Edited version of private advice

Authorisation Number: 1012622838437

Ruling

Subject: Sale of private company shares

Question 1

Will the Taxpayer's shares in the A Pty Ltd qualify as active assets under section 152-35 and subsection 152-40(3) of the ITAA 1997?

Answer

Yes.

Question 2

Does a dividend of more than $Nil arise under section 109D of the Income Tax Assessment Act 1936 (ITAA 1936) in respect of the loan by the New Private Company to the New Discretionary Trust of the purchase price of the shares in A Pty Ltd to be acquired from the Taxpayer?

Answer

No.

Question 3

Does section 109J of the ITAA 1936 operate to exclude the repayments on the loan from the Taxpayer by the New Private Company back to the Taxpayer from being dividends under section 109C of the ITAA 1936?

Answer

Yes.

Question 4

Does Part IVA of the ITAA 1936 apply to the sale by the Taxpayer to the New Discretionary Trust?

Answer

No.

Question 5

Does Part IVA of the ITAA 1936 apply to the interest free loans from the Taxpayer to the New Private Company, and from the New Private Company to the New Discretionary Trust, in respect of the purchase price of the A Pty Ltd shares acquired by the New Discretionary Trust from the Taxpayer?

Answer

No.

This ruling applies for the following periods:

Income year ended 30 June 2014 to the income year in which the Taxpayer's interest free loan to the New Private Company is fully repaid.

The scheme commences on:

The date on which the Taxpayer sells their shares in A Pty Ltd to the New Discretionary Trust.

Relevant facts and circumstances

The Taxpayer is a resident who owns shares in A Pty Ltd, which is a resident private company.

For all of the period in which the Taxpayer has held the shares in A Pty Ltd, the total of the market values of the active assets of the company was at least 85% of the market value of all of the company's assets.

The following scheme is proposed:

1. The New Discretionary Trust, being an associate of the Taxpayer, will be established to acquire the ordinary shares in A Pty Ltd from the Taxpayer (who is seeking to apply the small business 50% reduction under Subdivision 152-C of the ITAA 1997 to the discounted capital gain that will arise from the disposal of the shares). This will create a loan from the Taxpayer to the trust of the sales price of the shares.

2. The New Private Company, being an associate of the Taxpayer, will be set up to borrow funds from the Taxpayer and on-lend them to the New Discretionary Trust to repay the loan from the Taxpayer. This happens in the first year of the private company's existence, whilst it has no retained earnings.

3. The loan between the New Private Company and the New Discretionary Trust and the loan between the New Private Company and the Taxpayer will not be interest bearing.

4. The New Discretionary Trust will later distribute the fully franked dividends it receives from A Pty Ltd to the New Private Company. The New Private Company will then use these trust distributions to repay the interest free loan from the Taxpayer.

5. The Taxpayer is most likely to use the loan repayments received from the New Private Company, being the cash consideration for the disposal of their shares in A Pty Ltd to the New Discretionary Trust, to make additional non-concessional contributions into a superannuation fund to provide for their retirement.

6. The ownership of the shares in A Pty Ltd by the New Discretionary Trusts will provide flexibility and succession planning, allowing the business to be transferred to other family members and the distribution of business profits to the family members actually generating them.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 109C,

Income Tax Assessment Act 1936 Section 109D,

Income Tax Assessment Act 1936 Section 109J,

Income Tax Assessment Act 1936 Section 109Y,

Income Tax Assessment Act 1936 Part IVA,

Income Tax Assessment Act 1936 Subsection 177A(1),

Income Tax Assessment Act 1936 Subsection 177C(1),

Income Tax Assessment Act 1936 Section 177CB,

Income Tax Assessment Act 1936 Section 177D,

Income Tax Assessment Act 1997 Section 152-15,

Income Tax Assessment Act 1997 Section 152-35 and

Income Tax Assessment Act 1997 Section 152-40.

Reasons for decision

Question 1

Summary

The Taxpayer's shares in A Pty Ltd will qualify as active assets under section 152-35 and subsection 152-40(3) of the ITAA 1997.

Detailed reasoning

Relevantly, under subsections 152-35(1) and 152-35(2) of the ITAA 1997, the Taxpayer's shares in A Pty Ltd will satisfy the active asset test if they were an active asset of theirs for a total of at least half the period in which they have owned them.

Relevantly, the Taxpayer's shares in A Pty Ltd will be an active asset under subsection 152-40(3) of the ITAA 1997, if the total of the market values of the active assets of the company is 80% or more of the market value of all of the company's assets.

As the total of the market values of the active assets of A Pty Ltd was at least 85% of the market value of all of the company's assets, the Commissioner accepts that the Taxpayer's shares in A Pty Ltd will satisfy the active asset test.

Question 2

Summary

A dividend of more than $Nil does not arise under section 109D of the ITAA 1936 in respect of the loan by the New Private Company to the New Discretionary Trust of the purchase price of the shares in A Pty Ltd to be acquired from the Taxpayer.

Detailed reasoning

Under subsection 109D(1) of the ITAA 1936, the New Private Company will be taken to have paid a dividend to the New Discretionary Trust at the end of the income year, however section 109Y of the ITAA 1936 limits the amount of the dividend taken to have been paid by the New Private Company under subsection 109D(1AA) of the ITAA 1936 to the amount of its distributable surplus, which will be $Nil.

Question 3

Summary

Section 109J of the ITAA 1936 will operate to exclude the repayments on the loan from the Taxpayer by the New Private Company back to the Taxpayer from being dividends under section 109C of the ITAA 1936.

Detailed reasoning

Section 109J of the ITAA 1936 states:

A private company is not taken under section 109C to pay a dividend because of the payment of an amount, to the extent that the payment:

(a)  discharges an obligation of the private company to pay money to the entity; and

(b)  is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm's length.

Section 109J of the ITAA 1936 will therefore exclude the loan repayments by the New Private Company to the Taxpayer, because:

• they will discharge an obligation of the New Private Company to repay the loan to the Taxpayer, and

• with the loan being interest free, the repayments will actually be less, and not more, than would have been required to discharge the obligation had the New Private Company and the Taxpayer been dealing with each other at arm's length.

Question 4

Summary

Part IVA of the ITAA 1936 will not apply to the sale by the Taxpayer of their shares in A Pty Ltd to the New Discretionary Trust.

Detailed reasoning

Part IVA of the ITAA 1936 applies to an arrangement where the following elements exist:

(a) there is a scheme as defined in subsection 177A(1) of the ITAA 1936

(b) there is a tax benefit as defined in subsection 177C(1) of the ITAA 1936 obtained by a taxpayer in connection with a scheme, and

(c) it would be concluded having regard to the eight factors listed in subsection 177D(2) of the ITAA 1936 that a person who entered into or carried out the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme.

Is there a scheme?

Subsection 177A(1) defines scheme to mean:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings, and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

The Commissioner of the view that scheme is defined widely enough to include the proposed sale by the Taxpayer of their shares in A Pty Ltd to the New Discretionary Trust.

Is there a tax benefit?

Subsection 177C(1) of the ITAA 1936 defines a tax benefit obtained by a taxpayer in connection with a scheme to include at paragraph (a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out.

Subsection 177CB(1) of the ITAA 1936 applies to deciding, under section 177C of the ITAA 1936, whether any of the tax benefits listed under subsection 177C(1) of the ITAA 1936 would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out.

Annihilation approach

The first alternative approach is the annihilation approach under subsection 177CB(2), which states:

177CB(2)

A decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme).

Under the annihilation approach, the Taxpayer will not sell their shares in A Pty Ltd, as CGT event A1 under section 104-10 of the ITAA 1997 will not occur, meaning there will be no discounted capital gain to apply the small business 50% reduction under Subdivision 152-C of the ITAA 1997.

In other words, in the absence of this scheme, there is no less advantageous tax effect that will flow to the Taxpayer compared to the tax effect that would have been secured by them in connection to the proposed scheme.

Reconstruction approach

The second alternative approach is the reconstruction approach under subsection 177CB(3), which states:

177CB(3)

A decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme.

There are two reasonable alternatives available to the Taxpayer under the reconstructive approach.

The first reasonable alternative is that they would hold on to all of their shares in A Pty Ltd for at least 15 years before selling them in connection with their retirement. This would enable the small business 15-year exemption under Subdivision 152-B of the ITAA 1997 to be applied to fully disregard the capital gain that will arise.

The second reasonable alternative is that they would sell all of their shares in A Pty Ltd in connection with their retirement before for 15 years). This would enable the small business retirement exemption under Subdivision 152-D of the ITAA 1997 to be applied to reduce the already reduced discounted capital gain, after applying the small business 50% reduction under Subdivision 152-C of the ITAA 1997 as per the proposed scheme, by up to a further $500,000.

In other words, under both of the reasonable alternatives, a more advantageous tax effect, as opposed to a less advantageous tax effect, will flow to the Taxpayer compared to the tax effect that would have been secured by them in connection to the proposed scheme.

Conclusion

In conclusion, as there will be no tax benefit under subsection 177C(1) of the ITAA 1936 obtained by the Taxpayer in connection to the proposed sale of their shares in A Pty Ltd, Part IVA of the ITAA 1936 will not apply.

Question 5

Summary

Part IVA of the ITAA 1936 will not apply to the interest free loans from the Taxpayer to the New Private Company, and from the New Private Company to the New Discretionary Trust, in respect of the purchase price of the shares acquired by the New Discretionary Trust from the Taxpayer.

Detailed reasoning

Part IVA of the ITAA 1936 applies to an arrangement where the following elements exist:

(a) there is a scheme as defined in subsection 177A(1) of the ITAA 1936

(b) there is a tax benefit as defined in subsection 177C(1) of the ITAA 1936 obtained by a taxpayer in connection with a scheme, and

(c) it would be concluded having regard to the eight factors listed in subsection 177D(2) of the ITAA 1936 that a person who entered into or carried out the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme.

Is there a scheme?

Subsection 177A(1) defines scheme to mean:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings, and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

The Commissioner of the view that scheme is defined widely enough to include the proposed interest free loans from the Taxpayer to the New Private Company and from the New Private Company to the New Discretionary Trust.

Is there a tax benefit?

Subsection 177C(1) of the ITAA 1936 defines a tax benefit obtained by a taxpayer in connection with a scheme to include at paragraph (a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out.

Subsection 177CB(1) of the ITAA 1936 applies to deciding, under section 177C of the ITAA 1936, whether any of the tax benefits listed under subsection 177C(1) of the ITAA 1936 would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out.

Annihilation approach

The first alternative approach is the annihilation approach under subsection 177CB(2) of the ITAA 1936, which states:

177CB(2)

A decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme).

Under the annihilation approach, the Taxpayer will not have made the interest free loan to the New Private Company and the New Private Company would not have on-lent interest free to the New Discretionary Trust, meaning that they would be still owed money by the New Discretionary Trust equal to the purchase price of the shares. Furthermore, the New Discretionary Trust would not able to make repayments to the Taxpayer unless its trustee resolves in each applicable income year not to distribute the dividends it may receive from A Pty Ltd (as its directors have the discretion to declare and pay dividends).

This means that the trustee would be assessed and liable to pay tax on the trust's net income at the highest marginal tax rate of 46.5% under subsection 99A(4) of the ITAA 1936. This is contrast to the New Private Company being taxed at 30% on its proposed present entitlement to the trust's net income.

Therefore, a less advantageous tax effect will flow to the New Discretionary Trust, being the relevant taxpayer.

Conclusion

In conclusion, the Commissioner is of the view that a tax benefit of 16.5% under subsection 177C(1) of the ITAA 1936 will be obtained by the New Discretionary Trust (i.e. the relevant taxpayer) on the income (i.e. dividends from A Pty Ltd) which is the source of the loan repayments.

Is there a dominant purpose?

Subsections 177D(1) and 177D(2) (which replaced paragraphs 177D(a) and 177D(b) with effect from 16 November 2012) of the ITAA 1936 state:

Scheme for purpose of obtaining a tax benefit

177D(1)

This Part applies to a scheme if it would be concluded (having regard to the matters in subsection (2)) 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 the purpose of:

a) enabling a taxpayer (a relevant taxpayer) to obtain a tax benefit in connection with the scheme; or

(b) enabling the relevant taxpayer and another taxpayer (or other taxpayers) each to obtain a tax benefit in connection with the scheme;

whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers.

Having regard to certain matters

177D(2)

For the purpose of subsection (1), have regard to the following matters:

(a) the manner in which the scheme was entered into or carried out;

(b) the form and substance of the scheme;

(c) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

(d) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

(e) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

(f) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

(g) any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out;

(h) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f).

Paragraphs 79 to 82 of Law Administration Practice Statement PS LA 2005/24 Application of General Anti-Avoidance Rules provide further guidance on the application of 177D of the ITAA 1936:

79. Section 177D provides that Part IVA applies to a scheme in connection with which the taxpayer has obtained a tax benefit if, after having regard to eight specified factors, it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the purpose of enabling the taxpayer to obtain the tax benefit.

80. The objective test in paragraph 177D(b) is the core of Part IVA and has been described by the High Court as the 'pivot' or 'fulcrum' on which Part IVA turns. It is frequently referred to as the 'statutory predication test'.

81. Section 177D refers to 'the purpose' of the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme. The person need not be the taxpayer. Subsection 177A(5) clarifies that the 'purpose' includes the dominant purpose where there are two or more purposes.

82. The dominant of two or more purposes is the ruling, prevailing or most influential purpose.

It is evident from the relevant facts provided that there are two purposes for the Taxpayer to carry out the scheme of creating the interest free loans and interposition of the New Private Company between the Taxpayer and the New Discretionary Trust:

1. To ensure that the use of the New Discretionary Trust for succession planning and asset protection does not inadvertently delay the effective completion of that succession planning (i.e. the complete transfer of the business to other family members) and the Taxpayer receiving the full cash consideration for their A Pty Ltd shares to make the additional superannuation contributions to provide for their retirement.

2. To allow the New Discretionary Trust to obtain a tax benefit of 16.5% under subsection 177C(1) of the ITAA 1936 on the income (i.e. the A Pty Ltd dividends) which is the source of the loan repayments and cash consideration payable to the Taxpayer.

Conclusion

After having regard to all eight factors in subsection 177D(2) of the ITAA 1936, the Commissioner accepts that the Taxpayer's dominant purpose in carrying out the scheme is for the first purpose and not for the New Discretionary Trust to obtain a tax benefit.

Therefore Part IVA of the ITAA 1936 will not apply.