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Ruling

Subject: Franking Credits and Consolidation

Question 1:

Will the proposed disposal of the Class E ordinary share in XYZ Pty Ltd (XYZ) by A, B, C and D as joint holders of that share to Head Company Pty Ltd (Head Company) result in CGT event A1 under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) happening and a capital gain made by each of the joint shareholders in relation to the disposal of their respective interests in the Class E share?

Answer:

Yes, the Class E share is subject to capital gains tax upon disposal.

Question 2:

Will the capital gain that would arise from CGT event A1 from the proposed disposal of the remaining shares in XYZ (i.e. all the shares other than the Class E share) to Head Company be disregarded under subsection 104-10(5) of the ITAA 1997 because those shares were acquired before 20 September 1985?

Answer:

Yes.

Question 3:

The proposed disposal of the shares in XYZ acquired before 20 September 1985 (i.e. the pre CGT shares) will result in CGT event K6 under subsection 104-230(2) of the ITAA 1997 happening. If the market value of the post-CGT property of XYZ is less than the cost base, will a capital gain be made from the disposal of these shares in XYZ under section 104-230 of the ITAA 1997?

Answer:

If the market value of the post-CGT property of XYZ is less than its cost base, then no capital gain will be made from the disposal of XYZ shares.

Question 4:

Will section 177E of the Income Tax Assessment Act 1936 (ITAA 1936) apply in respect of the proposed disposal of all of the shares in XYZ as an arrangement that is a scheme by way of or in the nature of dividend stripping, or a scheme having substantially the effect of a scheme by way of or in the nature of dividend stripping?

Answer:

No, section 177E does not apply.

Question 5:

Will the Commissioner make a determination pursuant to subsection 177EB(5) of the ITAA 1936 that no credit is to arise in the franking account of Head Company following XYZ joining the tax consolidated group of which Head Company is the head company?

Answer:

No, on the assumption that the retained earnings balance of XYZ Pty Ltd immediately before it becomes a subsidiary member of the Head Company tax consolidated group will not decrease below $X, then the Commissioner will not make a determination pursuant to subsection 177EB(5).

This ruling applies for the following period:

1 July 2012 to 30 June 2013

The scheme commences on:

Date of disposal of XYZ shares.

Relevant facts and circumstances

XYZ Pty Ltd (XYZ) is a privately held company with four individual shareholders being A, B, C and D (Owners). They each hold Class A shares in XYZ which were acquired before 20 September 1985. They also jointly own one Class E share in XYZ which was acquired after 20 September 1985.

A, B, C and D are also the ultimate owners of the Head Company Pty Ltd (Head Company) tax consolidated group. Their ownership in Head Company is through the Head Company Trust, which is a discretionary family trust in which they are named beneficiaries.

All of the assets and liabilities that XYZ currently holds arose after 20 September 1985.

The Owners wish to sell dispose their shareholding in XYZ to Head Company in order to consolidate these assets under one holding structure.

According to its 30 June 2011 financial statements and tax return, XYZ has a Franking account balance of $X, and a retained earnings balance of $X.

No explicit dividend policy exists for XYZ and XYZ has not paid a dividend in recent history. In the foreseeable future, XYZ will not pay a dividend to Head Company, nor will any property of XYZ be disposed in a manner, which allows Head Company to recoup or substantially recoup its initial investment.

Proposed sale of XYZ

The shareholders wish to dispose of their shareholding in XYZ to Head Company for the market value of XYZ as determined by independent market valuation of XYZ. As a result, XYZ will join the Head Company tax consolidated group.

Assumptions

On the Taxpayers' advice, the Commissioner will make the following assumption:

· Given the Taxpayer has only provided the 30 June 2011 Balance Sheet for XYZ Pty Ltd, and not more recent financial statements, the Commissioner will assume that the retained earnings balance of XYZ Pty Ltd immediately before it becomes a subsidiary member of the Head Company tax consolidated group will not decrease below $X.

Relevant legislative provisions

Section 104-10 ITAA 1997

Section 104-230 ITAA 1997

Section 177E ITAA 1936

Section 177EB ITAA 1936

Reasons for decision

Question 1:

Detailed reasoning

Section 104-10(1) of ITAA 1997 states that:

CGT event A1 happens if you dispose of a CGT asset.

Section 104-10(2) of ITAA 1997 states that:

You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur:

(a) if you stop being the legal owner of the asset but continue to be its beneficial owner; or

(b) merely because of a change of trustee.

Section 104-10(4) of ITAA 1997 states that:

You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

In the present case, one Class E share in XYZ was acquired by the Owners after 20 September 1985. The disposal of this Class E share by these joint owners to Head Company will constitute a disposal under subsection 104-10(2) of the ITAA 1997. Both XYZ and Head Company are privately held companies. There is no evidence to suggest that the Class E share in XYZ was held by a trust under an expressed trustee/beneficiary relationship. The facts put forward by the Taxpayer suggest that this Class E share was jointly owned by the four joint holders named above. Therefore, the exceptions to change of ownership under subsections 104-10(2)(a) and (b) do not apply.

Since it was acquired after 20 September 1985, subsection 104-10(5) will not apply.

Therefore, this Class E share is subject to capital gains tax upon disposal under subsection 104-10(4) of ITAA 1997, subject to confirmation that the disposal proceeds are more than the asset's cost base, then a capital gain will be made by each of the joint shareholders in relation to the disposal of their respective interests in the Class E share.

Question 2:

Detailed reasoning

Paragraph 104-10(5)(a) of ITAA 1997 states that that a capital gain or capital loss you make is disregarded if you acquired the asset before 20 September 1985.

Since the Class A shares were acquired in 1984, they are all pre-CGT shares, and therefore fall within the subsection 104-10(5)(a) of ITAA 1997. Subject to the application of CGT Event K6 (which will be discussed in Question 3), the capital gain from the proposed disposal of these shares in XYZ will be disregarded by the application of Section 104-10(5) of ITAA 1997.

Question 3:

Detailed reasoning

The Taxpayer has advised that 100% of the assets and liabilities that XYZ currently holds were acquired after 20 September 1985. Therefore, subsection 104-230(2) is satisfied because 'the market value of property of the company or trust… that was acquired on or after 20 September 1985… must be at least 75% of the net value of the company or trust' (paragraph 104-230(2)(a)).

Therefore, we can confirm that this disposal will trigger CGT Event K6 by the operation of subsection 104-230(1). We note that the Taxpayer has conceded in their question itself that CGT Event K6 will be triggered.

Given that CGT Event K6 has been triggered, the question posed is "…If the market value of the post-CGT property of XYZ is less than the cost base, will a capital gain be made from the disposal of these shares in XYZ under section 104-230 of the ITAA 1997?"

Subsection 104-230(6) of ITAA 1997 states that:

You make a capital gain equal to the part of the capital proceeds from the share or interest that is reasonably attributable to the amount by which the market value of the property referred to in subsection 2 is more than the sum of the cost bases of that property.

By applying subsection 104-230(6), we conclude that if the market value of the post-CGT property of XYZ is less than the cost base, then there will be no capital gain made from the disposal of these shares in XYZ. Furthermore, there is a note at subsection 104-230(6) that 'you cannot make a capital loss' in this situation.

To assess the quantum of any capital gain or loss, we would require the Taxpayer to furnish independent market valuation of all of the assets held by XYZ. As the Taxpayer has not provided this independent market valuation, we can only provide the above general tax advice to this question at this stage.

Question 4:

Detailed reasoning

Ordinary meaning of "dividend stripping"
Although the term "dividend stripping" is not defined in the ITAA 1936, the Explanatory Memorandum to the Act introducing section 177E of the ITAA 1936 (the Income Tax Laws Amendment Act (No 2) 1981) discussed the concept of dividend stripping as follows:

Schemes within the category of being, or being in the nature of, dividend stripping schemes would be ones where a company (the "stripper") purchases the shares in a target company that has accumulated profits that are represented by cash or other readily-realisable assets, pays the former shareholders a capital sum that reflects those profits and then draws off the profits by having paid to it a dividend (or a liquidation distribution) from the target company.


The concept of dividend stripping was outlined by Hill J in the Federal Court case CPH Property Pty Ltd and Others v Commissioner of Taxation (1998) 98 ATC 4983 at 5004:

"…it involves a company which is pregnant with accumulated profits out of which a dividend would reasonably be likely to be declared or has already been declared or where the company is about to receive profits in the future out of which a dividend would reasonably be likely to be declared."

Further, on appeal by the Commissioner to the Full Federal Court (FCT v Consolidated Press Holdings Limited (No 1) 99 ATC 4945), the Full Federal Court referred to four cases as examples of dividend stripping, and noted that those cases had the following common characteristics:

· a target company, with substantial undistributed profits creating a potential tax liability;

· the sale or allotment of shares in the target company to another party;

· the payment of a dividend to the purchaser or allottee;

· the purchaser escaping Australian tax on the dividends so declared; and

· the vendor shareholders receiving a capital sum for their shares in an amount the same as or very close to the dividends paid to the purchasers.

The Full Federal Court also noted that in each case the scheme was carefully planned for the predominant if not sole purpose of the vendor shareholders avoiding tax on a distribution of dividends.

Another common aspect of a dividend stripping scheme involves the purchase of shares in a company with substantial accumulated profits, and the drawing off of those profits by the purchaser to recoup the purchase price.

This arrangement and the circumstances described by the Taxpayer show that XYZ was incorporated in the 1960s, and at all stages of its existence XYZ has always remained an associated company to the Head Company tax consolidated group which it now seeks to join. XYZ has not paid a dividend in recent history, and in the foreseeable future, XYZ will not pay a dividend to Head Company, therefore the circumstances necessary to attract the application of section 177E will not be present.

After applying the factors considered by the Federal Court in the Consolidated Press Holdings case, we conclude that this is not a scheme that has a dominant purpose of avoiding tax that might have been otherwise payable if the profits of XYZ were distributed to its shareholders as dividends. This scheme does not constitute a traditional dividend stripping scheme nor does it have substantially the same effect of a scheme in the nature of dividend stripping, therefore section 177E of the ITAA 1936 does not apply to this arrangement.

Question 5:

Detailed reasoning

While a group is consolidated, the head company maintains a single franking account for the group as a whole, and the franking accounts of subsidiary members are inoperative. When a subsidiary member joins a consolidated group, any surplus in its franking account is transferred to the head company's franking account. The franking credit resulting from the transferred surplus remains with the head company even if the subsidiary member subsequently leaves the group.

XYZ will join the Head Company tax consolidated group and as a result the surplus in XYZ's franking account of approximately $X will be transferred to Head Company's franking account (as head company of the Head Company tax consolidated group).

Section 177EB of the ITAA 1936 states:

Application of section

(3) This section applies if:
(a) there is a scheme for a disposition of membership interests in an entity (the joining entity); and
(b) as a result of the disposition, the joining entity becomes a subsidiary member of a consolidated group; and
(c) a credit arises in the franking account of the head company of the group because of the joining entity becoming a subsidiary member of the group; and
(d) having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the credit referred to in paragraph (c) to arise in the head company's franking account.

Bare acquisition of membership interests

(4)It is not to be concluded for the purposes of paragraph (3)(d) that a person entered into or carried out a scheme for a purpose mentioned in that paragraph merely because the person acquired membership interests in the joining entity.

Relevant circumstances

(10) The relevant circumstances of a scheme include the following:
(a) the extent and duration of the risks of loss, and the opportunities for profit or gain, from holding membership interests in the joining 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 head company 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 in the joining entity);
(b) whether the head company, or a person holding membership interests in the head company, would, in the year of income in which the joining entity became a subsidiary member of the group or any later year of income, derive a greater benefit from franking credits than other persons who held membership interests in the joining entity immediately before it became a subsidiary member of the group;
(c) the extent (if any) to which the joining entity was able to pay a franked dividend or distribution immediately before it became a subsidiary member of the group;
(d) whether any consideration paid or given by or on behalf of, or received by or on behalf of, the head company in connection with the scheme (for example, the amount of any interest on a loan) was calculated by reference to the franking credit benefits to be received by the head company;
(e) the period for which the head company held membership interests in the joining entity;
(f) any of the matters referred to in subparagraphs 177D(b)(i) to (viii).

Subsection 177EB(3) of the ITAA 1936 specifies four conditions that must be satisfied for the Commissioner to make a determination under subsection 177EB(5) of the ITAA 1936 that no credit is to arise in the head company's franking account because of the joining entity becoming a subsidiary member of the consolidated group. In the present circumstances the first three pre-conditions contained in paragraphs 177EB(3)(a), (b) and (c) would be satisfied. In determining whether the fourth condition in paragraph 177EB(3)(d) is satisfied, it is necessary to consider whether, having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the credit referred to in paragraph (c) to arise in the head company's franking account.

Subsection 177EB(10) of the ITAA 1936 elaborates upon what factors are to be included in a consideration of the relevant circumstances. In the present case, the commercial reasons for the disposal of XYZ into the Head Company tax consolidated group have been provided by the Taxpayer, and have been considered highly relevant business reasons for proposing this transaction.

In addition, an important factor in the taxpayer's favour is the ability of XYZ to pay a substantial franked dividend immediately before it becomes a subsidiary member of the group, such that the transfer of any remaining excess franking credits can be seen as merely incidental in the course of implementing this scheme. XYZ's ability to pay substantial dividends is an important factor considered under subsection 177EB10(c). To ensure that subsection 177EB10(c) is properly considered in relation to the most up to date facts, the Taxpayer has consented to the Tax Office placing the following important assumption in answering this question:

The Commissioner will make the following assumption:

Given the Taxpayer has only provided the 30 June 2011 Balance Sheet for XYZ Pty Ltd, and not more recent financial statements, the Commissioner will assume that the retained earnings balance of XYZ Pty Ltd immediately before it becomes a subsidiary member of the Head Company tax consolidated group will not decrease below $X.

Other factors under subsection 177EB(10) were also considered. In relation to paragraph 177EB(10)(b), we found that on the facts provided by the Taxpayer, the Head Company, or a person holding membership interests in the Head Company, will not derive a greater benefit from franking credits than the current Owners.

Paragraph 177EB(10)(d) of the ITAA 1936 accesses whether any consideration paid or given on behalf of the Head Company in connection with the scheme was calculated by reference to the franking credit to be received by the Head Company. The ruling request states the consideration to be paid by the Head Company was to be determined based on an independent valuation of XYZ (hence arms length market value amount). The ruling indicates that the consideration will not referable to the value of XYZ's franking credits, as required by this subsection.

PS LA 2005/24 states that the identification of a tax benefit requires consideration of the income tax consequences of an alternative hypothesis (the counterfactual), which is what the current owners might reasonably be expected to have done, but for undertaking this scheme. In this case if the current owners wish to consolidate their group then Head Company has to obtain the shares in XYZ. The only way to avoid the franking credit arising in the head company's account would be to pay the current shareholders of XYZ a dividend and utilise the franking credits. Had the franking credits gone to the consolidated group (without a dividend being paid) then the owners of Head Company may receive the benefit of the franking credits, but as the sole shareholder of Head Company is the Head Company Trust, which is a discretionary trust, they may not receive any benefit. Thus there is no benefit to them of conducting this scheme as it actually may not benefit them at all.

Paragraph 94 of PS LA 2005/24 states that the identification of any step or aspect of the scheme that is apparently explicable for no purpose but a tax purpose will go to the manner in which the scheme was entered into or carried out. In this case considering both the scheme and the counterfactual there does not appear to be any steps outside normal commercial planning in order to consolidate.

We also note that pursuant to subsection 177EB(4), the bare acquisition of membership interests does not trigger section 177EB; and that subsection 177EB(5) states that "no credit is to arise" where the Commissioner makes such a determination, which precludes the possibility of partially disallowing the franking credit that arises in the head company's franking account.

After considering the facts and reasons that the Taxpayer has put forward for implementing this scheme, we have concluded that the transfer of franking credits to the head company in this case was merely incidental to this arrangement. Therefore, Commissioner will not make a determination pursuant to subsection 177EB(5) that no credit is to arise in the head company's franking account.