Edited version of your written advice

Authorisation Number: 1012664191755

Ruling

Subject: Non-arm's length income and Part IVA

Questions

1. Are the franked distributions from the Company to the Fund non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act (ITAA 1997)?

2. Are the franked distributions from the Company to the Fund made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the ITAA 1997?

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

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

Answers

1. No

2. Yes

3. Yes

4. Yes

This ruling applies for the following period

Year of income ending 30 June 2014

Year of income ending 30 June 2015

Year of income ending 30 June 2016

The scheme commences on

1 July 2013

Relevant facts and circumstances

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

Factual arrangement

The Taxpayer is over 60 years of age and retired.

The Taxpayer owns all issued shares in the Company. The Taxpayer is the sole director of the Company.

Before retiring, the Taxpayer worked on a full-time basis for the Company. The Company has ceased trading and will not conduct any activities in the future.

You have advised of the expected retained earnings of the Company at the time of transfer of the shares in the Company. It is advised that an independent market valuation (on a net assets on realisation basis) of the Company has been obtained.

The Taxpayer is the only member of the Fund. The Taxpayer is one of the two individual trustees of the Fund. The Taxpayer is currently receiving a superannuation income stream benefit from the Fund.

It is intended that the following steps will be implemented:

(a) the issued shares in the Company will be split;

(b) the Taxpayer will make a non-concessional superannuation contribution by way of an in-specie transfer of shares in the Company to the Fund with a value recognised by the Fund as an accretion to his interest(s) in the Fund;

(c) the Taxpayer will commence to be paid a new superannuation income stream from the Fund based on the non-concessional contribution;

(d) the remaining shares in the Company will be purchased by the Fund at their market value. An initial cash payment will be made by the Fund for the purchase, with the balance being paid under a deferred instalment arrangement through annual instalments over three years. The payment arrangement is to be appropriately documented by a solicitor and undertaken on a commercial basis;

(e) the Taxpayer is expected to make a capital gain on the disposal of the shares in the Company. It is advised that the Taxpayer will be eligible for the 50% discount and may also utilize the small business CGT concessions in relation to the capital gain;

(f) the Taxpayer will transfer an amount from the sale of the shares in the Company to the Trust, which is a related discretionary trust that they control and of which they are a beneficiary;

(g) at least 45 days after the contribution and purchase of the shares, the Company will pay a fully franked distribution to the Fund with a franking credit on the distribution. This will continue to be paid per annum until all retained earnings of the Company are paid to the Fund;

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

(i) the Fund is also said to be entitled to an annual refund of the unused franking credit tax offsets;

(j) once the assets of the Company have all been paid out as dividends to the Fund, the Company will be wound up; and

(k) upon winding up of the Company, the Fund will incur a capital loss.

The Taxpayer has advised that their purpose in taking these steps is to better provide for:

(a) their retirement, and;

(b) asset protection for themselves.

Assumptions

That the value of the Company is the amount that would be arrived at by an independent valuer as the market value of the shares in the Company taking into account all relevant factors including (but not limited to):

(a) the market value of the commercial property and the cash assets of the company;

(b) the risk of claims being made against the Company; and

(c) the statutory right to the franking credit tax offset and subsequent refund to be conferred on a Fund in pension phase as a result of the transactions.

The deferred instalment payment arrangement is between the Taxpayer (as vendor shareholder) and the Fund.

The reference to the instalment arrangement being undertaken on a commercial basis is a reference to a commercial rate of interest being paid by the Fund to the Taxpayer.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA.

Income Tax Assessment Act 1936 Section 177E.

Income Tax Assessment Act 1936 Section 177EA.

Income Tax Assessment Act 1936 Section 177F.

Income Tax Assessment Act 1997 Section 202-40.

Income Tax Assessment Act 1997 Section 202-45.

Income Tax Assessment Act 1997 Section 202-55.

Income Tax Assessment Act 1997 Section 202-60.

Income Tax Assessment Act 1997 Section 202-65.

Income Tax Assessment Act 1997 Section 207-20.

Income Tax Assessment Act 1997 Section 207-145.

Income Tax Assessment Act 1997 Section 207-155.

Income Tax Assessment Act 1997 Section 295-390.

Income Tax Assessment Act 1997 Section 295-545.

Income Tax Assessment Act 1997 Section 295-550.

Superannuation Industry (Supervision) Act 1993 Subsection 67(1).

Superannuation Industry (Supervision) Act 1993 Section 67A.

Further issues for you to consider

This ruling decision is limited to the application of sections 295-550 and 207-145 of the ITAA 1997 and Part IVA of the ITAA 1936 and has not otherwise considered the application of the substantive provisions of the ITAA 1997 or ITAA 1936 or the Superannuation Industry (Supervision) Act 1993 (the SISA) to the proposal other than as mentioned below.

We note that the proposal raises considerations of a regulatory nature for the Fund. The acquisition of shares in a Company which holds assets that are subject to potential future warranty claims may mean that the Fund's investment (and return on investment) is in jeopardy. This potentially raises issues as to whether the Fund is being maintained for the sole purpose of providing retirement benefits (as required by section 62 of the SISA) as opposed to achieving some other purpose.

While an independent market valuation (on the basis of net assets on realisation) of the Company (rather than the shares) has been provided we note the following in relation to that valuation:

_ the 'Total Assets' of the valuation report is understated. This understatement flows through to the subsequent amounts in the calculation;

_ in valuing the Company there is provision for 'discounted cash flow - deferred instalment arrangement' which reduces the value of the Company's net tangible assets. This would require further explanation as the arrangement, as proposed, has that deferred instalment arrangement as between the Taxpayer (vendor shareholder) and the Fund (purchaser) rather than the Company. We are therefore not sure of the basis for the deferred instalment arrangement reducing the value of the net tangible assets of the Company;

_ it is said that the value of the Company's franking account to the SMSF has been taken into account and offset with the warranty risk exposure. It is not clear what values were ascribed to the warranty risk exposure or to the value of the franking account to the SMSF, although a warranty contingent liability - current claim minimum has been provided for in the figures relied upon.

While these factors may affect that valuation, we have provided the Ruling on the assumption the market value for the shares in the Company is correct. We have not sought to further pursue (under section 359-40 of the Taxation Administration Act 1953) whether the amount provided does in fact represent the market value of the shares as we consider that, leaving aside section 295-550 of the ITAA 1997, the arrangement gives rise to the application of sections 207-145 of the ITAA 1997 and also Part IVA of the ITAA 1936. That is, we do not want to unnecessarily put the taxpayer to further cost as concerns the valuation matter. However, if it turns out that the assumption is not correct and the market value is materially different, the Ruling concerning section 295-550 of the ITAA 1997 will not be able to be relied upon.

Reasons for decision

Question 1

Summary

Leaving aside considerations of section 207-145 of the ITAA 1997 and Part IVA of the ITAA 1936 as dealt with in the subsequent questions, as the shares are acquired by the Fund at market value, the dividends received by the Fund from the Company will not be treated as non-arm's length income of the Fund.

Detailed reasoning

In accordance with section 295-545 of the ITAA 1997 the income of a complying superannuation fund is split into a 'non-arm's length component' and a 'low tax component'.

The note to subsection 295-545(1) of the ITAA 1997 explains that a concessional rate (15%) of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal tax rate (45%). These rates are set out in the Income Tax Rates Act 1986.

Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income. The phrase 'non-arm's length income' has the meaning given by section 295-550.

Dividends paid to an entity by a private company, along with ordinary or statutory income reasonably attributable to such a dividend (such as the franking credits), are non-arm's length income of the entity unless the amount is consistent with an arm's length dealing (subsection 295-550(2) of the ITAA 1997).

Subsection 295-550(3) of the ITAA 1997 requires consideration of the following matters when deciding whether an amount is consistent with an arm's length dealing:

(a) the value of shares in the company that are assets of the entity; and

(b) the cost to the entity of the shares on which the dividend was paid; and

(c) the rate of that dividend; and

(d) whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend; and

(e) whether the company has issued any shares to the entity in satisfaction of a dividend paid by the company (or part of it) and, if so, the circumstances of the issue; and

(f) any other relevant matters.

The Commissioner has issued Taxation Ruling TR 2006/7 'Income tax: special income derived by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust in relation to the year of income'. This Ruling refers to former section 273 of the ITAA 1936 which concerned 'special income' (now termed non-arm's length income) and continues to provide the ATO view so far as the new provision (section 295-550 of the ITAA 1997) expresses the same ideas as section 273 of the ITAA 1936.

In the facts of this case the shares are to be contributed and purchased at their stated market value, such that the shares are reflected at that market value (reduced by the amount owing under the deferred instalment arrangement) in the member's account. This is a relevant consideration under paragraph 295-550(3)(a) of the ITAA 1997 and the acquisition of shares at market value is consistent with an arm's length dealing.

The Fund, as the only shareholder will ultimately receive all of the retained earnings of the Company as dividend distributions which will be fully franked. This will in effect provide the Fund with a dividend rate equal to 100% of the assets of the Company, which may be considered more consistent with a non-arm's length dealing (paragraphs 295-550(3)(c) and (f) of the ITAA 1997). However, this has to be balanced against the Fund's acquisition value of the shares and that as the only shareholder following the acquisition of the shares the Fund is the only entity to which the distribution of retained earnings can be made. We also note that the investment by the Fund is not without risk insofar as there may be further warranty claims made against the Company, which may reduce the assets of the Company.

As there are no other shareholders the rate of dividends on other shares (as mentioned under paragraph 295-550(3)(d) of the ITAA 1997) is not relevant. Further, as the Company has not issued any shares to the Fund in satisfaction of a dividend paid by the company (as mentioned under paragraph 295-550(3)(e)) this is also not relevant.

Relying upon the assumption made as to the market value of the shares in the Company, we consider that in the circumstances the dividend income paid to the Fund by the Company is not to be treated as non-arm's length income of the Fund.

Question 2

Summary

The franked distributions from the Company to the Fund are made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the ITAA 1997. Consequently the amount of the franking credit on each of the distributions is not included in the assessable income of the Fund under section 207-20 and the Fund is not entitled to tax offsets under Subdivision 207-F because of the distributions (paragraphs 207-145(e) and (f)).

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997

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

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

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

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

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

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

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

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

Dividend stripping operations

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

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

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

(c) the payment of a dividend to the purchaser or allottee of shares by target co;

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

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

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

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

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

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

Will the franked distributions from the Company to the Fund be distributions made as part of a dividend stripping operation?

The payment of the franked distributions from the Company to the Fund will be made as part of a 'dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997 because each of the elements of a scheme 'by way of, or in the nature of, dividend stripping' will be present. For the reasons below, each of the central characteristics of a scheme by way of or in the nature of dividend stripping identified above is satisfied.

First element: The Company has substantial undistributed profits. Accordingly, the element of a dividend stripping operation identified in paragraph 32(a) above is satisfied.

Second element: There will be a sale or allotment of shares in the target co to another party. The Taxpayer will transfer shares (by way of a contribution) to the Fund. The remaining shares held by the Taxpayer will be transferred (by way of a sale) to the Fund. As to those shares transferred by way of a sale, there will be a sale of shares in the Company. The Taxpayer will receive a capital sum for those shares, even though that sum will be paid in instalments. As to the shares transferred by way of a contribution, while there will be no sale, there will be a transfer of shares in the Company to the Fund which will result in an accretion to the value of the Taxpayer's interest(s) in the Fund. This is a mere 'variation on the paradigm' which will not remove the scheme from satisfying the central characteristics of a 'dividend stripping operation': FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45]. Alternatively, the scheme will have 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping'.

There is nothing in the concept of a scheme by way of or in the nature of a dividend stripping operation which would require that the sale or transfer involve a share trader or be a company-to-company transaction attracting an inter-company dividend rebate. In FCT v. CPH (FFC) at [136], the Full Court referred to a dividend stripping operation involving a sale and allotment to individuals.

Accordingly, whether by way of contribution in return for an accretion of capital for the Taxpayer or by way of a sale, the element of a 'dividend stripping operation' in paragraph 32(b) above is satisfied.

Third element: The Company will pay franked distributions to the Fund equal to the value of the Company's retained earnings. The fact that the franked distributions are paid to the Fund over several years and not as a single distribution is merely a 'variation on the paradigm' which will not remove the scheme from satisfying the central characteristics of a 'dividend stripping operation': FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45]. Alternatively, the scheme will have 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping'. Accordingly, the element of a dividend stripping operation in paragraph 32(c) above is satisfied.

Fourth element: On the assumption that the franked distributions are not non-arm's length income of the Fund (within the meaning of section 295-550 of the ITAA 1997) the franked distributions are said to be exempt from income tax under subsection 295-390(1) of the ITAA 1997. In the result, absent the application of subsection 207-145(1) the Fund will obtain refunds of the unused franking credit tax offsets in relation to the franked distributions.

The reference in FCT v. CPH (FFC) at [136] to various different means by which tax can be escaped (including application of an inter-company dividend rebate) was not an exhaustive description of the means by which tax can relevantly be escaped on the dividend by a dividend stripping operation. Accordingly, the element of a dividend stripping operation in paragraph 32(d) above is satisfied.

Fifth element: The Taxpayer will benefit from an accretion to the value of their interest in the Fund as a result of the transfer of shares in the Company to the Fund by way of in-specie contribution.

The Taxpayer will also receive a capital sum for the remaining shares in the Company. Of this sum, an amount will be received at the time of sale and the remaining amount will be paid in annual instalments.

The Taxpayer will therefore receive a capital sum, as well as an accretion to the value of their interest in the Fund, which in total approximately equals the dividend amounts that are paid out by the Company to the Fund. It is not significant that the dividends are paid over a number of years, rather than paid at once. This is no more than a 'variation on the paradigm' which does not remove the scheme from one satisfying the central characteristics of a 'dividend stripping operation'.

Although the Taxpayer will not receive direct payment for shares in the Company and the proceeds from the sale of shares are received in instalments, this is (again) only a 'variation on the paradigm' which will not remove the scheme from one which has the central characteristics of a 'dividend stripping operation': FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45]. Alternatively, the scheme will have 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping'.

Accordingly, the element of a 'dividend stripping operation' in paragraph 32(e) above is satisfied.

Sixth element: The sixth element of a dividend stripping operation identified above is satisfied for the following reasons:

(a) The arrangement proposed and described above is carefully planned. It involves all the parties acting in concert. The parties are all related, being the Taxpayer or the company or Fund controlled by them.

(b) From the point of view of the Fund, the principal or pre-dominant economic effect of the arrangement proposed and described above is obtaining tax benefits: namely, the attraction of the exemption in subsection 295-390(1) of the ITAA 1997 to the franked distributions and generating refunds of the unused franking credit tax offsets. In relation to the contribution of the shares, it is the exemption in subsection 295-390(1) as it applies to the franked distribution, and the refund of the unused franking credit tax offset that increases the amount available for subsequent tax free distribution as a superannuation benefit to the Taxpayer as a member of the Fund. In relation to the purchase of the shares it is the tax benefits that overwhelmingly provide the explanation for the increase in the value of the Fund. That is, the Fund must pay an amount to acquire dividend income in that same amount along with the franking credit tax offset. It is only the franking credit tax offset amount that results in an actual increase in the value of the Fund.

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

(d) From the point of view of the vendor shareholder (the Taxpayer), the principal or predominant effect of the proposed arrangement is the substitution of a capital amount for the disposal of the shares, instead of franked distributions, with a resultant lower incidence of tax (under the applicable capital gains tax provisions): see Lawrence v. FCT at [44]. If the retained earnings of the Company were paid as franked distributions by the Company, then the Taxpayer would expect to incur a larger tax liability. The franking credit tax offset refund amounts are available for subsequent tax free distribution as superannuation benefits to the Taxpayer.

(e) It is no answer to say that the arrangement is undertaken for the purposes of retirement planning and to provide for the Taxpayer's better retirement rather than for the purpose of avoiding tax. This is because that poses a false dichotomy of the kind referred to in Commissioner of Taxation v. Spotless Services Limited (1996) 186 CLR 404 (FCT v. Spotless) at 415 - 416. This is because on an objective assessment, the substantial aspect of the arrangement that makes it desirable retirement planning for the Taxpayer and gives rise to the enhanced value is the tax benefits obtained through the channelling of the franked distributions through the Fund: namely, the exemption of the franked distributions and the refund of the franking credit tax offsets referred to in paragraph 8(g) above.

(f) It is also no answer to say that the arrangement is undertaken for the purpose of keeping the Taxpayer's wealth in the hands of other entities rather than in their own name as an aspect of wealth protection. If those were the objectives, they could be more simply achieved by the Company distributing its assets to the Taxpayer to transfer to the Trust or transferring directly to the Trust at their direction. The relevant difference being the tax effects achieved by the arrangement proposed and described at paragraph 8(h) and (i) above would not be achieved.

(g) Furthermore, the fact that the Taxpayer may be assessed on a net capital gain made in respect of the disposal of the shares in the Company to the Fund does not mean that a 'dividend stripping operation' cannot arise. In Lawrence v. FCT, the Full Court of the Federal Court observed at [44] that 'notwithstanding the advent of comprehensive taxation of capital gains, this characteristic remains relevant because the methods of calculating capital gains invariably lead to a lower amount of tax'.

Question 3

Summary

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

Detailed reasoning

Section 177E of Part IVA of the ITAA 1936

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

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

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

(b) the scheme is one:

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

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

(c) a result of the scheme is that property of the target co is disposed of;

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

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

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

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

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

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

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

First condition: The breadth of the definition of 'scheme' in section 177A of the ITAA 1936 has been judicially noted: British American Tobacco Australia Services Ltd v. Federal Commissioner of Taxation [2010] FCAFC 130; (2010) 189 FCR 151 at [30]. It includes any 'scheme, plan, proposal, action, course of conduct, or course of action'. The steps above clearly constitute a scheme within the meaning of subsection 177A(1).

The scheme described above is plainly a 'scheme that is in relation to a company', namely the Company.

For this reason, the first condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 51(a) above is satisfied.

Second condition: For the reasons given above the steps set out involves a 'scheme' by way of or in the nature of dividend stripping. For this reason, the second condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 51(b) is satisfied.

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

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

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

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

(c) a bailment of property by the company; and

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

The scheme, involves the payment by the Company of franked distributions to the Fund and thus is a scheme the result of which is the disposal of property of the Company within the meaning of paragraph 177E(2)(a) of the ITAA 1936.

Accordingly, the third condition in subsection 177E(1) of the ITAA 1936 is satisfied.

Fourth condition: As noted above, the franked distributions to be paid represents all or substantially all of the Company's retained earnings. Therefore, the Commissioner has formed the view that the franked distributions will represent, in whole or in part, a distribution of the profits of the Company. For this reason, the fourth condition in subsection 177E(1) of the ITAA 1936 is satisfied.

Fifth condition: If, before the scheme described above was entered into, the Company paid a franked distribution out of profits to its then shareholder being the Taxpayer, it is reasonable to expect that an additional amount would have been included in his assessable income equal to the value of the franked distributions. For this reason, the fifth condition in subsection 177E(1) of the ITAA 1936 is satisfied

Sixth condition: The scheme is to be entered into after 27 May 1981. Therefore, the sixth condition in subsection 177E(1) of the ITAA 1936 is satisfied.

For those reasons, if the scheme in paragraph 8 above is entered into, there will be taken to be a scheme to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e)). Further, the Taxpayer will be taken to have obtained a tax benefit in connection with the scheme, being the amount or amounts which, had the Company paid franked distributions prior to entering into the scheme, would have formed part of their assessable income for each income year (paragraph 177E(1)(f) and (g)).

Question 4

Summary

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

Detailed reasoning

Section 177EA of the ITAA 1936

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

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

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

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

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

(c) the distribution was, or is expected to be, a franked distribution (paragraph 177EA(3)(c));

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

(e) 'having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit' (paragraph 177EA(3)(e)).

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

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

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

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

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

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

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

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

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

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

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

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

It is clear that the 'jurisdictional facts' in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 and described in paragraphs 64(a) to (d) above are satisfied. This is because:

(a) there is a 'scheme for the disposition of membership interests' as the relevant scheme involves the transfer of shares in the Company by the taxpayer to the Fund (see subparagraphs 8(b) and (d) above). Accordingly, the jurisdictional fact in paragraph 177EA(3)(a) is satisfied;

(b) it is expected that the distributions to the Fund will be frankable distributions and they are expected to be franked distributions (see subparagraph 8(g) above). Accordingly, the jurisdictional fact in subparagraph 177EA(3)(b)(i) and paragraph 177EA(3)(c) is satisfied;

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

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

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

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

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

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

(a) the value attributed to the transfer of shares by the Taxpayer and reflected as an accretion to the value their interest in the Fund, as well as the consideration paid by the Fund for shares in the Company do not appear to have been calculated by reference to any imputation benefits (cf., paragraph 177EA(17)(f)). However, given the close relationship of all parties to the scheme and the fact that the tax effect of the scheme is not dependent on the dividend being calculated by reference to the franking credits, the weight of this factor is slight;

(b) the franked distributions do not appear to be equivalent to receipts of amounts in the nature of interest (cf., paragraph 177EA(17)(h)). However, this matter does not appear to have a relevance to the operation of the scheme. Accordingly, its probative value is slight;

(c) the franked distributions appear to be paid from taxed and not untaxed profits (cf., paragraph 177EA(17)(ga)). However, again, since the economic and tax effect of the scheme is achieved by the attraction of the franking credit tax offset and refund, this is a matter of limited weight.

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

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

(a) the period of time the Fund will hold the shares in the Company prior to the payment of the first franked distribution is short and following payment of all of the retained earnings of the Company as franked distributions the Company will be wound up. The Company will conduct no trading activities in that period and its assets are only cash and commercial property. After payment of each franked distribution, the Company's value will diminish until it becomes worthless. The Fund was not the economic owner of the shares when the Company generated the franking credits and thus did not bear any significant risk in the period of its holding of the shares in the Company in relation to the accruing of those franking credits. This undermines the principles of the imputation system: Explanatory Memorandum to the Taxation Laws (Amendment) Bill (No 3) at [8.5] (cf., paragraphs 177EA(17)(a) and (i));

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

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

(a) the scheme involves a carefully orchestrated and interlinked series of transactions (cf., paragraph 177D(2)(a)) between persons who are all connected with the Taxpayer, being either themself or the Company or Fund which they control and is interested in (cf., paragraph 177D(2)(h));

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

(c) the scheme is to be implemented over number of years due to the Company remaining liable for any warranty claims following the cessation of its business. The Company will at the end of that time be worthless and subsequently wound up (cf., paragraph 177D(2)(c));

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

(i) the Fund will receive the franked distributions as well as a refund of the franking credit tax on the basis that the franked distributions are exempt income pursuant to section 295-390 of the ITAA 1997; and will incur a capital loss on the Company's deregistration. The Fund will incur a liability under the instalment purchase arrangement, and will utilize an amount of cash to purchase the shares. The difference in the economic position of the Fund with and without the scheme is overwhelmingly due to the effect of the refund of the franking credit tax offsets. (cf., paragraph 177D(2)(d));

(ii) the Taxpayer will have an amount, referable to the net capital gain made upon disposal of the shares in the Company included in their assessable income and, because of the method of calculating net capital gains, this will be a lesser amount than would be included if the franked distributions were paid directly to them, even if they do not elect to use the small business CGT concessions. (cf., paragraph 177D(2)(d)); and

(iii) the Taxpayer will receive the benefit of a pension in a tax free form from the Fund supported by the franked distributions (to the extent they are not used to reimburse the Fund for the payment of the instalments for the purchase of the shares) and the refunds of the franking credit tax offsets received by the Fund. In the absence of the scheme the Taxpayer would otherwise reasonably expect to receive franked distributions from the Company and could reasonably expect to incur a taxation liability in respect of that income. The Taxpayer would therefore have the benefit of a lesser amount (i.e. the dividend amount reduced by tax payable ('top-up tax')) to the extent that their marginal tax rate exceeds the company tax rate (cf., paragraph 177D(2)(e)).

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

It is no answer to say that the main purpose of the scheme is the maximising of the Taxpayer's wealth in retirement. That draws the same false dichotomy as was rejected in FCT v. Spotless. This is because it is the tax effect referred to above which achieves the maximisation of wealth in retirement over that which would otherwise be achieved. The suggested explanation of wealth protection has inadequate probative weight.

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