Edited version of your written advice

Authorisation Number: 1012888113300

Date of advice: 26 May 2017

Ruling

Subject: Employee share scheme

Question 1

Will a Participating Employee (an employee under the Employee Share Scheme) be a qualified person in respect of any franked dividends that have been paid by the Employer on its shares for the purposes of section 207-145 of the Income Tax Assessment Act 1997 (ITAA 1997) and therefore be entitled to tax offsets under Division 207 in respect of those dividends?

Answer

Yes.

This ruling applies for the following periods

Years ending 30 June 2016 to 2020

The scheme commences on:

xxx 20xx

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.

1. The Holding Company owns all the shares in the Operating Company. The Operating Company is the Holding Company’s only subsidiary.

2. The Operating Company is a professional practice and is registered with ASIC.

3. The Holding Company wants to establish an employee share scheme plan (the Plan) that allows employees to acquire and dispose of interests on a no goodwill basis.

4. The Constitution of the Holding Company includes specific provisions that prevent employees to deal with the interests at a value above actual book value.

The Plan

5. The Plan is administered by the Holding Company.

6. Under the Plan, the Holding Company will invite selected employees to acquire ordinary shares in the Holding Company on the terms set out in the Plan and those on the invitation.

7. Employees will be required to pay a purchase price for the shares equal to the actual book value of the shares at the time of acquisition.

8. Employees accepting the invitation must submit an application with payment to the Holding Company. The application is an irrevocable offer to acquire the shares on the given terms.

9. Upon acceptance by the Holding Company, shares will be issued to or transferred to the employee, who then becomes a Participating Employee.

10. The terms of the Plan provide that a Participating Employee will, at all times from when a Participating Employee is provided Shares under the Plan:

a. hold legal and beneficial ownership of the shares.

b. be entitled to all dividends or other accretions that arise in respect of the Shares.

c. not be liable to forfeit their shares or any interest in their shares.

11. If a Participating Employee ceases to be an employee, the Participating Employee must transfer the Plan Shares to the trustee of the ESS Trust (ESS Trustee) or as directed by the Board in exchange for the actual book value of the shares at the time unless otherwise determined by the Board or Founder.

12. Shares transferred to the ESS Trustee will be held under the terms of the ESS Trust Deed.

13. In an event of default, the Participating Employee may be required to sell or dispose of their shares for not more than the Actual Book Value of the plan shares.

14. Other than in exceptional circumstances, the only dealing permitted under the Plan is the realisation of the Participating Employees’ interest in the Shares if the Participating Employee ceases to be an employee. This realisation occurs at the actual book value.

Actual Book Value

15. The Actual Book Value is determined in accordance with a specified formula and is broadly calculated as the net tangible assets of the Holding Company excluding dividends declared, divided by the number of issued ordinary shares.

Loan to purchase Shares

16. The Plan provides that the Operating Company may provide a loan to an Employee who is invited to participate in the Plan for the purpose of purchasing the Shares.

17. The terms of the Loan provide that:

a. the loan must be applied to acquire Shares.

b. the employee directs the Operating Company to apply the amount of the loan on their behalf.

c. the Loan is limited recourse and interest free.

d. the Loan will be repayable if:

i. any dividends are paid on the shares that are acquired under the plan using the Loan

ii. an employee is paid a cash bonus by the Holding Company, Operating Company or the ESS Trust, or

iii. the employee’s interest in the Shares that are acquired under the Plan is realised under the terms of the Plan. In this Case, the employee is required to repay the lesser of the outstanding balance of the Loan and an amount equal to the disposal proceeds which the Employee is entitled to receive from the realisation of the Shares.

e. the Loan is unsecured such that the Operating Company will not have any recourse under the Loan against the employee or any of their assets

f. the Loans recourse will be limited to the Shares that are acquired by the Employee using the Loan and the repayments set out above.

Relevant legislative provisions

Income Tax Assessment Act 1936 former section 160APHJ

Income Tax Assessment Act 1936 former section 160APHM

Income Tax Assessment Act 1936 former section 160APHN

Income Tax Assessment Act 1936 former section 160APHO

Income Tax Assessment Act 1997 Division 83A

Income Tax Assessment Act 1997 Division 207 of the ITAA 1997

Income Tax Assessment Act 1997 section 207-20

Income Tax Assessment Act 1997 section 207-145

Income Tax Assessment Act 1997 section 960-410

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

As there are no related payments made in respect of the dividends paid on the Shares to the Employees and the Employees bear sufficient material risks of loss or gain in relation to the Shares, the Employees are qualified persons under former subsection 160APHO of the Income Tax Assessment Act 1936 (ITAA 1936) and, therefore, must include the distributed franking credits in their assessable income and are entitled to the applicable tax offsets under Division 207 of the ITAA 1997.

Detailed reasoning

Section 207-20 states:

207-20(1)

If an entity makes a *franked distribution to another entity, the assessable income of the receiving entity, for the income year in which the distribution is made, includes the amount of the *franking credit on the distribution. This is in addition to any other amount included in the receiving entity's assessable income in relation to the distribution under any other provision of this Act.

207-20(2)

The receiving entity is entitled to a *tax offset for the income year in which the distribution is made. The tax offset is equal to the *franking credit on the distribution.

Distributions on the held shares will be subject to section 207-145, which precludes the inclusion of the franking credit on the distribution in an entity’s assessable income under section 207-20 or 207-35 and the entitlement to the tax offset because of the distribution in certain circumstances. Subsection 207-145(a) relevantly provides that such a situation is where an entity is not a qualified person.

A qualified person is defined in former subsection 160APHO(1) of the ITAA 1936. Former subsection 160APH of the ITAA 1936 provides:

160AP

HO(1) [``qualified person'']

A taxpayer who has held shares or an interest in shares on which a dividend has been paid is a qualified person in relation to the dividend if:

(a) where neither the taxpayer nor an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend - the taxpayer has satisfied subsection (2) in relation to the primary qualification period in relation to the dividend; or

(b) where the taxpayer or an associate of a taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend - the taxpayer has satisfied subsection (2) in relation to the secondary qualification period in relation to the dividend.

160APHO(2) [Qualification period]

A taxpayer who has held shares or an interest in shares on which a dividend has been paid satisfies this subsection in relation to a qualification period in relation to the shares or interest if, during the period:

(a) where the taxpayer held the shares - the taxpayer held the shares for a continuous period (not counting the day on which the taxpayer acquired the shares or, if the taxpayer has disposed of the shares, the day on which the disposal occurred) of not less than:

(i) if the shares are not preference shares - 45 days; or

(ii) if the shares are preference shares - 90 days; or

(b) where the taxpayer held the interest in the shares - the taxpayer held the interest for a continuous period (not counting the day on which the taxpayer acquired the interest or, if the taxpayer has disposed of the interest, the day on which the disposal occurred) of not less than:

(i) if the shares are not preference shares - 45 days; or

(ii) if the shares are preference shares - 90 days.

160APHO(3) [Calculating days shares or interest held]

In calculating the number of days for which the taxpayer continuously held the shares or interest, any days on which the taxpayer has materially diminished risks of loss or opportunities for gain in respect of the shares or interest are to be excluded, but the exclusion of those days is not taken to break the continuity of the period for which the taxpayer held the shares or interest.

160APHO(4) [Beneficiary of widely held trust]

This section does not apply to a taxpayer in respect of an interest in shares held by the taxpayer as a beneficiary of a widely held trust.

Related payments

Former section 160APHN of ITAA1936 provides that a related payment will be taken to have been made if its effect is to pass on the benefit of the dividend to one or more other persons under the arrangement.

Payments of the dividends where the employee has used a Loan will be applied against this Loan. This application is still for the benefit of the employee as the payments are made to meet the employee’s obligations under the loan. Thus, the employee or their associates are not under an obligation to make any related payments.

Materially diminished risks of loss or opportunities for gain

The employees must also meet the qualification period criteria contained in former subsection 160APHO(2), which provides that the shareholder must have continually held the shares for at least 45 days. This is further qualified by former subsection 160APH(3), which provides that 'in calculating the number of days for which the taxpayer continuously held the shares or interest, any days on which the taxpayer has materially diminished risks of loss or opportunities for gain in respect of the shares or interest are to be excluded, but the exclusion of those days is not taken to break the continuity of the period for which the taxpayer held the shares or interest’ (emphasis added).

Former section 160APHM provides:

160APHM(2) Material diminution if net position has less than 30% of risks and opportunities.

A taxpayer is taken to have materially diminished risks of loss or opportunities for gain on a particular day in respect of shares held by the taxpayer, or in respect of an interest held by the taxpayer in shares, if the taxpayer's net position on that day in relation to the shares or interest has less than 30% of those risks and opportunities.

160APHM(3) Net position worked out by reference to deltas.

A taxpayer's net position is worked out using the financial concept known as delta (see section 160APHJ). For example, an option to sell a share with a delta of minus 0.5 in relation to the share reduces the risks of loss and opportunities for gain by 50%.

Former section 160APHJ provides that a position in relation to a share or interest is anything that has a delta in relation to the shares or interest and relevantly includes any non-recourse loans made to acquire the share or interest.

Given the above, while there is a diminished risk of loss or opportunity for gain of at least 70% (a delta of less than 0.3), then the Participating Employee will not be classed as a qualified person.

The Participating Employee will acquire their interest in shares by way of a non-recourse loan. Former paragraph 160APHJ(2)(f) of the ITAA 1936 lists ’a non-recourse loan’ as a position. While ’a non-recourse loan’ is not listed in the examples under the meaning of short position in former subsection 160APHJ(3), paragraph 4.54 of the Explanatory Memorandum to the Tax Laws Amendment Bill (No. 2) 1999 states:

Similarly, a non-recourse loan, that is, a loan which is repayable only up to the value of certain property (e.g. shares), effectively contains a put option to sell the shares to the lender, and a delta can be calculated in relation to this notional option. The value to a taxpayer of an indemnity or surety in respect of share losses would also behave like an option to sell shares.

A non-recourse loan has been made to acquire the interest in shares and is only repayable up to the value of the issue price of the unit (which is the market value of the share allocated to the unit). The non-recourse loan provides the shareholder with a level of protection that is economically equivalent to a put option to sell the shares to the lender; the non-recourse loan is an additional short position with a negative delta. An at-the-money put option typically has a delta of -0.5, thus this will be the delta ascribed to the non-recourse loan.

The ownership of the share is a long position with a delta of +1. As there are no other positions, the net position is a delta of 0.5 at the time the shares are acquired and the loan is given. Thus, the employees maintain more than 30% of the risks and opportunities and the holding period requirements pursuant to section 160APHO(3) are satisfied. Therefore, the qualification period requirement under subsection 160APHO(2) will be met and the Participating Employee will be a qualified person pursuant to subsection 160APHO(1).

As the described Participating Employees are qualified persons in relation to the dividends paid on the Shares for the purposes of former section 160APHO of the ITAA 1936, the franking credits on distributions to them are included in their assessable income and they are entitled to the applicable tax offsets under Division 207 of the ITAA 1997.

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