Edited version of your private ruling

Authorisation Number: 1012577693879

Ruling

Subject: Dividend Access Share (DAS) Arrangement

Question 1

Is the DAS arrangement of the type described in the private ruling application a scheme 'by way of or in the nature of dividend stripping within the meaning of section 177E of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No. Having regard to the purpose of the DAS arrangement and the relevant circumstances (including the fact that the sole shareholder in both the original company and the newly established company receiving the dividend is, and will remain, the same resident individual taxpayer), section 177E of the ITAA 1936 does not apply in relation to the arrangement as described.

Question 2

If the DAS is redeemed or ceases to exist automatically within four years of issue, will the requirements of section 725-90 of the Income Tax Assessment Act 1997 (ITAA 1997) be satisfied and no amount will be treated as a capital gain under CGT event K8 under section 104-250 of the ITAA 1997?

Answer

Yes, if the dividend is paid and the DAS is redeemed or ceases to exist automatically within four years of issue, the requirements of section 725-90 of the ITAA 1997 be satisfied and no amount will be treated as a capital gain under CGT event K8 of section 104-250 of the ITAA 1997.

Question 3

Would the issue of the 'DAS satisfy the equity interest meaning of subdivision 974-C of the ITAA 1997 and would not be considered a debt interest under subsection 974-20(1) of the ITAA 1997?

Answer

Yes the share is an equity interest within the meaning of section 974-70 of the ITAA 1997.

Question 4

Would the provisions of subdivision 204-D of the ITAA 1997 (dividend streaming) apply to this arrangement?

Answer

No.

Question 5

Would the provisions of Division 7A of Part III of the ITAA 1936 not apply to the payment of a dividend following the issue of a DAS to a private company shareholder?

Answer

Given that the payment on the DAS is in fact a dividend payment, there is nothing to which Division 7A can apply.

Question 6

Would the arrangement described be a scheme to which sections 177A to 177D of Part IVA of the ITAA 1936 may apply?

Answer

No.

This ruling applies for the following period:

1 July 2013 to 30 June 2014.

The scheme commences on:

The date of the Ruling

Relevant facts and circumstances

Background

XY Pty Ltd is an Australian resident company incorporated in 200X and wholly owned by A. A was and remains the sole shareholder since incorporation of the company. The company is a profitable trading company and A is the sole director of the company.

As at 30 June 2013, the share capital of XY Pty Ltd comprised X ordinary shares. The company's financial statements for the year ended 30 June 2013 show an amount of retained earnings but no amount for share capital. The company, as at 1 July 2013, had a franking account balance and in mm/20XX the balance had increased.

The current dividend policy of XY Pty Ltd is to declare (fully franked) dividends at the discretion of the sole director, A. Dividends have been paid where funds were surplus to the company's needs and when A required funds for private purposes.

XY Pty Ltd proposes to undertake a restructure whereby it will issue one DAS to a newly incorporated entity (Newco) and subsequently pay a significant dividend to Newco. The DAS will then be redeemed.

XY Pty Ltd states the purpose for undertaking the proposed restructure is to:

(a) provide a level of asset protection to both A and XY Pty Ltd (while still having the full amount of the funds available to be loaned back to XY Pty Ltd should the need arise); and

(b) reduce the net assets of XY Pty Ltd in preparation for the implementation of an employee share arrangement whereby key employees can acquire new ordinary shares in the company at a more achievable market value share price.

The Constitution of XY Pty Ltd as originally drafted in 200X provides a clause for the issue of DASs. The DAS, when issued, will have the following characteristics:

· The right to a fixed, cumulative preferential dividend at a rate determined at the discretion of the sole director and payable within 30 days. [Clause of the Constitution]

· Issue price of X ($X).

· Voting rights are limited to the right to vote at general meetings in the event that:

o the dividend payable on the DAS is more than 30 days in arrears;

o there is a proposal to wind up the company, sell or dispose of the company's main undertaking, reduce or return issued capital, or any other matter which affects the rights attached to the DAS. [Clause of the Constitution]

· No rights to participate in surplus assets on winding up other than a return of the issue price. [Clause of the Constitution]

· Redeemable at the discretion of the director for no payment or automatically for no payment within X months of the date of issue. [Clause of the Constitution]

Proposed arrangement

The proposed restructure involves the following steps:

· Newco will be incorporated. Newco will be an Australian resident company and its sole shareholder will be A.

· XY Pty Ltd will, for payment of the issue price of $X, issue one DAS to Newco.

· XY Pty Ltd will declare and pay a fully franked dividend to Newco.

· The monies from the dividend will be deposited into Newco's bank account as soon as possible after the dividend is paid.

· The DAS will be redeemed by XY Pty Ltd approximately 1 month before the implementation and issue of the employee share arrangement.

Following the redemption of the DAS new ordinary shares will be offered to a number of key employees of XY Pty Ltd:

The ordinary shares will be offered to the key employees at full market value. XY Pty Ltd intends to provide a loan to the key employees to facilitate their acquisition of ordinary shares at full market value.

Newco will not issue shares to any entity other than A.

XY Pty Ltd proposes to maintain its dividend policy of paying dividends where funds are surplus to the company's needs.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 7A of Part III

Income Tax Assessment Act 1936 section 177A

Income Tax Assessment Act 1936 section 177C

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1997 section 104-250

Income Tax Assessment Act 1997 Subdivision 122-A

Income Tax Assessment Act 1997 Subdivision 204-D

Income Tax Assessment Act 1997 section 204-30

Income Tax Assessment Act 1997 section 725-90

Income Tax Assessment Act 1997 section 725-145

Income Tax Assessment Act 1997 Subdivision 974-C

Income Tax Assessment Act 1997 section 974-20

Income Tax Assessment Act 1997 subsection 974-20(1)

Income Tax Assessment Act 1997 section 974-30

Income Tax Assessment Act 1997 section 974-70

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 section 974-160

Reasons for decision

Issue 1

Question 1

Summary

Not dividend stripping.

Detailed reasoning

Section 177E of the ITAA 1936 is a specific provision inserted within the general anti-avoidance provisions found in Part IVA of the ITAA 1936. Section 177E specifically brings within the ambit of Part IVA dividend stripping schemes, including schemes having substantially the effect of dividend stripping.

Section 177E of the ITAA 1936 operates where four pre-conditions are satisfied. These are set out in paragraphs 177E(1)(a) to 177E(1)(d) of the ITAA 1936.

Under the proposed arrangement there will not be a release of profits to shareholders in a tax free or substantially tax free form. The only way A will receive money in respect of the dividend paid to Newco on the DAS will be by way of assessable dividends paid by Newco. This would result in an amount being included in A's assessable income in the year of income in which they receive the assessable dividends. The amount to be included in A's assessable income is comparable to the tax benefit A will be taken to have obtained in connection with the scheme. Consequently the Commissioner will not make a determination to cancel the tax benefit that accrues to the taxpayers in the arrangement.

Thus, the critical feature which distinguishes this arrangement from a scheme by way of, or in the nature of, dividend stripping, or having substantially the same effect thereof, is the fact that the shareholder of the original company, a resident individual, is and will remain the sole shareholder of the new company. Because of this, there is no ability for Newco to pay out the dividends in a tax-free or substantially tax free form.

Question 2

Summary

No K8 event will arise.

Detailed reasoning

Section 725-90(1) of the ITAA 1997 provides that a direct value shift will not have consequences for an entity if:

a) the one or more things referred to in paragraph 725-145(1)(b) of the ITAA 1997 brought about a state of affairs, but for which the direct value shift would not have happened; and

(b) as at the time referred to in that paragraph, it is more likely than not that, because of the scheme, that state of affairs will cease to exist within 4 years after that time.

Paragraph 725-145(1)(b) of the ITAA 1997 explains that there is a direct value shift under a scheme involving equity or loan interests in an entity if the decrease is reasonably attributable to one or more things done under the scheme and occurs at or after the time when that thing, or the first of those things, is done.

Therefore, it is necessary to firstly consider whether the things done under the scheme, that are reasonably attributed to the decrease in market value of one or more equity or loan interests, brought about a state of affairs but for which the direct value shift would not have happened.

In this case, the scheme involves the issuance of a DAS by XY Pty Ltd to Newco for $X.The DAS carries a right to a dividend at the discretion of the sole director. A dividend will be declared on the DAS and paid to the DAS holder. There is a decrease of the market value of XY Pty Ltd upon the issue of the new share and payment of dividend, and an increase in the market value of Newco. The share will be redeemed at the discretion of the director for no payment or automatically for no payment within X months of the date of issue.

The term 'state of affairs' is not defined in either the ITAA 1997 or the ITAA 1936, however, when read in the context of section 725-90 of the ITAA 1997 it is considered to mean the factual circumstances or situation that caused the value shift.

Through the issuing of the DAS and the payment of the dividend the market value of the shares in XY Pty Ltd will decrease. The relevant state of affairs could therefore include both the issuance of the new share and the declaration and payment of a dividend to the holder of the new class of share.

However, in accordance with paragraph 725-90(1)(b) of the ITAA 1997, consideration must be given to whether the state of affairs will cease to exist within 4 years after the time that the things under the scheme are done.

The facts indicate that the DAS will be redeemed for no payment within X months of the date of issue. The dividend will also be paid before X months of the date of issue. Hence, the state of affairs will cease to exist within X months of the date of issue. Paragraph 725-90(1)(b) of the ITAA 1997 is therefore satisfied.

Question 3

Summary

The DAS is an equity interest.

Detailed reasoning

Broadly, a scheme gives rise to an equity interest if it satisfies the equity test and does not satisfy the debt test (Sections 974-15 and 974-70 of the ITAA 1997).

The debt test is satisfied if the 5 criteria set out in subsection 974-20(1) of the ITAA 1997 are satisfied:

(1) the scheme is a financing arrangement for the entity (issuer).

This condition does not have to be met if the issuing entity is a company and the interest is an interest as a member of stockholder of the company (see 974-20(1) of the ITAA 1997). The DAS gives rise to an interest in the issuing company as a member.

(2) the entity receives, or will receive, a financial benefit or benefits under the scheme.

Section 974-160 of the ITAA 1997 defines the term 'financial benefit' to, among other things, mean 'anything of economic value'.

You have argued that the provision of $X, the issue price, 'would not be considered a financial benefit in that it would not be considered something of economic value'. There is nothing in this definition which would suggest that there is any concept of de minimus such that only things of an unspecified sufficient value should be considered. The $X issue price would therefore fall within the definition of 'financial benefit'. See ATO ID 2003/898 where $2 was considered to be a financial benefit.

(3) the entity has an effectively non-contingent obligation (ENCO) under the scheme to provide a financial benefit(s) to one or more entities after the time when the financial benefit referred to in paragraph (b) is received.

The term ENCO is defined in section 974-135 of the ITAA 1997. Broadly, an entity has an ENCO if, having regard to the pricing, terms and conditions of the scheme, there is in substance an ENCO to provide a financial benefit. Note that the provision of an equity interest in the issue does not constitute a financial benefit: see subsection 974-30(1) of the ITAA 1997.

The definition of ENCO requires a consideration of the economic substance of the transaction. In this regard, the relevant Explanatory Memorandum (Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001). notes the following:

2.175 The debt test therefore uses the concept of an effectively non-contingent obligation as opposed to a legally (or formally) non-contingent obligation. Thus a scheme under which an entity has a right but not a legal obligation to provide a financial benefit could nevertheless be debt if, having regard to the pricing, terms and conditions of the scheme, the entity is in substance or effect inevitably bound, to exercise that right.

2.176 The concept of an effectively non-contingent obligation is, however, not intended to displace regard to legal rights and obligations. This is particularly so where those rights and obligations are consistent with arm's length transactions of commercial substance and reflect the clear intention of the parties.

Thus, in TR 2008/3 the Commissioner notes, after referring to the above:

38. Therefore, where the provision of a financial benefit on an instrument is formally subject to a contingency, that formal contingency may be disregarded if, upon consideration of the pricing, terms and conditions of issue of an instrument, the substance or effect of the arrangement is that the financial benefit will be provided by the issuer, despite the formal contingency. Artificial or contrived contingencies may be disregarded (subsection 974-135(6)). A contingency that is immaterially remote, as explained above, will be disregarded.

The DAS will be redeemed for no consideration. Newco is therefore not under an obligation to provide any financial benefits on redemption.

The payment of the dividend would also not be considered an ENCO because it is dependent, in accordance with the terms and conditions of the issue of the DAS, upon the discretion of the director. For example se ATO IDs 2003/200, 2003/527, 2003/898.

(4) it is more likely than not that the value provided will be at least equal to the value received.

It is more likely than not that the value provided (in the form of a dividend) to the holder of the DAS will be more than the value received by the company on the issue of the DAS.

(5) the value provided and the value received are both not nil.

Both the value provided (dividend) and the value received (issue price) are not nil.

While criteria (1), (2), (4) and (5) are met, criteria (3) is not satisfied and therefore the DAS does not satisfy the debt test. As it is an interest in the company as a member, the DAS is an equity interest within the meaning of section 974-70 of the ITAA 1997.

Question 4

Summary

Dividend streaming provisions will not be applicable.

Detailed reasoning

Under subsection 204-30(1) of the ITAA 1997, the Commissioner may make a determination set out in subsection 204-30(3) of the ITAA 1997, if an entity streams a distribution in such a way that:

(a) an imputation benefit is, or apart from this section would be, received by a member of the entity as a result of the distribution or distributions; and

(b) the member would derive a greater benefit from franking credits than another member of the entity; and

(c) the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits.

As has been noted in a number of Class Rulings the Commissioner has adopted the meaning of 'streaming' set out in the Explanatory Memorandum introducing Subdivision 204-D of the ITAA 1997 (Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002):

'selectively directing the flow of franked distributions to those members who can most benefit from the imputation credits'.

See for example CR 2013/93, paragraph 115.

The dividend policy of XY Pty Ltd will remain unchanged after the issue of the DAS. Furthermore, there is no entity which can derive a greater benefit from franking credits than another entity as both Newco and A will obtain the full benefit of the franking tax offset and A is the sole shareholder of both companies.

Therefore, the Commissioner will not make a determination under subsection 204-30(3) of the ITAA 1997.

Question 5

Summary

Division 7A provisions will not be applicable.

Detailed reasoning

Given that the payment on the DAS is in fact a dividend payment, there is nothing to which Division 7A can apply.

Question 6

Summary

Part IVA provisions will not be applicable.

Detailed reasoning

Part IVA of the ITAA 1936 applies to any scheme that has been carried out or is entered into for the dominant purpose of enabling a taxpayer to obtain a tax benefit in connection with the scheme. The application of Part IVA requires all of the following conditions to be present:

(i) a scheme has been carried out or entered into after 27 May 1981;

(ii) a taxpayer has or will obtain a tax benefit in connection with the scheme; and

(iii) the dominant purpose of the scheme was to enable the taxpayer to obtain a tax benefit

The scheme

The scheme can be identified as follows:

(a) The incorporation of Newco;

(b) The issuing of a DAS to Newco;

(c) The payment of the dividend;

(d) The subsequent redemption of the DAS.

Tax benefit

For the purposes of this arrangement, only paragraph (a) of the definition of 'tax benefit' in subsection 177C(1) of the ITAA 1936 is relevant.

To identify the 'tax benefit', it is necessary to identify the counterfactual or 'alternative postulate'.

The EM introducing the most recent changes to Part IVA of the ITAA 1936 provides the following:

1.102 A tax advantage cannot meaningfully be linked to a scheme by comparing the tax consequences of the scheme to the tax consequences that would have flowed if the parties had chosen to pursue some other objective. To provide a meaningful comparison, the tax consequences of the scheme should be compared with the tax consequences of an alternative that is reasonably capable of achieving for the taxpayer substantially the same non-tax results and consequences as those achieved by the scheme. (emphasis added)

The stated, non-tax results are:

(i) asset protection; and

(ii) bringing the market value of XY Pty Ltd down to a reasonable level to enable equity participation by employees.

Thus, any counterfactual must also achieve these same results.

An alternative arrangement would be to introduce a new wholly owned company and use Subdivision 122-A of the ITAA 1997 to obtain rollover relief.

Under this alternative, there is no tax benefit as Newco would not pay any tax under either scenario. Similarly, the alternative of paying a dividend directly to A would produce the same tax outcome as receiving a dividend from Newco.

There is, therefore, no tax benefit to which Part IVA of the ITAA 1936 can apply.