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Edited version of your written advice
Authorisation Number: 1013118825310
Date of advice: 14 December 2016
Ruling
Subject: Employee Share Schemes
Questions A1 to A7 apply to CompanyX
Question A1
Will CompanyX obtain an income tax deduction in respect of contributions by CompanyX to the Trustee of the Employee Share Trust ('Trustee') to fund the acquisition of CompanyX shares by the Employee Share Trust ('Trust')?
Answer
Yes
Question A2
Is an irretrievable contribution by CompanyX to the Trustee of the Trust to fund the acquisition of CompanyX shares by the Trust for allocation to the Employee deductible to CompanyX in the income year in which it is made?
Answer
Yes, provided the participant Employee acquires a beneficial interest in the CompanyX shares in the same income year.
Question A3
Will the Commissioner seek to make a determination that Part IVA of the Income Tax Assessment Act 1936 ('ITAA 1936') applies to deny, in part or full, any deduction claimed by CompanyX for contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trust?
Answer
No
Question A4
Will CompanyX obtain an income tax deduction in respect of costs incurred in relation to the implementation and ongoing administration of the Trust in the year in which they are incurred?
Answer
Yes
Question A5
If the Trustee uses a contribution received from Company X to subscribe for shares in Company X, will the subscription proceeds be included in the assessable income of Company X?
Answer
No
Question A6
Will the provision of options and shares to the Employee under the Plan be a fringe benefit within the meaning of the Fringe Benefits Tax Assessment Act 1986 ('FBTAA')?
Answer
No
Question A7
Will contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares be treated as a fringe benefit within the meaning of the FBTAA?
Answer
No
Questions B1 to B10 apply to Trustee and the Employee
Question B1
Will the contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trust be assessable income of the Trust?
Answer
No
Question B2
Will contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares and/or the expenses of operating the Trust be treated as a deemed dividend within the meaning of Division 7A of ITAA 1936?
Answer
No
Question B3
When as a result of a participant's Options converting to shares under the Plan, the Trustee allocates shares to a participant under the Plan, will a capital gain or capital loss arise for the Trustee or participant?
Answer
No, provided the participant acquires the shares for the same or less than the cost base of the shares in the hands of the Trustee.
Question B4
When the Trustee sells shares to a third party, being shares that were previously allocated to a participant under the Plan, will a capital gain or capital loss arise for the Trustee?
Answer
No
Question B5
When the Trustee transfers registered ownership of shares to a participant previously allocated the shares under the Plan, will a capital gain or capital loss arise for the Trustee or the participant?
Answer
No
Question B6
If the Trustee receives and accumulates dividends on unallocated shares held in the Trust:
a. Will the dividend and any franking credit be taxable to the Trustee or can the Trustee choose to be taxed on the dividend?; and
b. If so, will the Trustee be entitled to a tax offset for any franking credits attaching to the dividend?
Answer
a. Yes, the dividend and attached franking credit will be included in the assessable income of the Trust and the Trustee will be assessed on that income under section 99A of the ITAA 1936.
b. Yes, provided the Trustee holds the shares at risk for a continuous period of at least 45 days during the period beginning the day after the Trustee acquires the shares and ending 45 days after the shares become ex-dividend.
Question B7
If the Trustee receives a dividend on Allocated Shares held for a participant in the Trust during an income year, and applies Trust property representing it for the benefit of the participant by the end of the income year:
a. Will the dividend and any franking credit be included in the participant's assessable income?; and
b. Will the participant be entitled to a tax offset for any franking credit attaching to the dividend?
Answer
a. Yes
b. Yes, provided the participant holds its interest in those shares at risk for a continuous period of at least 45 days, during the period beginning the day after the participant acquires its interest in the shares and ending 45 days after the shares become ex-dividend.
Question B8
Will contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares be included in the Employee's assessable income?
Answer
No
Question B9
When shares acquired at the time of an Initial Public Offering before the Vesting Date are forfeited in the event of cessation of employment before the Vesting Date:
a. Will an amount be included in the participant's assessable income under Subdivision 83A-C of Income Tax Assessment Act 1997 ('ITAA 1997'); and
b. Will a capital gain or capital loss arise for the participant?
Answer
a. No
b. No, provided the participant receives no consideration for the forfeiture of shares and no consideration was paid by the participant to acquire the shares.
Question B10
If Options are converted to shares:
a. Is the first time the Employee will be taxed as a result of being granted Options the earliest of the following three times ('earliest time'):
● the time when the Employee ceases employment,
● 15 years after acquiring the Options, or
● expiry of any forfeiture restriction and the ESOP sale restriction,
or the time of disposal of the shares if that occurs within 30 days after that earliest time?
b. Will the amount then included in the Employee's assessable income be the market value of the shares at that time?
c. If the shares are disposed of by the Employee 30 days or more after that earliest time, in calculating any capital gain or loss, will the Employee's cost base include the amount that had thus previously been included in the Employee's assessable income?
Answer
a. Yes
b. Yes
c. Yes
This ruling applies for the following periods:
From 30 June 201X to 30 June 20XX
The scheme commences on:
June 201X
Relevant facts and circumstances
Background
1. CompanyX is an Australian resident private company.
2. CompanyX has established an Executive Share Option Plan ('Plan') to align the interests of its employees or directors involved in the management of CompanyX ('Executives') with its own interests. The Executives will be offered options to acquire CompanyX shares.
3. X CompanyX Executives were granted a total of Y options under the Plan. It is anticipated that further offers will be made annually.
4. The Employee Share Trust ('Trust') facilitates the award of shares to eligible participants under the Plan, and other employee incentive plans established by CompanyX. The trustee of the Trust is a wholly-owned subsidiary of CompanyX and the Trust is governed by its Trust Deed.
5. CompanyX has established a tax consolidated group and is the head company of the consolidated group. The Trust retains its own status independent of the group for tax purposes and has not been absorbed within the tax consolidated group.
Executive Share Option Plan ('Plan')
6. The Plan is fundamental to CompanyX's growth strategy and was established as part of CompanyX's remuneration policy with the intention of attracting and retaining suitable Executives.
7. The purpose of the Plan is to:
a. Create an ownership culture;
b. Reward performing Executives by aligning their reward with shareholder wealth and increase company profitability and shareholder returns;
c. Attract Executives by providing long-term incentives; and
d. Retain Executives and increase their loyalty and productivity.
8. The objective of the Plan is to encourage commitment of participating Executives towards the success of the CompanyX group.
9. The Plan broadly operates as follows:
a. The Board gives eligible Executives of the CompanyX group ('Participants') an opportunity to participate in the Plan by offering options. The Board has discretion over who is eligible, how many options will be offered and on what terms, for example, whether monetary consideration is payable by the Participant to acquire or exercise the option. However this ruling does not consider the circumstances where an Eligibility Condition is included in the terms of options granted to a Participant.
b. Upon acceptance of the offer, the Board will grant the options to the Participants. The Plan Administrator will issue to the Participant a certificate or statement (in a form approved by the Board) stating the number of shares to which the option relates, the grant date and the vesting date.
c. Subject to the options vesting, each option gives the Participants the right to acquire an ordinary share in CompanyX, or a beneficial interest in an ordinary share in CompanyX through the Trust.
d. The vesting conditions are satisfied if the options have not been forfeited and the Participant remains employed in the CompanyX group at the earlier of:
(i) The vesting date stated in the offer; or
(ii) A Trade Sale.
And any other conditions specified in the offer being satisfied
e. A trade sale is defined to be an arm's length sale by:
(i) CompanyX of at least X% of the value of CompanyX Group's businesses and consolidated net assets; or
(ii) One or more CompanyX shareholders of their shares in CompanyX comprising in total of at least X% of its Diluted Issued Capital.
The trade sale does not include any internal restructure under which the control of CompanyX does not materially change.
f. Options can be forfeited if:
(i) The Participant ceases employment before the earlier of the vesting date or a trade sale; or
(ii) There is a breach of any other vesting condition; or
(iii) The options have expired.
g. If the Participant ceases employment in 'Special Circumstances' (as defined in the Plan), then the Board may resolve for the options to vest, forfeit or be allowed to be held until vesting conditions are satisfied.
h. Within 60 days after the vesting of the options, the Board shall resolve to convert the options to shares.
i. The Board may also resolve to convert options to shares if an Initial Public Offering (IPO) happens before the vesting of the options, as an IPO would be easier to achieve without options being on the register. However the shares would be subject to forfeiture restrictions.
j. If the Board resolves to convert options to shares, the Board shall procure:
(i) The issue or transfer of the same number of shares to the Participant; or
(ii) The trustee of the Employee Share Trust to hold the same number of Shares beneficially for the Participant; and
(iii) Such shares or beneficial interest in shares to be held on terms of the Plan and subject to any sale restriction and forfeiture restriction, if applicable.
k. Shares acquired on the conversion of options will rank equally with all existing shares for dividends, new issues and any other shareholder distributions or benefits on and from the date of acquisition.
Forfeiture restriction
l. Shares acquired on the exercise of options as a result of an IPO would be forfeited if the Participant ceases employment with CompanyX before the vesting date. The Participant would receive no consideration for the transfer or redemption of their shares as a result of the forfeiture.
Sale restriction
m. The Participants are restricted from dealing with their options (i.e. selling, mortgaging etc.) other than by conversion of the options by the Board under the Plan.
n. The Participants are also restricted from dealing with shares (i.e. selling mortgaging or disposing of any legal or equitable interest etc.). The Plan's share sale restriction will continue until the later of:
(i) The date the Participant ceases employment with the CompanyX group; or
(ii) 12 months after the date of Trade Sale, if options had vested due to a Trade Sale; or
(iii) 12 months after vesting date, if options had vested at vesting date; or
(iv) The time specified by the Board at the time of vesting
o. However, the Plan's sale restriction may cease under special circumstances, for example, if the sale is permitted or required by any Shareholder Agreement, or the Board determines it to be appropriate.
p. Within a certain period after the sale restriction ceases to apply, the Board may procure a sale of the shares by the participant as follows:
(i) Transfer of shares by the Participant, or Trustee, to a third party; or
(ii) Buy-back and cancellation of shares in accordance with the Corporations Act 2001 from the Participant or Trustee; or
(iii) Redemption of the Participant's beneficial interest in the shares by the Trustee.
q. However if the Board decides not to procure a sale in accordance with the Plan, then the Participant may deal with the Shares to the extent permitted by the Shareholder Agreement, Constitution and any applicable law and policies.
Employee Share Trust (the Trust)
10. When the options are converted to shares under the Plan, the Board can resolve to procure the Trustee of the Employee Share Trust to provide the shares to the participant rather than issue or transfer the shares direct to the participant.
11. The trust is established for the sole purpose of acquiring shares in CompanyX and providing beneficial interests in those shares to the participants in order to satisfy CompanyX's obligations under the Plan (and any other employee incentive plans established by CompanyX).
12. The Trust operates as follows:
a. The structure of the Trust and the Plan are such that shares are allocated on vesting of options (or an earlier IPO) and will be held by the Trustee if decided by the Board.
b. In order to satisfy its obligation to provide shares to the participants under the Plan, CompanyX will make an irretrievable cash contribution to the Trustee for the sole purpose of enabling the Trustee to subscribe for and purchase the requisite number of CompanyX shares (in accordance with the Plan) for the benefit of the participants.
c. CompanyX will also pay the Trustee for any costs or expenses incurred in establishing, administering, maintaining or terminating the Trust or the Plan, or to fund activities that are merely incidental to the purpose of the Trust.
d. Subsequently, the Trustee utilises the irretrievable cash contributions paid by CompanyX to acquire CompanyX shares for the benefit of participants as directed by the Board of Directors in accordance with the Plan Rules and Trust Deed.
e. The contributions cannot be refunded to CompanyX or any subsidiary, except in the case of an administrative error.
f. The Trustee will keep a Plan register for each Plan, which records:
(i) Each Participant's Plan balance, including the number of shares allocated to the Participant, the date of acquisition and any other assets acquired by the Trustee in respect of it;
(ii) The number of unallocated shares in the general Plan balance; and
(iii) Any other details considered necessary by the Trustee.
g. The Participant's do not have any right to inspect the Plan register, except in relation to the shares held for that Participant.
h. Allocated CompanyX shares are held on a separate fixed trust for the participant who will be the beneficial owner of the shares, and have the same rights, benefits and privileges as if the participant was the legal owner of the shares, subject to restrictions in the Trust Deed and Plan.
i. In respect of allocated shares:
(i) Dividends and other shareholder distributions/entitlements would be paid either in aggregate to the Trustee, to be distributed to the participants, or directly to the participants by CompanyX.
(ii) The Trustee will be responsible for ascertaining the participant's voting preference and exercising all votes on behalf of the participants.
(iii) The participant can require the Trustee to sell its shares to the extent permitted by the Plan. However, the participant would need the Board's permission to require the Trustee to transfer legal ownership of the shares to the participant.
j. The Trustee will hold unallocated shares (i.e. shares not held for a particular participant) if the Trustee previously had allocated shares to a participant but they were subsequently redeemed by the Trustee, as a result of the shares being either forfeited or sold. Any unallocated shares will be held on discretionary trust for all eligible participants.
k. In respect of unallocated shares, the Trustee can apply any income on the shares towards paying expenses incurred by the Trustee in the execution of the Trust, towards acquiring further shares to be held for purposes of the Trust or accumulate the income in the Trust.
13. The Trustee does not have the power to provide participants with additional benefits, such as a loan or other financial assistance. The Trustee also does not have the power to engage in any activities unrelated to obtaining shares and providing those shares to the participants.
14. Each participant is presently entitled to, and has an indefeasible vested interest in, so much of the net income of the trust for a year of income which is attributable to that participant's allocated shares.
15. Each participant is specifically entitled to all of any franked distribution and financial benefits relating to a capital gain which is attributable to that participant's allocated shares.
16. The participants do not have any entitlement in respect of any contributions made by CompanyX to the Trustee.
17. The Trustee is required to act independently of CompanyX.
Purpose for utilising the Trust to facilitate the Plan
18. The commercial reasons for utilising the Trust by CompanyX, instead of transferring registered ownership of the shares directly to the participant, include:
a. Administrative convenience, for example, streamlining general meetings, simplify voting, having fewer shareholders on the register etc.
b. Privacy of remunerative arrangements between Executives.
c. Help enforce the Plan's sale restriction.
d. Flexibility of cost management, capital management and any other future incentives.
e. Enable CompanyX to meet legal requirements relating to dealing with its own shares and insider trading under the Corporations Act 2001.
Offer to The Employee
19. The Employee is an Executive in CompanyX. Their base pay is $Z (including super).
20. The Employee was offered Z options under the Plan.
a. The Employee accepted the offer.
b. The options were granted to the Employee.
c. The options have a zero acquisition and exercise price.
d. The vesting date for the options is dd/mm/yyyy.
e. There are no other vesting conditions specified in the offer.
f. The options are provided to the Employee above and beyond the terms of their employment contract, and are not in substitution for any pre-agreed remuneration.
g. The Employee does not own or control more than 10% of CompanyX's shares.
Relevant legislative provisions
Fringe Benefits Tax Assessment Act 1986
Fringe Benefits Tax Assessment Act 1986 subsection 136(1)
Fringe Benefits Tax Assessment Act 1986 paragraph 136(1)(f)
Fringe Benefits Tax Assessment Act 1986 paragraph 136(1)(ha)
Fringe Benefits Tax Assessment Act 1986 paragraph 136(1)(h)
Income Tax Assessment Act 1936 subsection 44(1)
Income Tax Assessment Act 1936 section 95
Income Tax Assessment Act 1936 section 97
Income Tax Assessment Act 1936 paragraph 97(1)(a)
Income Tax Assessment Act 1936 subsection 99A(4A)
Income Tax Assessment Act 1936 Division 7A in Part III
Income Tax Assessment Act 1936 section 109C
Income Tax Assessment Act 1936 subsection 109C(1)
Income Tax Assessment Act 1936 section 109ZB
Income Tax Assessment Act 1936 subsection 109ZB(3)
Income Tax Assessment Act 1936 Division 1A of the former Part IIIAA
Income Tax Assessment Act 1936 section 160APHD
Income Tax Assessment Act 1936 section 160APHJ
Income Tax Assessment Act 1936 subsection 160APHJ(2)
Income Tax Assessment Act 1936 subsection 160APHJ(4)
Income Tax Assessment Act 1936 subsection 160APHJ(5)
Income Tax Assessment Act 1936 section 160APHL
Income Tax Assessment Act 1936 subsection 160APHL(10)
Income Tax Assessment Act 1936 subsection 160APHM(2)
Income Tax Assessment Act 1936 section 160APHO
Income Tax Assessment Act 1936 subsection 160APHO(3)
Income Tax Assessment Act 1936 section 160APHU
Income Tax Assessment Act 1936 Part IVA
Income Tax Assessment Act 1936 subsection 177A(1)
Income Tax Assessment Act 1936 subsection 177C(1)
Income Tax Assessment Act 1936 section 177CB
Income Tax Assessment Act 1936 subsection 177CB(2)
Income Tax Assessment Act 1936 subsection 177CB(3)
Income Tax Assessment Act 1936 section 177D
Income Tax Assessment Act 1936 section 177F
Income Tax Assessment Act 1936 subsection 177F(1)
Income Tax Assessment Act 1997 section 6-5
Income Tax Assessment Act 1997 section 6-10
Income Tax Assessment Act 1997 section 8-1
Income Tax Assessment Act 1997 subsection 8-1(1)
Income Tax Assessment Act 1997 paragraph 8-1(2)(a)
Income Tax Assessment Act 1997 section 10-5
Income Tax Assessment Act 1997 section 20-20
Income Tax Assessment Act 1997 subsection 20-20(2)
Income Tax Assessment Act 1997 subsection 20-20(3)
Income Tax Assessment Act 1997 section 20-30
Income Tax Assessment Act 1997 Subdivision 83A-B
Income Tax Assessment Act 1997 Subdivision 83A-C
Income Tax Assessment Act 1997 Division 83A
Income Tax Assessment Act 1997 subsection 83A-10(1)
Income Tax Assessment Act 1997 subsection 83A-10(2)
Income Tax Assessment Act 1997 subparagraph 83A-105(3)(b)(ii)
Income Tax Assessment Act 1997 section 83A-110
Income Tax Assessment Act 1997 subsection 83A-120(5)
Income Tax Assessment Act 1997 section 83A-120
Income Tax Assessment Act 1997 subsection 83A-120(6)
Income Tax Assessment Act 1997 section 83A-125
Income Tax Assessment Act 1997 section 83A-210
Income Tax Assessment Act 1997 section 83A-310
Income Tax Assessment Act 1997 section 83A-315
Income Tax Assessment Act 1997 section 102-20
Income Tax Assessment Act 1997 section 104-25
Income Tax Assessment Act 1997 subsection 104-25(3)
Income Tax Assessment Act 1997 paragraph 104-35(5)(c)
Income Tax Assessment Act 1997 subsection 104-10(2)
Income Tax Assessment Act 1997 section 104-75
Income Tax Assessment Act 1997 section 104-85
Income Tax Assessment Act 1997 section 106-50
Income Tax Assessment Act 1997 paragraph 104-155(5)(c)
Income Tax Assessment Act 1997 section 130-85
Income Tax Assessment Act 1997 subsection 130-85(4)
Income Tax Assessment Act 1997 paragraph 130-85(4)(a)
Income Tax Assessment Act 1997 paragraphs 130-85(4)(b)
Income Tax Assessment Act 1997 paragraph 130-85(4)(c)
Income Tax Assessment Act 1997 section 130-90
Income Tax Assessment Act 1997 subsection 207-35(4)
Income Tax Assessment Act 1997 subsection 207-35(6)
Income Tax Assessment Act 1997 section 207-45
Income Tax Assessment Act 1997 subsection 207-50(4)
Income Tax Assessment Act 1997 paragraph 207-150(1)(a)
Income Tax Assessment Act 1997 subsection 960-100
Income Tax Assessment Act 1997 subsection 995-1(1)
Income Tax Assessment Regulations 1997 regulation 83A.315.03
Reasons for decision
Questions A1 to A7 apply to CompanyX
Question A1
Will CompanyX obtain an income tax deduction in respect of contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trust?
Summary
Contributions made by CompanyX to the Trustee in accordance with the Trust Deed and Plan are irretrievable and necessarily incurred in carrying on the business of CompanyX. There is nothing to indicate that the contributions should otherwise be excluded by subsection 8-1(2) of the ITAA 1997. As such the contributions are deductible under section 8-1 of the ITAA 1997.
Detailed reasoning
The contributions made by CompanyX to the Trustee will be deductible under section 8-1 of the ITAA 1997 if either of the positive limbs in subsection 8-1(1) are satisfied and none of the negative limbs in subsection 8-1(2) apply.
Subsection 8-1(1) of the ITAA 1997 provides an entitlement to a deduction from assessable income for any loss or outgoing, to the extent that it is incurred in gaining or producing assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. The relevant negative limb is paragraph 8-1(2)(a), which denies a deduction to the extent that the expenditure is capital, or of a capital nature.
Losses or outgoings incurred
CompanyX provides contributions to the Trustee to be used in accordance with the Trust Deed and Plan Rules for the sole purpose of enabling the Trustee to acquire CompanyX shares for the benefit of the participants.
A contribution is incurred when ownership of the contribution passes from the taxpayer and the taxpayer cannot retrieve the contribution. The contributions made by CompanyX to the Trustee are irretrievable as they cannot be refunded, except in the case of an administrative error.
Therefore the contributions are considered to be losses or outgoings incurred for the purposes of subsection 8-1(1).
Relevant nexus
A sufficient connection must exist between the contributions made to the Trustee and the derivation of assessable income by CompanyX for a deduction to be available under section 8-1 of the ITAA 1997.
The Commissioner has set out in Draft Taxation Ruling TR 2014/D1 Income tax: employee remuneration trust arrangements ('TR 2014/D1') the situations in which a contribution to an Employee Remuneration Trust ('ERT') would ordinarily satisfy the nexus of being necessarily incurred in carrying on a business.
TR 2014/D1 applies to ERT arrangements as described in paragraph 9 of that Draft Ruling. As the Trust is an ERT and the Plan meets the criteria in paragraph 9, the Draft Ruling applies in this case.
Paragraph 14 of TR 2014/D1 states that a contribution will satisfy the nexus of being necessarily incurred in carrying on a business where:
● The employer engages employees in the ordinary course of carrying on the business; and
● The employer makes a contribution to the trustee of an ERT; and
● The primary purpose of the contribution, at the time it is made, is for it to be applied, within a relatively short period, to the direct provision of remuneration of employees.
The purpose of the Plan is to provide an incentive to employees involved in the management and operating performance of the CompanyX business. The purpose of the contributions is to fund the acquisition of CompanyX shares by the Trustee for the benefit of the employee participants under the Plan.
The irretrievable contributions are only made to the Trustee by CompanyX once the options are converted to shares and the Board resolves for the Trustee to acquire/hold the shares beneficially for the participant. At the time of each contribution, CompanyX will give the Trustee a notice listing the specific participants for whom the contribution is being made and the number of shares to be acquired in respect of each participant.
Therefore it is expected the Trustee would apply the contributions in order to allocate CompanyX shares to specific employees within a relatively short period after the contributions have been made to the Trustee.
Accordingly, there is a sufficient nexus between the contributions by CompanyX and the derivation of its assessable income.
Capital
However, deductions are not allowable to the extent that the contributions are capital in nature.
TR 2014/D1 sets out the Commissioner's view as to the circumstances in which contributions to an ERT are considered to be capital in nature.
Paragraph 186 of TR 2014/D1 states:
A contribution to the trustee of an ERT is of capital or of a capital nature, where the contribution secures for an employer an asset or advantage of an enduring or lasting nature that is independent of year to year benefits that the employer derives from a loyal and contented workforce.
The advantage obtained by CompanyX, due to the Trustee acquiring a direct interest in it, is the enhancement of capital value from the movement of value out of profit to share capital, which is structural and enduring.
However we must also consider the application of the de minimis rule. Where an advantage is only very small or trifling when compared to the arrangement as a whole, then the advantage will not be taken into account for the purposes of determining deductibility under section 8-1 of the ITAA 1997.
Paragraph 202 of TR 2014/D1 states that a capital structure advantage will be considered only small or trifling where the employer:
● Intends that any direct interest acquired by the Trustee will be transferred to Employees within a short period of time; and
● Does not anticipate that the shares will be on-sold to a third party at that time or shortly thereafter.
The employees receive beneficial interests in CompanyX shares within a short period of time after contributions are made by CompanyX to the Trust. Once the shares are allocated by the Trustee to the employees (or once the vesting date has passed for shares allocated prior to vesting as a result of an IPO), the intended underlying remunerative benefit of providing shares at zero cost to the employees, is provided.
Even if legal title to the shares is retained by the Trustee, the employee acquires absolute interest of the shares and is treated as being the owner of the shares, having substantially the same rights, benefits and privileges as if the employee was the legal owner of the shares. Further the sale restriction under the Plan ensures that the shares will not be immediately disposed by the participants.
As the capital advantage is sufficiently small or trifling when compared to the arrangement as a whole, the Commissioner would not seek to apportion the deduction.
Therefore, CompanyX would be entitled to a deduction under section 8-1 of the ITAA 1997 for the irretrievable cash contributions it makes to the Trustee of the Trust to fund the acquisition of CompanyX shares by the Trust.
Question A2
Is an irretrievable contribution by CompanyX to the Trustee of the Trust to fund the acquisition of CompanyX shares by the Trust for allocation to the Employee deductible to CompanyX in the income year in which it is made?
Summary
The irretrievable contributions made by CompanyX will be deductible in the income year in which they are made, provided the participant acquires a beneficial interest in the CompanyX shares in the same income year.
Detailed reasoning
The deduction for irretrievable contributions under section 8-1 of the ITAA 1997 would generally be allowable in the income year in which CompanyX incurred the outgoing. However, under certain circumstances, the timing of the deduction is specifically determined under section 83A-210 of the ITAA 1997.
Section 83A-210 of the ITAA 1997 applies if there is a relevant connection between the money provided to the Trustee and the acquisition of employee share scheme (ESS) interests (directly or indirectly) by the employee under an employee share scheme in relation to the employee's employment.
Section 83A-210 will operate in circumstances where the contribution occurs before the time the beneficiary acquires the ESS interest. In such circumstances section 83A-210 will operate to delay the deduction under section 8-1 until such time as the relevant ESS interest is acquired by the employee.
An ESS interest in a company is defined in subsection 83A-10(1) as either a beneficial interest in a share in the company or a beneficial interest in a right to acquire a beneficial interest in a share in the company.
The options under the Plan provide the participants the right to acquire a beneficial interest in CompanyX shares, and thus are ESS interests. The contributions are made to the Trust by CompanyX to provide the participants with a beneficial interest in CompanyX shares, which also fall within the definition of an ESS interest.
The contributions will only be made by CompanyX once the Board has resolved to convert the participant's existing options to shares, and notified the Trustee of the number of shares that need to be acquired for the specific participant. Thus, it is assumed that the participant will acquire a beneficial interest in the shares shortly after the contribution is made, and the shares are acquired by the Trustee.
Provided the participant acquires its beneficial interest in CompanyX shares in the same income year in which the contribution is made, the contributions will be deductible in the income year in which they are made.
Question A3
Will the Commissioner seek to make a determination that Part IVA of the ITAA 1936 applies to deny, in part or full, any deduction claimed by CompanyX for contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trust?
Summary
Part IVA will not apply as the Commissioner does not consider that a tax benefit is obtained in connection with the scheme.
Detailed reasoning
Part IVA of the ITAA 1936 is a general anti-avoidance provision, giving the Commissioner the discretion to cancel a 'tax benefit' that has been obtained, or would (but for section 177F) have been obtained, by a taxpayer in connection with a scheme to which Part IVA applies.
In order for Part IVA to apply, the following requirements must be satisfied:
● There is a scheme to which Part IVA applies;
● A tax benefit was or would (but for subsection 177F(1)) have been obtained;
● The identified tax benefit was or would have been obtained in connection with the identified scheme; and
● The person who entered into or carried out the identified scheme (or any part of the scheme) did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit.
Scheme
A 'scheme' is broadly defined in subsection 177A(1) of the ITAA 1936 as:
(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.
Under this definition, a scheme can be a series of steps taken together or a single step.
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 entering into or carrying out the scheme, and the existence of the tax benefit, must both be considered against a comparison with an alternative.
The scheme for the purposes of section 177A(1) of the ITAA 1936 is the establishment of the Plan and the Trust, as well as payments by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trustee to allocate and hold the shares for the benefit of the participants.
Tax Benefit
Having established the existence of a scheme, Part IVA will only apply if it is determined that a tax benefit was or would have been obtained in connection with that scheme.
Broadly, subsection 177C(1) identifies four types of tax benefits as follows:
● An amount not being included in the taxpayer's assessable income;
● A deduction being allowable to the taxpayer;
● A capital loss being incurred by the taxpayer; and
● A foreign tax credit being allowable to the taxpayer.
In order to determine that a tax benefit has been obtained, it is necessary to compare the tax consequence of the scheme in question with the tax consequences that would have arisen, or might reasonably be expected to have arisen, if the scheme had not been entered into or carried out.
Section 177CB - The bases for identifying tax benefits
For schemes entered into or carried out on or after 16 November 2012, section 177CB provides the framework for deciding under section 177C whether any of the following tax effects would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out:
(a) An amount being included in the assessable income of the taxpayer;
(b) The whole or part of a deduction not being allowable to the taxpayer;
(c) The whole or part of a capital loss not being incurred by the taxpayer;
(d) The whole or part of a foreign income tax offset not being allowable to the taxpayer;
(e) The taxpayer being liable to pay withholding tax on an amount.
The 'would have' and 'might reasonably be expected to' limbs of subsection 177C(1) are separate and distinct bases upon which the existence of a tax effect can be demonstrated.
Subsection 177CB(2) confirms that a decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme) (the annihilation approach). In considering such a postulate, the scheme must be assumed never to have happened, that is, it is annihilated, deleted or extinguished to determine the tax effects based on the remaining events or circumstances.
Generally the annihilation approach will be applicable where there are no economic consequences from the scheme other than the tax benefit. The annihilation approach is not appropriate in this case as annihilating the scheme would be inconsistent with the non-tax results and consequences sought by the participants in the scheme.
Subsection 177CB(3) explains that a decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme (the reconstruction approach).
In determining whether such a postulate is a reasonable alternative, particular regard must be had to the substance of the scheme and any result or consequence for the taxpayer that is or would be achieved by the scheme. Any results in relation to the operation of the Act (as defined) that would be achieved by the postulate for any person (whether or not a party to the scheme) must be disregarded.
In order to determine the tax benefit that would be derived by CompanyX from this scheme, it is necessary to examine what CompanyX might reasonably have been expected to enter into to achieve its aim in relation to employee remuneration.
A possible postulate is that CompanyX issued new shares to the employees directly. Under this postulate CompanyX may not receive a deduction which is available under the current scheme. However this alternative postulate is not a reasonable alternative as it does not achieve the same commercial results, in particular the privacy of remunerative arrangements between Executives and administrative convenience.
The applicant has stated that if the scheme had not been entered into, then CompanyX would have chosen to incentivise its staff using an alternative method which would result in same or similar costs for incentive remuneration, revealing no tax benefit. Examples provided by the Applicant include CompanyX purchasing shares for employees on market via a broker, or alternatively remunerating employees directly through cash bonuses, all of which may entitle CompanyX to a deduction.
Conclusion
The possible postulates to the scheme are either not reasonable alternatives to the scheme, as they do not achieve the same commercial results or consequences for the applicant, or they do not give rise to any tax benefit. Therefore there is no tax benefit obtained in connection with the scheme and as a result Part IVA will not apply.
Question A4
Will CompanyX obtain an income tax deduction in respect of costs incurred in relation to the implementation and ongoing administration of the Trust in the year in which they are incurred?
Summary
The costs incurred in relation to the implementation and ongoing administration of the Trust are deductible under section 8-1 of the ITAA 1997 as they are part of the ordinary recurring costs to CompanyX in order to remunerate employees.
Detailed reasoning
As discussed in question A1 above, section 8-1 of the ITAA 1997 provides that a taxpayer can deduct from their assessable income any loss or outgoing to the extent that it is incurred in gaining or producing their assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing their assessable income.
CompanyX pays expenses incurred by the Trust in establishing, administering, maintaining and terminating the employee share trust.
These expenses are part of the ordinary employee remuneration costs of CompanyX and are therefore deductible under section 8-1 of the ITAA 1997 in the year in which they are incurred. This is consistent with the ATO view expressed in ATO ID 2014/42.
Further, the costs are revenue, and not capital, in nature on the basis that they are regular and recurrent employment expenses. Therefore, the expenses are not excluded from being deductible under paragraph 8-1(2)(a) of the ITAA 1997.
Question A5
If the Trustee uses a contribution received from CompanyX to subscribe for shares in CompanyX, will the subscription proceeds be included in the assessable income of CompanyX?
Summary
The subscription proceeds will not be included in the assessable income of CompanyX as they are:
● Considered to be capital in nature and will not be ordinary income under section 6-5 of the ITAA 1997;
● Not recoupments under section 20-20 of the ITAA 1997; and
● Excluded from being a CGT event by paragraphs 104-35(5)(c) and 104-155(5)(c) of the ITAA 1997.
Detailed reasoning
Section 6-5 of the ITAA 1997 provides that assessable income includes income according to ordinary concepts, which is called ordinary income. Further, section 6-10 of the ITAA 1997 provides that assessable income also includes statutory income.
Ordinary Income
Income according to ordinary concepts is not defined in the ITAA 1997. However, there is a substantial body of case law which discusses factors which indicate whether an amount has the character of income according to ordinary concepts.
In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 the High Court of Australia held that whether a receipt is income or capital depends on its objective character in the hands of the recipient. They further stated at page 138 that:
To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business.
Receipts of a capital nature do not constitute income according to ordinary concepts, whether or not acquired in carrying on a business.
The character of the subscription proceeds received by CompanyX from the Trustee can be determined by the character of the right or thing disposed of in exchange for the receipt. In this case, CompanyX shares were provided to the Trustee in exchange for the subscription proceeds.
As the character of the shares is capital, it can be concluded that the subscription proceeds take the character of the share and accordingly are also capital in nature. Therefore, the subscription proceeds received by CompanyX will not be ordinary income under section 6-5 of the ITAA 1997.
Statutory Income
Recoupment
Subsection 20-20(2) of the ITAA 1997 provides that if a taxpayer receives an amount as a recoupment of a loss or outgoing, it will be assessable income if the taxpayer received it by way of insurance or indemnity and that amount can be deducted as a loss or outgoing in the current year or earlier income year.
The subscription proceeds received by CompanyX for the subscription of shares by the Trustee do not have the character of insurance or indemnity.
Subsection 20-20(3) of the ITAA 1997 makes assessable a recoupment of a loss or outgoing that is deductible, or has been deducted in a previous income year, where the deduction was claimed under a provision in section 20-30 of the ITAA 1997.
The subscription proceeds are received by CompanyX in return for issuing shares to the Trust, not as a recoupment of previously deducted expenditure under section 8-1 regarding bad debts or rates and taxes to which section 20-30 of the ITAA 1997 will apply.
Therefore the subscription proceeds will not be an assessable recoupment under section 20-20 of the ITAA 1997.
Capital Gains Tax
Section 102-20 of the ITAA 1997 states that:
You make a capital gain or loss if and only if a CGT event happens.
The relevant CGT events that may be applicable when the subscription proceeds are received by CompanyX are CGT events D1 (creating a contractual or other rights) and H2 (receipt for event relating to a CGT asset).
However, both CGT events do not happen if a company issues or allots equity interests or non-equity shares in the company. In this case, CompanyX is issuing shares, being equity interests as defined in section 974-75 of the ITAA 1997, to the Trustee. Therefore CGT events D1 and H2 do not happen.
As no CGT event occurs, there is no amount that will be assessable as a capital gain to CompanyX.
Conclusion
Therefore, when the Trustee satisfies its obligations under the Plan by subscribing for shares in CompanyX, the subscription proceeds will not be included in the assessable income of CompanyX under section 6-5 or section 20-20, nor trigger a CGT event under Division 104 of the ITAA 1997.
Question A6
Will the provision of options and shares to the Employee under the Plan be a fringe benefit within the meaning of the FBTAA?
Summary
The options given to the Employee are ESS interests and will be excluded from the definition of a fringe benefit by paragraph 136(1)(h) of the FBTAA.
The provision of shares will not give rise to a fringe benefit as a benefit has not been provided in respect of the Employee's employment, but rather in respect of the conversion of the options under the Plan.
Detailed reasoning
A fringe benefit is defined in subsection 136(1) of the FBTAA as being a benefit provided to an employee or an associate of an employee 'in respect of' the employment of the employee. However, certain benefits are excluded from being a fringe benefit by virtue of paragraphs (f) to (s) of the fringe benefit definition.
Options
The definition of a fringe benefit in paragraph 136(1)(h) of the FBTAA states that a fringe benefit does not include:
A benefit constituted by the acquisition of an ESS interest under an employee share scheme (within the meaning of the Income Tax Assessment Act 1997) to which Subdivision 83A-B or 83A-C of that Act applies.
As stated previously in question A2, an ESS interest in a company is defined in subsection 83A-10(1) as either a beneficial interest in a share in the company or a beneficial interest in a right to acquire a beneficial interest in a share in the company. The options provided to the Employee are ESS interests as they provide the Employee the right to acquire a beneficial interest in CompanyX shares. The ESS interests are provided to the Employee under an employee share scheme at a discount, as the Employee acquired the options for no consideration. Therefore, either subdivision 83A-B or 83A-C will apply to the options acquired under the Plan.
As such, the provision of options to the Employee in relation to their employment will be excluded from the definition of fringe benefit by paragraph 136(1)(h) of the FBTAA.
Shares
As stated above, in general terms, a fringe benefit is defined in subsection 136(1) of the FBTAA as being a benefit provided to an employee or an associate of an employee in respect of the employment of the employee.
The meaning of the phrase 'in respect of' was considered by the Full Federal Court in J and G Knowles and Associates Pty Ltd v Federal Commissioner of Taxation (2000) 96 FCR 402. The court at page 410 said:
Whatever question is to be asked, it must be remembered that what must be established is whether there is a sufficient or material, rather than a, causal connection or relationship between the benefit and the employment.
Under the Plan, shares are provided to the Employee if the Board resolves to convert the options to shares. Therefore, any benefit received by the Employee would be in respect of the exercise of existing options, and not in respect of employment.
Therefore, the provision of shares will not give rise to a fringe benefit as a benefit has not been provided in respect of the employment of the Employee, but rather in respect of the exercising of a right under the Plan.
Question A7
Will contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares be treated as a fringe benefit within the meaning of the FBTAA?
Summary
As the Trust is an employee share trust (EST), contributions made by CompanyX to the Trust to fund the acquisition of CompanyX shares will be excluded from being a fringe benefit.
Detailed reasoning
The definition of a fringe benefit in paragraph 136(1)(ha) of the FBTAA states that a fringe benefit does not include:
A benefit constituted by the acquisition of money or property by an employee share trust (within the meaning of the Income Tax Assessment Act 1997)
An 'employee share trust' is defined in subsection 995-1(1) of the ITAA 1997 as having the meaning given by subsection 130-85(4) of the ITAA 1997.
Subsection 130-85(4) of the ITAA 1997 provides that an employee share trust for an 'employee share scheme' is a trust whose sole activities are:
(a) Obtaining shares or rights in a company; and
(b) Ensuring that ESS interests in the company that are beneficial interests in those shares or rights are provided under the employee share scheme to employees, or to associates of employees, of:
(i) The company; or
(ii) A subsidiary of the company; and
(c) Other activities that are merely incidental to the activities mentioned in paragraphs (a) and (b).
An employee share scheme is defined in subsection 83A-10(2) of the ITAA 1997 as a scheme under which ESS interests in a company are provided to employees, or associates of employees (including past or prospective employees) in relation to the employees' employment.
The Plan is an employee share scheme within the meaning of subsection 83A-10(2) of the ITAA 1997 because it is a scheme under which options and ultimately shares are provided to eligible employees in relation to the employee's employment.
Under the Plan, CompanyX has established the Trust for the sole purpose of the Trustee acquiring shares in CompanyX and allocating those shares to employees. Therefore, paragraphs 130-85(4)(a) and (b) of the ITAA 1997 are satisfied because:
● The Trust acquires shares in CompanyX; and
● The Trust ensures that the ESS interests, being beneficial interests in CompanyX shares, are provided under an employee share scheme by allocating those shares to the employees of CompanyX in accordance with the Trust Deed and relevant Plan Rules.
Undertaking the activities mentioned in paragraphs 130-85(4)(a) and (b) of the ITAA 1997 will also require that the Trustee undertake incidental activities that are a function of managing the employee share plan and administering the Trust.
ATO ID 2010/108 explains that the activities which are considered to be merely incidental (in accordance with paragraph 130-85(4)(c) of the ITAA 1997) include:
● The opening and operation of a bank account to facilitate the receipt and payment of money;
● The receipt of dividends in respect of shares held by the trust on behalf of an employee, and their distribution to the employee;
● The receipt of dividends in respect of unallocated shares and using those dividends to acquire additional shares for the purposes of the employee share scheme;
● Dealing with shares forfeited under an employee share scheme including the sale of forfeited shares and using the proceeds of sale for the purposes of the employee share scheme;
● The transfer of shares to employee beneficiaries or the sale of shares on behalf of an employee beneficiary and the transfer to the employee of the net proceeds of the sale of those shares;
● The payment or transfer of trust income and property to the default beneficiary on the winding up of the trust where there are no employee beneficiaries; and
● Receiving and immediately distributing shares under a demerger.
The provisions of the Plan Rules and Trust Deed collectively make it clear that the Trustee can only use the contributions for the acquisition of shares for eligible employees in accordance with the Plan. Further the Trust Deed states that the Trust will be managed and administered so that it satisfies the definition of 'employee share trust' for the purposes of subsection 130-85(4) of the ITAA 1997.
All other activities of the Trust are merely incidental to those activities in accordance with paragraph 130-85(4)(c) of the ITAA 1997. Thus, the Trust is an employee share trust, which is consistent with the ATO view expressed in ATO ID 2010/108.
Therefore, the contributions to the Trustee to fund the acquisition of CompanyX shares will not be treated as a fringe benefit.
Questions B1 to B10 apply to Trustee and The Employee
Question B1
Will the contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trust be assessable income of the Trust?
Summary
Irretrievable cash contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares by the Trust will not be assessable income of the trust.
Detailed reasoning
Section 95 of the ITAA 1936 defines the 'net income of the trust estate' as the total assessable income of the trust, calculated as if the trust were a taxpayer in respect of that income and a resident, less all allowable deductions.
As stated in question A5, assessable income includes both ordinary and statutory income.
None of the provisions listed in section 10-5 of the ITAA 1997 are relevant in this situation and therefore the irretrievable contributions will be included in net income of the trust only if they are income according to ordinary concepts.
Pursuant to the Trust Deed, all contributions by CompanyX to acquire CompanyX shares constitute accretions to the corpus of the trust. Contributions are made by CompanyX under an employee share scheme and the Trustee must use the contributions to acquire CompanyX shares in accordance with the terms of the Trust Deed and the Plan Rules.
Consistent with ATO ID 2002/965, the contributions constitute capital receipts to the Trustee, and will not be assessable income of the Trust.
Question B2
Will contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares and/or the expenses of operating the Trust be treated as a deemed dividend within the meaning of Division 7A of ITAA 1936?
Summary
Contributions made by CompanyX to the Trustee will not be deemed dividends under section 109C of the ITAA 1936, as its operation would be excluded under subsection 109ZB(3) of the ITAA 1936.
Detailed reasoning
Division 7A of the ITAA 1936 deals with the circumstances under which certain payments made by a private company will be treated as dividends.
Payments treated as dividends
Subsection 109C(1) of the ITAA 1936 states that a private company is taken to pay a dividend to an entity if the private company makes a payment to the entity during the year and either:
● The entity is a shareholder or an associate of the shareholder in the company at the time of the payment; or
● A reasonable person would conclude that the payment was made because the entity has been a shareholder or associate at some time.
An entity is defined in section 960-100 of the ITAA 1997 and includes the trustee of a trust.
The contributions made by CompanyX to the Trustee would satisfy subsection 109C(1) of the ITAA 1936 if the Trustee holds CompanyX shares at the time the contribution is made. Section 109C of the ITAA 1936 would apply to treat the amount of the contributions to be a deemed dividend, subject to CompanyX's distributable surplus for the relevant income year, unless an exception applies.
Exception
Subsection 109ZB(3) of the ITAA 1936 provides that Division 7A does not apply to a payment made to a shareholder, or shareholder's associate, in their capacity as an employee or an associate of an employee.
Subsection 109ZB(3) of the ITAA 1936 appears within a provision designed to set an 'ordering' between Division 7A and the fringe benefits tax provisions in the FBTAA. Specifically, what is meant by 'an employee' for the purpose of this provision takes on the meaning it is given in the FBTAA. In considering benefits provided to employees or associates of employees in the context of that Act (specifically, in the definition of a 'fringe benefit'), Edmonds J in Commissioner of Taxation v Indooroopilly Children Services (Qld) Pty Ltd concluded that the reference to an employee is a reference to a particular employee.
The Trustee is an associate of any CompanyX employee who is a beneficiary of the trust. Contributions are made by CompanyX to the Trustee once the Board resolves to provide a particular participant a share. At the time of each contribution, the Board will provide the Trustee a notice listing the CompanyX's employees, for whom the contribution is being made, i.e. the portion of the contribution and the applicable number of shares to be acquired in respect of each employee. As the contribution would be made to the Trustee in respect of a particular CompanyX employee, subsection 109ZB(3) of the ITAA 1936 will be satisfied.
Therefore, the contributions made by CompanyX to the Trustee will not be deemed to be dividends under section 109C of the ITAA 1936, as its operation would be excluded under subsection 109ZB(3) of the ITAA 1936.
Question B3
When as a result of a participant's options converting to shares under the Plan, the Trustee allocates shares to a participant under the Plan, will a capital gain or capital loss arise for the Trustee or participant?
Summary
Any capital gain or capital loss that arises for the Trustee, or the participants, will be disregarded under section 130-90 of the ITAA 1997 if the participants acquire the shares for less than or equal to the cost base of the shares in the hands of the Trustee at the time the CGT event happens.
Detailed reasoning
Under section 130-90 of the ITAA 1997, any capital gain or capital loss made by an employee share trust, or a beneficiary of the trust, will be disregarded to the extent that:
1. It results from a CGT event E5 or E7;
2. The CGT event happens in relation to a share;
3. The beneficiary had acquired a beneficial interest in the share by exercising a right;
4. The beneficiary's beneficial interest in the right was an ESS interest to which Subdivision 83A-B or 83A-C applied; and
5. The beneficiary did not acquire the beneficial interest in the share for more than its cost base in the hands of the Trust at the time the CGT event happens.
Employee share trust
The term 'employee share trust' is defined in subsection 995-1(1) of the ITAA 1997 as having the meaning given by subsection 130-85(4) of the ITAA 1997.
As discussed in question A7 above, the Trust constitutes an employee share trust under subsection 130-85(4) of the ITAA 1997.
CGT event E5 happens in relation to a share
Under section 104-75 of the ITAA 1997, CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust against the trustee.
Once the Board resolves to convert the options to shares, and the trustee allocates the shares to the participants, the participants become absolutely entitled to CompanyX shares.
Therefore, CGT event E5 happens in relation to CompanyX shares allocated to participants at the time the participants become absolutely entitled to CompanyX shares as against the Trustee.
Acquisition of beneficial interest in share by exercising right
Under the Plan Rules, once the Board resolves to convert a participant's option to a share, the participant acquires a beneficial interest in the share. The participant is treated as being the owner of the share, having substantially the same rights, benefits and privileges as if the employee was the legal owner of the share, subject to the sale restrictions under the Plan.
ESS interest to which Subdivision 83A-B or 83A-C applies
Pursuant to subsections 995-1(1) and 83A-10(1) of the ITAA 1997, an ESS interest in a company is a beneficial interest in either a share in the company or a right to acquire a beneficial interest in a share of the company. As discussed in question A2 above, the options are ESS interests.
Under the Plan, ESS interests are provided to participants in relation to their employment. The ESS interests will be acquired at a discount. Therefore, either subdivision 83A-B or 83A-C will apply to the options acquired under the Plan.
Acquisition at less than cost base of Employee Share Trust
Under the Plan the Board has the discretion to offer options which require an exercise price to be payable by the participants. It is assumed that if an exercise price is payable by the participants, it will be less than or equal to the cost base of the share to the trustee.
Therefore, section 130-90 of the ITAA 1997 will disregard any capital gain or capital loss made by the Trustee or the participant under section 104-75 of the ITAA 1997, if the participant does not acquire their beneficial interest in the CompanyX share for more than its cost base in the hands of the trust at the time the CGT event E5 happens.
Question B4
When the Trustee sells shares to a third party, being shares that were previously allocated to a participant under the Plan, will a capital gain or capital loss arise for the Trustee?
Summary
The capital gain or capital loss from the trustee selling shares to a third party, to which the participant was absolutely entitled, will arise for the participant, not the Trustee.
Detailed reasoning
Under section 106-50 of the ITAA 1997, once a participant becomes absolutely entitled to a CGT asset as against the trustee of a trust, the asset is treated as being the participant's asset, instead of being an asset of the trust.
As stated in question B3 above, once the Board resolves to convert the options to shares, and the trustee allocates the shares to the participants, the participants become absolutely entitled to CompanyX shares.
Therefore, from the time the participants are allocated shares, for CGT purposes the shares are treated as being owned by the participants. As such, any capital gain or capital loss from the trustee selling the shares allocated to a participant to a third party will arise for the participant, not the trustee.
Question B5
When the Trustee transfers registered ownership of shares to a participant previously allocated the shares under the Plan, will a capital gain or capital loss arise for the Trustee or the participant?
Summary
No capital gain or capital loss will arise for the Trustee or the participant as there is no change in ownership for CGT purposes.
Detailed reasoning
Under section 104-85 of the ITAA 1997, CGT event E7 happens if the trustee disposes of a CGT asset of the trust to the beneficiary in satisfaction of the beneficiary's interest in the trust capital.
Subsection 104-10(2) of the ITAA 1997 states that a CGT asset is disposed if a change of ownership occurs from one entity to another.
As discussed in question B3 and B4 above, from the time the participants are allocated shares, they become absolutely entitled to the shares and the shares are treated as being owned by the participants.
When the trustee transfers the registered ownership of shares to the participant, for CGT purposes, the shares are already treated as being owned by that participant. Therefore, there is no disposal of a CGT asset as there is no change in ownership for CGT purposes. Therefore CGT event E7 does not occur and no capital gain or capital loss will arise for the Trustee or the participant.
Question B6
If the Trustee receives and accumulates dividends on unallocated shares held in the Trust:
a. Will the dividend and any franking credit be taxable to the Trustee or can the Trustee choose to be taxed on the dividend?; and
b. If so, will the Trustee be entitled to a tax offset for any franking credits attaching to the dividend?
Summary
If the Trustee chooses to accumulate dividends on unallocated shares, instead of allocating the dividends for the benefit of eligible employees and distributing that income to the eligible employee, then the Trustee will pay tax on the dividend income. The franking credit attached to those dividends will be included in the assessable income of the trust.
The Trustee will be entitled to a tax offset for any franking credits attached to dividends received on unallocated shares and accumulated in the Trust, provided the Trustee holds the shares at risk for a continuous period of at least 45 days during the qualification period.
Detailed reasoning
(a) Tax liability in relation to accumulated dividends and franking credits attached to unallocated shares
The net income of the trust is defined in section 95 of the ITAA 1936 to be the total assessable income of the trust estate calculated under Division 6 of the ITAA 1936 as if the trustee were a taxpayer in respect of that income, less all allowable deductions.
Subsection 44(1) of the ITAA 1936 includes in the assessable income of a resident shareholder dividends that are paid to the shareholder by the company out of profits derived by it from any source. Therefore the dividends would be included in the Trustee's calculation of its net income for a year of income under section 95 of the ITAA 1936.
Under section 97 of the ITAA 1936, the beneficiary of a trust, who is not under any legal disability, is assessed on its share of the net income of the trust estate to which it is presently entitled to.
The Trust Deed provides that each participant is presently entitled to so much of the net income of the trust which is attributable to that participant's allocated shares.
The Trust Deed provides that the participant has no legal or beneficial interest in unallocated shares. The participants would only be deemed to be presently entitled to franked distributions on unallocated shares if the Trustee allocates those distributions to the participants.
However, if the trustee does not allocate the distributions on unallocated shares to participants, then the distributions would be accumulated as an accretion to the Trust Fund.
When there is a part of the net income of a resident trust estate that is not included in the assessable income of a beneficiary of the trust estate in accordance with section 97 of the ITAA 1936, the trustee shall be assessed and is liable to pay tax on that part of the net income of the trust estate.
Therefore, if the Trustee chooses to accumulate dividends on unallocated shares, instead of allocating the dividends for the benefit of eligible employees, the Trustee will be liable to pay tax on those dividends as the participants would not be presently entitled to those dividends.
Further, in accordance with subsection 207-35(6) of the ITAA 1997 the Trustee will include any franking credits on the distributions attached to unallocated shares, and accumulated in the trust, in its assessable income.
(b) Entitlement to tax offset for franking credits attached to dividends on unallocated shares
Section 207-45 of the ITAA 1997 provides that an entity to whom a franked distribution flows indirectly in an income year is entitled to a tax offset for that income year that is equal to its share of the franking credit on the distribution.
The note to section 207-45 of the ITAA 1997 explains that the entities in the section are the ultimate recipients of the distribution because the distribution does not flow indirectly through them to other entities and are the ultimate taxpayer to acknowledge the tax already paid in respect of the profits underlying the distribution.
Where a franked distribution is made to the Trustee and the Trustee is liable to a share of the trust's net income for that income year under section 99A of the ITAA 1936, a franked distribution is taken to flow indirectly to the trustee.
Where a franked distribution flows indirectly to a taxpayer, paragraph 207-150(1)(a) of the ITAA 1997 will deny a tax offset otherwise provided under section 207-45 of the ITAA 1997 if the taxpayer is not a qualified person in relation to the distribution for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.
The former section 160APHO of the ITAA 1936 sets out the definition of a qualified person for the purpose of Division 1A of the former Part IIIAA of the ITAA 1936. Effectively, the Trustee will be a qualified person if they hold shares on which a dividend has been paid for a continuous period of not less than 45 days, during the period beginning the day after the Trustee acquires the shares and ending on the 45th day after the shares become ex-dividend.
However, subsection 160APHO(3) of ITAA 1936 requires days during which an entity has a materially diminished risk be excluded. An entity is taken to have a materially diminished risk on a particular day if their net position on that day is less than 30% of the risks and opportunities relating to the shares.
The net position of a taxpayer or fund in relation to shares is calculated by adding the taxpayer's or fund's 'long position' in the shares and 'short position' in the shares. A long position includes shares in relation to themselves with a delta of +1. At the time the Trustee acquires the shares from CompanyX their net position will be 1.
Under the Plan Rules and Trust Deed, there are no further positions entered into over the shares which would affect the Trustee's net position. Therefore, provided the Trustee holds the shares at risk for the qualification period, the Trustee will be a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936, and be entitled to a tax offset for any franking credits attaching to the dividends on unallocated shares.
Question B7
If the Trustee receives a dividend on Allocated Shares held for a participant in the Trust during an income year, and applies Trust property representing it for the benefit of the participant by the end of the income year:
a. Will the dividend and any franking credit be included in the participant's assessable income?; and
b. Will the participant be entitled to a tax offset for any franking credit attaching to the dividend?
Summary
The participant's assessable income will include the dividends, and any franking credits on the dividends, received by the Trustee which are attributable to the participant's allocated shares.
The participant will be entitled to a tax offset for any franking credits attaching to distributions on shares allocated to them, provided they have held the interest in those shares at risk for a continuous period of at least 45 days, not counting the day of acquisition or disposal.
Detailed reasoning
(a) Tax liability in relation to dividends and franking credits attached to allocated shares
As stated in QB6, the net income of the trust is defined in section 95 of the ITAA 1936 to be the total assessable income of the trust estate calculated under Division 6 of the ITAA 1936 as if the trustee were a taxpayer in respect of that income, less all allowable deductions.
Subsection 44(1) of the ITAA 1936 includes in the assessable income of a resident shareholder dividends that are paid to the shareholder by the company out of profits derived by it from any source. Therefore the dividends would be included in the Trustee's calculation of its net income for a year of income under section 95 of the ITAA 1936.
Under section 97 of the ITAA 1936, the beneficiary of a trust, who is not under any legal disability, is assessed on its share of the net income of the trust estate to which it is presently entitled to.
Pursuant to the Trust Deed, dividends on allocated shares must be held and applied by the Trustee for the benefit of the participant.
The Trust Deed provides that each participant is presently entitled to so much of the net income of the trust which is attributable to that participant's allocated shares.
Therefore the participant's assessable income will include the dividends received by the Trustee which are attributable to the participant's allocated shares. Further, in accordance with subsection 207-35(4) of the ITAA 1997 the participant will include any franking credits on the distributions attached to allocated shares held for their benefit in their assessable income.
(b) Entitlement to tax offset for franking credits attached to dividends on allocated shares
Section 207-45 of the ITAA 1997 provides that an individual to whom a franked distribution flows indirectly in an income year is entitled to a tax offset for that income year that is equal to its share of the franking credit on the distribution.
Where a franked distribution is made to the Trustee and the beneficiary includes in their assessable income a share of the trust's net income for that income year under paragraph 97(1)(a) of the ITAA 1936, a franked distribution is taken to flow indirectly to the beneficiary.
Where a franked distribution flows indirectly to the taxpayer, paragraph 207-150(1)(a) of the ITAA 1997 will deny a tax offset otherwise provided under section 207-45 of the ITAA 1997 if the taxpayer is not a qualified person in relation to the distribution for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.
The participant, being a beneficiary of the trust, will only be a qualified person under former Division 1A of Part IIIAA of the ITAA 1936, if the Trustee is also a qualified person in relation to the dividends.
As stated in question B6, the Trustee will be a qualified person in relation to the dividends provided Trustee holds the shares at risk for a continuous period of at least 45 days during the qualification period.
Whether or not the participant is a qualified person in relation to the dividends depends on whether the trust is a widely held trust as defined in former section 160APHD of the ITAA 1936. A widely held trust is defined as a trust that is neither a closely held fixed trust nor a non-fixed trust.
As the Trust is a non-fixed trust, it is not a widely held trust. A beneficiary of a non-widely held trust is a qualified person in relation to the dividend 'if the taxpayer has held that interest at risk, not counting the day of acquisition or disposal, for a continuous period of at least 45 days'. However, any days where an entity has a materially diminished risk are excluded. An entity is taken to have a materially diminished risk on a particular day if their net position on that day is less than 30% of the risks and opportunities relating to the shares.
As the participant's interest in the share allocated to it is an employee share scheme security, disposal and forfeiture conditions are not considered to be a position for the purposes of former Division 1A of Part IIIAA of the ITAA 1936, and can be disregarded.
Former section 160APHL of the ITAA 1936 calculates the taxpayer's interest in the relevant share using a formula. It also provides that the taxpayer's interest in the relevant shares is a long position with a delta of +1 in relation to itself. For the purpose of subsection 160APHL(10) the additional short position required by this subsection is disregarded because the taxpayer's interest is an employee share scheme security. The participant's net position will be +1 in relation to their interest in the relevant share.
Therefore, the participants will be entitled to a tax offset for any franking credits attaching to distributions on shares allocated to them, provided they have held the interest in those shares at risk for a continuous period of at least 45 days, not counting the day of acquisition or disposal.
Question B8
Will contributions by CompanyX to the Trustee to fund the acquisition of CompanyX shares be included in the Employee's assessable income?
Summary
As the contributions made by CompanyX to the Trustee are as a result of its obligations under the Plan, and not by reason of the services performed by the Employee, the contributions will not be included in the Employee's assessable income.
Detailed reasoning
As stated in question A5, assessable income includes both ordinary and statutory income.
None of the provisions listed in section 10-5 of the ITAA 1997 are relevant in this situation. Therefore, the irretrievable contributions will be included in the Employee's assessable income if they are income according to ordinary concepts.
Paragraph 221 of TR 2014/D1 states as follows:
Contributions that are provided to the trustee of an ERT for the benefit of a particular employee by reason of the services performed by the employee will be assessable to that employee as salary or wages.
CompanyX makes contributions to the Trustee to fulfil its obligations under the Plan. Under the Plan Trust Deed, CompanyX has an obligation to make irretrievable contributions to the Trustee once the Board has resolved to provide shares to the participant through the Trust.
Further, the Employee has entered into an employment contract with CompanyX and is entitled to a base salary and super. The Plan is above and beyond the terms of the Employee's contract, and is not in substitution for any pre-agreed remuneration. The Employee will not forgo any part of their remuneration for the contribution.
Therefore as the contributions made by CompanyX to the Employee are as a result of its obligations under the Plan, and not by reason of the services performed by the Employee, the contributions will not be included in the Employee's assessable income.
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