Edited version of your written advice

Authorisation Number: 1012821714350

Date of advice: 15 June 2015

Ruling

Subject: Is dividend income assessable under proposed arrangement?

Issue 1

General anti-avoidance rule

Question 1

Will the Commissioner make a determination under section 177F of the Income Tax Assessment Act 1936 (the ITAA 1936) to cancel any tax benefit arising on the payment of a dividend under the proposed arrangement?

Answer

No, the Commissioner will not seek to make a determination under section 177F of the ITAA 1936 to cancel any tax benefit arising on the payment of a dividend under the proposed arrangement.

Issue 2

Imputation benefits

Question 1

Will the Commissioner make a determination under paragraph 204-30(3)(c) of the Income Tax Assessment Act 1997 (the ITAA 1997) in relation to the payment of a dividend under the proposed arrangement?

Answer

No, the Commissioner will not make a determination under paragraph 204-30(3)(c) of the ITAA 1997 in relation to the payment of a dividend under the proposed arrangement.

Question 2

Will the Commissioner make a determination under paragraph 177EA(5)(b) of the ITAA 1936 in relation to the payment of a dividend under the proposed arrangement?

Answer

No, the Commissioner will not make a determination under paragraph 177EA(5)(b) of the ITAA 1936 to in relation to the payment of a dividend under the proposed arrangement.

Issue 3

Stripping of company profits

Question 1

Does the Commissioner consider that the payment of a dividend under the proposed arrangement results in a scheme to which section 177E of the ITAA 1936 applies?

Answer

No, the Commissioner does not consider that the payment of a dividend under the proposed arrangement results in a scheme to which section 177E of the ITAA 1936 applies.

Question 2

Does the Commissioner consider that the payment of a dividend under the proposed arrangement results in a scheme to which paragraph 207-145(1)(d) of the ITAA 1997 applies?

Answer

No, the Commissioner does not consider that the payment of a dividend under the proposed arrangement results in a scheme to which paragraph 207-145(1)(d) of the ITAA 1997 applies.

Issue 4

Value shifting

Question 1

Will the change to the constitution and by-laws under the proposed arrangement result in a value shift that will have tax consequences under Division 725 of the ITAA 1997?

Answer

No, the change to the constitution and by-laws under the proposed arrangement will not result in a value shift that will have tax consequences under Division 725 of the ITAA 1997.

This ruling applies for the following period(s)

1 July 2014 to 30 June 2018

The scheme commences on

1 July 2014

Relevant facts and circumstances

Company A is the head company in a company group and owns all of the shares in the following subsidiary members:

• Company B;

• Company C;

• Company D;

• Company E;

• Company F; and

• Company G.

Company C is the main operating entity and has been operating a consulting practice trading as Company C since the 19XXs.

There are X business sections that make up the business as a whole.

The business sections are identifiable by the business area they operate in their geographical location and their business focus (short term or long term projects).

The company group is not consolidated for taxation purposes.

Company A has shareholders, some of which are companies and some of which are individuals. It is understood that all the shareholders are either directors or senior managers of Company A or entities that are associates of those directors or shareholders. P is one of these shareholders.

Each of the principals involved in the business sections is responsible for managing projects, design related services, staff management and attend internal and client meetings with the exception of P who does not engage in design related services.

All of the shareholders are Australian residents for taxation purposes.

At present dividend payments are made to shareholders based on their proportionate shareholding in Company A.

Under the proposed arrangement, Company A wants to be able to provide dividend returns that reflect both the profit results of a business section and the profitability of the business as a whole. The applicant equates this concept of a 'business section profit' to a 'short term profit' that can be paid subject to the profitability of the business as a whole. Providing a dividend return based on short-term business section results will allow some of the profits of a particular business section to be returned directly to the shareholder who has invested in that business and who works in that particular business section. P was offered to acquire shares because they were working in the Corporate business section.

Company A has explained that the proposed arrangement is modelled on a 'franchising model' whereby:

The head office is treated as a head franchisor and the business sections are treated as franchisees.

The head office holds a one-third stake in the business section (notionally) while nominated shareholders hold a (notional) two-third stake in the business section. The nominated shareholders are regarded as having a notional investment in the business section.

The head office will take a fee of X% of turnover from the business section and that amount is treated as long-term profit.

X% of the profit remaining after the head office fee is paid as PAYGW bonuses to staff (including senior managers and directors).

The business section profit is the amount remaining (if any) after the head office fee and PAYGW bonuses.

The business section profit is then payable one-third to the head office (part of long-term profit) as a head office dividend and two-thirds to the shareholders who notionally own part of the business section as the business section dividend.

Under the proposed arrangement and in line with this 'model' Company A will pay to its shareholders an amount of the head office fee (funded from the payment of the X% fee) and head office dividend (sourced one-third from the business section profits) as an 'ordinary' dividend.

It is proposed that Company A will then pay to the shareholders allocated to a particular business section their share of the business section's profit. In this way, Company A intends to allow dividends to be paid in different proportions to existing legal shareholdings based on the results achieved by a particular business section (therefore it is intended that not every shareholder will receive this additional part of a dividend if their business section has not achieved the required profit results). It is the payment of a dividend that contains a business section profit component that is the focus of the analysis in this ruling request and therefore, for convenience, the payment of such a dividend is referred to throughout this analysis as a business section profit dividend).

The shareholder's share of the business section profit (the two-thirds remaining) is proportionate based on the shareholder's holdings in Company A. The shareholders would also receive their proportionate share of the profits of other business sections that flows through as head entity profit.

The payment of a dividend is subject to cash flow being available to pay such a dividend, the requirements of section 254T of the Corporations Act 2001 and a determination by the Board of Directors as to whether payment of any dividend is prudent.

Company A intends to give effect to the proposed arrangement by amending its constitution and its by-laws in the following manner:

(i) The Constitution will be amended so that:

(a) Directors can pay dividends on one ordinary share to the exclusion of any other ordinary share and at such times and in such amounts as they determine.

(ii) The by-laws will be amended so that:

(a) In determining the amount of a dividend to be paid on the ordinary shares held by a particular shareholder the directors must have regard to:

(i) The amount of the head entity profits a shareholder is entitled to; and

(ii) The amount of business section profits that a shareholder is entitled to.

(b) The entitlement to head entity profits will be determined by dividing the number of ordinary shares held by a shareholder into the total number of ordinary shares on issue, and multiplying that fraction by the amount of head entity profits to be paid as a dividend. Head entity profits are amounts referrable to the X% fee charged to a business section and one-third of a business section's profit.

(c) Business section profits will be defined to be the profits of a business section remaining after taking a charge against those profits of X% of turnover and payment of X% of the remaining profit as PAYGW bonuses to directors, senior managers and staff.

(d) X% of the business section profit will be contributed to the head entity profits.

(e) The entitlement to the remaining business section profits will be determined using the following formula: number of ordinary shares held by a shareholder in business section/number of ordinary shares held by all shareholders in that business section multiplied by remaining business section profits.

Company A only pays fully franked dividends. The Applicant has indicated that there is nothing known to them that would change this position in the foreseeable future. The Commissioner understands that Company A has not paid any dividends over the last couple of years on the basis that it is currently unable to achieve the desired split of the business section profits from the profits of the business as a whole.

Assumption(s)

The shareholders of Company A that are employed as directors and senior managers in the group and the associates of shareholders that are employed as directors and senior managers are paid market salaries and will continue to receive market level remuneration in respect of their employment; and

In determining whether to pay dividends, in what amounts and to whom, and in particular in determining whether a shareholder is entitled to a particular share of business section profit, the Board of Company A have established a process which will be set out in the company's by-laws and the Board will follow this process.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 177A

Income Tax Assessment Act 1936 subsection 177A(1)

Income Tax Assessment Act 1936 section 177C

Income Tax Assessment Act 1936 subsection 177C(1)

Income Tax Assessment Act 1936 paragraph 177C(1)(a)

Income Tax Assessment Act 1936 subsection 177CB(2)

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 subsection 177D(2)

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1936 subsection 177E(1)

Income Tax Assessment Act 1936 paragraph 177E(1)(a)

Income Tax Assessment Act 1936 paragraph 177E(1)(b)

Income Tax Assessment Act 1936 paragraph 177E(1)(c)

Income Tax Assessment Act 1936 paragraph 177E(1)(d)

Income Tax Assessment Act 1936 paragraph 177E(2)(a)

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 subsection 177EA(3)

Income Tax Assessment Act 1936 paragraph 177EA(3)(a)

Income Tax Assessment Act 1936 paragraph 177EA(3)(b)

Income Tax Assessment Act 1936 paragraph 177EA(3)(c)

Income Tax Assessment Act 1936 paragraph 177EA(3)(d)

Income Tax Assessment Act 1936 paragraph 177EA(3)(e)

Income Tax Assessment Act 1936 subsection 177EA(5)

Income Tax Assessment Act 1936 paragraph 177EA(5)(a)

Income Tax Assessment Act 1936 subsection 177EA(14)

Income Tax Assessment Act 1936 paragraph 177EA(14)(d)

Income Tax Assessment Act 1936 paragraph 177EA(14)(e)

Income Tax Assessment Act 1936 subsection 177EA(17)

Income Tax Assessment Act 1997 Subdivision 204-D

Income Tax Assessment Act 1997 section 203-30

Income Tax Assessment Act 1997 subsection 203-30(1)

Income Tax Assessment Act 1997 section 204-30

Income Tax Assessment Act 1997 paragraph 204-30(3)(a)

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

Income Tax Assessment Act 1997 subsection 204-30(6)

Income Tax Assessment Act 1997 paragraph 204-30(6)(a)

Income Tax Assessment Act 1997 subsection 204-30(7)

Income Tax Assessment Act 1997 subsection 204-30(8)

Income Tax Assessment Act 1997 Division 207

Income Tax Assessment Act 1997 section 207-20

Income Tax Assessment Act 1997 section 207-35

Income Tax Assessment Act 1997 section 207-45

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

Income Tax Assessment Act 1997 paragraph 207-145(1)(d)

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 Division 725

Income Tax Assessment Act 1997 section 725-55

Income Tax Assessment Act 1997 paragraph 725-50(b)

Income Tax Assessment Act 1997 Subdivision 727-E

Income Tax Assessment Act 1997 subsection 727-355(1)

Income Tax Assessment Act 1997 subsection 727-355(2)

Income Tax Assessment Act 1997 subsection 727-355(3)

Income Tax Assessment Act 1997 subsection 960-130(1)

Reasons for decision

Issue 1 - Question 1

Summary

The Commissioner will not make a determination under section 177F of the ITAA 1936 to cancel any tax benefit arising on the payment of a dividend under the proposed arrangement.

Detailed reasoning

Part IVA of the ITAA 1936 is a general anti-avoidance provision that gives the Commissioner the discretion to cancel a tax benefit that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained by a taxpayer in connection with a scheme to which Part IVA applies.

Before the Commissioner can exercise the discretion in subsection 177F(1) of the ITAA 1936, the requirements of Part IVA of the ITAA 1936 must be satisfied. These requirements are that:

• a 'tax benefit' as identified in section 177C of the ITAA 1936, was or would, but for subsection 177F(1) of the ITAA 1936 have been obtained;

• the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A of the ITAA 1936; and

• having regard to section 177D of the ITAA 1936, the scheme is one to which Part IVA of the ITAA 1936 applies.

Paragraph 53 of ATO Practice Statement Law Administration PSLA 2005/24 Application of General Anti-Avoidance Rules states:

Focusing on the various elements of Part IVA should not obscure the way in which the Part as a whole is intended to operate. What constitutes a scheme is ultimately meaningful only in relation to the tax benefit that has been obtained since the tax benefit must be obtained in connection with the scheme. Likewise, the dominant purpose of a person in entering into or carrying out the scheme, and the existence of the tax benefit, must both be considered against a comparison with an alternative.

Scheme

For Part IVA of the ITAA 1936 to apply, the identified scheme must fall within the definition of 'scheme' in subsection 177A(1) of the ITAA 1936. Subsection 177A(1) defines scheme as:

scheme means:

(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 proposed arrangement, as set out above, would fall within the definition of a scheme, as at the very least, a plan or a proposal (at this stage). Once the proposed arrangement is voted upon and adopted by the directors of Company A it would become an arrangement within paragraph (a) of the definition. It is noted that the proposed arrangement establishes a framework within which the Directors of Company A can make decisions regarding the payment of dividends. Given the broad definition of scheme and its intended operation, the proposed arrangement would meet the definition of 'scheme'.

Tax benefit

In order to reach a conclusion as to whether a tax benefit has been obtained, and to quantify it, the tax consequences of the scheme need to be compared with the tax consequences that arise under an alternative postulate.

Subsection 177C(1) of the ITAA 1936 contains two bases upon which the existence of a tax benefit can be demonstrated. The first limb requires a comparison of the tax consequences of the scheme with the tax consequences that 'would have' resulted if the scheme had not occurred. The second limb requires a comparison of the tax consequences of the scheme with the tax consequences that 'might reasonably be expected to have' resulted if the scheme had not occurred. These are separate and distinct bases upon which the existence of a tax benefit can be demonstrated.

Under the "annihilation approach" (the first limb of paragraph 177C(1)(a) of the ITAA 1936 that considers what would have resulted if the scheme had not occurred), a decision that a certain tax effect is achieved must be made solely on the basis of a postulate comprising all of the events or circumstances that actually happened or existed, other than those that form part of the scheme; subsection 177CB(2) of the ITAA 1936.

Under this approach, a taxpayer will have obtained a tax benefit in connection with a scheme if it can be demonstrated that a relevant tax effect would have flowed, as a matter of law, from the application of the tax law to the facts remaining once the scheme is assumed away, that is, a tax effect less advantageous to the taxpayer than the tax effect secured by the taxpayer in connection with the scheme.

In this case, if the scheme is assumed away, what is left is the current situation that Company A and its shareholders are in. That is, the shareholders of Company A would, if the Directors exercise their discretion to do so, receive dividends sourced from the profits of the business (from all of the business sections as a whole) based on their proportionate legal shareholding in Company A. However, as the business section profit dividend also reflects the profit of the business section, it is appropriate that this profit is shared amongst the shareholders in proportion to their contribution to the creation of that profit (to the exclusion of other shareholders who have not achieved the required profit targets in their individual business section).

Therefore, until the Directors exercise their discretion to declare and pay a dividend, including the declaration and payment of a business section profit dividend, no tax benefit arises under the comparison between the scheme and the alternative counterfactual.

Dominant purpose

In the event that a dividend is so declared and paid as intended under the proposed arrangement, the Commissioner is of the view that, to the extent this creates a tax benefit to the shareholder(s) of Company A, the requisite dominant purpose of obtaining the tax benefit is not present. Specifically, having regard to the eight factors in subsection 177D(2) of the ITAA 1936 it could not be objectively concluded that the dominant purpose of Company A or any of the shareholders was to obtain a tax benefit. The dominant purpose of the proposed arrangement is to enable the Directors of Company A to share the benefits of ownership of the business amongst the legal shareholders in a manner that best reflects the profitability of the business as a whole (long-term profits) and that rewards individual efforts in the business sections via the payment of dividends reflecting short-term profits (subject to the profitability of the business as a whole).

Accordingly, the Commissioner will not make a determination under section 177F of the ITAA 1936 to cancel any tax benefit arising on the payment of a dividend under the proposed arrangement.

For completeness, it is noted that there may be a different outcome under Part IVA in the event of manipulation of the proposed structure in a manner contrary to that envisaged by the group. This includes any variation to the assumptions made, including that the discretion is not exercised in a way that is consistent with the process outlined in the ruling application or that directors and senior managers do not continue to receive market level remuneration in respect of their employment.

Issue 2 - Question 1

Summary

The Commissioner will not make a determination under paragraph 204-30(3)(c) of the ITAA 1997 in relation to the payment of a dividend under the proposed arrangement.

Detailed reasoning

Subdivision 204-D of the ITAA 1997 enables the Commissioner to make a determination to either impose a franking debit in a company's franking account or deny an imputation benefit in respect of a distribution where franked distributions are streamed to a member of a corporate tax entity in preference to another member.

Subsection 204-30(1) of the ITAA 1997 prescribes the circumstances under which the Commissioner can make such a determination. It states:

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 the 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.

Therefore, in order to determine whether the Commissioner should make a determination under paragraph 204-30(3)(c) of the ITAA 1997, the following issues need to be considered:

• whether the shareholders will be a 'members' of Company A for the purposes of section 204-30 of the ITAA 1997;

• whether 'imputation benefits' will be received by the shareholders as a result of the business section profit dividend;

• whether there exist members of Company A that would derive 'a greater benefit from franking credits than another member' of Company A; and

• whether the payment of a business section profit dividend would constitute 'streaming' having regard to whether there are members of Company A that would derive a greater benefit from franking credits than other members and whether those members will receive lesser or no imputation benefits.

Will the shareholders be 'members' of Company A?

Members of an entity are defined in the table contained in subsection 960-130(1) of the ITAA 1997. Item 1 of the table defines a member of a company as:

a member of the company or a stockholder in the company

Therefore, the shareholders of Company A will be members of it for the purposes of subsection 204-30(3) of the ITAA 1997.

Will 'imputation benefits' be received by the shareholders?

The term 'imputation benefit' is defined in subsection 204-30(6) of the ITAA 1997 which states:

A *member of an entity receives an imputation benefit as a result of a distribution if:

(a) the member is entitled to a *tax offset under Division 207 as a result of the distribution; or

(b) an amount would be included in the member's assessable income as a result of the distribution because of the operation of section 207-35; or

(c) a *franking credit would arise in the franking account of the member as a result of the distribution; or

(d) an exempting credit would arise in the *exempting account of the member as a result of the distribution; or

(e) the member would not be liable to pay *withholding tax on the distribution, because of the operation of paragraph 128B(3)(ga) of the Income Tax Assessment Act 1936; or

(f) the member is entitled to a *tax offset under section 210-170 as a result of the distribution.

Under the proposed arrangement as understood by the Commissioner, the payment of an ordinary dividend to a shareholder of Company A, including the payment of any business section profit dividend is expected to be fully franked. Further, each shareholder in Company A is an Australian resident at all relevant times. Therefore, a Company A shareholder will receive an imputation benefit as a result of receiving a distribution of this nature.

This is on the basis that an Australian resident shareholder of Company A should, as a result of receiving a business section profit dividend, receive the benefit of a tax offset (in satisfaction of the requirement in paragraph 204-30(6)(a) of the ITAA 1997) or receive a franking credit to its franking account (where the relevant shareholder is a company) in satisfaction of the requirement in paragraph 204-30(6)(c).

Whether there exist members of Company A that would derive 'a greater benefit from franking credits than another member' of Company A?

Subsection 204-30(8) of the ITAA 1997 provides a non-exhaustive list (refer also to subsection 204-30(7) of the ITAA 1997) of circumstances where a member of an entity will be considered to derive a greater benefit from franking credits than another member of the entity. The circumstances are as follows:

(a) whether the other member is a foreign resident;

(b) whether the other member would not be entitled to a tax offset under Division 207 of the ITAA 1997 because of the distribution;

(c) whether the other member's amount of income tax payable as a consequence of the business section profit dividend is less than the tax offset to which they would be entitled;

(d) whether the other member is a corporate tax entity at the time the distribution is made, but no franking credit arises for the entity as a result of the business section profit dividend;

(e) whether the other member is corporate tax entity at the time the distribution is made, but will not be able to pass on the benefit of franking credits to its own members because it is not a franking entity or is unable to make frankable distributions; and

(f) whether the other member is an exempting entity.

The circumstances listed in subsection 204-30(8) of the ITAA 1997 contemplate an assessment of the capacity of members of an entity to effectively utilise the benefits associate with franking credits attached to the distributions made to them.

Company A's membership comprises shareholders, some of which are individuals (some of which are acting in the capacity of trustees of trusts) and some of which are companies (all of which are acting in the capacity of trustees of trusts), and all of which are Australian residents for taxation purposes. As a result, all of the shareholders of Company A would be capable of effectively utilising the franking credits which would attach to a franked business section profit dividend if such a distribution was to be made. Therefore, there are no members of Company A that could derive a greater benefit from franking credits than another member of Company A.

Accordingly, it could not be concluded that Company A is directing distributions so as to confer greater benefits from franking upon a member that is able to derive a greater benefit from franking credits to the exclusion of a member that is unable to do so, even in the event that one or more shareholders receive a business section profit dividend to the exclusion of any other shareholders.

Therefore the Commissioner would not seek to make a determination under paragraph 204-30(3)(c) of the ITAA 1997 where Company A pays a business section profit dividend to one or more shareholders to the exclusion of other shareholders.

For completeness, it is the Commissioner's view that even if it were arguable that a particular member of Company A would derive a greater benefit from franking credits than another member via the payment of a business section profit component of a dividend, it could not be concluded that the arrangement would constitute 'streaming'. This analysis is set out below.

Whether the payment of the business section profit dividend constitutes streaming?

The term 'streams' is not defined for the purposes of the Income Tax Acts. However, the concept of 'streaming' is described in paragraph 3.28 of the Explanatory Memorandum to the New Business Tax System (Imputation) Act 2002 (the EM) as:

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

Paragraphs 3.29 and 3.30 of the EM go on to stipulate:

3.29 The law uses an essentially objective test for streaming, although purpose may be relevant where future conduct is a relevant consideration. It will normally be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of members on the basis of their ability to use franking benefits is a key element of streaming.

3.30 Thus, streaming is unlikely to occur when a corporate tax entity, making franked distributions distinguishes between 2 classes of members, both of which comprise members who can and who cannot benefit from imputation credits. However, where one class is predominately able to use imputation credits and the other is predominately not, it may be apparent that an arrangement is streaming, notwithstanding the presence in each class of a small minority of the other type of member.

Whether or not a streaming arrangement has been implemented requires an objective determination to be made of whether the arrangement involves the selective directing of franked distributions to those members who can most benefit from franking credits to the exclusion of others. Section 204-30 of the ITAA 1997 is intended to be sufficiently broad in its scope and may apply to any strategy directing at defeating the policy of the law by avoiding wastage of franking credits through such arrangements.

Under the proposed arrangement, Company A will continue to pay each shareholder a fully franked ordinary dividend funded from the head entity fee and head office dividend (fully franked) in proportion to their shareholding in Company A.

The payment of the additional business section profit dividend is governed by a desire on the part of Company A to reward certain shareholders for the performance of the particular business section in which they are working based on the results of that individual business section.

In circumstances where all the shareholders of Company A can utilise franking credits (refer to the analysis above) and where distributions are expected to be fully franked, the payment of a business section profit dividend to one shareholder to the exclusion of another shareholder does not constitute the streaming of franking benefits to members who can most benefit from them.

Therefore, it would be concluded objectively that the primary reason a shareholder received a business section profit dividend would be to reward the notional owner of that business section for the performance of that business section rather than in order for those shareholders to obtain franking credits.

Furthermore, clause 10.1 of the constitution of Company A restricts ownership of shares in it to either:

(a) an individual who is an Employee;

(b) a trust Controlled by an Employee;

(c) a company Controlled by an Employee; or

(d) a person agreed to by X% of the Shareholders to own Shares in the Company.

It is therefore reasonable to conclude that the membership of Company A is determined by an employment relationship between Company A and the individuals whom own shares in it (or associated entities controlled by those employees) in order to allow those employees to share in the profits of Company A. Entities that are not employees (or associated entities thereof) cannot invest in the company (unless the requirements of clause 10.1(d) of the constitution are met).

Therefore, the Commissioner would not seek to make determination under paragraph 204-30(3)(c) of the ITAA 1997 in respect of the payment of a franked distribution under the proposed arrangement.

Issue 2 - Question 2

Summary

The Commissioner will not make a determination under paragraph 177EA(5)(b) of the ITAA 1936 in relation to the payment of a dividend under the proposed arrangement.

Detailed reasoning

Section 177EA of the ITAA 1936 is primarily directed at schemes involving franking credit trading. Its introduction was designed to secure the integrity of one of the underlying principles of the dividend imputation system, namely, to ensure that the benefits of imputation are restricted to the true economic owners of shares and only to the extent that those shareholders are able to use those franking credits themselves.

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

(a) there is a scheme for a disposition of membership interests, or an interest in membership interest in a corporate tax entity; and

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and

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

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

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

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

Scheme for the disposition

The term 'scheme for the disposition' as used in paragraph 177EA(3)(a) of the ITAA 1936 is defined pursuant to subsection 177EA(14) of the ITAA 1936. The term is defined broadly and includes:

• creating, altering or extinguishing a right, power or liability attaching to, or otherwise relating to, the membership interests or interest in the membership interest (paragraph 177EA(14)(d) of the ITAA 1936); and

• substantially altering any of the risks of loss, opportunities for profit or gain, involved in holding or owing the membership interests or have the interest in the membership interest (paragraph 177EA(14)(e) of the ITAA 1936).

Under the proposed arrangement, the amendments to be made to Company A's constitution and its by-laws will alter a shareholder's right in relation to how they will be able to receive a dividend on an ordinary share. The amendments will also substantially alter a shareholder's rights and opportunity to receive particular business section profits generated by Company A when compared to the rights and opportunities which are presently exist in relation to an ordinary share in Company A.

Therefore, the proposed amendments to be made to the rights attaching to an ordinary share in Company A would constitute a disposition of a membership interest under subsection 177EA(14) of the ITAA 1936. As a consequence, the requirement in paragraph 177EA(3)(a) of the ITAA 1936 would be satisfied.

Factors in paragraph 177EA(3)(b) to (d) of the ITAA 1936

Under the proposed arrangement, the conditions set out in paragraphs 177EA(3)(b) to (d) of the ITAA 1936 will also be satisfied.

It is expected that a franked distribution will be payable to the shareholders in respect of their membership interests and therefore they will receive an imputation benefit as a result of those distributions.

The key issue in this instance is whether, having regard to the relevant circumstances of the scheme, it would be concluded that there is a purpose, which is more than merely an incidental purpose, of enabling a relevant taxpayer to obtain an imputation benefit under the scheme (per paragraph 177EA(3)(e) of the ITAA 1936).

Under this arrangement, the 'relevant taxpayer' would be a shareholder in Company A and the scheme would comprise the steps in the proposed arrangement regarding the amendments to be made to Company A's constitution and its by-laws.

Relevant circumstances of the scheme

The 'relevant circumstances of the scheme' that the Commissioner must have regard to when applying paragraph 177EA(3)(e) of the ITAA 1936 are set out in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed in that subsection encompass a range of circumstances which, taken individually or collectively, could indicate the requisite purpose of enabling a relevant taxpayer to obtain an imputation benefit.

The Explanatory Memorandum to the Taxation Laws Amendment Bill (No.3) 1998 ('the EM') provides further guidance in determining whether the relevant purpose exists. In particular paragraph 8.74 of the EM states:

The test of purpose under the new section 177EA is a test of objective purpose. The question posed by the rule is whether, objectively, it would be concluded that a person who entered into or carried out the scheme under which the disposition of shares occurs, did so for the purpose of obtaining a tax advantage relating to franking credits. In determining the purpose of the scheme, the purpose of one of the persons who entered into or carried out the scheme (whether or not that person is the person receiving the franking credit benefit) will be sufficient to attract the rule.

Paragraph 8.76 of the EM also clarifies the concept of 'incidental purpose'. It states:

A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with another purpose, or merely follows another purpose as its natural incidence. For example, when a taxpayer holds shares in the ordinary way to obtain the benefit of any increase in share price and the dividend income flowing from the shares, a franking credit benefit is generally no more than a natural incident of holding shares, and generally the purpose of obtaining the benefit simply follows incidentally a purpose of obtaining shares: it is therefore merely an incidental purpose.

Paragraph 8.77 of the EM goes on to contrast this with the following:

On the other hand, if a taxpayer, being a company, entered into a scheme involving the disposition of shares for the immediate purpose of obtaining a tax advantage of itself (for example, one deriving from an allowable deduction and the inter-corporate dividend rebate) and another, substantial, purpose of obtaining franking credits (which will ultimately benefit its shareholders), the fact that the taxpayer may regard the immediate benefit of the first tax advantage as more important the deferred benefit of obtaining the franking credits does not mean that the second purpose is merely incidental to the first.

The application of section 177EA of the ITAA 1936 to the issuing of a stapled security by a bank was the focus of the High Court in the case of Mills v Federal Commissioner of Taxation 83 ATR 514; 2012 ATC 20-360 ('Mills').

When looking at the application of paragraph 177EA(3)(e) of the ITAA 1936, the Court took the view that the enquiry posed by that provision was to be answered from the perspective of a 'reasonable person'.

Gageler J held the following at paragraph 74 of 83 ATR 514:

… the question posed by s 177EA(3)(e), and to be answered from the perspective of a reasonable person, can be broken down into two sub-questions. In issuing PERLS V, did the Bank have a purpose of enabling holders to obtain franking credits? If so, was that purpose subordinate to or in subsidiary conjunction with some other purpose?

Viewing the enquiry to be made under paragraph 177EA(3)(e) of the ITAA 1936 through this prism, the Court went on to conclude that although enabling the holder of the stapled security to obtain an imputation credit was 'central to the design of the scheme', this did not mean that the provision of the imputation credit is excluded from being an incidental purpose. The design of the scheme in this instance was directed to the raising of Tier 1 capital for the bank. As such the provision of an imputation credit to the security holder (whilst itself being a purpose) was incidental for the purposes of paragraph 177EA(3)(e) of the ITAA 1936.

Having regards to the facts and circumstance of the proposed arrangement as outlined in the ruling application it would be concluded that, in light of the decision in Mills, the requirements for applying paragraph 177EA(3)(e) of the ITAA 1936 would not be met.

Whilst a shareholder, on receiving a dividend from Company A, including a business section profit dividend, will receive a franking credit (on the basis that Company A only pays fully franked dividends) the attachment of franking credits to that distribution would only be an incidental purpose to the scheme.

Objectively, the main purpose of the scheme is to distribute the group's profits to the shareholders of Company A and to reward particular owners for the performance of the individual business section in which they are working.

Therefore, the Commissioner considers that the proposed amendments to the constitution and by-laws of Company A as to how and when it can pay dividends to its shareholders are not designed to stream dividends to particular shareholders who can benefit more than other shareholders from the receipt of franking credits. Further, there is nothing to suggest that the proposed arrangement has any element of a franking trading scheme.

Issue 3 - Question 1

Summary

The Commissioner does not consider that the payment of a dividend under the proposed arrangement results in a scheme to which section 177E of the ITAA 1936 applies.

Detailed reasoning

Subsection 177E(1) of the ITAA 1936 states:

Where:

(a) as a result of a scheme that is, in relation to a company:

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

(ii) A scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping;

any property of the company disposed of;

(b) in the opinion of the Commissioner, the disposal of that property represents, in whole or in part, a distribution (whether to a shareholder or another person) of profits of the company (whether of the accounting period in which the disposal occurred or of any earlier or later accounting period);

(c) if, immediately before the scheme was entered into, the company had paid a dividend out of profits of an amount equal to the amount determined by the Commissioner to be the amount of profits the distribution of which is, in his or her opinion, represented by the disposal of the property referred to in paragraph (a), an amount (in this subsection referred to as the notional amount) would have been included, or might reasonably be expected to have been included, by reason of the payment of that dividend, in the assessable income of a taxpayer in a year of income; and

(d) the scheme has been or is entered into after 27 May 1981, whether in Australia or outside Australia;

the following provisions have effect:

(e) the scheme shall be taken to be a scheme to which this Part applies;

(f) for the purposes of section 177F, the taxpayer shall be taken to have obtained a tax benefit in connection with the scheme that is referable to the notional amount not being included in the assessable income of the taxpayer of the year of income; and

(g) the amount of that tax benefit shall be taken to be the notional amount.

It is noted for completeness that paragraph 177E(2)(a) of the ITAA 1936 goes on to stipulate that a reference in subsection 177E(1) of the ITAA 1936 to the disposal of property of a company shall be read as including a payment of a dividend by the company.

Section 177E of the ITAA 1936 will apply where the four conditions in paragraphs 177E(1)(a) to (d) of the ITAA 1936 are satisfied. Each of these will now be considered in light of the facts presented to the Commissioner.

Paragraph 177E(1)(a) - scheme by way of or in the nature of dividend stripping

Scheme

The term 'scheme' as used in paragraph 177E(1)(a) of the ITAA 1936 is defined in section 177A of the ITAA 1936.

In this case, the proposed arrangement to be entered into by Company A including the proposed amendment of its constitution and by-laws to allow its Directors a discretion to pay dividends on ordinary shares to the exclusion of any other ordinary share, would constitute a 'scheme' as set-out in section 177A of the ITAA 1997.

The key issue for the purposes of applying paragraph 177E(1)(a) of the ITAA 1936 is whether the proposed arrangement is a scheme by way of or in the nature of 'dividend stripping' or a scheme that provides substantially the same effect as a dividend strip.

Dividend stripping

The term 'dividend stripping' is not defined within the Income Tax Acts, therefore guidance as to its meaning must be gleaned from the common law.

The term has been the subject of detailed judicial discussion in the Full Federal Court case of Lawrence v Commissioner of Taxation [2009] FCAFC 29; (2009) 175 FCR 277; 209 ATC 20-096 (Lawrence) and the High Court case of Federal Commissioner of Taxation v Consolidated Press Holdings and Ord (2001) 207 CLR 235; [2001] HCA 32; 2001 ATC 4343; 47 ATR 229 (Consolidated Press).

In Consolidated Press the High Court cited with approval the Full Federal Court's adoption (in Federal Commissioner of Taxation v Consolidated Press Holdings Ltd and Ors (No1) (1999) 91 FCR 524; [1999] FACA 1199) of Gibbs J's list in the case of Federal Commissioner of Taxation v Patcorp Investments Ltd (1976) 140 CLR 247; 76 ATC 4225; (1976) 6 ATR 420 of common characteristics of earlier dividend stripping cases.

Those characteristics, subsequently adopted in Lawrence, include:

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

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

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

iv. the purchaser or allottee escaping Australian income tax on the dividend so declared;

v. the vendor shareholders receiving a capital sum for the shares in an amount the same as or very close to the dividends paid to the purchasers (there being no capital gains tax at the relevant times); and

vi. the scheme being 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 by the target company.

From the facts presented to the Commissioner the only similar feature of the proposed arrangement that can be identified with the indicia prescribed by Gibbs J, is point (i) above; namely that Company A currently has a large amount of undistributed profits.

That fact aside, the facts and circumstances of the proposed arrangement that is the subject of this ruling do not display any of the characteristics of 'dividend stripping' or a scheme that is in 'the nature' of dividend stripping.

As a result the requisite conditions of paragraph 177E(1)(a) of the ITAA 1997 would not be satisfied. Therefore, the Commissioner does not consider that the payment of a dividend under the proposed arrangement will result in a scheme to which section 177E of the ITAA 1936 applies.

Issue 3 - Question 2

Summary

The Commissioner does not consider that the payment of a dividend under the proposed arrangement results in a scheme to which paragraph 207-145(1)(d) of the ITAA 1997 applies.

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997 stipulates that the gross-up and tax offset treatment provided under sections 207-20, 207-35 and 207-45 of the ITAA 1997 do not apply if an entity makes a distribution as part of a dividend stripping operation (per paragraph 207-145(1)(d) of the ITAA 1997).

Pursuant to section 207-155 of the ITAA 1997, a distribution will be taken to be made as part of a dividend stripping operation where 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.

From the analysis undertaken above, the Commissioner is of the view that based on the facts of the proposed arrangement it cannot be concluded that the scheme subject to this ruling amounts to dividend stripping or something in the nature of dividend stripping. As such, paragraph 207-145(1)(d) of the ITAA 1997 would not be satisfied.

Consequently, the Commissioner is of the view that the payment of a dividend under the proposed arrangement does not result in a scheme to which paragraph 207-145(1)(d) of the ITAA 1997 applies.

Issue 4 - Question 1

Summary

The change to Company A's constitution and by-laws under the proposed arrangement will not result in a value shift that will have tax consequences under Division 725 of the ITAA 1997.

Detailed reasoning

Division 725 of the ITAA 1997 applies where there is a direct value shift under a scheme involving equity interests in an entity.

In order to apply Division 725 of the ITAA 1997 and for any tax consequences to arise, the 'controlling entity test' set-out in paragraph 725-50(b) of the ITAA 1997 must be satisfied.

Pursuant to section 725-55 of the ITAA 1997, the 'controlling entity test' in paragraph 725-50(b) of the ITAA 1997 is satisfied where an entity (the controller) controls the target entity (i.e. Company A) at some time starting when the scheme is entered into and ending when the scheme has been carried out.

Subdivision 727-E of the ITAA 1997 provides the circumstances in which an entity will be regarded as controlling an entity for value shifting purposes. In particular, subsections 727-355(1) to (3) of the ITAA 1997 contain the relevant tests to be applied.

These are the:

• 50% stake test;

• 40% stake test; or

• actual control test.

From the facts presented to the Commissioner there is no entity (being any of the shareholders of Company A) that would satisfy either the 50% stake test, the 40% stake test or the actual control test as set-out in subsections 727-355(1) to (3) of the ITAA 1997.

As such, there is no entity that would be a controlling entity of Company A for the value shifting purposes at any time during the carrying out of the proposed arrangement.

Accordingly, the change to the constitution and by-laws under the proposed arrangement will not result in a value shift that will have tax consequences under Division 725 of the ITAA 1997.

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