winding up of The Company only to the extent of capital paid up on the RPS and in priority over other classes of non-preference shares;

• The RPS will be issued for a subscription amount of $X each;

• The holder of an RPS can only be a natural person and hold the share beneficially;

• Any dividends declared and paid on the RPS by The Company in a financial year cannot exceed 25% of the total dividends declared and paid by The Company on any ordinary share;

• Once issued, an RPS is not transferrable to another person.

6. The Company will not debit its share capital account to fund the payment of dividends to both ordinary shareholders and RPS holders.

7. The existing shareholders of The Company will amend the existing constitution and execute required documentation and resolutions to allow for the issue of the RPS class.

8. You state that:

The Company will not be involved in the streaming of franking benefits as dividends paid by the company will not be made with a variable percentage of franking credits attached depending on the class of share.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 104-250

Income Tax Assessment Act 1997, subsection 145-15(1)

Income Tax Assessment Act 1997, Division 149

Income Tax Assessment Act 1997, subsection 149-15(1)(b)

Income Tax Assessment Act 1997, section 149-30

Income Tax Assessment Act 1997, section 202-40

Income Tax Assessment Act 1997, subsection 202-45(d)

Income Tax Assessment Act 1997, subsection 202-45(e)

Income Tax Assessment Act 1997, subsection 202-45(h)

Income Tax Assessment Act 1997, section 202-45

Income Tax Assessment Act 1997, Subdivision 204-D

Income Tax Assessment Act 1997, section 204-30

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

Income Tax Assessment Act 1997, subsection 204-30(3)

Income Tax Assessment Act 1997, subsection 204-30(3)(c)

Income Tax Assessment Act 1997, Division 207

Income Tax Assessment Act 1997, section 207-20

Income Tax Assessment Act 1997, section 207-30

Income Tax Assessment Act 1997, subsection 207-71(1)

Income Tax Assessment Act 1997, Subdivision 207-F

Income Tax Assessment Act 1997, section 207-145

Income Tax Assessment Act 1997, section 207-150

Income Tax Assessment Act 1997, section 207-155

Income Tax Assessment Act 1997, Division 725

Income Tax Assessment Act 1997, subsection 725-145(1)

Income Tax Assessment Act 1997, subsection 725-145(2)

Income Tax Assessment Act 1997, subsection 725-145(3)

Income Tax Assessment Act 1997, subsection 725-150(1)

Income Tax Assessment Act 1997, section 725-245

Income Tax Assessment Act 1997, Division 974

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

Income Tax Assessment Act 1997, section 974-10

Income Tax Assessment Act 1997, subsection 974-10(1)

Income Tax Assessment Act 1997, subsection 974-10(2)

Income Tax Assessment Act 1997, subsection 974-15(1)

Income Tax Assessment Act 1997, subsection 974-20(1)

Income Tax Assessment Act 1997, section 974-70

Income Tax Assessment Act 1997, subsection 974-70(1)

Income Tax Assessment Act 1997, subsection 974-70(1)(b)

Income Tax Assessment Act 1997, section 974-75

Income Tax Assessment Act 1997, subsection 974-75(1)

Income Tax Assessment Act 1997, section 995-1

Income Tax Assessment Act 1936, section 45

Income Tax Assessment Act 1936, subsection 45(1)

Income Tax Assessment Act 1936, section 45A

Income Tax Assessment Act 1936, subsection 45A(1)

Income Tax Assessment Act 1936, section 45B

Income Tax Assessment Act 1936, subsection 45B(1)

Income Tax Assessment Act 1936, Part IVA

Income Tax Assessment Act 1936, subsection 177A(1)

Income Tax Assessment Act 1936, subsection 177C(1)

Income Tax Assessment Act 1936, subsection 177D(2)

Income Tax Assessment Act 1936, section 177E

Income Tax Assessment Act 1936, subsection 177E(1)(a)

Income Tax Assessment Act 1936, section 177EA

Income Tax Assessment Act 1936, subsection 177EA(3)

Income Tax Assessment Act 1936, subsection 177EA(5)(b)

Income Tax Assessment Act 1936, section 177F

Income Tax Assessment Act 1936, subsection 177F(1)

Income Tax Assessment Act 1936, former sections 160APHC to 160APHU

Reasons for decision

Issue 1

Question 1

Will the proposed RPS be treated as equity interests under Division 974 of the ITAA 1997 upon issue?

Summary

The RPS will satisfy the equity test, because each RPS that is issued by The Company will result in the individual holder becoming a member and shareholder in the company.

If an equity interest also satisfies the debt test, the tie-breaker rule will result in the interest being a debt interest.

The RPS will not satisfy the debt test in subsection 974-20(1) of the ITAA 1997, as the directors of The Company have absolute discretion relating to the payment of dividends on the RPS, meaning that there is no effectively non-contingent obligation regarding the RPS.

Because the proposed RPS fails the debt test, the tie-breaker rule will not operate, and therefore, they will constitute an equity interest in The Company.

Detailed reasoning

Division 974: Debt vs. Equity

Division 974 of the ITAA 1997 sets out the rules for defining what constitutes equity in a company, and what constitutes debt. This categorisation determines whether a return paid by a company on a financing interest that it has issued will be frankable (i.e. treated as a dividend) or deductible (i.e. treated as interest on a debt).

The objects of Division 974 are set out in section 974-10 of the ITAA 1997. Subsections 974-10(1) of the ITAA 1997 provide as follows:

An object of this Division is to establish a test for determining for particular tax purposes whether a scheme, or the combined operation of a number of schemes:

(a) gives rise to a debt interest; or

(b) gives rise to an equity interest.

Further, subsection 974-10(2) of the ITAA 1997 states that:

Another object of Division 974 is that the test referred to in subsection (1) is to operate on the basis of the economic substance of the rights and obligations arising under the scheme, or schemes, rather than merely on the basis of the legal form of the scheme, or schemes.

Equity interest

The meaning of an 'equity interest' in a company is defined in section 974-70 of the ITAA 1997. A scheme, or related schemes, gives rise to an equity interest in a company under section 974-70 of the ITAA 1997 if the scheme, or the notional scheme, satisfies the equity test in section 974-75 of the ITAA 1997 and does not satisfy the 'tie-breaker' test in subsection 974-70(1)(b) of the ITAA 1997- i.e. the interest must not be a debt interest, or form part of a larger interest that is a debt interest.

A scheme, or notional scheme, satisfies the equity test in relation to a company if it gives rise to an interest of the kinds listed in the table contained in section 974-75(1) of the ITAA 1997. Item 1 of the table covers all kinds of shares, including redeemable preference shares. As with other items in the table, interests covered by item 1 will not be equity interests if they are debt interests (subsection 974-70(1)(b) of the ITAA 1997).

As discussed in ATO Interpretative Decision ATO ID 2003/873 income tax: Debt/Equity interest: Redeemable Preference Shares- equity interest redeemable preference shares are equity interests, as defined in subsection 974-70(1) of the ITAA 1997, because:

• the issue of [redeemable preference shares] is a scheme (as defined in subsection 995-1(1));

• the scheme falls within one of the items in the equity interest table in subsection 974-75(1) (principally the [redeemable preference shares] give rise to an interest as a member of the issuing company, Item 1 of the equity interest table);

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

• the [redeemable preference shares] are not characterized as, and do not form part of the larger interest that is characterized as a debt interest (as defined in subsection 974-15(1)) in the issuing company.

The redeemable preference shares (RPS) you propose to will satisfy the equity test, because each RPS that is issued by The Company will result in the individual holder becoming a member and shareholder in the company.

Notwithstanding the above, it is also necessary to consider the 'tie-breaker' provision outlined at subsection 974-5(4) of the ITAA 1997, to ascertain if the nature of the interest is also a debt interest, in which case, the character of the interest will be taken as being a debt interest, despite the fact that it is also an equity interest.

Debt interest

Subsection 974-15(1) of the ITAA 1997 defines the meaning of a 'debt interest' as follows:

A scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1).

Subsection 974-20(1) of the ITAA 1997 states that a scheme satisfies the debt test 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:

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

b) 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 RPS will not satisfy the debt test in subsection 974-20(1) of the ITAA 1997, as there is no effectively non-contingent obligation to provide a financial benefit. This is because:

• the directors of The Company have absolute discretion to declare and pay dividends on the RPS;

• dividends on the RPS are non-cumulative; and

• the redemption of the RPS will be at the discretion of The Company's directors, which entitles the individual RPS holder to a return of their subscribed capital.

Conclusion

In accordance with section 974-70 of the ITAA 1997, as the proposed RPS will fail the debt test, they will constitute equity interests in The Company.

Question 2

Will the existing ordinary shareholders continue to maintain a greater than 50% beneficial interest in the ordinary income of The Company under subsection 149-15(1)(b) of the ITAA 1997 following the issue of the RPS?

Summary

Because the dividends declared and paid on the RPS by The Company in a financial year cannot exceed 25% of the total dividends declared and paid by The Company on any existing ordinary shares, a majority underlying interest will continue to be maintained by the existing ordinary shareholders in The Company's income, thereby satisfying subsection 149-15(1)(b) of the ITAA 1997.

Detailed reasoning

Division 149 of the ITAA 1997 will apply where there is a change in the majority underling interests in a pre-CGT asset owned by a company or trust. Specifically, subsection 149-30(1) of the ITAA 1997 provides that:

The asset stops being a pre-CGT asset at the earliest time when majority underlying interests in the asset were not held by ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985.

ATO Interpretive Decision ATO ID 2011/107 Capital Gains Tax: Division 149 majority underlying interests - new shareholder (ATO ID 2011/107) covers the situation where a new shareholder with a discretionary right to 100% of the dividends of a company is admitted to the membership of the company. In this situation, ATO ID 2011/107 states:

However, the issue of a share to Company H introduced a new shareholder in whose favour a distribution of income could be made.

Due to the discretionary right to dividends which all shares carry, Company B can distribute the dividends to one shareholder to the exclusion of the other shareholders. This means that Company B could pay 100% of any dividends to Company H, who in turn could distribute it to T, who in turn could distribute it to any of the individuals who are members of the class of beneficiaries.

Accordingly, the possibility exists that the ultimate owners (individuals X, Y and Z) who between them collectively had majority underlying interests in the asset immediately before 20 September 1985 may receive less than 50% of the ordinary income that may be derived by Company B from the asset.

In the above example, the requirement in subsection 149-15(1)(b) of the ITAA 1997 is not satisfied, because the possibility exists for more than 50% of the ordinary income derived from the asset to be distributed to shareholders who did not hold shares prior to 20 September 1985.

However, the circumstances in ATO ID 2011/107 are distinguishable from your situation because you propose to cap the dividends payable on the RPS to no more than 25% of the total dividends paid to the existing ordinary shareholders. As such, the discretionary payment of dividends on an ad hoc basis to the RPS holders will not affect the existing majority underlying ownership interests, as the existing owners will maintain a greater than 50% interest in the ordinary income generated by The Company.

Thus, a majority underlying interest will continue to be maintained by the existing ordinary shareholders in The Company's income, thereby satisfying subsection 149-15(1)(b) of the ITAA 1997.

Question 3

Will the proposed issue of the RPS and subsequent payment of dividends to RPS holders trigger tax consequences under Division 725 of the ITAA 1997, and cause a CGT event K8 (section 104-250 of the ITAA 1997) to occur?

Summary

In order for there to be an entity interest direct value shift there must be an impact on the market value of the existing interests in a target entity, with an associated increase in market values, or issue at a discount of other interests in that entity. These things must happen under a scheme.

In the case of The Company, the RPS will be issued at market value, and their issue will not impact on the market value of the existing equity interests of The Company. Therefore, the issue of the RPS will not trigger the operation of Division 725 of the ITAA 1997, and as such, it will not cause CGT event K8 to occur.

Detailed reasoning

The first step in determining the application of the entity interest direct value shifting rules contained in Division 725 of the ITAA 1997 is determining if there is an entity interest direct value shift.

Broadly, Division 725 of the ITAA 1997 applies when there is an increase in the value, or issue at a discount of some interests (called 'up interests'), in a company or trust (the target entity), and a decrease of value in the other interests ('down interests') in the target entity that are attributable to a scheme.

Specifically, subsection 725-145(1) of the ITAA 1997 states that:

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) and (3) are satisfied.

Broadly:

• subsection 725-145(2) of the ITAA1997 specifies that one or more of the equity or loan interests in the target entity must be issued at a discount and be reasonably attributable a thing done under the scheme, and

• Subsection 725-145(3) of the ITAA 1997 specifies that there must be an increase in the market value of one or more equity or loan interests in the target entity which is reasonably attributable to a thing done under the scheme.

'Discount' is defined in subsection 725-150(1) of the ITAA 1997, and refers to an equity or loan interest being issued at an amount less than its market value.

The characteristics of the RPS you propose to issue are such that their market value will equate to their issue price of $X, this is because the RPS:

• do not have any voting rights,

• only entitle the holder to receive discretionary non-cumulative dividends,

• only entitle to the holder to the return of their paid up capital and any unpaid declared dividends at the time of redemption,

• can only be held by a natural person who must also hold the beneficial interest, and

• are not transferrable to another person.

Essentially, the RPS can only ever belong to the individual to whom they were issued, for the benefit of that individual, and can only ever be disposed of by redemption by The Company at their issue price. Thus, the market value of the RPS would be their issue price of $X.

Similarly, given the characteristics of the RPS, their issue would not impact on the market value of the existing ordinary shares. The Company have the option to redeem the RPS at any time, and non-cumulative dividends are only payable at the discretion of the directors.

Therefore, the provisions in Division 725 of the ITAA 1997, relating to direct value shifting, affecting interests in companies and trusts, will have no application to the proposed RPS because:

• the RPS will be issued at their market value; and

• there will not be a decrease in the market value of the existing equity interests in The Company as a result of the issue of the RPS.

CGT event K8 in section 140-250 of the ITAA 1997 relates specifically to the occurrence of a down interest taxing event under section 725-245 of the ITAA 1997. As there has not been a direct value shift under Division 725 of the ITAA 1997, there has not been a down interest taxing event, as referred to in in section 725-245 of the ITAA 1997. As such, CGT event K8 will not happen upon issue of the RPS.

Question 4

Will dividends declared in respect of the redeemable RPS be prevented from being frankable distributions, as defined in section 202-40 of the ITAA 1997, due to the operation of subsection 202-45 (d), (e) or (h) of the ITAA 1997?

Summary

A dividend is frankable to the extent that it is not unfrankable. Distributions in respect of non-equity shares (subsection 202-45(d) of the ITAA 1997) or those sourced from your share capital account (subsection 202-45(e) of the ITAA 1997) are unfrankable.

Because the RPS are not non-equity shares, and you will not be debiting your share capital account in order to pay dividends on the RPS, dividends on the RPS will not be unfrankable as a result of subsections 202-45(d) or (e) of the ITAA 1997.

Additionally, based on what you have told us, because the issue of the RPS does not involve the issue of bonus shares, or the provision of capital benefits to shareholders, subsection 202-45(h) of the ITAA 1997 will not operate to make dividends on the RPS unfrankable.

Detailed reasoning

A distribution, or a non-share dividend, is a 'frankable distribution' to the extent that it is not unfrankable under section 202-45 of the ITAA 1997 (section 202-40 of the ITAA 1997).

Therefore, to determine the extent to which a distribution, or non-share dividend is frankable, you must first determine the extent (if any) to which it is unfrankable.

You have told us that, in your circumstances, subsections 202-45(d), (e) and (h) of the ITAA 1997 are relevant. Subsections (d), (e) and (h) of 202-45 of the ITAA 1997 state that the following distributions are unfrankable:

(d) a distribution in respect of a non-equity share; and

(e) a distribution that is sourced, directly or indirectly, from a company's share capital account.

….

(h) an amount that is taken to be an unfranked dividend for any purpose:

(i) under section 45 of that Act (streaming bonus shares and unfranked dividends);

(ii) because of a determination of the Commissioner under section 54C of that Act (streaming dividends and capital benefits);

Subsection 202-45(d)

Section 995-1 of the ITAA 1997 defines a 'non-equity share' as being a share that is not an equity interest in the company.

It has already been determined in question one that the RPS will be treated as equity interests under Division 974 of the ITAA 1997. Therefore, as the distribution is not in respect of a non-equity share, subparagraph 202-45(d) of the ITAA 1997 will not apply to deem the dividends unfrankable.

Subsection 202-45(e)

Further, you have explained that The Company will not debit its share capital account to fund the payment of dividends to both ordinary shareholders and RPS shareholders of the company. Therefore, subsection 202-45(e) of the ITAA 1997 will not apply.

Subsection 202-45(h)

Subsection 202-45(h) of the ITAA 1997 makes reference to section 45, 45A and 45B of the ITAA 1936, which are general anti-avoidance rules that in general terms refer to:

• Capital streaming arrangements where bonus shares are provided to some shareholders and unfranked or minimally franked dividends are paid to other shareholders (section 45 of the ITAA 1936).

• Capital streaming arrangements where capital benefits (other than merely providing shares) are provided to some shareholders, and dividends (usually not fully franked dividends) are paid to other shareholders where the shareholders receiving the capital benefits derive greater benefit from them than the other shareholders (section 45A of the ITAA 1936).

• Situations where capital benefits (other than merely providing shares) are provided in substitution for dividends in circumstances where a person enters into the arrangement with a purpose of ensuring that a taxpayer's tax liability is less that it would have been if the capital benefit had been a dividend (section 45B of the ITAA 1936).

Section 45 of the ITAA 1936

The application of section 45 is set out in subsection 45(1) of the ITAA 1936 in the following terms:

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.

Based on the information you have provided the proposed RPS scheme does not involve issuing bonus shares to shareholders as an alternative to paying dividends or paying minimally franked dividends to some shareholders in preference to others.

Thus, based on what you have told us, section 45 of the ITAA 1936 will have no application to your proposal to issue the RPS.

Section 45A of the ITAA 1936

Section 45A applies in the circumstances set out in subsection 45A(1) of the ITAA 1936, which states that:

This section applies in respect of a company that, whether in the same year of income or in different years of income, streams the provision of capital benefits and the payment of dividends to its shareholders in such a way that:

(a) the capital benefits are, or apart from this section would be, received by shareholders (the advantaged shareholders) who would, in the year of income in which the capital benefits are provided, derive a greater benefit from the capital benefits than other shareholders; and

(b) it is reasonable to assume that the other shareholders (the disadvantaged shareholders) have received, or will receive, dividends.

….

Based on the information you have provided the proposed issue of the RPS does not involve the provision of capital benefits and the payment of dividends as set out in subsection 45A(1) of the ITAA 1936.

As such, based on what you have told us, the Commissioner would not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies.

Section 45B of the ITAA 1936

Of relevance, section 45B of the ITAA 1936 will apply (subsection 45B(2) of the ITAA 1936) if:

(a) there is a scheme under which a person is provided with …. a capital benefit by a company; and

(b) under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with …. the capital benefit, obtains a tax benefit; and

(c) 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 a taxpayer (the relevant taxpayer) to obtain a tax benefit.

Based on the information you have provided the proposed issue of the RPS does not involve the provision of capital benefits and the provision of a tax benefit as set out in subsection 45B(2) of the ITAA 1936.

As such, based on what you have told us, the Commissioner would not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies.

Conclusion Subsection 202-45(h)

Based on what you have told us there will be no amounts taken to be an unfranked dividend in accordance with section 45, 45A or 45B of the ITAA 1936 relating to the issue of the RPS. As such subsection 202-45(h) of the ITAA 1997 will not operate to deny franking credits on the RPS.

Conclusion

In accordance with the above, the dividends declared in respect of the RPS will not be unfrankable distributions due to the operation of subsections (d), (e) or (h) of section 202-45 of the ITAA 1997.

Question 5

Will the future payment of dividends to the individual holders of the proposed RPS be considered dividend streaming under Subdivision 204-D of the ITAA 1997?

Summary

Broadly, dividend streaming involves structuring distributions by a corporate entity in such a way as to give those members who benefit most from imputation credits (e.g. taxable residents) a greater imputation benefit than those who benefit less (e.g. non-residents).

Dividend streaming may occur by making franked distributions to some members ('favoured members') of the entity, and unfranked distributions to other members ('disadvantaged members').

Merely refraining from making a distribution to a particular class of member does not, of itself, constitute dividend streaming. Rather, it is the structuring of the distribution in such a way as to stream the benefit of imputation credits so that the favoured members, who can better utilize the franking credits, receive a disproportionate amount of the imputation credits, compared to the disadvantaged members who derive little or no benefit from the imputation credits.

In the case of the proposed RPS, when a dividend is declared for both ordinary shareholders and RPS shareholders, both classes of shares would be franked to the same extent.

You have said that:

The Company will not be involved in the streaming of franking benefits as dividends paid by the company will not be made with a variable percentage of franking credits attached depending on the class of share.

In these circumstances, the Commissioner would not make a determination under Subdivision 204-D of the ITAA 1997 that imputation benefits are being streamed. Thus, based on the facts you have provided, you will not be undertaking dividend streaming.

Detailed reasoning

The term 'streaming' is not defined in the ITAA 1997. Paragraph 3.28 of The Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 (EM NBTS) describes streaming as:

…. selectively directing the flow of franked distributions to those members who could most benefit from imputation credits.

Section 204-30 of the ITAA 1997 contains a specific anti-streaming rule which, once the trigger conditions contained in subsection 204-30(1) are met, allows the Commissioner to make a determination under subsection 204-30(3) to impose sanctions that negate any imputation benefit that may result from dividend streaming.

Subsection 204-30(1) states that:

This section empowers the Commissioner to make determinations if an entity streams one or more distributions (or one or more distributions and the giving of other benefits), whether in a single franking period or in a number of franking periods, in such a way that:

(a) an imputation benefit is, or apart from this section would be, received by a member of the entity as a result of the distribution or distributions; and

(b) the member would derive a greater benefit from franking credits than another member of the entity; and

(c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

The member that derives the greater benefit from franking credits is the favoured member. The member that receives the lesser imputation benefits is the disadvantaged member.

The Company is proposing to issue RPS to individuals in their own capacity as natural persons. You have stated that:

The Company will not be involved in the streaming of franking benefits as dividends paid by the company will not be made with a variable percentage of franking credits attached depending on the class of share.

Thus, when a dividend is declared for both ordinary shareholders and RPS shareholders, both classes of shares would be franked to the same extent. It would be difficult to conclude in these circumstances that one class of shareholder is being treated more favourably than another, resulting in dividend streaming.

Based on the facts you have outlined, it is concluded that there will be no streaming for the purposes of subdivision 204-D. As such, the Commissioner would not make a determination under Subdivision 204-D of the ITAA 1997 that imputation benefits are being streamed.

Question 6

Will the individual, Australian resident holders of the RPS, who are qualified persons, be entitled to franking credits under Division 207 of the ITAA 1997?

Summary

Section 207-20 of the ITAA 1997 allows a tax offset for an amount of franking credit associated with dividends, for Australian resident recipients of franked distributions.

There are integrity measures that affect the availability of these franking credits, which are contained in section 207-70 of the ITAA 1997. Franking credits can be denied if the recipient is not a qualified person, for a scheme involving dividend stripping, dividend streaming, or franking credit trading.

Based on what you have told us, none of the integrity measures will affect the availability of franking credits for recipients of dividends relating to the RPS. Provided the recipient is an Australian resident, and a qualified person.

Detailed reasoning

Generally, where a corporate tax entity makes a franked distribution to one of its members, section 207-20 of the ITAA 1997:

• includes the franking credit attached to a franked distribution in the assessable income of the recipient of the dividend, and

• allows a tax offset equal to the franking credit on the distribution.

There are exceptions to the general availability of franking credits, for instance, when the recipient is a non-resident of Australia, or when other integrity measures apply.

Recipient must satisfy the residency requirement

Section 207-70 of the ITAA 1997 denies franking credits as a result of section 207-20, if the entity receiving the franked distribution does not satisfy the residency requirement contained in section 207-75 of the ITAA 1997. Of relevance is subsection 207-75(1) of the ITAA 1997, which states:

An entity that receives a distribution satisfies the residency requirement at the time the distribution is made if:

a) in the case of an individual - the individual is an Australian resident ….

Thus, in general, to be entitled to franking credits, the recipient must be an Australian resident.

In the case of a distribution from The Company relating to the RPS, it would be a matter for the individual recipient of the franked dividend to determine that they are an Australian resident at the time when the dividend was made, and to establish eligibility for any franking credits attached to the RPS.

Other integrity measures affecting the availability of franking credits for recipients

Subdivision 207-F of the ITAA 1997 contains integrity measures which, in certain circumstances, can deny franking credits to recipients if the imputation system is manipulated.

Section 207-145 of the ITAA 1997 sets out the circumstances where franking credits will not be available to recipients:

• the entity in receipt of the dividend is not a qualified person,

• the Commissioner has made a determination under subsection 204-30(3)(c) of the ITAA 1997 relating to dividend streaming,

• the distribution is part of a dividend stripping operation, or

• the Commissioner has made a franking credit benefit determination under subsection 177EA(5)(b) of the ITAA1936, general anti-avoidance rules relating to franking credit trading and dividend streaming.

Qualified person

In order to be a 'qualified person', the holding period, and related payments rules contained in the former sections 160APHC to 160APHU of the ITAA 1936, must be satisfied. Broadly:

• the holding period rule, (with some exceptions) requires taxpayers to hold shares at risk for more than 45 days (90 days for preference shares), and

• the related payments rule, requires taxpayers who are under an obligation to make a related payment in relation to a dividend to hold the relevant shares at risk for more than 45 days (90 days for preference shares) during the qualification period.

The main exception to the above is the small shareholders exception for natural persons whose tax offset entitlement does not exceed $5,000 for the income year.

In the case of The Company, the qualified person requirement is a matter for the recipient of the franked distribution, not The Company. It would be up to an individual recipient of a dividend from The Company to ensure that they are a qualified person, in order to maintain eligibility for any franking credit from the RPS.

Subsection 204-30(3)(c) of the ITAA 1997

The application of Subdivision 204-D of the ITAA 1997, relating to dividend streaming, is considered at question 5 of this ruling. As explained in question 5, as the RPS arrangement does not constitute dividend streaming, the Commissioner's powers to make a determination under subsection 204-30(3) of the ITAA 1997 are not enlivened.

Therefore, based on the facts you have provided, the Commissioner would not make a determination under Subsection 204-10(3)(c) of the ITAA 1997 to deny franking credits to recipients of dividends from the RPS.

Part of a dividend stripping operation

The application of section 207-155 of the ITAA 1997, which relates to dividend stripping, is considered at question 7 of this ruling. In short, based on the facts you have provided, it is considered that the RPS are not part of a dividend stripping scheme, the Commissioner will not make a determination under subsection 204-30(3)(c) of the ITAA1997 to deny franking credits.

Subsection 177EA (5) (b) of the ITAA 1936

The application of the anti-avoidance rules in section 177EA of the ITAA 1936 is considered at question 8 of this ruling. As the reasoning at question 8 explains, based on what you have told us, the Commissioner will not be making a determination under 177EA(5) of the ITAA 1936 to deny franking credits associated with dividends paid on the RPS.

Conclusion

Based on what you have told us, there is nothing to indicate that franking credits under section 207-30 of the ITAA 1997 will not be available to Australian resident holders of the RPS who are qualifying persons.

Question 7

Will section 207-155 of the ITAA 1997, or section 177E of the ITAA 1936, apply to the future payment of dividends to the individual holders of the RPS?

Summary

Dividend stripping does not have a precise legal meaning, but it generally refers to a scheme whereby an entity purchases shares in a company (Target Company) with substantial accumulated profits that are in cash, or a readily realisable form. The purchase price reflects the value of the accumulated profits.

Once the shares are acquired, a dividend approximating the purchase price is paid to the acquiring entity. The scheme is carefully planned, with all parties acting in concert for the predominant or sole purpose of the vendor shareholders, avoiding tax on a distribution of dividends by the Target Company.

The issue of the RPS does not exhibit the characteristics of a dividend stripping scheme because:

• they will be issued at a nominal price of $X;

• there does not appear to be a dominant purpose of the existing ordinary shareholders avoiding tax on dividends paid by The Company; and

• there is a commercially justifiable reason, relating to succession planning, for issuing the RPS.

Therefore, the Commissioner would not consider the issue of the RPS a dividend stripping scheme, as intended by 207-155 of the ITAA 1997, or section 177E of the ITAA 1936.

Detailed reasoning

Section 207-155 of the ITAA 1997 states that:

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.

The threshold condition for the application of section 177E of the ITAA 1936, found in subsection 177E (1) (a), is in substantially the same terms to section 207-155 of the ITAA 1997.

The consequences of a scheme being considered a dividend stripping scheme are found in:

• sections 207-145 and 207-150 of the ITAA 1997, which operate to deny franking credits on distributions from dividend stripping operation; and

• section 177E of the ITAA 1936, which is a general anti-avoidance provision relating specifically to dividend stripping schemes, where the tax benefit associated with a dividend scheme can be cancelled in whole or part, if determined by the Commissioner.

Dividend stripping is not a defined term, and it does not have a precise legal meaning. The meaning of dividend stripping is considered in paragraphs 8-10 of Taxation Ruling IT 2627 Income Tax: Application of Part IVA to Dividend Stripping Arrangements, which state:

8. The term 'dividend stripping' has no precise legal meaning. Therefore, it is not possible in this Ruling to provide exhaustive definitions of what does and what does not satisfy that expression.

9. However, it can be said that in its traditional sense a dividend stripping scheme would include one where a vehicle entity (the stripper) purchases shares in a target company that has accumulated or current years' profits that are represented by cash or other readily-realisable assets. The stripper pays the vendor shareholders a capital sum that reflects those profits and then draws off the profits by having paid to it a dividend (or a liquidation distribution) from the target company.

10. No exhaustive list of other examples can be given of what might constitute a dividend stripping scheme for the purposes of section 177E. Having regard to the overall scope and purpose of the section, an important element to be looked at will be any release of profits of a company to its shareholders in a non-taxable form, regardless of the different methods that might be used to achieve this result.

Dividend stripping is further considered in Taxation Determination TD 2014/1 Income tax: is the 'dividend access share' arrangement of the type described in this Taxation Determination a scheme 'by way of or in the nature of dividend stripping' within the meaning of section 177E of Part IVA of the Income Tax Assessment Act 1936? The characteristics of a dividend stripping scheme are listed in paragraph 17 of TD 2014/1, of relevance:

• the vendor shareholders [receive] a capital sum for the shares in an amount the same as or very close to the dividends paid to the purchasers …. , and

• the scheme [is] carefully planned, with all the parties acting in concert, for the predominant if not the sole purpose of the vendor shareholders, in particular, avoiding tax on a distribution of dividends from the company.

The individual holders of the RPS will subscribe to capital in The Company at a nominal market value of $X. It could not be said that the existing ordinary shareholders would be receiving a capital sum for shares in an amount the same, or very close to the dividends paid to the RPS holders.

Additionally, the following characteristics of the RPS do not readily lend themselves to constituting a scheme with the sole or predominant purpose of avoiding tax, because:

• the dividends on the RPS cannot exceed 25% of the total dividends declared and paid by The Company on any ordinary shares;

• the holder of the RPS can only be a natural person and hold their share beneficially; and

• once issued, the RPS is not transferrable to another person.

Based on the above, it cannot be said that the existing ordinary shareholders are acting in concert with the RPS members for the sole or predominant purpose of avoiding tax on distributions from The Company. Furthermore, there will be no release of company profits in a non-taxable form.

Thus, based on what you have told us, and having regard to the characteristics and objective purpose of the RPS issue, the Commissioner would not consider the proposed arrangement a dividend stripping scheme, or in the nature of dividend stripping.

Question 8

Will section 177EA of the ITAA 1936 apply to the future payment of dividends to the individual holders of the RPS?

Summary

In accordance with subsection 177EA(3) of the ITAA 1936, it cannot be concluded that a purpose of at least one of the participants was to enable the relevant taxpayer to obtain an imputation benefit, other than as an incidental benefit. This is because the characteristics of the RPS do not lend themselves to franking credit trading or dividend streaming and no proposed or actual shareholder of The Company will obtain a greater benefit from franking credits than any other.

As such, section 177EA of the ITAA 1936 will have no application to the future declaration and payment of dividends to RPS holders.

Detailed reasoning

Section 177EA is directed at schemes involving franking credit trading and dividend streaming. The reason for the introduction of section 177EA into Part IVA of the ITAA 1936 was explained in The Explanatory Memorandum to the Taxation Laws Amendment Bill (No 3) 1998 (paragraph 8.124) as follows:

One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them undermines this principle. Similarly, dividend streaming (i.e. the streaming of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings.

The rules in section 177EA of the ITAA 1936 are intended to act as a back-up to the specific anti-streaming rules in subdivision 204-D of the ITAA 1997, and associated provisions that came into operation at the same time.

Subsection 177EA (3) of the ITAA 1936 sets out the circumstances that section 177EA of the ITAA 1936 applies, they are:

(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 is expected to be payable 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;

(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.

Key to the operation of subsection 177EA(3) of the ITAA 1936 is paragraph (e), where, after a consideration of the circumstances, there must be a purpose, which is more than a merely incidental purpose, of obtaining, or enabling the relevant taxpayer to obtain, an imputation benefit a result of a scheme.

In the case of the proposed RPS, you have explained that their issue forms part of the succession planning for The Company to increase the connectivity, engagement, and involvement of the RPS holders to the business of The Company.

As previously explained in question 5 of this ruling, the RPS scheme does not constitute dividend streaming.

The characteristics of the RPS do not readily lend themselves to franking credit trading because:

n when dividends are paid on RPS they cannot be greater than 25% of the total dividends declared and paid by The Company on any ordinary share;

n the RPS can only be held by a natural person who must beneficially hold the share; and

n once issued the RPS are not transferrable to another person.

As such, any imputation benefit received by the holders of the RPS will merely be incidental to the purpose you have outlined.

Thus, based on what you have told us, section 177EA of the ITAA 1936 will have no application to the future payment of dividends to individual holders of the RPS.

Question 9

Will the Commissioner make a determination under Part IVA of the ITAA 1936 to the whole, or part, of the proposed arrangement?

Summary

The issue of the RPS represents a scheme, as defined in part IVA of the ITAA 1936. However, there is nothing to indicate that the parties to the proposed RPS issue will obtain a tax benefit as a result of entering into the scheme.

It is not necessary to consider the matters contained in subsection 177D(2) of the ITAA 1936, relating to the dominant purpose of The Company entering into the scheme, as there is no identifiable tax benefit to the parties to the proposed arrangement by virtue of them entering into the scheme.

The Commissioner will not make a determination under section 177F of the ITAA 1936 in respect of the proposed RPS as specified in the scheme.

Detailed reasoning

Law Administration Practice Statement PS LA 2005/24 Application of the General Anti-Avoidance Rules deals with the application of the general anti-avoidance rules, including Part IVA of the ITAA 1936.

Before the Commissioner can exercise the discretion in respect of Part IVA under subsection 177F(1) of the ITAA 1936, three requirements must be met:

(i) there must be a scheme within the meaning of section 177A of the ITAA 1936;

(ii) a tax benefit arises that was obtained or would be obtained in connection with the scheme but for Part IVA of the ITAA 1936; and

(iii) having regard to the matters in subsection 177D(2) of the ITAA 1936, the scheme is one to which Part IVA of the ITAA 1936 applies.

The Scheme

Subsection 177A(1) of the ITAA 1936 defines a 'scheme' as:

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

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

The issue of the RPS is considered to be a scheme for the purposes of subsection 177A(1) of the ITAA 1936.

Tax Benefit

Broadly, a 'tax benefit' is defined in subsection 177C(1) of the ITAA 1936 as:

• an amount not being included in the assessable income of the taxpayer as a result of the scheme (subsection 177C(1)(a) of the ITAA 1936),

• a deduction being allowable to the taxpayer as a result of the scheme (subsection 177C(1)(b) of the ITAA 1936),

• a capital loss being incurred by the taxpayer as a result of the scheme (subsection 177C(1)(bb) of the ITAA 1936,

• a loss carry back tax offset being allowable under the scheme (subsection 177C(1)(baa) of the ITAA 1936),

• a foreign income tax offset is allowable under the scheme (subsection 177C(1)(bb) of the ITAA 1936), or

• withholding tax not being payable as a result of the scheme (subsection 177C(1)(bc).

The issue of the RPS will not result in the occurrence of any of the elements of a tax benefit, as outlined above. Therefore, the parties to the proposed arrangement will not derive a tax benefit as a result of the issue of the RPS.

Dominant Purpose

As it has been established that The Company does not obtain a tax benefit by entering into the scheme, it is not necessary to consider the matters contained in subsection 177D(2) of the ITAA 1936, relating to the dominant purpose of entering into the scheme.

Conclusion

As there is no identifiable tax benefit as a result of the issue of the RPS, the Commissioner will not make a determination under section 177F of the ITAA 1936 regarding the issue of the RPS.

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