Edited version of private advice

Authorisation number: 1051536556407

Date of advice: 28 June 2019

Ruling

Subject: Sale of shares - part IVA

Issue

Part IVA

Question 1

Are the franked dividend payments from Parent Co to the Taxpayer to fund the acquisition of shares in Parent Co by the Taxpayer from an individual, H, part of a scheme to which the provisions of section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936) apply?

Answer

No

Question 2

Will the dividends paid by Parent Co to the Taxpayer under the scheme be distributions to which paragraph 207-145(1)(d) of the ITAA 1997 applies?

Answer

No

This ruling applies for the following period:

1 July 2018 to 1 July 2025

The scheme commences on:

1 July 2018

Relevant facts and circumstances

The corporate group consists of Parent Co and its subsidiaries.

Prior to the proposed transaction, the shareholding of Parent Co is as follows:

·      H holds a minority shareholding interest; and

·      A family member of H ('D') holds a majority shareholding interest. The shares are held directly by D and indirectly through a company ('The Taxpayer') that D controls.

The shareholdings of H and D in Parent Co were acquired prior to 20 September 1985.

The shares in the Taxpayer are held by Trustee Co, as trustee for both the H Trust and the D Trust. H is an eligible beneficiary of the H Trust. D is the sole shareholder and director of Trustee Co.

The assets of Parent Co and its subsidiaries consist of assets that:

·      were acquired prior to 20 September 1985;

·      were acquired on or after 20 September 1985 which are trading stock; and

·      were acquired on or after 20 September 1985 which are not trading stock

A taxable gain will arise when CGT event K6 happens upon H disposing of their shares to the Taxpayer.

Parent Co has paid dividends to H in the past, but not in recent years.

H has had minimal involvement in the business to date.

H has granted an option to D to acquire all of the shares held by H in Parent Co, on H's death. D has granted a put option to H requiring D's estate to buy all of H's shares in Parent Co in the event of D's death. If the options are exercised, the Deed requires that the price payable for H's shares is the market value of the shares at the date of death.

Proposed sale of the Taxpayer's interests in Parent Co to the Taxpayer

H has now agreed to sell their shares in Parent Co to D, rather than waiting for events which will enable the options to acquire H's shares to be exercised.

Reasons for the proposed sale

H has provided a number of reasons for the proposed sale.

Nature of dealing between H and D in respect of the proposed sale

H has separately engaged advisers who are independent from those advising D. Offers and counteroffers were made over a period of more than 12 months.

Proposed terms of sale

It is proposed that the consideration, which is based on the net asset value of Parent Co, will be paid by the Taxpayer to H as follows:

·      upon settlement, a cash sum will be paid. This amount will be funded from an interest bearing loan from another company, Family Member Co, that is owned and controlled by D. H has no legal or beneficial interest in Family Member Co.

The funds will be borrowed by Family Member Co under existing banking facilities and will be on-lent to the Taxpayer with interest charged; and

·      the balance of the consideration will be paid by instalments over a period of years with interest charged on the outstanding balance. H will have a right to claim on a guarantee provided by Parent Co in respect of the instalment payments.

Effective upon completion, H will have no further rights or obligations in respect of the options granted.

Funding of repayment of loan to the Taxpayer and future instalments

The repayment to Family Member Co of the loan to the Taxpayer will be funded by dividends from Parent Co.

The instalment payments of the purchase price payable by the Taxpayer to H will be funded by dividends from Parent Co.

No amount of the dividends to be paid by Parent Co will be a distribution to which paragraphs (c) to (j) of section 202-45 of ITAA 1997 apply.

Dividends paid by Parent Co will be paid to all shareholders in proportion to their shareholding. Further, all dividends will be equally franked.

To the extent that Parent Co is unable to pay dividends to fund the future instalments, the Taxpayer will borrow from Family Member Co (or other entities controlled by D from time to time) the amounts due.

Relevant legislative provisions

Income Tax Assessment Act 1936 (ITAA 1936)

Section 177A

Subsection 177D(2)

Section 177E

Section 177EA

Income Tax Assessment Act 1997 (ITAA 1997)

Section 202-5

Subsection 204-30(6)

Subdivision 207-F

Section 207-20

Paragraph 207-145(1)(d)

Section 207-155

Section 960-115

Section 960-135

Section 960-120

Section 995-1

Reasons for decision

Issue

Part IVA

Question 1

Are the franked dividend payments from Parent Co to the Taxpayer to fund the acquisition of shares in Parent Co by the Taxpayer from H, part of a scheme to which the provisions of section 177EA of ITAA 1936 apply?

Summary

The franked dividend payments from Parent Co to the Taxpayer to fund the acquisition of shares in Parent Co by the Taxpayer from H, are not part of a scheme to which the provisions of section 177EA of ITAA 1936 apply.

Detailed reasoning

Section 177EA was enacted as a general anti-avoidance rule to curb the unintended usage of franking credits through dividend streaming and franking credit trading schemes. Broadly, section 177EA targets schemes that involve a disposition of shares or similar equity instruments entered into with a purpose of enabling the taxpayer to obtain an imputation benefit (including franking credits). Where section 177EA operates, the Commissioner has a choice as to whether to debit the company's franking account or deny the franking credit benefit to the recipient of the dividend (subsection 177EA(5)).

In order for section 177EA to apply, the following requirements must be satisfied under subsection 177EA(3):

· there must be a "scheme for a disposition" of "membership interests", or an "interest in membership interests", in a corporate tax entity: (paragraph 177EA(3)(a));

·      a frankable distribution has been paid, or is payable, or is expected to be payable in respect of the membership interests; or a distribution has been paid, or is payable, or is expected to be payable in respect of the interest in the membership interests: (paragraph 177EA(3)(b));

·      the distribution was, or was expected to be a franked distribution or a distribution franked with an exempting credit: (paragraph 177EA(3)(c));

·      a person would receive, or could reasonably be expected to receive, imputation benefits as a result of the dividend or distribution. This person is referred to as the "relevant taxpayer": (paragraph 177EA(3)(d)); and

·      having regard to the relevant circumstances, it would be concluded that a purpose of at least one of the participants was to enable the relevant taxpayer to obtain an imputation benefit: (paragraph 177EA(3)(e)).

A "scheme" is widely defined in section 177A and paragraph 177EA(14)(b) relevantly provides that a "scheme for the disposition of membership interests" includes any scheme that involves entering into any contract, arrangement, transaction or dealing that affects the legal or equitable ownership of membership interests or of an interest in membership interests.

Section 960-135 of the ITAA 1997 states that if you are a member of an entity each interest, or set of interests, in the entity by virtue of which you are a member of the entity is a membership interest of yours in the entity.

A "corporate tax entity" is defined in section 960-115 of the ITAA 1997 as a company, a corporate limited partnership, a corporate unit trust or a public trading trust.

A distribution is a franked distribution if it is franked in accordance with section 202-5 of the ITAA 1997 which requires:

·      The entity to be a franking entity and a resident at the time of the distribution:

·      The distribution to be a frankable distribution; and

·      The entity to allocate franking credits to the distribution

Situations in which a relevant taxpayer would directly receive an imputation credit as a result of a distribution are outlined in subsection 204-30(6) of the ITAA 1997 and include where a shareholder is entitled to the franking credit offset under Division 207 of the ITAA 1997 (paragraph 204-30(6)(a) of the ITAA 1997).

If the elements of paragraphs 177EA(3)(a) to (d) are satisfied, section 177EA applies if the conclusion regarding the purpose of at least one of the participants in the scheme can be drawn (section 177EA(3)(e)).

It must be possible for a reasonable person to conclude, having regard to the relevant circumstances, that a purpose of at least one of the participants in the scheme was to obtain an imputation benefit. The Commissioner must make a determination under subsection 177EA(5) if section 177EA applies.

To satisfy paragraph 177EA(3)(e), the relevant purpose does not have to be the dominant purpose of the scheme. However, the purpose must be more than an incidental purpose.

The decision-maker must consider the relevant circumstances as specified by subsection 177EA(17). These encompass a range of circumstances, which taken individually or collectively, could indicate the requisite purpose. Due to the diverse nature of the circumstances, some may or may not be present at any one time in relation to a particular scheme. The relevant circumstancesof a scheme include the following:

·      the extent and duration of the risks of loss, and the opportunities for profit or gain, from holding membership interests, or having interests in membership interests, in the corporate tax entity that are respectively borne by or accrue to the parties to the scheme, and whether there has been any change in those risks and opportunities for the relevant taxpayer or any other party to the scheme (for example, a change resulting from the making of any contract, the granting of any option or the entering into of any arrangement with respect to any membership interests, or interests in membership interests, in the corporate tax entity): (paragraph 177EA(17)(a) of the ITAA 1997);

·      whether the relevant taxpayer would, in the year of income in which the distribution is made, or if the distribution flows indirectly to the relevant taxpayer, in the year in which the distribution flows indirectly to the relevant taxpayer, derive a greater benefit from franking credits than other entities who hold membership interests, or have interests in membership interests, in the corporate tax entity: (paragraph 177EA(17)(b) of the ITAA 1997);

·      whether, apart from the scheme, the corporate tax entity would have retained the franking credits or exempting credits or would have used the franking credits or exempting credits to pay a franked distribution to another entity referred to in paragraph (b): (paragraph 177EA(17)(c) of the ITAA 1997);

·      whether, apart from the scheme, a franked distribution would have flowed indirectly to another entity referred to in paragraph (b): (paragraph 177EA(17)(d) of the ITAA 1997);

·      if the scheme involves the issue of a non-share equity interest to which section 215-10 of the Income Tax Assessment Act 1997 applies--whether the corporate tax entity has issued, or is likely to issue, equity interests in the corporate tax entity:

o  that are similar, from a commercial point of view, to the non-share equity interest; and

o  distributions in respect of which are frankable: (paragraph 177EA(17)(e) of the ITAA 1997);

·      whether any consideration paid or given by or on behalf of, or received by or on behalf of, the relevant taxpayer in connection with the scheme (for example, the amount of any interest on a loan) was calculated by reference to the imputation benefits to be received by the relevant taxpayer: (paragraph 177EA(17)(f) of the ITAA 1997);

·      whether a deduction is allowable or a capital loss is incurred in connection with a distribution that is made or that flows indirectly under the scheme: (paragraph 177EA(17)(g) of the ITAA 1997);

·      whether a distribution that is made or that flows indirectly under the scheme to the relevant taxpayer is sourced, directly or indirectly, from unrealised or untaxed profits: (paragraph 177EA(17)(ga) of the ITAA 1997);

·      whether a distribution that is made or that flows indirectly under the scheme to the relevant taxpayer is equivalent to the receipt by the relevant taxpayer of interest or of an amount in the nature of, or similar to, interest: (paragraph 177EA(17)(h) of the ITAA 1997);

·      the period for which the relevant taxpayer held membership interests, or had an interest in membership interests, in the corporate tax entity: (paragraph 177EA(17)(i) of the ITAA 1997);

·      any of the matters referred to in subsection 177D(2): (paragraph 177EA(17)(j) of the ITAA 1997).

According to the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 3) 1998, a purpose is an incidental purpose "when it occurs fortuitously or in sub-ordinate conjunction with another purpose, or merely follows another purpose as its natural incident". The High Court considered the meaning of " an incidental purpose " in the context of paragraph 177EA(3)(e) in Mills v FC of T 2012 ATC ¶ 20-360. Gageler J adopted the statement in the Explanatory Memorandum as the proper construction of the phrase, "an incidental purpose", in paragraph 177EA(3)(e). Applying that meaning to the issue before him, Gageler J stated (at para 67):

On that construction of s 177EA(3)(e), there is in the case of a capital raising where the issuer intends to frank distributions on the equity interests disposed of a ' purpose ..... of enabling ' the holders of those equity interests to obtain franking credits. Any such capital raising is therefore potentially within the scope of s 177EA(3)(e). If, however, the intended franking of distributions serves no purpose other than to facilitate the capital raising then the purpose is an incidental purpose: s 177EA(3)(e) is not engaged and s 177EA does not apply. That is to be contrasted with franking credit trading and franking credit streaming where it is the issue of equity interests that is incidental to the provision of the franking credits.

The characteristics that may be present in the proposed arrangement include:

·      A scheme for a disposition of membership interests includes a taxpayer selling its ownership of shares in a company. The proposed transaction involves entering into a sale of shares agreement whereby H disposes of their ownership of membership interests in Parent Co to the Taxpayer. As Parent Co is a company it is a corporate tax entity: (paragraph 177EA(3)(a));

·      Frankable distributions are expected to be paid to the Taxpayer in respect of its membership interests in Parent Co, which the Taxpayer will use to repay the loan from Family Member Co and to make instalment payments to H: (paragraph 177EA(3)(b));

·      Dividends paid by Parent Co will be paid to shareholders in proportion to their shareholding. Parent Co will be a franking entity by virtue of being a corporate tax entity and a resident at the time of the distribution. The distributions which the Taxpayer will receive from Parent Co will be franked. Parent Co will allocate franking credits to these distributions. Thus any distribution paid will be a franked distribution: (paragraph 177EA(3)(c));

·      The relevant taxpayer in this case is the Taxpayer. The Taxpayer will receive imputation benefits as a result of any future distributions: (paragraph 177EA(3)(d));

Even if the elements of paragraphs 177EA(3)(a) to (d) are satisfied, section 177EA cannot apply unless a conclusion can be drawn regarding the purpose of at least one of the participants in the scheme (paragraph 177EA(3)(e)).

The Commissioner considers that the proposed arrangement will not be entered into for the purpose of obtaining an imputation benefit. The relevant circumstances as outlined in subsection 177EA(17) as they apply in this case are:

·      The Taxpayer's existing shares carry the same rights to vote and to dividends as the shares to be acquired from H. The title to, property in, and risk of the Sale Shares (being the shares currently held by H) will pass to the Taxpayer on and from Completion.

·      Dividends paid by Parent Co will be paid to all shareholders in proportion to their shareholding and will be franked to the same extent. Thus the Taxpayer will not derive a greater benefit from the franking credits attached to the dividend than other shareholders in the income year in which the distribution will be made.

·      The consideration which H will receive (being the principal and interest on the outstanding instalments) has not been calculated by reference to any imputation benefits.

·      The manner in which the scheme is carried out accords with the manner in which ordinary business dealings are conducted in circumstances where a majority shareholder is seeking to purchase the shares of a minority shareholder; and

·      The form and substance of the scheme are the same. There is no discrepancy between the legal form of the scheme and its commercial and economic substance.

After consideration of the relevant circumstances, the Commissioner concludes that the provision of the imputation benefits to the Taxpayer is incidental to the purpose of the scheme which is to achieve effective financial separation between H and D.

The scheme is not a case of Franking credit trading and franking credit streaming.

The Commissioner will therefore not make a determination under subsection 177EA(5) of the ITAA 1997.

Question 2

Will the dividends paid by Parent Co to the Taxpayer under the scheme be distributions to which paragraph 207-145(1)(d) of the ITAA 1997 applies?

Summary

The dividends paid by Parent Co to the Taxpayer under the scheme will not be distributions to which paragraph 207-145(1)(d) of the ITAA 1997 applies.

Detailed reasoning

The general rule in section 207-20 of the ITAA 1997 under which taxpayers apply a gross-up and credit treatment on the receipt of a franked distribution does not apply if the imputation system has been manipulated in the circumstances described in Subdivision 207-F.

Subdivision 207-F creates the appropriate adjustment to cancel the effect of the gross-up and offset rules where the entity concerned has manipulated the imputation system in a manner not permitted under the income tax law.

Paragraph 207-145(1)(d) of Subdivision 207-F provides that a distribution made as part of a dividend stripping operation constitutes an impermissible manipulation of the imputation system.

Section 207-155 provides 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 proposed arrangement is not part of a scheme to which the provisions of section 177E of the ITAA 1936 apply. Therefore it follows that the Commissioner does not consider the scheme to be a dividend stripping operation within the meaning of section 207-155. Accordingly paragraph 207-145(1)(d) is not applicable.

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