Edited version of private advice

Authorisation Number: 1012626932467

Ruling

Subject: Redeemable Preference Shares

Client name

X Pty Ltd

Y (as holder of A Class Redeemable Preference Shares)

Z (as holder of B Class Redeemable Preference Shares)

Question 1

Are each of the A Class Redeemable Preference Shares (A Class RPS) and B Class Redeemable Preference Shares (B Class RPS) to be issued to shareholders of X Pty Ltd (X or the company) considered to be equity interests under Subdivision 974-C of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

In respect of franked dividends paid in respect of each of the A Class RPS and B Class RPS:

a. Will the distributions from the company to the shareholders be treated as frankable distributions under section 202-40 of the ITAA 1997?

b. If so, and the company pays franked dividends to the shareholders, will the shareholders be assessable on the franking credits under subsection 207-20(1) of the ITAA 1997?

c. In relation to (b), will the shareholders be entitled to a tax offset equal to the franking credits under subsection 207-20(2) of the ITAA 1997?

Answer

(a) Yes

(b) Yes

(c) Yes

Question 3

In respect of the shareholders that are issued A Class RPS and B Class RPS:

a. Will the shareholder have a capital gain from capital gains tax (CGT) event K8 (subsection 104-250(1) of the ITAA 1997) in relation to the issue of each of the A Class RPS and B Class RPS?

b. Will the shareholder have a capital gain from CGT event K8 (subsection 104-250(1) of the ITAA 1997) in relation to the declaration or payment of dividends to each of the A Class RPS and B Class RPS shareholders?

Answer

(a) No

(b) No

Question 4

In respect of the shareholders that are issued A Class RPS and B Class RPS:

Will the shareholder have a capital gain from CGT event H2 (section 104-155 of the ITAA 1997) from the issue of the A Class RPS and B Class RPS?

Answer

No

Question 5

Will the following specific and general anti-avoidance provisions apply to the issue of A Class RPS and B Class RPS by the company to the shareholders:

a. The dividend streaming provisions (Subdivision 204-D of the ITAA 1997)?

b. The dividend stripping provisions in section 177E of the Income Tax Assessment Act

1936 (ITAA 1936)?

c. The capital streaming provisions (section 45 to section 45D of the ITAA 1936)?

d. The general anti-avoidance provisions relating to imputation benefits (section 177EA

of the ITAA 1936)? and

e. The general anti-avoidance provisions in Part IVA of the ITAA 1936?

Answer

(a) No

(b) No

(c) No

(d) No

(e) No

This ruling applies for the following period:

1 July 2012 to 20 June 2015

The scheme commences on:

1 July 2012

Relevant facts and circumstances:

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

1. X Pty Ltd (X) is a widely held private company. The maximum interest held by any one shareholder is less than 10% of the total shares issued, as at September 2012.

2. There is a mixture of entities who are shareholders: some individuals, some companies, and some trustees of trusts including superannuation funds. All shareholders are Australian residents for taxation purposes.

3. X operates (via its subsidiary company XX) a business of providing services.

4. Over the years employees of XX have purchased shares in the company. However, in late 20yy and early 20xx it became clear that the formula for the valuation of shares which had been used was flawed and consequently those shareholders who had purchased shares in X in recent years had paid an amount for their shares in excess of the fair market value of those shares. Some of the shareholders who had paid an amount for the shares in excess of the fair market value are current employees of XX and others are former employees of XX.

5. The fact that some shareholders had paid in excess of the fair market value for their shares caused a number of problems including disgruntled employees and problems with succession +

6. An independent valuation, obtained in July 2012, confirmed that the formula being used by X to value its shares was flawed.

7. The Board of X considered a number of solutions to these problems, including a share buy-back and a return of capital. However, the only commercially realistic solution was the issue of Redeemable Preference Shares.

8. The driving force for the proposed arrangements was to restore employees' faith in X and its future succession plan by providing some compensation to current employees who had paid an excessive amount for their shares. Associated with the desire to strengthen the succession plan for the company was the perceived need to pay out shareholders who were no longer employees of XX, at a value equating to the net tangible assets of the company. By late 20xx, nearly 20% of the shares of X were owned by former employees of XX. This was perceived to be undesirable, resulting in some sense of loss of ownership of the enterprise by the shareholders who were current employees.

9. Shareholders agreed in late 20xx by special resolutions to:

(a) use a formula based on the net tangible assets of the company to value its shares;

(b) create A Class Redeemable Preference Shares (A Class RPS), for those who had paid in excess of $AA.00 for each of their ordinary shares; and

(c) create B Class Redeemable Preference Shares (B Class RPS), as a means to buy out former employees.

10. The relationships between X and shareholders and between shareholders are all arm's length business relationships. Further, shareholders who would benefit from the arrangement did not participate in the vote on the resolution.

11. The shareholders being compensated by the issue of A Class RPS are those shareholders who paid in excess of $AA.00 per ordinary share. There are 12 in this group: 9 individuals and 3 trustee companies. The number of A Class RPS shares that will be issued to each of these 9 individuals or trustee companies will depend on the difference that they paid for each ordinary share and $AA.00. The bigger the difference, the more A Class RPS they will receive.

12. Thus the issue of A Class RPS to the recipients is done on the basis of compensating those shareholders for paying an excessive amount for their ordinary shares. A Class RPS are not issued on the basis of the tax attributes of the recipient. Indeed, the beneficiaries of the three trusts, in respect of the three trustee company shareholders, are not known by X.

13. It is proposed that all dividends to be paid by X, to ordinary shareholders and holders of A Class RPS and B Class RPS will be franked to the same extent, which is expected to be 100%. It is proposed to pay this dividend from retained earnings. Thus the proposed dividend will not depend on future profits.

14. A Class Redeemable Preference Shares have the following rights:

(a) The holder of the A Class Redeemable Preference Shares shall have no entitlement to any repayment of capital;

(b) The holders of the A Class Redeemable Preference Shares shall have no rights to participate in any surplus assets or profits of the Company;

(c) The holders of A Class Redeemable Preference Shares shall be entitled to a cumulative dividend up to the amount specified in Clause (e);

(d) The holders of A Class Redeemable Preference Shares shall not have any voting rights other than any proposed change to the rights of their own class;

(e) The payment of dividends to A Class Preference Shareholders shall have preference to all other shareholders. Subject to the rights of the A Class Redeemable Preference Shareholders, the holders of A Class Redeemable Preference Shares shall be entitled to a dividend that is in preference to any other class of share up to a cumulative value of $1.00 per share; and

(f) Upon the payment of a dividend or dividends totalling $1.00 per share to an A Class Redeemable Preference Shareholder, the share shall be cancelled.

15. Those who are issued with A Class RPS will retain their ordinary shares. When the holders of A Class RPS have been paid dividends totalling $1.00 for each A Class RPS, then those preference shares will be cancelled; but they will retain their ordinary shares.

16. Y is a proposed holder of A Class RPS.

17. The B Class RPS will be issued to former employees who have agreed to convert their ordinary shares to B Class RPS. The holders of B Class RPS will not retain their ordinary shares. The 'Share Price' referred to in the paragraph below is based on a formula which in turn is based on the net tangible assets of X. In essence, the issue of B Class RPS is a mechanism to pay out, via the payment of dividends, former employees of XX at a value based on the net tangible assets of the company.

18. B Class Redeemable Preference Shares shall have the following rights:

(a) The holders of the B Class Redeemable preference Shares shall have no rights to any repayment of capital;

(b) The holders of the B Class Redeemable preference Shares shall have no rights to participate in any surplus assets or profit of the Company;

(c) The holders of B Class Redeemable Preference Shares shall be entitled to a cumulative dividend up to the amount specified in Clause (f);

(d) The holders of B Class Redeemable Preference Shares shall not have any voting rights other than any proposed change to the rights of their own class;

(e) The payment of dividends to B Class Preference Shareholders shall be in preference to all other shareholders, other than A Class Redeemable Preference Shares;

(f) The holders of B Class Redeemable Preference Shares shall be entitled to a dividend that is in preference to any other class of share (other than A class shares) up to a cumulative value of Share Price as at the date of default less any dividend received since the date of the calculation of the Share Price; and

(g) Upon the payment of the dividend or dividends totalling the specified Share Price to a B Class Redeemable Preference Shareholder, the share shall be cancelled.

19. Z is a proposed holder of B Class RPS.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 974-C

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

Income Tax Assessment Act 1997 Subsection 974-70(1)

Income Tax Assessment Act 1997 Subsection 974-75(1)

Income Tax Assessment Act 1997 Subsection 974-75(2)

Income Tax Assessment Act 1997 Subsection 974-135(3)

Income Tax Assessment Act 1997 Section 202-40

Income Tax Assessment Act 1997 Section 202-45

Income Tax Assessment Act 1997 Subsection 207-20(1)

Income Tax Assessment Act 1997 Subsection 207-20(2)

Income Tax Assessment Act 1997 Subsection 104-250(1)

Income Tax Assessment Act 1997 Section 725-50

Income Tax Assessment Act 1997 Section 725-55

Income Tax Assessment Act 1997 Section 725-355

Income Tax Assessment Act 1936 Section 318

Income Tax Assessment Act 1997 Section 104-155

Income Tax Assessment Act 1936 Subsection 160M(7)

Income Tax Assessment Act 1997 Subdivision 204-D

Income Tax Assessment Act 1936 Section 177E

Income Tax Assessment Act 1936 Section 45

Income Tax Assessment Act 1936 Section 45A

Income Tax Assessment Act 1936 Section 45B

Income Tax Assessment Act 1936 Section 45BA

Income Tax Assessment Act 1936 Section 45C

Income Tax Assessment Act 1936 Section 45D

Income Tax Assessment Act 1936 Section 177EA

Income Tax Assessment Act 1936 Section 177A

Income Tax Assessment Act 1936 Section 177CB

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1936 Section 177E

Income Tax Assessment Act 1936 Section 177F

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1

Summary

The A Class Redeemable Preference Shares and B Class Redeemable Preference Shares are considered to be equity interests under Subdivision 974-C of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

The A Class Redeemable Preference Shares and B Class Redeemable Preference Shares satisfy the equity test in subsection 974-75(1) of the ITAA 1997. The A Class Redeemable Preference Shares and B Class Redeemable Preference Shares fail the debt test in subsection 974-20(1) of the ITAA 1997 as they do not meet the effectively non-contingent obligation requirement in paragraph (c) of that subsection. In this document the term Redeemable Preference Shares includes both A Class Redeemable Preference Shares and B Class Redeemable Preference Shares; and the term Redeemable Preference Shareholders means holders of those shares.

Equity test

Subsection 974-70(1) of the ITAA 1997 states that:

A *scheme gives rise to an equity interest in a company if, when the scheme comes into existence:

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

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

[Notes to the subsection omitted.]

The table in subsection 974-75(1) of the ITAA 1997 specifies that a scheme satisfies the equity test in relation to a company if it gives rise to:

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

- Item 2 - An interest that carries a right to a variable or fixed return from the company if either the right itself, or the amount of the return is contingent on the economic performance of the company (whether past current or future).

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

The condition in Item 1 is satisfied as the holders of Redeemable Preference Shares are members of the company, X.

Subsection 974-75(2) of the ITAA 1997 provides, in substance, that for items in the table other than item 1, there must also be a financing arrangement. 'Financing arrangement' is defined in section 974-130 of the ITAA 1997. It appears that there is no financing arrangement and therefore items 2 and 3 of the equity test are not satisfied. It is not expedient to analyse this in detail as the equity test has been satisfied by virtue of satisfying item 1 of the table.

However, if the equity test and the debt test are both satisfied, then the interest is a debt interest. Accordingly, it is necessary to consider the debt test.

Debt test

Subsection 974-20(1) of the ITAA 1997 states that:

A *scheme satisfies the debt test in this subsection in relation to an entity if:

(a) the scheme is a *financing arrangement for the entity; and

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

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

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

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

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

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

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

Thus, pursuant to subsection 974-20(1) of the ITAA 1997 there are five conditions which must be satisfied for the interest to be classified as a debt interest. The first condition, set out in paragraph (a) of the subsection is not relevant where the interest is an equity interest by virtue of item 1 of the table to subsection 974-75(1) of the ITAA 1997, which is the case with this matter. This consequently leaves four conditions to be satisfied.

Paragraph 974-20(1)(c) of the ITAA 1997 about an effectively non-contingent obligation is not satisfied.

Meaning of effectively non-contingent obligation (ENCO)

Subsection 974-135(3) of the ITAA 1997 specifies:

An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a *connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation.

It is considered that the Redeemable Preference Shares fail the debt test as there is no ENCO as required by paragraph 974-20(1)(c) of the ITAA 1997. This is because there is no obligation to pay a dividend until the directors of an entity declare a dividend. In other words, the obligation of X to pay a dividend is contingent on the directors declaring a dividend.

The issue of the Redeemable Preference Shares is a scheme that falls within item 1 of the equity interest table in subsection 974-75(1) of the ITAA 1997. Further the Redeemable Preference Shares are not characterised as, and do not form, part of a larger interest that is characterised as a debt interest in the issuing company. The Redeemable Preference Shares are therefore classified as an equity interest as defined above in section 974-70 of the ITAA 1997.

Question 2

Summary

The dividends paid in respect of the Redeemable Preference Shares:

(a) are frankable within the meaning of section 202-40 of the ITAA 1997;

(b) Redeemable Preference Shareholders are assessable on the franking credit pursuant to subsection 207-20(1) of the ITAA 1997; and

(c) Redeemable Preference Shareholders are entitled to a tax offset equal to the franking credit pursuant to subsection 207-20(2) of the ITAA 1997.

Detailed reasoning

Subsection 202-40(1) of the ITAA 1997 states:

A *distribution is a frankable distribution, to the extent that it is not unfrankable under

section 202-45.

Sections 202-45 of the ITAA 1997 states:

The following are unfrankable:

(a) (Repealed by No 101 of 2003)

(b) a distribution to which paragraph 24J(2)(a) of the Income Tax Assessment Act 1936 applies that is taken under section 24J of the Income Tax Assessment Act 1936 to be *derived from sources in a prescribed Territory, as defined in subsection 24B(1) of the Income Tax Assessment Act 1936 (distributions by certain *corporate tax entities from sources in Norfolk Island);

(c) where the purchase price on the buy-back of a *share by a *company from one of its

*members is taken to be a dividend under section 159GZZZP of that Act - so much of

that purchase price as exceeds what would be the market value (as normally understood) of

the share at the time of the buy-back if the buy-back did not take place and were never

proposed to take place;

(d) a distribution in respect of a *non-equity share;

(e) a distribution that is sourced, directly or indirectly, from a company's *share capital account;

(f) an amount that is taken to be an unfrankable distribution under section 215-10 or 215-15;

(g) an amount that is taken to be a dividend for any purpose under any of the following provisions:

(i) unless subsection 109RB(6) or 109RC(2) applies in relation to the amount - Division 7A of Part III of that Act (distributions to entities connected with a *private company);

(ii) (Repealed by No 79 of 2007);

(iii) section 109 of that Act (excessive payments to shareholders, directors and associates);

(iv) section 47A of that Act (distribution benefits - CFCs);

(h) an amount that is taken to be an unfranked dividend for any purpose:

(i) under section 45 of that Act (streaming bonus shares and unfranked dividends);

(ii) because of a determination of the Commissioner under section 45C of that Act (streaming dividends and capital benefits);

(i) a *demerger dividend;

(j) a distribution that section 152-125 or 220-105 says is unfrankable.

Conclusion

The Redeemable Preference Shares are equity interests as defined in section 974-75 of the ITAA 1997. The distributions under the Redeemable Preference Shares do not fall under any of the paragraphs in section 202-45 of the ITAA 1997, quoted above. Therefore, the distributions of dividends from the company to the Redeemable Preference Shareholders are capable of being franked under section 202-40 of the ITAA 1997.

The next issue is whether, when franked dividends are paid to the Redeemable Preference Shareholders, those shareholders are assessable on the franking credits under subsection 207-20(1) of the ITAA 1997?

Subsection 207-20(1) of the ITAA 1997 states that:

If an entity makes a *franked distribution to another entity, the assessable income of the

receiving entity, for the income year in which the distribution is made, includes the amount

of the *franking credit on the distribution. This is in addition to any other amount included in

the receiving entity's assessable income in relation to the distribution under any other

provision of this Act.

Conclusion

If the taxpayer pays franked dividends to the Redeemable Preference Shareholders, those shareholders will be assessed on the franking credits attached to the dividends pursuant to subsection 207-20(1) of the ITAA 1997.

In relation to the above, will the Redeemable Preference Shareholders be entitled to a tax offset equal to the franking credits under subsection 207-20(2) of the ITAA 1997.

Subsection 207-20(2) of the ITAA 1997 states that:

The receiving entity is entitled to a *tax offset for the income year in which the distribution is made. The tax offset is equal to the *franking credit on the distribution.

Conclusion

The Redeemable Preference Shareholders will be entitled to a tax offset equal to the franking credit on the distribution under subsection 207-20(2) of the ITAA 1997.

Question 3

Summary

The shareholders that are issued Redeemable Preference Shares:

(a) will not have a CGT event K8 triggered in relation to the issue of Redeemable Preference Shares;

(b) nor will they have a CGT event K8 triggered in relation to the declaration or payment of dividends to Redeemable Preference Shareholders.

Detailed reasoning

Pursuant to subsection 104-250(1) of the ITAA 1997 CGT event K8 happens if there is a taxing event generating a gain for a 'down interest' under section 725-245 of the ITAA 1997. There is a note to the subsection referring to the rest of Division 725.

Within Division 725 of the ITAA 1997, section 725-50 is the operative section. It provides that a direct value shift under a scheme involving equity or loan interests in an entity (the target entity) has consequences for an entity under Division 725 if, and only if, the five conditions in paragraphs (a) to (e) of the section are satisfied.

However, at least one of these conditions is not satisfied. This is, the controlling interest test, set out in section 725-55 of the ITAA 1997 (which is paragraph (b) in section 725-50) is not satisfied.

Section 725-55 of the ITAA 1997 requires that an entity (the controller) must control (for value shifting purposes) the target entity at some time during the period starting when the scheme is entered into and ending when it has been carried out. For the definition of control, in the value shifting context, the section refers to sections 727-355 to 727-375 of the ITAA 1997.

In fact, section 727-355 of the ITAA 1997 is relevant to the control of a company. The other two sections refer to control of trusts. Based on section 727-355, an entity controls a company if the entity, or the entity and its associates between them:

(a) controls at least 50% of the voting power of the company, or is entitled to at least 50% of any dividends, or is entitled to receive at least 50% of the distribution of the capital of the company [per subsection 727-355(1) of the ITAA 1997];

(b) controls at least 40% of the votes/dividend/distribution of capital unless another entity and its associates in fact controls the company [per subsection 727-355(2) of the ITAA 1997]; or

(c) in fact controls the company [per subsection 727-355(3) of the ITAA 1997].

The term 'associate' is widely defined by section 318 of the Income Tax Assessment Act 1936 (ITAA 1936). However, the definition revolves around family connections. It would not apply to X where there are xx shareholders from different families and where no one shareholder owns more than 10% of the total shares issued.

Accordingly, there is no controller and consequently, the direct value shifting provisions in Division 725 of the ITAA 1997 are not applicable and CGT event K8 is not applicable.

There is also an argument that the fifth condition in section 725-50 of the ITAA 1997, being paragraph (e), does not apply. This condition is that neither of sections 725-90 and 725-95 of the ITAA 1997 applies. These sections do apply if there is a reversal within four years.

That is, in terms of subsection 725-90(1) of the ITAA 1997, the direct value shift does not have consequences for an entity under Division 725 of the ITAA 1997, if it is more likely than not that, because of the scheme, the state of affairs brought about by the scheme will cease to exist within four years.

It is almost certain that the A Class RPS will cease to exist within four years due to dividends totalling $1.00 being paid out on each share and the A Class RPS being cancelled. Thus the argument is that the state of affairs, being the existence of the A Class RPS, has ceased to exist and thus there has been a reversal. However, the dividend has been paid out and the A Class RPS holders have had the use of this dividend. Thus there is an argument that there has not been a reversal.

Similar conceptual arguments apply in relation to the B Class RPS.

It seems preferable to conclude that CGT event K8 does not apply on the basis that there is no controller, rather than on basis that there has been a reversal of the state of affairs brought about by the scheme.

Question 4

Summary

The shareholders that are issued Redeemable Preference Shares will not have a CGT event H2 (pursuant to section 104-155 of the ITAA 1997) from the issue of the Redeemable Preference Shares.

Detailed reasoning

CGT event H2 is a rewrite of subsection 160M(7) of the ITAA 1936 which served as a catch-all provision to impose CGT on capital receipts/proceeds that do not fall within the ambit of other CGT events.

Relevantly, subsection 104-155(1) of the ITAA 1997 provides that:

CGT event H2 happens if:

(a) an act, transaction or event occurs in relation to a *CGT asset that you own; and

(b) the act, transaction or event does not result in an adjustment being made to the asset's *cost base or *reduced cost base.

[Example and Note omitted]

Paragraph 104-155(5)(c) of the ITAA 1997 provides an exception to the operation of section 104-155(1) of the ITAA 1997. The exception applies where a company issues or allots equity interests or non-equity shares in itself.

Application to A Class Redeemable Preference Shares

In this case, current employees will have redeemable shares allocated to them in respect of their ordinary shareholdings. These redeemable shares will only entitle them to cumulative dividends of $1 per share and the cancellation of the shares once that amount is paid.

As the redeemable shares will be issued to affected shareholders in addition to their ordinary shareholdings, there is no act, transaction or event that occurs in relation to a CGT asset that the taxpayer owns (ie. ordinary shares); and as such, CGT event H2 will not have any application.

In the event there is an act, transaction or event in relation to shares that the taxpayer owns, the exception under paragraph 104-155(5)(c) of the ITAA 1997 would apply; such that CGT event H2 will not have any application in these circumstances.

Application to B Class Redeemable Preference Shares

The Commissioner's view is that the conversion of shares can result in CGT event H2. See for example Class Ruling CR 2013/11 Income tax: conversion of shares - WorkPac Pty Ltd and Taxation Ruling TR 94/30 Income tax: capital gains tax implications of varying rights attached to shares.

From CR 2013/11:

CGT event H2

28. CGT event H2 happens if an act, transaction or event occurs in relation to a CGT asset that you own and the act, transaction or event does not result in an adjustment being made to the asset's cost base or reduced cost base (subsection 104-155(1)). The variation in the rights attached to the Class shares is an act, transaction or event in relation to those shares. Therefore, the variation results in CGT event H2 happening in respect of them.

29. A capital gain is made if the capital proceeds from the event are more than the incidental costs incurred in relation to it. A capital loss is made if the capital proceeds are less than the incidental costs (subsection 104-155(3)).

30. Subsection 116-20(2) provides that the capital proceeds from CGT event H2 happening are the money or other consideration received, or entitled to be received, because of the act, transaction or event…

In this case, former employees convert their Ordinary shares into B Class Redeemable Preference Shares, which will only entitle them to dividends to an agreed amount and the cancellation of the shares once that amount is paid.

CGT event H2 happens if an act, transaction or event occurs in relation to a CGT asset that the taxpayer (ie. shareholder) owns and the act, transaction or event does not result in an adjustment being made to the asset's cost base or reduced cost base (subsection 104-155(1) of the ITAA 1997). The variation in the rights attached to the Ordinary shares is an act, transaction or event in relation to those share for the purposes of CGT event H2 (ie. it raises the possibility that the variation results in CGT event H2 happening in respect of the Ordinary shares).

Subsection 116-20(2) of the ITAA 1997 provides that the capital proceeds from CGT event H2 happening are the total of:

• the money that the taxpayer received or is entitled to receive in respect of the CGT event at the time the CGT event (ie. conversion of shares takes place); and

• the market value of any property that the taxpayer received or is entitled to receive in respect of the CGT event (ie. conversion of shares takes place).

The affected shareholders will receive shares and dividends to an agreed amount which would be caught by the definition of capital proceeds.

However, as the shares are issued in relation to the conversion of existing shares, the exception under paragraph 104-155(5)(c) of the ITAA 1997 would apply; such that CGT event H2 will not have any application in these circumstances.

Question 5

Summary

None of the following specific and general anti-avoidance provisions apply to the issue of Redeemable Preference Shares by X:

(a) the dividend streaming provisions in Subdivision204-D of the ITAA 1997;

(b) the dividend stripping provisions in section 177E of the ITAA 1936;

(c) the capital streaming provisions in sections 45 to 45D of the ITAA 1936;

(d) the general anti-avoidance provision relating to imputation benefits in section 177EA of the ITAA 1936;

(e) the general anti-avoidance provisions in Part IVA of the ITAA 1936.

Detailed reasoning

(a) Dividend streaming

Subdivision 204-D of the ITAA 1997 deals with the streaming of distributions with imputation benefits.

In broad terms, it is an anti-avoidance measure to deal with the inappropriate streaming of distributions with imputation benefits - it applies in circumstances where an entity streams one or more distributions is such a manner that members who will obtain a greater benefit from franking credits receive the franking benefits over those who will receive lesser or no franking benefits.

The Commissioner has confirmed in a number of rulings (eg. Class Ruling CR 2013/55 Income tax: Australian and New Zealand Group Limited - ANZ Capital Notes) that streaming is not defined for the purposes of Subdivision 204-D of the ITAA 1997. However, the Commissioner understands it to refer to a company 'selectively directing the flow of franked distributions to those members who can most benefit from the imputation credits' (paragraph 3.28 of the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 ).

Circumstances where a member will be considered to derive a greater benefit from franking credits than another member of the entity include:

• the non-favoured member is a non-resident; or

• the favoured member but not the non-favoured member is entitled to a tax offset in respect of the distribution.

The provision enables the Commissioner to make a determination to either impose a franking debit or deny an imputation benefit where distributions with imputation benefits are streamed to a member in preference to another member.

In this case, the relevant considerations are:

• X's membership comprises xx entities (with reference to yy employees, 2 non-executive directors and zz former employees) being a mix of mainly individuals and trusts/trustee companies - all of whom are Australian residents.

• Redeemable Preference Shares are allocated to members to implement a compensatory measure. The allocation is based solely on the previous share acquisitions of the shareholders - without regard for their tax attributes or their individual tax position (eg, their capacity to effectively utilise the franking credit attached to the distributions in respect of the shares).

• whilst Redeemable Preference Shares will have priority, all dividends are to be franked to the same extent and it is expected that all will be fully franked.

Based on the information provided, it would be reasonable for the Commissioner to conclude that the requisite element of streaming does not exist in relation to any imputation benefits attached to each class of Redeemable Preference Shares, and as such he will not make a determination under paragraph 230-30(3)(c) of the ITAA 1997 to deny imputation benefits to the Redeemable Preference Shareholders.

(b) Dividend stripping

Section 177E of the ITAA 1936 deals with the stripping of company profits.

Broadly, it is an anti-avoidance measure to deal with any property of a company that is disposed as a result of:

• a scheme by way of, or in the nature of dividend stripping; or

• a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping.

Taxation Ruling IT 2627 Income tax: application of Part IVA to dividend stripping arrangements sets out the Commissioner's views on section 177E of the ITAA 1936 and the manner in which he applies the provision.

The ruling explains the meaning of dividend stripping:

8. The term 'dividend stripping' has no precise legal meaning. Therefore, it is not possible in this Ruling to provide exhaustive definitions of what does and what does not satisfy that expression.

9. However, it can be said that in its traditional sense a dividend stripping scheme would include one where a vehicle entity (the stripper) purchases shares in a target company that has accumulated or current years' profits that are represented by cash or other readily-realisable assets. The stripper pays the vendor shareholders a capital sum that reflects those profits and then draws off the profits by having paid to it a dividend (or a liquidation distribution) from the target company.

10. No exhaustive list of other examples can be given of what might constitute a dividend stripping scheme for the purposes of section 177E. Having regard to the overall scope and purpose of the section, an important element to be looked at will be any release of profits of a company to its shareholders in a non-taxable form, regardless of the different methods that might be used to achieve this result.

In this case, the relevant considerations are:

• Redeemable Preference Shares are allocated to members to implement a compensatory measure - which includes the distribution of fully franked dividends in respect of those shares;

• the distribution of fully franked dividends is not limited to Redeemable Preference Shareholders - it is available in respect of all classes of shares and all dividends are to be franked to the same extent and it is expected that all will be fully franked; and

• the dividends will form part of the assessable income of recipients.

Based on the information provided, it would be reasonable for the Commissioner to conclude there is no scheme to which section 177E of the ITAA 1936 would apply.

(c) Capital streaming

We will set out a brief overview of the legislative provisions governing capital streaming and our analysis that on the information given the legislative provisions would not apply in the circumstances.

See Class Ruling CR 2013/42 Income tax: Associated Retailers Limited - ARL Equity Notes and Class Ruling CR 2013/18 Income tax: National Australia Bank Limited - issue of convertible preference shares which provide a succinct overview.

Section 45

Section 45 of the ITAA 1936 applies where a company streams the provision of shares and the payment of minimally franked dividends to its shareholders in such a way that the shares are received by some (but not all) shareholders and minimally franked dividends are received by other shareholders. Minimally franked dividends are dividends which are not franked or are franked to less than 10%.

Section 45A

Section 45A of the ITAA 1936 applies in circumstances where a company streams the provision of capital benefits to certain shareholders who derive a greater benefit from the receipt of capital (the advantaged shareholders) and it is reasonable to assume that the other shareholders have received or will receive dividends (the disadvantaged shareholders).

The Commissioner may make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies. The effect of such a determination is that the capital benefit is taken to be an unfranked dividend.

Section 45B

Section 45B of the ITAA 1936 applies where certain payments are made to shareholders in substitution of dividends. Subsection 45B(2) of the ITAA 1936 sets out the conditions under which the Commissioner may make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies. These conditions are that:

• there is a scheme under which a person is provided with a capital benefit by a company (paragraph 45B(2)(a) of the ITAA 1936);

• under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with the capital benefit, obtains a tax benefit (paragraph 45B(2)(b) of the ITAA 1936); and

• having regard to the relevant circumstances of the scheme, it would be concluded 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 (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain a tax benefit (paragraph 45B(2)(c) of the ITAA 1936).

In this case, the relevant considerations are:

• the payments (dividends) will be made from retained earnings (past profits);

• the taxpayer has indicated that the payment of dividends from profits satisfies section 245T of the Corporations Act 2001; and

• the dividends will form part of the assessable income of recipients.

From the information provided, there is no streaming of capital benefits to certain shareholders and dividends to others. Nor are any payments being made in substitution for a dividend.

Accordingly, it cannot reasonably be concluded the entity or shareholders will enter into or carry out a scheme for the purpose of enabling the shareholders to obtain a tax benefit to which sections 45, 45A or 45B of the ITAA 1936 would apply.

(d) General imputation benefits anti-avoidance provisions

Section 177EA of the ITAA 1936 deals with the disposition of shares to obtain a franking credit benefit.

In broad terms, it is an anti-avoidance measure to deal with the disposition of shares where one of the purposes is to enable a taxpayer to obtain franking credit benefits.

Relevantly, subsection 177EA(3) of the ITAA 1936, provides that the following conditions must exist for the operation of the provision:

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

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in the membership interests, as the case may be; and

(c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

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

(e) having regard to the relevant circumstances of the scheme, it would be concluded 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 (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

Circumstances which are relevant in determining whether any person had the requisite purpose include, but are not limited to, the factors listed in subsection 177EA(17) of the ITAA 1936 - such as:

• the extent and duration of the risks of loss, and the opportunities for profit or gain, from holding shares in the company that are borne or accrue to the parties to the scheme;

• whether the relevant taxpayer would derive a greater benefit from franking credits than other entities that hold shares in the company;

• whether, apart from the scheme, the company 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; and

• the period for which the relevant taxpayer held shares in the company.

CR 2013/42 sets out the Commissioner's views on section 177EA of the ITAA 1936 and the manner in which he applies the provision.

Amongst other things, the ruling explains that the purpose must be other than an incidental purpose.

In this case, the relevant considerations are set out below.

Redeemable Preference Shares are allocated to members to implement a compensatory measure.

In relation to A Class Redeemable Preference Shares, it is to account for the difference between what they paid and $AA per share.

In relation to B Class Redeemable Preference Shares, it is to compensate former employees for the conversion of their Ordinary shares. This measure is being implemented to achieve a shareholder transition (their system was designed to minimise the number of shareholders who are external to the business).

The taxpayer has contended that there were three options available to them to achieve their objectives: being as payment of employee bonuses, refunds from shareholders who were overpaid upon the transfer of shares or selective dividends to aggrieved shareholders. Based on professional advice on the valuation of shares and the difficulty paying a bonus to former employees or compelling them to refund overpaid amounts, the Board considered that the only practical solution was the last option. The option was also adopted for commercial reasons; the share buybacks would have been prohibitive.

Pursuant to subsection 254W(2) of the Corporations Act 2001, in the case of a proprietary company, directors may pay dividends as they see fit, subject to the terms on which the shares were issued. However, based on the information provided there is no indication that that these shares were issued on a basis other than that each share in a class of shares the company has the same dividend rights.

The method chosen, ie. the allocation of redeemable preference shares, is reasonable in the context of the preservation of the uniformity of the ordinary shares (the taxpayer has taken into consideration whether such distortions would be commercially appropriate).

Proceeding on the basis that conditions (a) to (d) are met, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme, did so for a more than merely incidental purpose of enabling a shareholder to obtain an imputation benefit.

Based on the information presented, it would be reasonable for the Commissioner to conclude that a consideration of all the relevant circumstances of the scheme would not, on balance, lead to a conclusion that the purpose of enabling shareholders to obtain imputation benefits is more than incidental to the taxpayer's purpose of implementing an affordable compensatory measure and encouraging the reduction of external shareholdings in a manner that did not create distortions in other classes of shares. Accordingly, the Commissioner will not make a determination under section of 177EA of the ITAA 1936 to deny the whole, or part, of any imputation benefit attaching to the shares.

(e) General anti-avoidance provisions

Section 177D of the ITAA 1936 deals with the general anti-avoidance provisions to address schemes that have a sole or dominant purpose of avoiding tax.

Practice Statement Law Administration PS LA 2005/4 Application of General Anti-Avoidance Rules sets out the Commissioner's views on section 177D of the ITAA 1936 and the manner in which he applies the general anti-avoidance rules.

Class Ruling CR 2011/100 Income tax: scrip for scrip: exchange of shares in Map Airports International Limited for units in Map Airports Trust 2 and cash consideration provides a succinct overview of the operation and application of Part IVA of the ITAA 1936. The paragraphs below seek to apply paragraphs 69 to 72 inclusive of CR 20011/100 to the facts of this case.

The Commissioner has the discretion to cancel all, or part of, a tax benefit that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which section 177D or section 177E of the ITAA 1936 applies. 'Scheme' is defined broadly in section 177A of the ITAA 1936 and, in this case, would include all of the steps that comprise the adoption of the new method of determining the share price, the allocation of A Class Redeemable Preference Shares to current employees to compensate them for what was considered the overpayment of their Ordinary shares, and the conversion of the Ordinary shares held by previous employees to B Class Redeemable Preference Shares.

Section 177D of the ITAA 1936 applies to a scheme of which it would be concluded objectively, after having regard to the eight matters in subsection 177D(2) of the ITAA 1936, that it was entered into or carried out by any of its participants for the dominant purpose of enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit. In this case the relevant taxpayer(s) would be the shareholders.

For schemes to which section 177D of the ITAA 1936 applies, the reference to obtaining a tax benefit is explained, relevantly, in section 177CB of the ITAA 1936 as a reference to, but for the scheme, the whole or a part of a capital loss arising from the scheme not being incurred by the taxpayer.

In this instance, after having regard to the manner and other relevant circumstances of the share price readjustment scheme, as directed in subsection 177D(2) of the ITAA 1936, it is apparent that the form of the scheme is not inconsistent with the commercial objectives sought to be achieved by the taxpayer. Hence, it cannot be objectively inferred that the scheme would be entered into or carried out for the dominant purpose of enabling the relevant taxpayer(s) to obtain a tax benefit, as that term is explained in subsection 177CB(1) of the ITAA 1936.

Having regard to factors such as these are arm's length transactions that are not limited to certain shareholders, that the reassessment of share pricing is driven by the conclusion that the wrong pricing method was adopted (a conclusion supported by an external review) and the taxpayer's aim to reconfigure the shareholding structure for the future/viability of the company, it is reasonable to conclude that a tax benefit/tax avoidance is not the sole or dominant purpose of the scheme.