Edited version of your written advice

Authorisation Number: 1013040932324

Date of advice: 28 June 2016

Ruling

Subject: Dividend Value Shifting

Question 1

Will the proposed issue of Class C Shares result in a direct value shift under Division 725 of the ITAA 1997 and result in CGT event K8 happening under section 104-250 of the ITAA 1997?

Answer

No

Question 2

Will the dividend stripping provisions contained in section 177E of the ITAA 1936 and section 207-155 of the ITAA 1997 apply in relation to any future payment of dividends on the Class C Shares?

Answer

No

This ruling applies for the following periods:

1 July 2015 to 30 June 2016

The scheme commences on:

1 July 2015

Relevant facts and circumstances

The Directors of the company are contemplating issuing Class C Shares equal to a percentage of the issued capital to each of two key employees.

The Class C Shares will carry no other rights other than rights to dividends and will be subject to reversal should the employee leave the employ of the company for whatever reason.

The company currently has 4 Class A Shares issued, two of which are held by X and two of which are held by their spouse, Y.

The rights to the Class A shares are as follows;

1) the right to receive notice of, attend and vote at all general meetings in accordance with the provisions of the Constitution.

2) the right to receive such dividends, distributions, bonuses and other profits declared on each class shares

3) upon a reduction of capital or winding up of the company to participate equally with all other holders of shares in the surplus assets of the company.

X & Y are currently the only Directors of the company.

X is the Managing Director of the company and recognises that for the company to continue to grow they will be required to maintain and hold two key employees.

The Directors are keen to ensure that these two staff members stay with the company at least over the medium term and assist at the managerial level. The Directors are considering issuing Class C Shares to the two employees such that in the end they will each hold a percentage of the dividend entitlements of the company.

The Class C Shares would have the following rights;

1) no right to vote at any general meeting of the company but the right to receive notice of or to attend any general meeting of the company

2) the right to receive such dividends just two regions bonuses and other profits declared on each class of shares

3) upon a reduction of capital or winding up of the company no right to participate in the surplus profits or assets of the company

The Class C Shares would not be discretionary dividend shares.

It is anticipated that two employees will also become Directors of the company along with X and Y.

It is argued that the proposed arrangement will protect and increase the value of the existing shares for the reasons including retaining key employees and providing remuneration incentives to employees where the incentive is positively correlated with the value added to the company.

X and Y would not be giving up any equity in the company as they would continue to hold 100% voting rights in the company, 100% entitlements to return of capital and 100% entitlements to future shares issues.

The Class C Shares would not be transferable to anyone other than X and Y. Also, there will be no capital proceeds payable to the two employee shareholders in the event of the shares being cancelled or in the more likely event they are transferred to X and Y.

All parties will be dealing on arm's length terms for the purposes of the proposed scheme.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 177E.

Income Tax Assessment Act 1997 Section 104-250.

Income Tax Assessment Act 1997 Section 207-145.

Income Tax Assessment Act 1997 Section 207-150.

Income Tax Assessment Act 1997 Section 207-155.

Income Tax Assessment Act 1997 Division 725.

Income Tax Assessment Act 1997 Section 725-90.

Income Tax Assessment Act 1997 Section 725-145.

Reasons for decision

Question 1

Summary

The proposed issue of Class C Shares will not result in a direct value shift under Division 725 of the ITAA 1997 and will not result in CGT event K8 happening under section 104-250 of the ITAA 1997.

Detailed reasoning

There is a direct value shift under section 725-145 of the ITAA 1997 if, as a result of things done under a scheme, there is a decrease in the market value of one or more equity or loan interests in a company (the down interests) and either:

• equity or loan interests in the company are issued at a discount (the up interests); or

• there is an increase in the market value of one or more equity or loan interests in the company (the up interests).

A direct value shift may result in consequences under Division 725 of the ITAA 1997 which would include a realignment of the value of the equity or loan interests for tax purposes to reflect changes in market value attributable to the direct value shift and, in some cases, a capital gain being generated on the down interests (see CGT event K8 in section 104-250 of the ITAA 1997).

In the current circumstances, the directors of the company intend to issue Class C Shares equal to a percentage of the dividend entitlements of the company to each of their two key employees. The applicant has contended that the Class C Shares will carry no other rights other than rights to dividends.

The shares will also have no right to vote at a general meeting of the company, but the right to attend. If there was a reduction in capital or winding up of the company the shares will have no right to participate in the surplus profits or assets of the company and they will have no right to receive an offer of share pursuant to the Constitution.

The issue of the Class C shares is also subject to the employee remaining with the company, so should the employee leave the company for whatever reason; the share issue will be reversed with the arrangement for the shares to be transferred back to X and Y.

In accordance with subsection 725-90(1) of the ITAA 1997, a direct value shift will have no consequences under Division 725 of the ITAA 1997 if:

(a) The one or more things referred to in paragraph 725-145 91)(b) of the ITAA 1997 brought about a state of affairs, but for which the direct value shift would not have happened; and

(b) As at the time referred to in that paragraph, it is more likely than not that, because of the scheme, that state of affairs will cease to exist within 4 years after that time.

The issue of the shares to the employees is expected to increase the value of the company through the retention of the employees who add value through their services. Further, it is expected that the arrangement will protect and increase the value of the existing Class A shares for the reasons including retaining key employees and providing remuneration incentives to employees where the incentive is positively correlated with the value added to the company.

As the market value of the Class A shares is not expected to decrease under the proposed scheme, the issue of the Class C Shares will not result in a direct value shift under Division 725 of the ITAA 1997 and will not result in CGT event K8 happening under section 104-250 of the ITAA 1997.

Question 2

Summary

The dividend stripping provisions contained in section 177E of the ITAA 1936 and section 207-155 of the ITAA 1997 will not apply in relation to any future payment of dividends on the Class Shares.

Detailed reasoning

Section 207-155 of the ITAA 1997 states that:

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

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

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

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

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

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

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

Dividend stripping is not a defined term, and it does not have a precise legal meaning. The meaning of dividend stripping is considered in paragraphs 8 to10 of Taxation Ruling IT 2627 Income Tax: Application of Part IVA to Dividend Stripping Arrangements, which state:

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

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

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

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

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

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

In the current circumstances, the issue of the shares to the employees is expected to increase the value of the company through the retention of the employees who add value through their services. Further, it is expected that the arrangement will protect and increase the value of the Class A shares for the reasons including retaining key employees and providing remuneration incentives to employees where the incentive is positively correlated with the value added to the company.

Therefore, provided the dividends are paid in accordance with the rights attached to the shares and in accordance with expectations, then the act of paying the dividend will not cause a direct value shift. Accordingly, the dividend stripping provisions contained in section 177E of the ITAA 1936 and section 207-155 of the ITAA 1997 will not apply in relation to any future payment of dividends on the Class C Shares.

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