Edited version of your private ruling

Authorisation Number: 1012447728918

Ruling

Subject: Employee Share Trust

Question 1

Is an employee a 'qualified person' in relation to distributions from a particular employee share trust for the purposes of section 207-150 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

To the extent that the dividends distributed to the employee constitute franked distributions for the purposes of 207-B of the ITAA 1997, will the employee be entitled to tax offsets equal to his share of the franking credits on the franked distributions under section 207-45 of the ITAA 1997?

Answer

No.

This ruling applies for the following periods:

Income Tax Year ended 30 June 2013

Income Tax Year ended 30 June 2014

Income Tax Year ended 30 June 2015

Income Tax Year ended 30 June 2016

The scheme commences on:

1 July 2012

Relevant facts and circumstances

The employer intends to implement a long term equity plan (the plan) for the purpose of providing a long term equity structure to deliver equity based benefits to the employee and other eligible employees through an employee share trust.

The employer settles amounts of money upon the employer share trust and the trustee uses these amounts to make loans to eligible employees to enable the employees to acquire units in the trust.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 99A

Income Tax Assessment Act 1936 Division 1A of Part IIIAA

Income Tax Assessment Act 1936 section 160APHD

Income Tax Assessment Act 1936 subsection 160APHJ(4)

Income Tax Assessment Act 1936 section 160APHL

Income Tax Assessment Act 1936 subsection 160APHL(5)

Income Tax Assessment Act 1936 subsection 160APHL(7)

Income Tax Assessment Act 1936 subsection 160APHL(10)

Income Tax Assessment Act 1936 subsection 160APHL(11)

Income Tax Assessment Act 1936 subsection 160APHL(14)

Income Tax Assessment Act 1936 subsection 160APHM(2)

Income Tax Assessment Act 1936 subsection 160APHO(1)

Income Tax Assessment Act 1936 subsection 160APHO(2)

Income Tax Assessment Act 1936 subsection 160APHO(3)

Income Tax Assessment Act 1936 subsection 160APHM(2)

Income Tax Assessment Act 1997 Subdivision 207-B

Income Tax Assessment Act 1997 section 207-45

Income Tax Assessment Act 1997 section 207-50

Income Tax Assessment Act 1997 subsection 207-150(1)

Income Tax Assessment Act 1997 subsection 207-150(3)

Income Tax Assessment Act 1997 subsection 272-5(3)

Question 1

Summary

Is an employee a 'qualified person' in relation to distributions from a particular employee share trust for the purposes of section 207-150 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No.

Detailed reasoning

Section 207-45 of the ITAA 1997 outlines 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.

Pursuant to subsection 207-50(3) of the ITAA 1997, a franked distribution flows indirectly to a beneficiary of a trust in an income year if, and only if:

a) the distribution is made to the trustee of the trust, or flows indirectly to the trustee from another trust distribution;

b) the beneficiary has a share of the trust net income for that year; and

c) the beneficiary's share of the franked distribution is positive.

Under the plan the employee is entitled to receive a distribution equal to the dividend paid to the employee share trust, and any associated franking credits, in respect of each accounting period. The employee will therefore receive indirect franked distributions making him eligible to be entitled to tax offsets equal to his share of the franking credits on the distributions under section 207-45 of the ITAA 1997.

However, where a franked distribution flows indirectly to an entity in an income year, subsection 207-150(1) of the ITAA 1997 will deny the 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 Income Tax Assessment Act 1936 (ITAA 1936).

Qualified person

A beneficiary of a non widely held trust, as is the case in the employee's situation, must be a qualified person by satisfying both the qualification period rule and the related payments rule.

The former subsection 160APHO(1) of the ITAA 1936 defines a qualified person:

A taxpayer who has held shares or an interest in shares on which a dividend has been paid is a qualified person in relation to the dividend if:

(a) where neither the taxpayer nor an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend - the taxpayer has satisfied subsection (2) in relation to the primary qualification period in relation to the dividend; or

(b) where the taxpayer or an associate of a taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend - the taxpayer has satisfied subsection (2) in relation to the secondary qualification period in relation to the dividend.

The former subsection 160 APHO(2) ITAA 1936 defines the qualification period:

A taxpayer who has held shares or an interest in shares on which a dividend has been paid satisfies this subsection in relation to a qualification period in relation to the shares or interest if, during the period:

(a) ……

(b) where the taxpayer held the interest in the shares - the taxpayer held the interest for a continuous period (not counting the day on which the taxpayer acquired the interest or, if the taxpayer has disposed of the interest, the day on which the disposal occurred) of not less than:

(i) if the shares are not preference shares - 45 days; or


(ii) if the shares are preference shares - 90 days.

In determining whether the qualification period requirements are satisfied for the prescribed minimum period no account is taken of any days on which the employee has materially diminished risks of loss and opportunities for gain in respect of the shares as required by former subsection 160APHO(3) ITAA 1936.

Under former subsection 160APHM(2) ITAA 1936 a taxpayer has a materially diminished risk in relation to their interest if they have less than 30%, i.e. a delta of less than +0.3, of the risks associated with share ownership, as stated:

(2) A taxpayer is taken to have materially diminished risks of loss or opportunities for gain on a particular day in respect of shares held by the taxpayer, or in respect of an interest held by the taxpayer in shares, if the taxpayer's net position on that day in relation to the shares or interest has less than 30% of those risks and opportunities.

Net position worked out by reference to deltas

(3) A taxpayer's net position is worked out using the financial concept known as delta (see section 160APHJ). For example, an option to sell a share with a delta of minus 0.5 in relation to the share reduces the risks of loss and opportunities for gain by 50%.

A position with a positive delta is defined as a long position under former subsection 160 APHJ(4) ITAA 1936. This subsection expressly states an interest in shares is to be treated as a long position with a delta of +1 in relation to itself.

In this case, as the employee share trust is not widely held, the employee's interest in the relevant share is worked out according to the formula in former subsection 160APHL(5) ITAA 1936. The effect of this subsection is to determine the employee's interest in the relevant share through the use of the relevant formula. The interest is worked out from the employee's trust holding, i.e. his share of the trust corpus, modified by his share of the dividend associated with the holding.

When the employee's interest is worked out under former subsection 160APHL(5) ITAA 1936, he will have a long position with a delta of +1 in relation to his interest in the shares under former subsection 160APHL(7) ITAA 1936.

Former subsection 160APHL(10) ITAA 1936 sets out additional positions of the taxpayer to be considered in calculating the delta and states:

If:

(a) the trustee is not a family trust within the meaning of Schedule 2F; and

(b) the trust is not a trust for the purposes of this Act merely because of the reference to executors and administrators in paragraph (a) of the definition of trustee in subsection 6(1); and

(c) the taxpayer's interest in the relevant share or the relevant shares is not an employee share scheme security;

the taxpayer has, in addition to any other long and short position (including the positions that the taxpayer is taken to have under subsection (8)) in relation to the taxpayer's interest in the relevant share or relevant shares, a short position equal to the taxpayer's long position under subsection (7) and a long position equal to so much of the taxpayer's interest in the trust holding as is a fixed interest.

In regards to paragraph 160APL(10)(c), according to the terms of the employee share trust deed, it is considered that the employee's interest in the shares is a defeasible interest. It is not clear from the deed whether the interest will convert to an indefeasible interest within 10 years where the trustee does not cancel units relevant to a specific unit holder. As a result, the interest is not an employee share scheme security as defined under former section 160APHD ITAA 1936.

Therefore, under former subsection 160APHL(10) ITAA 1936 the employee will have a short position, i.e. a negative delta, equal to his long position arising under former subsection 160APHL(7) ITAA 1936, giving an overall delta of zero.

However, under former subsection 160APHL(10) ITAA 1936 the employee's interest will also give rise to a corresponding positive delta long position equal to his fixed interest in the trust holding. If this gives rise to a positive delta of at least +0.3 the employee would be entitled to claim the franking credits.

Under former subsection 160APHL(11) ITAA 1936 the taxpayer must have a vested and indefeasible interest in the part of the trust corpus comprised of their trust holding in order to have a fixed interest, as stated:

For the purposes of subsection (10), the taxpayer's interest in the trust holding is a fixed interest to the extent that the interest is constituted by a vested and indefeasible interest in so much of the corpus of the trust as is comprised by the trust holding.

A vested interest

A person has a vested right in something if he, she or it has a present right relating to it. A vested interest is one that is bound to take effect in possession at some point in time. As explained in Dwight v Commissioner of Taxation (1992) 92 ATC 4192 (Dwight), a vested interest may either be immediate, where it is described as "vested in possession" and refers to a present right of present enjoyment; or it may not, where it is described as "vested in interest" and refers to a present right of future enjoyment.

The conjunction of "vested and indefeasible' shows that the right must be absolute. A vested interest is to be contrasted with a contingent interest. The latter may never take effect in possession if the contingency is not met.

Vested and indefeasible

A vested interest is indefeasible where it is not able to be lost. It is defeasible where it can be brought to an end, and indefeasible where it cannot.

It is defeasible, for instance, where it is subject to a condition subsequent. For example, a future occurrence may lead to the divestment of a person's vested entitlement. The circumstances by which this may occur include the happening of an event, or the exercise of a power.

Events: A beneficiary's interest in particular assets of a trust will not be vested and indefeasible if:

(a) that is the effect of the Trust Deed;

(b) the assets are disposed of by the Trustee in the course of administration of the Trust prior to the vesting day;

(c) the person's status as a beneficiary as at the vesting date is subject to a condition precedent (i.e. a contingency).

Exercise of power: Where a beneficiary's vested interest is able to be divested by the exercise of a power by a trustee (or any other person), the interest is defeasible.

Does the employee have a vested and indefeasible interest?

In relation to the deed, a relevant clause requires that any outstanding loan between the employee and trust be repaid when any unit is cancelled. This clause requires immediate repayment of the loan.

Another relevant clause in the deed states that the employee will be paid any trust entitlement owed to him "subject to the repayment of any outstanding loan moneys".

The wording of the clause requiring repayment of outstanding loan moneys prior to the employee receiving trust entitlements suggests that the employee's interest is subject to a condition precedent, whereby a certain condition, being the repayment of the loan, has to be fulfilled prior to the employee's interest falling into possession. For this reason the employee's interest could be considered contingent.

In addition, the wording of the clause requiring repayment of outstanding loan moneys may also suggest that the employee's interest is subject to a condition subsequent which may lead to his entitlement being considered defeasible, whereby the employee's interest in the shares can only be satisfied in cash or by the in specie transfer of shares after the loan is repaid.

For these reasons, it is considered that the employee does not have a vested and indefeasible interest in so much of the corpus of the trust as is comprised by the trust holding.

Another clause of the deed adds further support to this conclusion as it states that once a unit is cancelled, notwithstanding that at such time it was not fully paid, no unit holder will have any liability to make any further contribution to the employee share trust or payment to the trustee in respect thereof.

Therefore, in the event that a unit is not fully paid and the unit holder does not make a further contribution to the employee share trust, the deed would operate to deny the unit holder any trust entitlements. As such, the clause requiring that an outstanding loan must to be repaid immediately after a unit is cancelled is overridden by another clause in the deed.

Distinguishing the plan from Dwight's Case

In Dwight, a plaintiff provided funds to be held as security for any costs that might be made against them should they be unsuccessful in litigation involving another entity (the defendant). In this case, the defendant had rights in the nature of an equitable lien over the funds to secure payment of it to them if an order for costs was made in their favour. The funds were held jointly by the solicitors for the plaintiff and the solicitors for the defendant. The issue became whether the plaintiff was presently entitled to interest income generated by those funds.

In Dwight, Hill J held that the plaintiff had a vested and indefeasible interest in the income and the plaintiff was therefore presently entitled to the interest. In making this finding, Hill J stated that an interest may be vested and indefeasible, notwithstanding that it is subject to a security interest in another. In addition, Hill J found that the mere existence of a lien or charge over property does not convert an interest otherwise vested and indefeasible into one that is vested but defeasible, or not vested at all.

In discussing the plaintiff's interest in the fund, Hill J went on to say, broadly speaking, that the plaintiff's funds and the interest generated on those funds remained the property of the plaintiff unless or until the court made an order for costs against the plaintiff. This right was subject only to a charge or lien in favour of the defendants to secure future cost orders.

Hill J distinguished Dwight from Harmer v FCT (1991) 173 CLR 264 (Harmer). In Harmer, a company had a fixed obligation to pay funds to another entity; however there were competing claims against those funds, so the funds were paid into court and litigation commenced to determine who was properly owed the funds. In Harmer, the High Court held that there was no beneficiary presently entitled to interest income generated by the funds paid into court and that the trustee of that money was therefore liable to tax on the resulting interest income under section 99A of the ITAA 1936. Unlike Dwight, the entity that paid the money into court had no further claim against those funds and the interests of the two claimants were, at best, contingent on the court making an order in their favour.

Similar to Harmer, under the plan, the underlying property of the employee share trust is not considered to be that of a unit holder and at best the unit holder would have an interest which is contingent on repayment of their loan. For this reason and in line with Dwight, it is not the existence of the lien that is converting an interest that is otherwise vested and indefeasible into one that is not, because the employee did not have the requisite vested and indefeasible interest in the corpus of the employee share trust to begin with.

On this basis, the employee will not have a positive delta in relation to his interest as there is no additional long position under former subsection 160APHL(10) ITAA 1936.

The employee, therefore, is not a "qualified person" for the purposes of Division 1A of former Part III AA of the ITAA 1936 as his interest in the shares will not be held for the required holding period.

Commissioner's Discretion

In circumstances where a beneficiary does not have a vested and indefeasible interest in the corpus of a trust, the Commissioner may, dependant upon the relevant circumstances, exercise the discretion available to him under former subsection 160APHL(14) of the ITAA 1936 to treat the beneficiary's interest as being vested and indefeasible. In exercising this discretion, the Commissioner is required to consider a range of factors under paragraph 160APHL(14)(c) ITAA 1936.

Subsection 160APHL(14) of the ITAA 1936 states:

160APHL(14) Commissioner may determine an interest to be vested and indefeasible.

If:

(a) the taxpayer has an interest in so much of the corpus of the trust as is comprised by the trust holding; and

(b) apart from this subsection, the interest would not be a vested or indefeasible interest; and

(c) the Commissioner considers that the interest should be treated as being vested and indefeasible, having regard to:

(i) the circumstances in which the interest is capable of not vesting or the defeasance can happen; and

(ii) the likelihood of the interest not vesting or the defeasance happening; and

(iii) the nature of the trust; and

(iv) any other matter the Commissioner thinks relevant;

the Commissioner may determine that the interest is to be taken to be vested and indefeasible.

As outlined previously, the condition under a clause requiring a unit holder to repay their loan with the trustee prior to receiving trust entitlements may be considered a condition precedent or a condition subsequent.

Where there is a condition precedent, any interest held by the unit holder would be considered contingent. As such the Commissioner would not exercise the discretion because the employee would not hold the requisite interest in the corpus of the trust as is comprised by the trust holding as required by paragraph 160APHL(14)(a) of the ITAA 1936.

In the event that the requirement to repay the loan is considered a condition subsequent and the employee is viewed as having an interest which was defeasible, it would be relevant for the Commissioner to focus on the factors provided in subparagraphs 160APHL(14)(c)(i) to (v) in exercising his discretion.

160APHL(14)(c)(i)

As discussed previously, a relevant clause in the deed requires that any outstanding loan must be repaid immediately after the cancellation of any unit. After cancellation of a unit, another clause makes it clear that, subject to the repayment of any outstanding loan moneys, no trust entitlements will be paid to a unit holder. Due to the outstanding condition of repayment of the loan, it is considered that a unit holder's interest could a condition precedent (contingent) or a condition subsequent (defeasible).

In addition, it is noted that there are other clauses in the deed which override the requirement that a loan must be repaid after cancellation of a unit. In this situation, the unit holder would not be obliged to repay the loan with the trustee and therefore the unit holder cannot be said to bear the risk of loss from shares held through the employee share trust.

160APHL(14)(c)(ii)

To be able to estimate the likelihood of a unit holder's interest not vesting or a defeasance happening, a number of additional facts would need to be ascertained at the point in time in which a unit holder's units are cancelled. For example, it is not currently possible to accurately determine whether a unit holder would be in the financial position to be able to repay their loan with the trustee or whether the unit holder would rely on a clause in the deed which indicates that no further payments are required to be made to the trustee upon cancellation of their units. As a number of assumptions would need to be relied upon, the Commissioner can not estimate the likelihood of a unit holder's interest not vesting or a defeasance happening.

160APHL(14)(c)(iii)

Subparagraph 160APHL(14)(c)(iii) requires the Commissioner to take into account the nature of the trust. In theory, this indicates that a trust exhibiting the nature of a fixed trust could contribute to the Commissioner's decision to exercise his discretion. In this case the employee share trust exhibits features of a fixed trust. However, this factor in itself is not considered determinative in exercising the Commissioner's discretion in this instance as the fixed elements of the employee share trust also contribute to the unit holdings of the employee share trust being capable of not vesting or a defeasance happening for the purposes of subparagraph 160APHL(14)(c)(i).

160APHL(14)(c)(iv)

Subparagraph 160APHL(14)(c)(iv) requires the Commissioner to consider any other matter he thinks relevant. The following factors have been taken into consideration:

The Explanatory memorandum to the Taxation Laws Amendment Bill (No. 2) 1999 (The EM) which accompanied the introduction of section 160APHL ITAA 1936 provides the following as an example of when the exercise of the Commissioner's discretion under subsection 160APHL(14) of the ITAA 1936 may be appropriate:

4.82 Even if an interest is not fixed and indefeasible, the Commissioner may, in appropriate circumstances, deem it to be so. For example, it may be appropriate to exercise this discretion, if necessary, in relation to beneficiaries of certain hardship trusts (e.g. trusts established under workers compensation legislation).

Using this example as a consideration for the exercise of this discretion, the circumstances in this case are not the type of circumstances envisaged by the introduction of the discretion under subsection 160APHL(14) of the ITAA 1936.

Generally speaking, one of the design features of the imputation system is that entities, which are not the true economic owners of a company and therefore not sufficiently subject to the risks of loss and opportunities for gain associated with ownership, are not able to claim a credit for the tax paid by the company.¹

In addition, the underlying intention of Division 1A of former Part IIIAA of the ITAA 1936 (according to the EM) is to ensure that the benefits of the franking credits on distributions paid on shares are only available to the true economic owners of the shares, that is, those persons who are sufficiently exposed to the risks of loss and opportunities for gain associated with ownership of the shares. The Division prevents persons who have only a small exposure, to the risks and opportunities of share ownership to obtain access to the full value of franking credits. As per paragraphs 4.6 and 4.7 of the EM, it was recognised that "A degree of wastage of franking credits is an intended feature of the imputation system."

It is noted that the first three factors of former subsection 160APHL(14) of the ITAA 1936 are the same as those applying in the discretion in subsection 272-5(3) of Schedule 2F to the ITAA 1936 to deem a fixed entitlement to the income and capital of a trust. Similarly such discretion is intended to provide for special circumstances where there is a low likelihood of a beneficiary's vested interest being taken away or defeated and where it would be unreasonable to treat the beneficiary's interest as not constituting a fixed entitlement.

It is the Commissioner's view that the employee would not be sufficiently exposed to the risk of loss or gain in respect of his shares.

The shares referable to the employee's unit holdings are not actively traded and therefore do not have an open market value. This indicates that the employee would not have any exposure to fluctuations in the market value of the shares.

The deed also does not allow the employee to deal with the shares held through the employee trust as he wishes and therefore does not confer the full rights of ownership. As a result, the employee does not have full economic ownership of the shares. Basically, there is no guarantee that the employee will obtain the shares upon cancellation.

Conclusion

Having considered all the factors above, it is considered that a contingency or defeasance of the interest in the Trust is possible by virtue of the deed. The likelihood of the contingency or defeasance occurring is unable to be quantified and the circumstances of this case are not of the type for which the exercise of the discretion under subsection 160APHL(14) of the ITAA 1936 was intended to apply.

Question 2

Summary

To the extent that the dividends distributed to the employee constitute franked distributions for the purposes of 207-B of the ITAA 1997, will the employee be entitled to tax offsets equal to his share of the franking credits on the franked distributions under section 207-45 of the ITAA 1997?

No.

Detailed reasoning

As the employee is not a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936, pursuant to the operation of subsection 207-150(1) of the ITAA 1997, he will not be entitled to tax offsets equal to his share of the franking credits on the franked distributions under section 207-45 of the ITAA 1997.

¹ Paragraph 3 of Taxation Determination TD 2007/11 Income tax: imputation: franking distributions qualified persons: does an entity have to be a qualified person within the meaning of Division 1A of former Part IIIAA of the Income Tax Assessment Act 1936 to avoid the application of paragraph 207-145(1)(a) and 207-150(1)(a) of the Income Tax Assessment Act 1997 in respect of a franked distribution made directly or indirectly to the entity on or after 1 July 2002?