Edited version of your written advice

Authorisation Number: 1013025207751

Date of advice: 30 May 2016

Ruling

Subject: Part IVA

Question 1

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

Answer

No

Question 2

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

Answer

No

Question 3

Are the franked distributions from Company D (the Company) to the Superannuation Fund (the Fund) made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 4

Are the franked distributions made from the Company to the Fund non-arm's length income of the Fund under section 295-550 of the ITAA 1997?

Answer

No

This ruling applies for the following periods

1 July 20AA to 30 June 20BB

1 July 20BB to 30 June 20CC

1 July 20CC to 30 June 20DD

The scheme commences on

1 July 20AA

Relevant facts and circumstances

1. Person A and Person B are currently over 65 years old. They are distant relations. They are both currently planning for their retirement and they wish to separate their financial affairs.

2. Person A and Person B, along with their spouses are currently the directors of Company D (the Company). The Company was incorporated in the 1970's. There are more than 10 issued $1 shares in the Company. Since the 1970's Person B has held various class shares in the Company and Person A has also held various class shares in the Company. All of the classes of shares have voting rights, rights to dividends (and an ability for a dividend to be paid on one class to the exclusion of another) and rights to the surplus assets on a winding up.

3. The total assets of the Company at 30 June 20AA shown in the Balance Sheet equal $Z. This comprises cash of $Y, and commercial property of $X. As at 30 June 20AA the Company had current liabilities of $W, reserves of $V and retained earnings of $U shown in the Balance Sheet.

4. As at 30 June 20EE there was $T standing to the credit of the Company's franking account.

5. The Company owned or had an interest in less than five commercial properties. A number of the properties of which the Company has 100% ownership are to be retained. Those properties are leased to related entities of the Company, at market value and on arm's length terms. All leases are documented. The related entities each operate a business from the properties. The approximate total annual rent from the properties is $S (net of GST). All outgoings (except land tax and insurance) are paid by the lessee.

6. The remaining property was sold prior to 30 June 20AA to an unrelated party. The proceeds from the sale of that property were distributed to the relevant owners in accordance with their ownership interests. The Company owned an interest in the property, the Superannuation Fund (the Fund) owned an interest in the property and another self-managed superannuation fund of which Person B is a member, also owned an interest in the property.

7. As a result of the sale of the property the Company made a capital gain of $R and has a likely tax liability in respect of that gain of $Q. The Company also now holds a significant amount of cash from the sale proceeds.

8. There is no intention that the Company will sell any of the remaining properties and there is no intention to deregister or liquidate the Company in the foreseeable future.

9. Person A and Person C are the individual trustees of the Fund. They are the only members of the Fund. They are both currently drawing an account based pension from the Fund based on the full value of their respective interests in the Fund.

10. The Fund holds cash as a result of the sale of property. The Fund trustees' investment strategy is to hold X% to Y% of assets in property. The departure of Person B from the family business has created an opportunity for the Fund to invest in property via the Company.

11. It is intended that the following steps will be implemented:

(a) a franked dividend of approximately $P will be paid to Person B and Person A in equal proportions from the existing cash held by the Company. This will leave approximately $O retained earnings in the Company;

(b) the remaining cash of approximately $N (after payment of dividends) held by the Company is to be retained to pay the income tax liability (of approximately $N), pay for repairs and maintenance for the remaining properties (of approximately. $M) and be retained for working capital requirements (of approximately $L);

(c) The working capital requirements of approximately $L, will be retained by the company for the following reasons:

(i) the Company does not hold a bond or security deposit for any of the leases for the remaining properties;

(ii) if a property is vacated by its current tenant, it is not known how difficult it will be to locate a new tenant;

(iii) the repairs proposed to be undertaken to a property could cause a level of disruption to the tenants and to trading;

(iv) there should be no need to contribute extra working capital to the Company. The Company would not be in a position to borrow additional funds as this would cause a possible contravention of the superannuation in-house asset rules for the Fund. In addition if further capital was required, there would be a need for new market valuations of the properties to be undertaken to ensure all new capital contributed was undertaken at market value;

(d) the repairs proposed for the properties will progress over time to minimise disruption to the tenants' trading. The cost of repairs totalling $M has been estimated by Person A.

(e) each of the A, B, C and D class shares in the Company will be converted into ordinary shares all of the one class;

(f) Person B and their spouse will resign as directors of the Company immediately before the transfer of the shares;

(g) Person B will transfer their shares in the Company to the Fund by way of sale. The shares will be transferred at market value. The market value of the shares will be negotiated between the parties on arm's length terms with real bargaining. Each party has sought their own independent advice and the shares will be valued by an arm's length qualified valuer, at a time close to the transfer of the shares to ensure that the price agreed reflects the current market value of the shares;

(h) the valuation will use the appropriate valuation methodologies, having regard to the Commissioner of Taxation's publication "Market valuation for tax purposes", and will be agreed by both parties and their advisors. The market value will use as a basis the market value of the remaining properties held by the Company and taking into account the remaining cash in the Company, its liabilities and the Company's franking account balance;

(i) no entities have any carry forward income or capital losses;

(j) no amount of the capital gain made by Person B on the sale of their shares in the Company will be included in his assessable income as they acquired the shares before 20 September 1985;

(k) the Fund will pay cash which it already holds to Person B for the shares;

(l) the shares purchased by the Fund will be recorded in the Fund's accounts at the market value that is paid;

(m) fully franked dividends will be paid to the Fund in proportion to its shareholding in the Company on an annual basis. The amount of the franked dividends to be paid by the Company is expected to be broadly the net profits derived by the Company, after tax, some $K per annum. The Fund's 50% share of the annual dividends is therefore expected to be approximately $J per annum;

(n) the franked dividends (including any attached franking credits) paid to the Fund and are said to be exempt income for the Fund. A proportion (as worked out under subsection 295-390(3) of the ITAA 1997) of the franked distribution which would otherwise be assessable income of the Fund will be treated as exempt from income tax under subsection 295-390(1) of the ITAA 1997. The relevant proportion is expected to be 100%. The Fund is expected to be entitled to refunds of the unused franking credit tax offset (arising from the franking credits attached to the dividends);

(o) the Company will continue to derive rental income from the properties it holds. There is no intention for the Company to dispose of the properties in the foreseeable future. There is an intention to keep the properties long term;

(p) at all times that the Fund holds the shares in the Company, the Company will meet the conditions in regulations 13.22C and 13.22D of the Superannuation Industry (Supervision) Regulations 1994 so that the shares in the Company will be excluded from being in-house assets of the Fund;

(q) Person A will retain their 50% shareholding in the Company and will receive their 50% share of the annual dividends mentioned in paragraph (m) above;

(r) Person A and Person C will continue to receive pensions from the Fund, and it is not anticipated that lump sums will be paid to them;

(s) no new members will be admitted to the Fund.

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 207-20

Income Tax Assessment Act 1997 section 207-35

Income Tax Assessment Act 1997 section 207-145

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 section 295-545

Income Tax Assessment Act 1997 section 295-550

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 to the proposal.

Reasons for decision

Question 1

Summary

12. The scheme is not a scheme to which section 177E of Part IVA of the ITAA 1936 applies. As such section 177F of the ITAA 1936 does not apply.

Detailed reasoning

Section 177E of Part IVA of the ITAA 1936

13. 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 of the ITAA 1936.

14. 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 (whether the profits are of the accounting period in which the disposal occurred or of any earlier or later accounting period);

(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].

15. 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].

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

16. Paragraph 177E(1)(a) of the ITAA 1936 requires that a scheme must exist by way of or in the nature of a dividend stripping operation.

Dividend stripping operations

17. 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.

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].

18. 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].

19. 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' can lie 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].

Application of section 177E of the ITAA 1936

20. While some of the characteristics of a dividend stripping operation exist (identified in paragraph 17 above) in this case, on balance, section 177E will not apply for the following reasons:

(a) the Fund is not purchasing the shares in the Company from a related party;

(b) the price of the shares will be determined as a matter or real bargaining between unrelated parties at an arm's length value;

(c) the purpose of Person B disposing of their shares to the Fund is to separate their financial affairs from Person A;

(d) Person A will retain their 50% shareholding in the Company;

(e) retained earnings are to be reduced by a significant dividend paid from the Company to the existing shareholders prior to the transfer of the shares to the Fund;

(f) all available cash will be paid from the Company as franked dividends prior to the transfer of the shares aside from an estimated amount to pay for immediate outgoings and a reasonable amount for working capital requirements;

(g) there is no intention of the Company to sell the remaining properties;

(h) there is no intention for Person A to transfer their shares to the Fund; and

(i) the acquisition of property by the Fund is in line with the Fund's investment strategy;

21. As there is no dividend stripping operation in this case, the conditions in section 177E(1) of ITAA 1936 are not satisfied, and the Commissioner will not issue a determination cancelling a tax benefit under section 177F.

Question 2

Summary

22. There is a not a scheme to which section 177EA of the ITAA 1936 applies, consequently, the Commissioner will not determine (under paragraph 177EA(5)(b)) that no imputation benefit arises for the Fund in respect of the distributions.

Detailed reasoning

Section 177EA of the ITAA 1936

23. 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.

24. 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)'.

25. 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)).

26. 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) of the ITAA 1936.

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

27. Overall, the balance of matters points towards a conclusion that there is no more than an incidental purpose of the scheme to enable the Fund to gain an imputation benefit in the form of a refundable tax offset. Therefore paragraph 177EA(3)(e) is not satisfied. Accordingly, there is not a scheme to which section 177EA of the ITAA 1936 applies and the Commissioner will not determine that no imputation benefit arises for the Fund in respect of the distributions.

Question 3

Summary

28. The franked distributions from the Company to the Fund are not made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the ITAA 1997.

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997

29. 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 section 207-20 or 207-35 of the ITAA 1997; 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.

30. 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) of the ITAA 1997 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.

Application of subsection 207-145(1) of the ITAA 1997

31. As discussed above at paragraphs 17 to 21 there is no dividend stripping operation in this case, therefore subsection 207-145(1) will not apply.

Question 4

Summary

32. The franked distributions from the Company to the Fund will not be non-arm's length income of the Fund under subsection 295-550(2) of the ITAA 1997.

Detailed reasoning

33. 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'.

34. 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.

35. 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 of the ITAA 1997.

36. 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).

37. 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.

38. 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.

39. In the facts of this case the shares are to be purchased by the Fund at their stated market value determined consistently with the approach outlined in paragraph 11(g) and (h) above. The shares are to be reflected at that market value in the members' accounts. 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.

40. The Fund, as a 50% shareholder, will receive 50% of the annual dividends paid from the annual profits of the Company which will be fully franked. This will in effect provide the Fund with dividend income derived from the assets of the Company for minimal investment risk given the company will be controlled by related parties which may be considered more consistent with a non-arm's length dealing (paragraphs 295-550(3)(c) and (f)).

41. However, this aspect of the arrangement has to be balanced against the Fund's acquisition value of the shares and that following that acquisition the Fund will receive a 50% share of the annual profits of the Company that are distributed. Having regard to those distributions, the rate of the dividend appears to be commensurate with an arm's length return on the amount invested by the Fund. The rate of dividends on other shares (as mentioned under paragraph 295-550(3)(d) of the ITAA 1997) is the same for all of the issued shares. Further, the Company will not issue any shares to the Fund in satisfaction of a dividend paid by the Company (as mentioned under paragraph 295-550(3)(e)) and therefore this matter is not relevant. In addition there will be no non-arm's length dealings conducted by the Company whilst the Fund is a shareholder.

42. Taking each of these matters into account, on balance, we consider that in the circumstances the annual distributions paid by the Company to the Fund should not be treated as non-arm's length income for the Fund.

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