Edited version of your private ruling

Authorisation Number: 1012500784150

Ruling

Subject: Franking credits

Question

Will the anti-avoidance provision, section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936), apply to the Trustee of the Trust (the Trust) in relation to the arrangement?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commenced on:

1 July 2012

Relevant facts and circumstances

After qualifying for the 45 day holding period rule, the Trust sold x Company A shares on an ex-dividend basis for $y per share.

The Trust subsequently bought x Company A shares on a cum-dividend basis for $w per share on the same day.

Subsequently, the Trust received a dividend of z cents per share for both parcels of Company A shares. The dividend was fully franked.

The second parcel of Company A shares was held for a sufficient period to meet the 45 day holding period rule.

Each shareholding was held fully at risk.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 204-30.

Income Tax Assessment Act 1997 Subdivision 207-A.

Income Tax Assessment Act 1997 Subdivision 207-B.

Income Tax Assessment Act 1997 Section 995-1.

Income Tax Assessment Act 1936 Paragraph 128B(3)(ga)

Income Tax Assessment Act 1936 Sections 160APHC to 160APHU.

Income Tax Assessment Act 1936 Section 177EA.

Income Tax Assessment Act 1936 Section 177D.

Reasons for decision

Dividends and Imputation

The general rule in relation to the receipt of franked dividends as set out in Subdivision 207-A of the Income Tax Assessment Act 1997 (ITAA 1997) is that for the income year in which the distribution is made, the recipient of a franked distribution:

· includes in their assessable income the amount of the franking credit on the distribution. This is in addition to any other amount included in the recipient's assessable income in relation to the distribution itself (i.e. in addition to the amount of the dividend itself under section 44 of the ITAA 1936.

· is entitled to a tax offset equal to the franking credit.

Subdivision 207-B of the ITAA 1997 contains special rules for dividends received by an interposed entity. In the case of a superannuation fund, the rules generally state that the trustee will include the amount of the dividend, grossed up by the amount of the franking credit, and will be entitled to the tax offset equal to the franking credit.

However, the effect of these general rules is nullified by the operation of section 207-145 of the ITAA 1997. If a franked distribution is made in the circumstances outlined in that section, then the inclusion of the franking credit and tax offset entitlement outlined above is not available. Pursuant to paragraph 207-145(1)(b), one of the circumstances in which this can happen is if the Commissioner has made a determination under paragraph 177EA(5)(b) of the ITAA 1936 to deny an imputation benefit in respect of a franked distribution.

General anti-avoidance rule and the application of section 177EA of the ITAA 1936

Section 177EA of the ITAA 1936 is a general anti-avoidance rule that safeguards the operation of the imputation system. The purpose of section 177EA is to protect the imputation system from abuse and ensure that the benefits of the imputation system flow to the economic owner of the share which is the source of the franked distribution. This is made clear in the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 3) 1998 (Explanatory Memorandum) that accompanied the introduction of section 177EA which provided:

"8.5 Two of the underlying principles of the imputation system are, firstly, that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves and, secondly, that tax paid at the company level is in broad terms imputed to shareholders proportionately to their shareholdings.

8.6 Franking credit trading schemes allow franking credits to be inappropriately transferred by, for example, allowing the full value of franking credits to be accessed without bearing the economic risk of holding the shares. These schemes undermine the first principle.

8.7 Companies can also engage in dividend streaming (i.e. the distribution of franking credits to select shareholders), which undermines the second principle by attributing tax paid on behalf of all shareholders to only some of them. Generally this entails the streaming of franking credits to taxable residents and away from non-residents and tax-exempts.

8.8 The Bill introduces a general anti-avoidance rule and anti-streaming measures to restore these underlying principles of the imputation system."

These principles are reinforced by commentary in the Supplementary Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 3) 1998 (Supplementary Explanatory Memorandum) that accompanied the amending legislation which further made reference to the concept of 'wastage' as follows:

"2.3 The object of the new section 177EA is to prevent abuse of the imputation system through schemes which circumvent the basic rules for the franking of dividends, including the proposed new holding period and related payment rules. New section 177EA is intended to be a 'catch-all' provision to deal with schemes not otherwise prevented by those basic rules. The policy of the Act in relation to imputation is explained in the principal explanatory memorandum at paragraph 8.5. One result of that policy is that there is an intended level of 'wastage' of franking credits resulting from their distribution to persons who cannot use them. Broadly speaking, abuse of the imputation system occurs when under a scheme franked distributions are diverted from the real owners of interests in companies, who have no use or a relatively limited use from franking benefits, to a person who has a relatively greater use for them, but who is not in substance the owner of an interest in the company: this is termed franking credit trading. Another form of abuse is the selective direction of franked dividends to only those shareholders, or holders of interests in shares, who have the greatest use for franking benefits; this is termed 'dividend streaming'. [Item 25, new section 177EA]"

Section 177EA of the ITAA 1936 can apply if, but for its application, a relevant taxpayer would receive or could reasonably be expected to receive an imputation benefit, and other conditions specified in subsection 177EA(3) of the ITAA 1936 are satisfied. Where these conditions are satisfied, the Commissioner has a discretion to either cancel the imputation benefits that would otherwise arise for the relevant taxpayer that receives a franked distribution, or (in certain circumstances) to make a franking debit determination for a corporate tax entity that makes a franked distribution.

Section 177EA of the ITAA 1936 will operate in circumstances where the following conditions as set out in subsection 177AE(3) of the ITAA 1936 are satisfied:

(a) there is a scheme for the disposition of membership interests, or an interest in membership interests, in a corporate tax entity;

(b) a frankable distribution has been, or is expected to be, paid in respect of the membership interests, or has flowed indirectly, or is expected to flow indirectly, in respect of the interest in the membership interests, to a person;

(c) the distribution was or is expected to be a franked distribution;

(d) except for section 177EA of the ITAA 1936, the person would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution;

(e) having regard to the relevant circumstances of the scheme (as set out in subsection 177EA(17)) of the ITAA 1936, it would be concluded that the person or one of the persons who entered into or carried out the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

The application of section 177EA of the ITAA 1936 to a particular scheme depends upon a careful weighing of all the relevant facts and surrounding circumstances.

Each of these conditions is considered below.

a) There is a scheme for the disposition of membership interests

The first requirement of subsection 177EA(3) of the ITAA 1936 is that there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity (paragraph 177EA(3)(a) of the ITAA 1936). Subsection 177EA(14) of the ITAA 1936 provides an inclusive meaning for the term 'scheme for a disposition' of membership interests or an interest in membership interests, by reference to a scheme which involves any of the matters set out in paragraphs 177EA(14)(a) to (f) of the ITAA 1936. Pursuant to paragraph 177EA(14)(b) of the ITAA 1936, a scheme for a disposition of membership interests or an interest in membership interests includes entering into any contract or arrangement that changes the legal or equitable ownership of the membership interests.

In the present case, the purchase of the 'replacement' Company A shares on the cum-dividend market on the same day that the Trust disposed of its 'original' Company A shares on the ex-dividend market constitutes a scheme for a disposition of membership interests as the legal ownership of the shares has changed. Hence Paragraph 177EA(3)(a) of the ITAA 1936 is satisfied as there is a scheme for the disposition of membership interests.

b) A frankable dividend is paid in respect of the membership interests

Secondly, paragraph 177EA(3)(b) of the ITAA 1936 requires that the franked distribution needs to flow directly to a person in respect of a membership interest.

As per the facts:

· a dividend of z cents per share is paid for each Company A share, and

· the dividend is fully franked

The Trust is able to receive the dividend and associated franking credit twice (in respect of its membership interests in Company A), once as the holder of the x shares that it sold ex-dividend and again as the holder of the x shares that it bought cum-dividend.

c) The distribution was, or is expected to be a franked distribution

Thirdly, paragraph 177EA(3)(c) of the ITAA 1936 requires that the distribution is a franked distribution. In the present case a dividend of z cents per share is paid for each Company A share and the dividend is fully franked.

d) The relevant taxpayer would receive an imputation benefit from the distribution

Paragraph 177EA(3)(d) of the ITAA 1936 requires that, except for the operation of section 177EA of the ITAA 1936, the relevant taxpayer would receive or be reasonably expected to receive imputation benefits as a result of the distribution. In this context, Subsection 177EA(2) of the ITAA 1936 provides that any expression defined in the ITAA 1997 has the same meaning as in the ITAA 1936. Section 995-1 of the ITAA 1997 provides that imputation benefit has the meaning given by section 204-30(6) of the ITAA 1997. Subsection 204-30(6) of the ITAA 1997 provides that a member of an entity receives an imputation benefit as a result of a distribution if

(a) the member is entitled to a tax offset under Division 207 of the ITAA 1997 as a result of the distribution; or

(b) an amount would be included in the member's assessable income as a result of the distribution because of the operation of section 207-35 of the ITAA 1997; or

(c) a franking credit would arise in the franking account of the member as a result of the distribution; or

(d) an exempting credit would arise in the exempting account of the member as a result of the distribution; or

(e) the member would not be liable to pay withholding tax on the distribution, because of the operation of paragraph 128B(3)(ga) of the ITAA 1936, or

(f) the member is entitled to a tax offset under section 210-170 of the ITAA 1997 as a result of the distribution.

With respect to the distributions received on both parcels of shares, it is accepted that the Trust will include the amount of the dividend in its assessable income, grossed up by the amount of the imputation credit. Further, absent the operation of 177EA of the ITAA, the Trust is entitled to claim the imputation benefit in respect of both distributions This condition is therefore satisfied.

e) The scheme is entered into for the purpose of obtaining the imputation benefit

Section 177EA(3)(e) of the ITAA 1936 requires a conclusion, having regard to the 'relevant circumstances' of the scheme, 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 of enabling the relevant taxpayer to obtain an imputation benefit. The purpose does not need to be the dominant purpose, but it must be more than an incidental purpose.

Subsection 177EA(17) of the ITAA 1936 provides the 'relevant circumstances' that are to be considered in drawing any conclusion of purpose, including the eight factors listed in paragraph 177D(b) of the ITAA 1936. However, subsection 177EA(17) of the ITAA 1936 does not provide an exhaustive list of relevant circumstances.

Each of the 'relevant circumstances' will now be considered as they relate to the present situation:

Paragraph 177EA(17)(a)

Paragraph 177EA(17)(a) of the ITAA 1936 refers to the extent and duration of the risks of loss and the opportunities for profit from holding the Company A shares.

The Trust's exposure to the relevant Company A securities over the course of the arrangement constitutes an exposure to a single group of x Company A shares. This group is sold (the ex-dividend shares) and repurchased (the cum-dividend shares) on the same day such that the Trust is only exposed to price movements for x shares. Conversely, the nature of the arrangement allows the Trust to benefit from the dividend and associated franking credits in respect of 2x shares. This offends one of the basic tenets of the imputation system as provided in the Explanatory Memorandum that accompanied the introduction of section 177EA of the ITAA 1936, which states that the benefits of imputation should only be available to the true economic owners of shares.

Generally, the greater the risk borne by the taxpayer receiving the franking credit benefit, the less likely it is that the requisite purpose in paragraph 177EA(3)(e) of the ITAA 1936 is present (paragraph 8.82 of the Explanatory Memorandum). In the present circumstances, it is considered that the economic exposure to the risks of ownership of one parcel of shares whilst benefitting from the fruits of ownership of two parcels of shares weighs heavily towards a conclusion as to the existence of the requisite purpose.

Accordingly, this matter supports a finding of the requisite purpose under paragraph 177EA(3)(e) of the ITAA 1936.

Paragraph 177EA(17)(b)

Paragraph 177EA(17)(b) of the ITAA 1936 refers to whether the relevant taxpayer would, in the year of income in which the distribution is made, derive a greater benefit from franking credits than other entities who hold membership interests in the company.

The Trust is a superannuation entity which is subject to an ordinary tax rate of 15%. The expression 'greater benefit from franking credits' is defined in section 995-1 of the ITAA 1997 as having a meaning affected by subsections 204-30(7) and (8) of the ITAA 1997. Subsections 204-30(7) and (8) of the ITAA 1997 provide that a favoured member of an entity derives a greater benefit from franking credits if the other member is a foreign resident. Whilst the arrangement takes place on a public exchange and it is thus difficult to identify the identity of the seller of the cum-dividend shares, it is considered that the only rationale that would lead to a supply of cum-dividend shares is where investors or entities are unable to utilise the impending receipt of imputation credits under the applicable provisions of the ITAA 1936 and those investors or entities were inadvertently or otherwise not in a position to dispose of their shares prior to the ex-date.

In this context, it is considered that a significant source of the cum-dividend shares would be non-resident holders, who are generally only able to derive a limited advantage from the receipt of an imputation credit, and are also generally not subject to Australian capital gains on the disposal of a publicly listed share.

Further, as an entity taxed at a rate of 15% that receives a refundable tax offset for franking credits at the rate of 30% for fully franked dividends, the Trust would derive a greater benefit from franking credits than a non-resident holder who sold their shares on the cum-dividend market. Accordingly paragraph 177EA(17)(b) of the ITAA 1936 is satisfied.

Paragraph 177EA(17)(c)

Paragraph 177EA(17)(c) of the ITAA 1936 refers to 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).

In the present case, the arrangement is not considered likely to influence the behaviour of the corporate tax entity making the franked distribution and thus this relevant circumstance is not indicative as to the existence of the relevant purpose.

Paragraph 177EA(17)(d)

Paragraph 177EA(17)(d) of the ITAA 1936 refers to whether, apart from the scheme, a franked distribution would have flowed indirectly to another entity referred to in paragraph (b). Again, there is no evidence to suggest that a franked distribution would have flowed indirectly to another entity.

Thus as with paragraph 177EA(17)(c) of the ITAA 1936, the matter in paragraph (d) does not point towards the requisite purpose.

Paragraph 177EA(17)(e)

Paragraph 177EA(17)(e) of the ITAA 1936 states:

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

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

(ii) distributions in respect of which are frankable.

The arrangement is in respect of ordinary shares thus paragraph 177EA(17)(e) of the ITAA 1936 is not relevant.

Paragraph 177EA(17)(f)

Paragraph 177EA(17)(f) of the ITAA 193 states that it is relevant whether any consideration paid, given or received by or on behalf of the relevant taxpayer was calculated by reference to the imputation benefit to be received by the relevant taxpayer.

The Trust purchased the cum-dividend shares on a public market for a price q cents more than they had just received for the sale of their ex-dividend shares. In this situation, there will be no contract for sale or agreement outlining how the parties have priced the transaction. Rather, the Trust has purchased on market for what it considered to be an acceptable price. However, this does not automatically defeat a conclusion that the benefit of the franking credits that will be attached to the announced dividend was not taken into account by the Trust in making the purchase decision. Viewed objectively, the Trust has paid an additional q cents for the cum-dividend shares. The only advantage this additional payment secures is the right to receive the additional dividend and franking credit. In an objective sense, it is unlikely a capital sum of q cents would be outlaid to 'purchase' an income entitlement of z cents. In this regard, it is considered that the consideration given by the Trust for the purchase of the Company A shares has taken into account the imputation benefit to be received in its pricing decision, as it is only after taking into account the imputation benefit that the pricing of the transaction makes any commercial sense.

Accordingly, the circumstance in paragraph 177EA(17)(f) of the ITAA 1936 points towards the presence of the requisite purpose.

Paragraph 177EA(17)(g)

Paragraph 177EA(17)(g) of the ITAA 1936 refers to 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. Pursuant to the arrangement, the Trust acquires the Company A shares on the cum-dividend market which involves them paying consideration for the shares that included a consideration of the value of the dividend as evidenced by the difference in the ex-dividend price and the cum-dividend price. After the dividend has been paid on the cum-dividend shares (or the cum-dividend shares themselves commence trading ex-dividend) the value of the shares will be reduced by the approximate value of the dividend. This may potentially give rise to a capital loss in the future if the Company A shares are disposed of. However, it is conceded that such a disposal and realisation of the potential capital loss is not an integral part of the arrangement.

Thus, the consideration in paragraph 177EA(17)(g) of the ITAA 1936 does not indicate a purpose of enabling the relevant taxpayer to obtain an imputation benefit.

Paragraph 177EA(17)(ga)

Paragraph 177EA(17)(ga) of the ITAA 1936 refers to whether a distribution made under the scheme is sourced from unrealised or untaxed profits.

The Trust is a passive recipient of a dividend paid. The source of the distribution is not relevant to the present arrangement. Accordingly, this characteristic in paragraph 177EA(17)(ga) of the ITAA 1936 does not indicate a purpose of enabling the Trust to obtain an imputation benefit.

Paragraph 177EA(17)(h)

Paragraph 177EA(17)(h) refers to whether a distribution under the scheme is equivalent to the receipt of interest or an amount in the nature of, or similar to, interest.

The dividends received in the present arrangement are ordinary dividends sourced in the profits of the paying entity. As it would appear that the shares in substance do not give rise to an interest like return, the matter in paragraph 177EA(17)(h) of the ITAA 1936 does not incline towards the presence of the requisite purpose.

Paragraph 177EA(17)(i)

Paragraph 177EA(17)(i) refers to the period for which the relevant taxpayer held membership interests, or had an interest in membership interests in the corporate tax entity.

If the present arrangement is pursued on a regular basis, it is likely that shares will be held for a period of six months at the end of which time legal ownership of ex-dividend shares will again be exchanged for legal ownership of the same number of cum-dividend shares. To a certain extent, such relatively short term trades are inconsistent with the long term nature of superannuation fund investing; however the ultimate exposure of the fund to the underlying share does not change in the long term. In simple terms, in the present situation, the fund would be exposed to x Company A shares in the long term, it would just be different Company A shares every six months. This 'churning' would be suggestive of a transaction motivated by something other than long term investment objectives. However, the Trust would be exposed to market movements for the x shares.

Paragraph 177EA(17)(j)

This paragraph requires an examination of the eight factors listed in section 177D(b) of the ITAA 1936:

(i) Manner in which scheme entered into or carried out;

(ii) Form and substance of scheme;

(iii) Timing and duration of scheme;

(iv) Result achieved by scheme under tax legislation;

(v) Change in financial position of taxpayer;

(vi) Change in financial position of connected persons;

(vii) Other consequences for taxpayer or other person;

(viii) Nature of connection between taxpayer and other persons.

Of these factors subparagraphs 177D(b)(i) to 177D(b)(v) of the ITAA 1936 are considered the most relevant.

Subparagraph 177D(b)(i) - Manner in which scheme entered into or carried out

In the context of subparagraph 177D(b)(i) of the ITAA 1936, the High Court said in FCT v. Spotless Services (1996) 34 ATR 183 at 191 that 'the terms 'manner' and 'entered into' are not given any restricted meaning. 'Manner' includes consideration of the way in which and method or procedure by which the particular scheme in question was established.'

Whilst the transaction takes place on the ASX, it does not take place on the ordinary market. In the ordinary course of trading on the ASX the terms cum-dividend and ex-dividend are mutually exclusive in the sense that a share is cum-dividend until it goes ex-dividend. It is only in a 'Special Market' that a share can be acquired cum-dividend after the ex-dividend date.

Thus, the manner in which the transaction takes place on the 'Special Market' would suggest that the sourcing of the imputation benefit by the Trust who values the benefit, from another entity who values it less, is suggestive that tax considerations are a considerable driver of the transaction as opposed to the transaction being an ordinary trade.

It is considered that the manner in which the scheme is entered into is indicative of the requisite purpose.

Subparagraph 177D(b)(ii) - Form and substance of scheme

In respect of subparagraph 177D(b)(ii), Callinan J stated in Federal Commissioner of Taxation v. Hart (2004) ATC 4599:

The reference in s177D(b)(ii) to the 'substance of the scheme' invites attention to what in fact the taxpayer may achieve by carrying it out, that is to matters whether forming part of, or not to be found within the four corners of an agreement or an arrangement. They also require that substance rather than form be the focus.

In your case, the substance of the arrangement is that the Trust has a continuing investment in Company A constituted by the original ex-dividend shares and the exact same number of replacement cum-dividend shares; i.e. in substance the Trust holds x shares in Company A. By way of contrast, the legal form of the arrangement is for the Trust to hold 2x Company A in two different parcels, with both parcels conferring an entitlement to dividends and franking credits. This disparity between the form and substance of the scheme is indicative of the requisite purpose.

Subparagraph 177D(b)(iii) - Timing and duration of scheme

With respect to subparagraph 177D(b)(iii) of the ITAA 1936 the timing of the scheme is very tight. The scheme can only be achieved on the two days following the ex-dividend day when the ASX allows the Special Market to operate in which the cum-dividend shares can be purchased. To purchase the shares earlier would involve double the outlay of capital (in that you would have to remain the owner of parcel A whilst purchasing parcel B). Further, if a taxpayer owned both parcels of shares at the same time and then disposed of parcel A, the application of the 'last-in first-out' rule in former section 160APHI of the ITAA 1936 would mean that the taxpayer would not be capable of being treated as a qualified person in respect of parcel B, which they would be taken to have disposed for the purposes of the holding period rule.

Subparagraph 177D(b)(iv) - Result achieved by scheme under tax legislation

With respect to subparagraph 177D(b)(iv) of the ITAA 1936, without the application of section 177EA of the ITAA 1936, it is likely that the Trust would receive a refundable tax offset in respect of the dividends received on both parcels of shares.

Subparagraph 177D(b)(v) - Change in financial position of taxpayer

With respect to subparagraph 177D(b)(v) of the ITAA 1936, the financial position of the trust will be improved through the receipt of the refundable tax offsets.

The remaining circumstances in subsection 177D(b) are not considered relevant in the present matter.

Conclusion

As stated, the matters listed in subsection 177EA(17) of the ITAA 1936 are not exhaustive of the 'relevant circumstances' which would support a conclusion that the requisite purpose of obtaining an imputation benefit existed. Further, paragraph 177EA(3)(e) of the ITAA 1936 does not require a conclusion that the dominant purpose was to obtain imputation benefits. It will be sufficient that, having regard to all relevant circumstances, the investor or one of the persons who entered into or carried out the scheme (including the Trust) did so for a purpose (other than an incidental purpose) of enabling the Trust to obtain an imputation benefit. Further, it is not necessary that every one of the factors listed in subsection 177EA(17) of the ITAA 1936 or paragraph 177D(b) of the ITAA 1936 be relevant to the scheme. The "overwhelming weight" of one factor alone may be sufficiently significant to form a conclusion as to purpose.

Overall, it is considered that based on the information provided, a reasonable person would conclude, after considering all the relevant circumstances, that the purpose of the scheme of enabling the Trust to obtain imputation benefits was more than incidental. The trade would make no sense if the tax considerations were not present. Whilst a counterfactual analysis is not necessary, it is considered that the only counterfactual would be to maintain ownership of the ex-dividend shares. This is what is achieved by the strategy in economic terms when a taxpayer strips away the franking credit benefit.

Therefore, on balance, the conditions of section 177EA of the ITAA 1936 are satisfied and consequently the anti-avoidance provisions apply to the arrangement. Thus, the Commissioner would make a determination pursuant to paragraph 177EA(5)(b) of the ITAA that no imputation benefit is to arise in respect of the franked dividend paid in respect of the second parcel of Company A shares acquired by the Trust pursuant to the arrangement. The effect of such a determination would be that the Trust would not include the franking credit received in respect of the second parcel of shares in its assessable income and would not be entitled to a tax offset in respect of the franking credit pursuant to subsection 207-145(1) of the ITAA 1997.