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Ruling

Subject: Redeemable Preference Shares

Question 1

Will the proposed issue of redeemable preference shares trigger tax consequences under Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Note: This decision has been limited to the issue about the direct value shifting reversal exception. You should also consider whether the arrangement as described may cause consequences to arise for shareholders under other income tax provisions, including section 177E and Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936).

Question 2

Will the proposed issue of redeemable preference shares be treated as equity interests under Division 974 of the ITAA 1997?

Answer

Yes.

Question 3

Will the proposed issue of redeemable preference shares trigger tax consequences under subdivision 204-D of the ITAA 1997?

Answer

No

Question 4

Will the proposed issue of redeemable preference shares trigger tax consequences under Division 7A of the ITAA 1936?

Answer

No

This ruling applies for the following periods:

1 July 2012 to 30 June 2015

The scheme commences on:

1 July 2012

Relevant facts and circumstances

1. ABC Pty Ltd and XYZ Pty Ltd ('The Companies") are trading companies that operate a business and have significant retained earnings.

2. The shareholders of the Companies are EFG Pty Ltd as trustee of the AAA Trust, and HIJ Pty Ltd as trustee of the BBB Discretionary Trust (collectively referred to as the "Existing Trusts"). The Existing Trusts have all made a Family Trust Election specifying the same individual.

3. The Existing Trusts are not passive and are used in other ventures.

4. CCC Pty Ltd as trustee of the DDD Trust, and EEE Pty Ltd as trustee of the FFF trust are newly established Discretionary Trusts ("the New Trusts") which will be shareholders in a newly established company holding all of the ordinary issued shares ("the Reserve Company")

5. The New Trusts have also made Family Trust Elections specifying the same individual as the Existing Trusts. The New Trusts hold the shares in 'the Newly Established Companies'). The reason for establishing the Reserve Company and the Newly Established Companies is to have companies in the group that are held by passive discretionary trusts for asset protection purposes.

6. Then they will adopt a new Constitution for the Companies which will allow them to issue a new share class called redeemable preference shares ("RPS").

7. Each share shall cease to exist at the expiration of 47 months following its issue. No amount is payable to the shareholder on the cessation of a share.


8. Once the RPS are issued to the Reserve Company and the Newly Established Companies, a fully franked dividend equal to the retained earnings of the Companies will be declared. As the Newly Established Companies require funding to allow them to continue to acquire assets then the Companies may declare dividends to them.

9. To the extent that the dividend to the Reserve Company cannot be cash flowed, the amount of the dividend will be loaned back to the Companies and security will be taken.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 725

Income Tax Assessment Act 1997 Section 725 -10

Income Tax Assessment Act 1997 Section 725 -50

Income Tax Assessment Act 1997 Section 725 -90

Income Tax Assessment Act 1997 Section 725-145

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 Section 974-20

Income Tax Assessment Act 1997 Section 974-70

Income Tax Assessment Act 1997 Section 974-75

Income Tax Assessment Act 1997 Section 974-135

Income Tax Assessment Act 1997 Subdivision 204-D

Income Tax Assessment Act 1997 Section 204-30

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Section 109C

Income Tax Assessment Act 1936 Section 109ZC

Reasons for decision

Question 1

Summary

The proposed issue of redeemable preference shares will not trigger tax consequences for the Company under Division 725.

Detailed reasoning

There can be consequences under Division 725 where there is a direct value shift involving the equity or loan interests in a target entity, as defined in section 725-145, for which the threshold conditions in section 725-50 are satisfied.

Under section 725-50 where RPS are issued, a direct value shift under a scheme involving equity or loan interests in an entity (the target entity) only has consequences if:

1) The target entity is a company or trust at sometime during the scheme period;
2) The controlling entity test (Section 725-55) is satisfied;
3) The cause of value shift requirements (Section 725-65) are satisfied;
4) The taxpayer is an affected owner of a down interest, or an affected owner of an up interest, or both; and
5) The value shift is not one that will be reversed or results from such a reversal (Section 725-95).

In addition, under section 725-10 the direct value shift rules only apply in relation to an interest that loses value of $150,000 or more.

Firstly, under section 727-620 it is necessary to consider whether the issue of RPS will fall within the definition of an equity or loan interest. This term includes a "primary interest" in an entity and in relation to a company, an RPS is an equity interest, being a share (Section 727-520(3) Item 1).

It is also necessary to consider whether there has been a direct value shift in relation to:

- amendments to the companies constitution to permit issues of RPS;
- the issue of the RPS;
- the declaration of a dividend to the holders of RPS; and
- the payment of a dividend to the holders of RPS.

Under section 725-145 there will be a direct value shift under a scheme involving equity or loan interests if:

1) there is a decrease in the market value of one or more equity or loan interests; and
2) the decrease is reasonably attributable to one or more things done under the scheme, and it occurs at or after the time when that thing, or the first of those things, is done; and
3) it has resulted from the issue of shares at a discount or there has been an increase in the value of one or more equity or loan interests in the company issuing the RPS.

The issue of RPS themselves may trigger a value shift if they are issued at a discount to their market value.

One of the threshold conditions for there to be consequences under Division 725 is that neither of sections 725-90 and 725-95 about direct value shifts that are reversed applies (paragraph 725-50(e)).

Section 725-90 applies where the state of affairs that is brought about by the things done under the scheme:

· will more likely than not cease to exist within four years after the time that the first of those things is done; and

· does not still exist at the earlier of the end of those four years or when a realisation event happens to an affected interest for the direct value shift.

The legislative context shows that the term 'state of affairs' is used to refer to the factual circumstance that is the trigger or cause for the value shift. The state of affairs is one but for which the direct value shift would not have happened (paragraph 725-90(1)(a)). The example that follows subsection 725-90(1) reads:

Under a scheme, the voting rights attached to a class of shares in a company are changed. As a result, the market value of shares in that class decreases, and the market value of other classes of shares in the company increases. The company's constitution provides that the change is to last for only 3 years.

The relevant state of affairs here is that the Company has accumulated profits, and there is a further class of shares proposed to be on issue with discretionary dividend rights. This arrangement will satisfy the reversal exception, as the terms of issue of the RPS require that they will cease to exist at the expiration of 47 months following their issue. The exclusion from the exception in subsection 725-90(2) does not apply to the facts. The first realisation event for an affected interest happens when the new class of share ends on cancellation, this causes CGT event C2 in section 104-25 to happen, as it falls within the definition of realisation event in section 977-5. Therefore relevant state of affairs does not still exist at the time of that realisation event.

Where there is a declaration and payment of a dividend to the holder of a RPS, this state of affairs will cease to exist when the dividend is paid; and is an event that will happen within the four year period. Therefore, this arrangement will still fall under the reversal exception specified under subsections 725-90(1) and (2).

In summary, according to the facts in this case, the RPS are issued with the condition that "each share shall cease to exist at the expiration of 47 months following its issue" therefore the reversal exception under section 725-90 will apply and there will be no consequences under Division 725 for this particular RPS issuance.

This decision has been limited to the issue about the direct value shifting reversal exception. Applicants would also need to consider whether the arrangement as described may cause consequences to arise for shareholders under other income tax provisions, including section 177E and Part IVA of the Income Tax Assessment Act 1936.

Question 2

Summary

The proposed issue of RPS will be treated has equity interests under Division 974.

Detailed reasoning

The RPS are not designed to be equivalent to a loan. They are issued for a nominal amount and dividends are at the total discretion of the directors so that the shareholder has no entitlement to any dividends unless the directors exercise that discretion.

Equity test

Subsection 974-70(1) states a scheme gives rise to an equity interest in a company if, when the scheme comes into existence:

(a)the scheme satisfies the equity test in subsection 974-75(1) in relation to the company because of the existence of an interest, and

(b)the interest is not characterised as, and does not form part of a larger interest that is characterised as, a debt interest in the company, or a connected entity of the company, under Subdivision 974-B (tie-breaker rule).

The table in subsection 974-75(1) specifies that a scheme satisfies equity test in relation to a company if it gives rise to:

- Item 1 - An interest in the company as a member or stockholder of the company

- Item 3 - An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return, is at the discretion of the company or a connected entity of the company

Debt test

Section 974-20 states that a scheme satisfies the debt test in this subsection in relation to an entity if:

(a) the scheme is a financing arrangement for the entity, and

(b) the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme; and

(c) the entity has, or the entity and a connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when

(i) the financial benefit referred to in paragraph (b) is received if there is only one, or

(ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and

(a) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(b) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

The scheme does not need to satisfy paragraph 974-20(a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company).

Meaning of effectively non-contingent obligation (ENCO)

Section 974-135 specifies:

(1) there is an ENCO to take action under a scheme if there is in substance or effect a non-contingent obligation to take action

(3) an obligation is non-contingent on any event, condition or situation, other than the ability or willingness of that entity or connected entity to meet the obligation.

It is considered that the dividend class shares fail the debt test as there is no ENCO as required by paragraph 974-20(1)(c). The company's ability to pay a dividend will depend on profits because it can only pay dividends out of profits pursuant to section 254T of the Corporations Act 2001. Further, any redemption of the dividend class share is at the discretion of the directors of the taxpayer.

As there is no ENCO, the requirements of paragraph 974-20(1)(d) will not be met (that is, that it is substantially more likely than not that the value of the financial benefit provided will equal or exceed the value of the financial benefit received).

The issue of the dividend class shares is a scheme that falls within Item 1 of the equity interest table in subsection 974-75(1). Further the dividend class shares are not characterised as, and do not form, part of a larger interest that is characterised as a debt interest in the issuing company. The dividend class shares should therefore be classified as an equity interest as defined above in section 974-70.

Question 3

Summary

The proposed issue of redeemable preference shares will not trigger tax consequences under subdivision 204-D.

Detailed reasoning

Subdivision 204-D contains provisions which aim to prevent the streaming of franking credits to one member of a corporate tax entity in preference to another.

Section 204-30 applies where an entity streams one or more distributions in such a way that the franking credits attaching to the distribution are received by those members of the entity who derive a greater benefit from them; and other members receive lesser imputation or no imputation benefits.

For this section to apply, members to whom distributions are streamed must be in a position to derive a greater benefit from the franking credits than other members.

Subsection 204-30(8) details examples of when a member of an entity will be taken to have derived a greater benefit from franking credits than another member. These are where the other member:

1) is not an Australian resident;
2) is not entitled to use the tax offset under Division 207;
3) incurs a tax liability as a result of the distribution that is less than the benefit associated with the tax offset attributable to the distributions;
4) is a corporate tax entity at the time the distribution is made, but no franking credit arises for the entity as a result of the distribution;
5) is a corporate tax entity at the time the distribution is made, but cannot use the franking credits to frank a distribution to its own members because it is not a franking entity or is unable to make a frankable distribution; and

6) is an exempting entity.

Streaming is not a defined term but the Explanatory Memorandum, to the New Business Tax (Imputation) 2002 at Chapter 3, Paragraph 28 described streaming as "selectively directing the flow of franked distributions to those members who can most benefit from imputation credits. "

The Explanatory Memorandum also states at paragraph 3.36 that in most cases, the members less able to benefit from imputation credits have a real interest in the undistributed profits of the corporate tax entity, although the entity may not have yet allocated those profits to the members. However, some corporate tax entities have membership interests where the rights of the members holding those interests are effectively discretionary, since the entity can make distributions to some members to the exclusion of other members at its discretion. In these entities, which are usually family companies or trusts, the members do not have anything, in a sense relevant for streaming purposes, resembling a definite interest in the profits of the corporate tax entity; they have only a possibility of being considered as a possible recipient of distributions.

At paragraph 3.37 of the EM states that in these cases, the receipt of franked distribution by one class of members does not imply that the other classes of members who have not received a franked distribution have deferred distribution of their share in the profits. More commonly it is reasonable to assume that they have simply missed out on any share in the profits. This is not streaming; all members with an actual share of the profits have appropriately received franked distributions.

The EM further states at paragraph 3.38 that the distribution of franked and unfranked distributions by a closely-held family company or trust among family members is unlikely to be streaming.

In the present case the company is issuing dividend class shares to the specific shareholders on the same terms and for the same price per share. The right to receive dividends under the dividend class shares is at the discretion of the directors of the company with the consent of the ordinary shareholder and the directors may pay dividends differently between different classes of dividend class shareholders.

It is considered that the ability of the directors to pay dividends differently between different classes of dividend class shareholders does not necessarily indicate the presence of dividend streaming.

In summary, there is no dividend streaming because the dividend policy is the same for the ordinary and dividend class shareholders. The distribution of dividends is at the discretion of the directors and the ordinary shareholder gives up any benefits it may receive from the distribution if the directors make dividend distribution to the dividend class shareholders.

Also, as outlined in the EM, where the interests of the shareholders are discretionary, the shareholders just have the possibility of being considered for a distribution. There is no guarantee that they will get it, so the distribution of franked dividends to one class of shareholders over another class of shareholders does not always indicate that streaming will occur.

While the two classes of shareholders are different, those within the same class of shareholdings will receive the same proportion of franked or unfranked dividends. Therefore it cannot be shown that the company is streaming the dividends to a particular class of shareholders.

Question 4

Summary

The proposed payment of a dividend to RPS holders will not trigger tax consequences under Division 7A of the ITAA 1936.

Detailed reasoning

Division 7A of the ITAA 1936 operates to treat certain payments and loans made by private companies as a deemed dividend (unfranked) in the hands of the recipient.

In this case the Company proposes to declare a dividend to the holders of the RPS and there are no other loans or forgiveness of debt being undertaken as a part of this scheme.

Payments covered by section 109C of the ITAA 1936 are limited to payments that are not otherwise dividends. Therefore the proposed payment of a dividend to the RPS holders will not trigger tax consequences under Division 7A of the ITAA 1936.