Edited version of private advice

Authorisation Number: 1012637862996

Ruling

Subject: Retirement planning

Question 1

Is the franked distribution from A Pty Ltd (the Company) to the B Superannuation Fund (the Fund) non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the franked distribution from the Company to the Fund made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the ITAA 1997?

Answer

Yes

Question 3

Is there a scheme to which Part IVA and therefore section 177F of the Income Tax Assessment Act 1936 (ITAA 1936) applies?

Answer

Yes

Question 4

Is there a scheme to which section 177EA of the ITAA 1936 applies?

Answer

Yes

This ruling applies for the following periods:

Year of income ended 30 June 2014

The scheme commences on:

1 July 2013

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. Taxpayer 1 and Taxpayer 2 are spouses (together, the Taxpayers). Taxpayer 1 and Taxpayer 2 have both reached retirement age.

2. The Taxpayers are the directors of the Company.

3. The Taxpayers are the trustees of the C Trust (the Trust), and in that capacity own all the shares in the Company. The cost base of the shares in the Company is nominal for the Taxpayers as trustees of the Trust.

4. The Taxpayers are beneficiaries of the Trust.

5. As reflected in the Company's Profit and Loss Statement for the year ended 30 June 2012, the Company received distributions from the Trust in that year. In the same income year, an amount was loaned by the Company to the Taxpayers.

6. The Company's net assets as at 30 June 2012 were approximately $X. The largest asset of the Company is the loan to the Taxpayers. The loan agreement requires repayments of principal and interest.

7. The Taxpayers intend to make the minimum payments in accordance with the loan agreement (said to be in compliance with Division 7A of the ITAA 1936) unless they take the steps set out in paragraph 10 below. The loan amount, and thus the net assets of the Company, for the purposes of the steps at paragraph 10 is approximately $X.

8. The Company has a franking account balance of approximately $X. The Company is in a position to pay a partially franked dividend equal to the whole of its retained earnings.

9. The Taxpayers, and Taxpayer 3, are members of the Fund. The trustee of the Fund is D Pty Ltd with the three members being directors of that trustee company. The Fund has invested predominantly in publicly listed shares and cash. The Taxpayers are currently each receiving an account-based pension from the Fund. Taxpayer 3's interest in the Fund is not supporting a superannuation income stream.

10. It is intended to implement the following steps:

(a) the Fund will liquidate its listed shares. The Fund is expected to incur a capital loss of approximately $X and brokerage fees of approximately $X to liquidate its listed shares;

(b) the Taxpayers will draw down approximately $X in total from the Fund by way of partial commutation of their respective pensions;

(c) the Taxpayers will use the $X from the Fund and a drawdown on a line of credit to repay the loan to the Company;

(d) the Company will convert all of its other assets to cash, so that it will hold approximately $X of cash represented by retained earnings, with no liabilities or other assets;

(e) the Company's shares will be professionally valued at market value. It is anticipated that the market value will be approximately $X. However, the exact value will be based on the cash assets of the Company at the time of valuation;

(f) the Fund will purchase the shares in the Company at that market value from the Trust. It is advised that the share purchase transaction will be fully documented and carried out on an arm's length basis. The Trust will make a net capital gain as a result of the disposal of the shares to the Fund, which is to be reflected as a net capital gain for the relevant beneficiaries.

(g) the shares will be purchased with any cash that remains in the Fund and the remainder will be borrowed by the Fund by way of vendor finance from the Trust under a limited recourse borrowing arrangement (LRBA);

(h) the shares will be held on trust (the LRBA holding trust) with the trustee of the LRBA holding trust acquiring the legal title and the trustee of the Fund acquiring a 'beneficial interest' in the shares (as referred to in paragraph 67A(1)(b) of the Superannuation Industry (Supervision) Act 1993 (SISA));

(i) the terms of the LRBA will be on an arm's length basis. The Fund will repay the loan after the Fund receives the franked distribution from the Company referred to below. Under the LRBA, the loan will have a maximum period of 12 months from the transfer of the shares in the Company. However, it is anticipated that the loan will not be repaid within a period of 45 days of the acquisition of the shares. It will, however, be repaid a short time after the dividend described in subparagraph 10(j) below is paid;

(j) after the expiry of 45 days from the purchase of the shares, the Company will pay a partially franked distribution to the Fund in an amount equal to the retained earnings of the Company;

(k) a proportion of the franked distribution, including the franking credit on that distribution, is said to be exempt from income tax for the Fund. A proportion (as worked out under subsection 295-390(3) of the ITAA 1997) of the franked distribution which would otherwise be assessable income of the Fund will be exempt from income tax under subsection 295-390(1) of the ITAA 1997. The relevant proportion is expected to be X%.

(l) The Fund is said to be entitled to a refund of the unused franking credit tax offset;

(m) the franked distribution will be used in part to repay the loan under the LRBA. Part of the remaining franked distribution and part of the unused franking credit tax offset (i.e. to the extent it does not relate to Taxpayer 3's interest in the Fund) will be used to pay pensions to the Taxpayers from the Fund. The Fund will not be paying either of the Taxpayers a superannuation lump sum;

(n) after payment of the franked distribution, the Company will be deregistered;

(o) upon the deregistration of the Company, the Fund will realise a capital loss equal to the market value of the shares in the Company at the time the Fund purchased the shares. It is expected that the Fund will use those capital losses to the extent possible given that there is one member of the Fund not in receipt of a pension;

(p) to largely maintain their retirement income streams the Taxpayers will subsequently each make a non-concessional contribution of $X to the Fund applying the "bring forward" method relevant to excess non-concessional contributions tax. The Taxpayers each satisfy the work test under subregulation 7.04(1) of the Superannuation Industry (Supervision) Regulations 1994 (SISR).

11. It is anticipated that the steps in the arrangement will occur over a period of months.

12. The Taxpayers' purposes in undertaking these steps are:

(a) to simplify their financial affairs;

(b) to minimise ongoing compliance costs of repaying principal and interest on the loan from the Company;

(c) to minimize the need for a high degree of risk management associated with complying with the loan agreement;

(d) to minimize the compliance costs of managing the loan and preparing annual financial statements and tax returns for the Company;

(e) to achieve the above outcomes whilst still largely maintaining the existing retirement income streams of the Taxpayers.

13. If the steps at paragraph 10 are not undertaken, it is intended that the Company will pay franked dividends over a number of years to the Trust which will be distributed to the Taxpayers to enable them to repay the loan to the Company.

Assumptions

14. There is a borrowing of money that would otherwise be prohibited under subsection 67(1) of the SISA but for the LRBA that complies with the requirements of section 67A of the SISA.

(Note: Not all forms of financial accommodation give rise to a borrowing of money. See Self Managed Superannuation Funds Ruling SMSFR 2009/2 Self Managed Superannuation Funds: the meaning of 'borrow money' or 'maintain an existing borrowing of money' for the purposes of section 67 of the Superannuation Industry (Supervision) Act 1993.)

15. The trust deed establishing the LRBA holding trust provides for the Fund to hold a fixed entitlement to the income of the holding trust.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 section 202-55

Income Tax Assessment Act 1997 section 202-60

Income Tax Assessment Act 1997 section 202-65

Income Tax Assessment Act 1997 section 207-20

Income Tax Assessment Act 1997 section 207-145

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 section 295-390

Income Tax Assessment Act 1997 section 295-545

Income Tax Assessment Act 1997 section 295-550

Superannuation Industry (Supervision) Act 1993 subsection 67(1)

Superannuation Industry (Supervision) Act 1993 section 67A

Superannuation Industry (Supervision) Regulations 1994 subregulation 7.04(1)

Reasons for decision

Question 1

Summary

16. Leaving aside considerations of section 207-145 of the ITAA 1997 and Part IVA of the ITAA 1936 as dealt with in the subsequent questions, the franked distribution that flows from the Company to the Fund would be non-arm's length income of the Fund under subsection 295-550(5) of the ITAA 1997. The franked distribution would therefore not be exempt as current pension income under either subsection 295-385(1) or 295-390(1) of the ITAA 1997.

Detailed reasoning

17. In accordance with section 295-545 of the ITAA 1997 the income of a complying superannuation fund is split into a 'non-arm's length component' and a 'low tax component'.

18. The note to subsection 295-545(1) of the ITAA 1997 explains that a concessional rate (15%) of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal tax rate (45%). These rates are set out in the Income Tax Rates Act 1986.

19. Subsection 295-545(2) of the ITAA 1997 provides that the non-arm's length component for an income year is the entity's non-arm's length income for that year less any deductions to the extent that they are attributable to that income. The phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997.

Application of subsection 295-550(5) of the ITAA 1997

20. Subsection 295-550(5) of the ITAA 1997 provides that:

Other income *derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm's length income of the entity if:

(a) the entity acquired the entitlement under a *scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at *arm's length; and

(b) the amount of the income is more than the amount that the entity might have expected to derive if those parties had been dealing with each other at arm's length.

Fixed entitlement

21. On the basis that the trust deed establishing the LRBA holding trust provides for the Fund to hold a fixed entitlement to the income of the holding trust subsection 295-550(5) of the ITAA 1997 is relevant. If that conclusion is not correct, any income derived by the Fund as beneficiary of the LRBA holding trust would be non-arm's length income of the Fund under subsection 295-550(4) of the ITAA 1997.

Entitlement acquired or income derived under a scheme

22. The term 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a) any *arrangement; or

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

23. The term 'arrangement' is also defined in subsection 995-1(1) of the ITAA 1997 to mean 'any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings'.

24. The Full Court of the Federal Court in Allen v Federal Commissioner of Taxation (2011) 195 FCR 416 (Allen) considered the term 'arrangement' as defined for the purposes of former subsection 273(7) of the ITAA 1936 - the immediate predecessor of subsection 295-550(5) of the ITAA 1997. That term was defined in terms almost identical to a combination of the definitions of 'scheme' and 'arrangement' in the ITAA 1997. The Court held that the series of steps undertaken by the parties that resulted in the acquisition of a fixed interest in the trust estate and the relevant distributions of income from that trust estate were readily seen to be an 'arrangement' to which the various entities were parties, and whose results were readily seen to be the consequence of that arrangement.

25. Similarly, for the purposes of applying subsection 295-550(5) of the ITAA 1997 in the present case, there is a series of steps undertaken by related parties resulting in the Fund's acquisition of a beneficial interest in the shares and a fixed entitlement to income resulting from that beneficial interest. It is therefore concluded that the entitlement is acquired and the income is derived under a scheme.

Whether parties are dealing with each other at arm's length and whether the income is more than it might otherwise have been

26. In determining whether the parties deal at arm's length it is necessary to consider any connection between them and any other relevant circumstances (see the meaning of 'arm's length' in subsection 995-1(1) of the ITAA 1997).

27. It is clear that the parties in the present case are not at arm's length. The Taxpayers, as trustees of the Trust, are the vendor shareholders and lenders under the LRBA. The Taxpayers are also directors of the Company that is paying the dividend to the Fund and the Taxpayers are also members of the Fund and directors of the corporate trustee of the Fund. The scheme therefore involves persons who are all connected being the Taxpayers themselves or entities which they control or are interested in.

28. As to whether or not they are dealing at arm's length, in Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204 Dowsett J summarised propositions, which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' (or similar) have been considered, as follows:

(a) in determining whether parties have dealt with each other at arm's length in a particular transaction, one may have regard to the relationship between them;

(b) one must also examine the circumstances of the transaction and the context in which it occurred;

(c) one should do so with a view to determining whether or not the parties have conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction;

(d) relevant factors which may emerge include existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal;

(e) where the parties are not in an arm's length relationship, one may infer that they did not deal with each other at arm's length, and that the resultant transaction is not at arm's length;

(f) however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship;

(g) un-related parties may, on occasions, deal with each other in such a way that the resultant transaction may not properly be considered to be at arm's length.

29. Although Dowsett J dissented in the application of those propositions in that case, Edmonds and Gordon JJ did not disapprove of his summary of those propositions.

30. In that case Edmonds and Gordon JJ further stated that:

Any assessment of whether parties were dealing at arm's length involves 'an assessment [of] whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining':..

31. Further, the Full Court of the Federal Court in Allen held that former paragraph 273(7)(a) of the ITAA 1936 - the immediate predecessor of paragraph 295-550(5)(a) of the ITAA 1997 - does not require that the 'dealing' consist only of the actual derivation of the income in question by 'the entity' but that the evident legislative intention of the provisions is to permit regard to be had to the totality of the steps that result in the entity's acquisition of its fixed entitlement to the income of the trust and any derivation of income by the entity through holding that entitlement.

32. In this case, it is consistent with Allen to consider the arrangement holistically to determine if income of the Fund is non-arm's length income. The arrangement is one effectively carried out by the Taxpayers in their various capacities as the shareholders and directors, beneficiaries/members or trustees of the parties to the arrangement. The holistic approach recognises that the purchase of the shares by the Fund from the Trust is financed by the Trust with the LRBA holding trust relevant only because there is a borrowing which would otherwise be prohibited under subsection 67(1) of the SISA. If the focus were limited only to the LRBA holding trust and Fund, it might more readily lead to a conclusion that subsection 295-550(5) of the ITAA 1997 applies because looking only at this part of the arrangement it would appear that the Fund acquired its (fixed) interest in the LRBA holding trust for nil consideration.

33. The final requirement as set out in paragraph 295-550(5)(b) of the ITAA 1997 is that the amount of the income derived by the Fund (through holding a fixed entitlement to the income of the LRBA holding trust) is more than the amount that the Fund might have expected to derive if the parties had been dealing with each other at arm's length. This is met if the Fund would have derived less dividend income (including the statutory income arising from the franking credits) but for the arrangement.

34. In determining if the income of the Fund from the shares is non-arm's length income, the following matters are considered relevant:

(a) The Fund has minimal or nil investment risk as beneficial owner of the shares as the only asset of the Company is cash, the Company has no liabilities and there are no trading or investment activities being conducted by the Company.

(b) There is no risk that the dividend won't flow to the Fund from the Company given the non-arm's length relationship that exists between all parties involved.

(c) During the relatively short period of time the shares are held by the Fund through the LRBA holding trust the Fund will realise all of the assets of the Company giving the Fund a return of 100% based on the stated market value of the shares and an after tax return in excess of 100% (i.e. with the refund of the unused franking credit tax offset).

(d) The purchase price of the shares for the Fund is indicated to be $X which takes no account of the statutory right to the franking credit tax offset and the subsequent refund that is conferred on a Fund as a result of the transaction.

(e) The net economic return enjoyed by the Fund in respect of the arrangement is the amount of the refunded franking credit tax offset less the interest expense incurred by the Fund. That return is significant when compared with the risk borne by the Fund under the scheme. If all the parties were dealing with each other at arm's length, it is expected that in return for a payment of $X the Fund could expect to acquire less than 100% of the shares and therefore derive less dividend income than $X. That is, in an arm's length arrangement the statutory right to the franking credit tax offset and the subsequent refund that is conferred on a Fund as a result of the transaction could be expected to factor in to the number of shares able to be acquired for $X.

35. It is therefore concluded that the dividend income of the Fund and the statutory income arising from the franking credits is non-arm's length income of the Fund.

Question 2

Summary

36. The franked distribution that flows from the Company to the Fund is made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the ITAA 1997. Consequently the amount of the franking credit on the distribution is not included in the assessable income of the Fund under section 207-20 or 207-35 of the ITAA 1997 and the Fund is not entitled to a tax offset under Subdivision 207-F because of the distribution (paragraphs 207-145(e), (f) and (g) of the ITAA 1997).

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997

37. Subsection 207-145(1) of the ITAA 1997 provides, relevantly, that where a franked distribution is made to an entity in circumstances where (in paragraph 207-145(1)(d)) 'the distribution is made as part of a dividend stripping operation', then, relevantly:

(a) (in paragraph 207-145(1)(e)) the amount of the franking credit on the distribution is not included in the assessable income of the entity under section 207-20 or 207-35 of the ITAA 1997;

(b) (in paragraph 207-145(1)(f)), the entity is not entitled to a tax offset under Subdivision 207-F because of the distribution; and

(c) (in paragraph 207-145(1)(g)) if the distribution flows indirectly through the entity to another entity - subsection 207-35(3) and section 207-45 of the ITAA 1997 do not apply to that other entity.

38. Section 207-155 of the ITAA 1997 defines when a distribution is made as part of a 'dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997 as follows:

A distribution made to a *member of a *corporate tax entity is taken to be made as part of a dividend stripping operation if, and only if, the making of the distribution arose out of, or was made in the course of, a *scheme that:

(a) was by way of, or in the nature of, dividend stripping; or

(b) had substantially the effect of a scheme by way of, or in the nature of, dividend stripping.

39. If the franked distribution is made 'as part of a dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997, the relevant effect will be that the amount of any franking credit on the distribution will not be included in the assessable income of the Fund and the Fund will not be entitled to a tax offset under Subdivision 207-F or section 207-45 of the ITAA 1997.

Dividend stripping operations

40. A 'dividend stripping operation' has been recognised as involving the following characteristics:

(a) a company with substantial undistributed profits (target co);

(b) a sale or allotment of shares in target co to another party;

(c) the payment of a dividend to the purchaser or allottee of shares by target co;

(d) the acquirer escaping Australian income tax on the dividend so declared;

(e) the vendor shareholder receiving a capital sum for their shares in an amount the same as or very close to the dividend paid out; and

(f) the transactions being carefully planned, with the parties acting in concert for the predominant purpose of avoiding tax on the distribution of dividends by target co.

See Commissioner of Taxation v. Consolidated Press Holdings Ltd [1999] FCA 1199; (1999) 91 FCR 524 (FCT v. CPH (FFC)) at [136] - [137] and [157], Commissioner of Taxation v. Consolidated Press Holdings Ltd [2001] HCA 32; (2001) 207 CLR 235 (FCT v. CPH (HC)) at [126] and [129]; and Lawrence v. Federal Commissioner of Taxation [2009] FCAFC 29; (2009) 175 FCR 277 (Lawrence v. FCT) at [42] - [43].

41. A scheme may still be a 'dividend stripping operation' because the making of a distribution was 'by way of or in the nature of dividend stripping' even if it contains features which vary from the paradigm case of dividend stripping, so long as it retains the central characteristics of a dividend stripping scheme: FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45].

42. A difference between a scheme 'by way of or in the nature of dividend stripping' and a scheme which has 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping' lies in the means adopted to distribute the profits of the target company. Where the means adopted do not involve a distribution, but some other step (such as the purchase by the target company of near worthless assets or assets later rendered near worthless by the target company) this involves a scheme having 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping': Lawrence v. FCT at [47] - [52].

Will the franked distribution be a distribution made as part of a dividend stripping operation?

43. The payment of the franked distribution that flows to the Fund will be made as part of a 'dividend stripping operation' within the meaning of paragraph  207-145(1)(d) of the ITAA 1997 because each of the elements (identified in paragraph 40 above) of a scheme 'by way of, or in the nature of, dividend stripping' will be present.

44. First element: The Company has substantial undistributed profits as its sole asset is cash represented by retained earnings. This creates a potential tax liability for either the Taxpayers as trustees of the Trust, and/or a beneficiary, or beneficiaries, of the Trust. If the franked distribution was paid to the Taxpayers as trustee of the Trust, under subparagraph 44(1)(a)(i) of the ITAA 1936, either the Taxpayers and/or a beneficiary, or beneficiaries, of the Trust would be assessed on an amount reflecting the franked distribution. Accordingly, the element of a dividend stripping operation identified in paragraph 40(a) above is satisfied.

45. Second element: There will be a sale or allotment of shares in the target co to another party. The Taxpayers as trustees of the Trust will sell the shares in the Company to the Fund and the Taxpayers as trustees of the Trust will receive a capital sum for those shares. There is nothing in the concept of a scheme by way of or in the nature of a dividend stripping operation which would require that the sale involve a share trader or be a company-to-company transaction attracting an inter-company dividend rebate. In FCT v. CPH (FFC) at [136], the Full Court referred to a dividend stripping operation involving a sale and allotment to individuals. Accordingly, the element of a dividend stripping operation in paragraph 40(b) above is satisfied.

46. Third element: The Company will pay a franked distribution which flows to the Fund equal to the value of the Company's cash assets. Accordingly, the element of a dividend stripping operation in paragraph 40(c) above is satisfied.

47. Fourth element: On the assumption that the franked distribution is not non-arm's length income of the Fund (within the meaning of section 295-550 of the ITAA 1997) the franked distribution is said to be exempt income of the Fund under section 295-390 of the ITAA 1997. In the result, absent the application of subsection 207-145(1) of the ITAA 1997 the Fund will obtain a refund of the unused franking credit tax offset in relation to the franked distribution. It does not detract from this conclusion that the shares are held under the LRBA. This is because the Fund holds the beneficial interest in the shares under the LRBA and the franked distribution flows to the Fund with the consequence that neither the LRBA holding trust nor the Fund is subject to tax on the franked distribution.

48. The reference in FCT v. CPH (FFC) at [136] to various different means by which tax can be escaped (including application of an inter-company dividend rebate) was not an exhaustive description of the means by which tax can relevantly be escaped on the dividend by a dividend stripping operation. Accordingly, the element of a dividend stripping operation in paragraph 40(d) above is satisfied.

49. Fifth element: The Taxpayers as trustees of the Trust will receive a capital sum of $X for the sale of the shares in the Company to the Fund. This amount equals the sum of the dividend. Accordingly, the element of a dividend stripping operation in paragraph 40(e) above is satisfied. It does not detract from this conclusion that the capital sum is, in part, initially recognised as a loan amount due to the Taxpayers as trustees of the Trust by the Fund, and that the loaned amount will not be paid to the Taxpayers as trustees of the Trust until the franked distribution has been paid by the Company.

50. Sixth element: The sixth element is satisfied for the following reasons:

(a) The arrangement proposed and described at paragraph 10 above is carefully planned. It involves all the parties acting in concert. The parties are all related, being the Taxpayers or companies or trusts controlled by them.

(b) From the point of view of the Fund, the principal or pre-dominant economic effect of the arrangement proposed and described at paragraph 10 above is obtaining a tax benefit: namely, the attraction of the exemption in subsection 295-390(1) of the ITAA 1997 to the franked distribution and generating a refund of the unused franking credit tax offset. That tax benefit overwhelmingly provides the explanation for the reinstatement of some of the value of the Fund as a result of the arrangement. The balance of the franked distribution is largely used to repay the loan (under the LRBA) to the Taxpayers as trustees of the Trust (from whom the shares in the Company were purchased) and thus has no other economic effect.

(c) A further tax effect for the Fund is the generation of a capital loss, which is at least partially available to be used so far as Taxpayer 3's interest is in accumulation phase.

(d) From the point of view of the vendor shareholders (the Taxpayers as trustees of the Trust), the principal or predominant effect of the arrangement proposed and described at paragraph 10 above is the substitution of a capital amount for the disposal of the shares, instead of dividend income, with a resultant lower incidence of tax (under the applicable capital gains tax provisions). The fact that the Taxpayers as trustee of the Trust and/or a beneficiary, or beneficiaries, of the Trust (which may include the Taxpayers) may have an assessable net capital gain in relation to the sale of the shares in the Company to the Fund does not mean that a dividend stripping scheme cannot arise. In Lawrence v. FCT the Full Court of the Federal Court observed at [44] that 'notwithstanding the advent of a comprehensive taxation of capital gains, this characteristic remains relevant because the methods of calculating capital gains invariably lead to a lower amount of tax').

(e) It is no answer to say that the arrangement is undertaken for the purposes of retirement planning and to provide for the Taxpayers' better retirement rather than for the purpose of avoiding tax. This is because that poses a false dichotomy of the kind referred to in Commissioner of Taxation v. Spotless Services Limited (1996) 186 CLR 404 (FCT v. Spotless) at 415 - 416. On an objective assessment, the aspect of the arrangement that makes it desirable retirement planning for the Taxpayers is the tax benefit obtained through the channeling of the franked distribution through the Fund: namely, the exemption of the franked distribution and the refund of the unused franking credit tax offset referred to in subparagraph 10(l) above.

(f) It is also no answer to say that the arrangement is undertaken for the purpose of simplifying the Taxpayers' financial affairs and minimizing the management of the loan and costs to the Company. If those were the objectives, they could be more simply achieved by the Company distributing its assets to the Taxpayers as trustees of the Trust and then being deregistered. The relevant difference would be that the tax effects achieved by the arrangement proposed and described at paragraph 10 above would not be achieved.

51. For these reasons, the arrangement proposed and described at paragraph 10 above is a dividend stripping operation within the meaning of subsection 207-145(1) of the ITAA 1997.

Question 3

Summary

52. There is a scheme to which Part IVA and therefore section 177F of the ITAA 1936 applies. The Commissioner may make a determination under section 177F that has the effect of cancelling the tax benefit.

Detailed reasoning

Section 177E of Part IVA of the ITAA 1936

53. Where the conditions of subsection 177E(1) of Part IVA of the ITAA 1936 are satisfied, paragraph 177E(1)(e) provides that the relevant scheme 'shall be taken to be a scheme to which this Part applies'; and paragraph 177E(1)(f) provides that 'the taxpayer shall be taken to have obtained a tax benefit in connection with the scheme' with the result that the Commissioner is empowered to issue a determination cancelling the tax benefit under section 177F of the ITAA 1936.

54. The conditions in subsection 177E(1) of the ITAA 1936 are to the following effect:

(a) there is a 'scheme' of the kind defined in subsection 177A(1) of the ITAA 1936 that is in relation to the company (target co);

(b) the scheme is one:

(i) by way of or in the nature of dividend stripping; or

(ii) having substantially the same effect as dividend stripping;

(c) a result of the scheme is that property of the target co is disposed of;

(d) the Commissioner forms the opinion that the disposal of property by the target co represents in whole or in part a distribution whether to a shareholder (called the vendor shareholder) or another person of profits of target co;

(e) had the target co, immediately before the scheme was entered into, paid a dividend out of profits equal to the amount of profits represented by the target co's disposal of property (the 'notional amount'), the notional amount would or might reasonably be expected to have been included by reason of the payment of the dividend in the assessable income of a taxpayer in a year of income; and

(f) the scheme was entered into after 27 May 1981.

See FCT v. CPH (FFC) at [118] - [123].

55. As noted above, if those conditions are satisfied, the scheme is taken to be one to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e)), and the taxpayer shall be taken to have obtained a tax benefit referable to the notional amount not being included in the assessable income of the taxpayer in the year of income: FCT v. CPH (FFC) at [124] - [127].

Are the conditions of subsection 177E(1) of the ITAA 1936 satisfied in relation to the franked distribution that flows from the Company to the Fund?

56. For the following reasons, each of the conditions in paragraphs 177E(1)(a) to (d) of the ITAA 1936 referred to in paragraph 54 above is satisfied.

57. First condition: The breadth of the definition of 'scheme' in section 177A of the ITAA 1936 has been judicially noted: British American Tobacco Australia Services Ltd v. Federal Commissioner of Taxation [2010] FCAFC 130; (2010) 189 FCR 151 at [30]. It includes any 'scheme, plan, proposal, action, course of conduct, or course of action'.

58. The steps in paragraph 10 above clearly constitute a scheme within the meaning of subsection 177A(1) of the ITAA 1936.

59. The scheme is plainly a 'scheme that is in relation to a company'.

60. For this reason, the first condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 54(a) above is satisfied.

61. Second condition: For the reasons given above in paragraphs 43 to 51 the steps set out in paragraph 10 above involves a 'scheme' by way of or in the nature of dividend stripping. Therefore, the second condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 54(b) above is satisfied.

62. Third condition: Subsection 177E(2) of the ITAA 1936 provides as follows:

Without limiting the generality of subsection (1), a reference in that subsection to the disposal of property of a company shall be read as including a reference to:

(a) the payment of a dividend by the company;

(b) the making of a loan by the company (whether or not it is intended or likely that the loan will be repaid);

(c) a bailment of property by the company; and

(d) any transaction having the effect, directly or indirectly, of diminishing the value of any property of the company.

63. The scheme involves the payment by the Company of the franked distribution that flows to the Fund and thus is a scheme the result of which is the disposal of property of the Company within the meaning of paragraph 177E(2)(a) of the ITAA 1936 (see paragraph 10(j) above).

64. Accordingly, the third condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 54(c) above is satisfied.

65. Fourth condition: As noted above in paragraph 10(j), the franked distribution is to be paid in an amount of $X which represents the Company's retained earnings. Therefore, the Commissioner has formed the view that the franked distribution will represent, in whole or in part, a distribution of the profits of the Company. For this reason, the fourth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 54(d) above is satisfied.

66. Fifth condition: If, before the scheme was entered into, the Company paid a franked distribution out of profits to its then shareholders, it is reasonable to expect that either the Taxpayers as trustees of the Trust and/or a beneficiary, or beneficiaries, of the Trust would be assessed on an amount reflecting the franked distribution. For this reason, the fifth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 54(e) above is satisfied

67. Sixth condition: The scheme is to be entered into after 27 May 1981. Therefore, the sixth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 54(f) above is satisfied.

68. For those reasons, if the steps in paragraph 10 above are entered into, there will be taken to be a scheme to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e) of the ITAA 1936). Further, the Taxpayers as trustee of the Trust and/or a beneficiary, or beneficiaries, of the Trust, will be taken to have obtained a tax benefit in connection with the scheme (paragraph 177E(1)(f)), being the amount which, had the Company paid a franked distribution prior to entering into the scheme, would have been assessed to the Taxpayers as trustees of the Trust or an amount reflecting the franked distribution would have been assessed to a beneficiary, or beneficiaries, of the Trust.

Question 4

Summary

69. There is a scheme to which section 177EA of the ITAA 1936 applies. The Commissioner may therefore determine (under paragraph 177EA(5)(b)) that no imputation benefit arises for the Fund in respect of that distribution.

Detailed reasoning

Section 177EA of the ITAA 1936

70. Subsection 177EA(5) of the ITAA 1936 gives the Commissioner the power (relevantly, in paragraph 177EA(5)(b)) to determine that no imputation benefit is to arise in respect of a distribution or specified part of a distribution that is made or flows indirectly to a relevant taxpayer.

71. In Mills v. Federal Commissioner of Taxation [2012] HCA 51; (2012) 87 ALJR 53 (Mills v. FCT) at [59], it was pointed out that subsection 177EA(3) of the ITAA 1936 'is an exhaustive statement of the jurisdictional facts that are necessary and sufficient for s177EA to apply so as to found an exercise of power by the Commissioner to deny a franking credit under s177EA(5)(b)'.

72. The 'jurisdictional facts' can be relevantly identified as follows:

(a) there is a scheme for the distribution of membership interests, or interests in membership interests, in a corporate tax entity (paragraph 177EA(3)(a) of the ITAA 1936). This includes entering into a contract, arrangement, transaction or dealing that changes or otherwise affects the legal or equitable ownership of the membership interests or interests in membership interests (paragraph 177EA(14)(b));

(b) a frankable distribution has been paid, or is payable, or expected to be payable in respect of the membership interest or has flowed indirectly, or flows indirectly, or is expected to flow indirectly in respect of the interest in membership interests (paragraph 177EA(3)(b));

(c) the distribution was, or is expected to be, a franked distribution (paragraph 177EA(3)(c));

(d) except for section 177EA, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, an imputation benefit as a result of the distribution (paragraph 177EA(3)(d)). An 'imputation benefit' includes receipt by the taxpayer of a tax offset under Division 207 of the ITAA 1997 or, in the case of a corporate taxpayer, a franking credit arising in the franking account of the taxpayer (subsection 177EA(16));

(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' (paragraph 177EA(3)(e)).

73. The 'relevant circumstances' are defined in subsection 177EA(17) of the ITAA 1936 to include 11 matters, the last of which (in paragraph 177EA(17)(j)) includes the eight matters in paragraphs 177D(2)(a) to (h) of the ITAA 1936.

74. Section 177EA of the ITAA 1936 was considered by the High Court in Mills v. FCT. The following propositions emerge from the judgment of Gageler J (with whom the other members of the Court agreed):

(a) the relevance of the 'relevant circumstances' in subsection 177EA(17) lies in the extent to which they are probative of the ultimate question of purpose (at [61]);

(b) the circumstances referred to in subsection 177EA(17) are not exhaustive of the circumstances that might be probative of that ultimate question. They are nevertheless mandatory relevant considerations. Where they exist, they must be taken into account and their degree of relevance will vary according to the extent to which they are probative of the ultimate question (at [61]);

(c) the reference to purpose in paragraph 177EA(3)(e) may, but need not, be that of the issuer. A purpose is a consequence intended by a person to result from some action and, in this context, refers to a consequence intended by the person in entering into or carrying out a scheme for the disposition of relevant interests. A person will often intend a single action to have multiple consequences (at [63]);

(d) a purpose is an 'incidental purpose' within the meaning of paragraph 177EA(3)(e) if it does no more than follow from some other purpose. A purpose can be incidental even when it is central to the design of a scheme if the design is directed to the achievement of another purpose (at [64] and [66]);

(e) the reference to 'enabling' in paragraph 177EA(3)(e) refers to 'supplying with the requisite means or opportunities' to the end of obtaining an imputation benefit (at [65]);

(f) a relevant purpose within the scope of paragraph 177EA(3)(e) need not be a 'dominant purpose'; a 'dominant purpose' is sufficient but not necessary to supply the relevant jurisdictional fact. It does not follow that 'a purpose which does no more than further or follow from some dominant purpose is incidental' (at [66]);

(g) counterfactual analysis is not antithetical to the assessment of purpose in paragraph 177EA(3)(e). Consideration of alternatives may assist the drawing of conclusions in a particular case that a purpose of enabling a holder to obtain a franking credit does or does not exist and, if it does exist, whether it is incidental to some other purpose (at [66]);

(h) in the case of a capital raising, if the franking of distributions serves no purpose other than to facilitate the capital raising, then the purpose is an incidental purpose within the meaning of paragraph 177EA(3)(e) (at [67]); and

(i) in the assessment of purpose in subsection 177EA(3), each of the factors in subsection 177EA(17) need not be analysed individually, so long as they are all taken into account, where probative, in a global assessment of purpose (at [73]).

Application of paragraphs 177EA(3)(a) - (d) of the ITAA 1936

75. It is clear that the 'jurisdictional facts' in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 and described in paragraphs 72(a) to (d) above are satisfied. This is because:

(a) there is a 'scheme for the disposition of membership interests' as the relevant scheme involves the sale of shares in the Company by the Taxpayers as trustees of the Trust to the Fund (see paragraph 10 above). Accordingly, the jurisdictional fact in paragraph 177EA(3)(a) is satisfied;

(b) it is expected that the distribution that flows to the Fund will be a frankable distribution and it is expected to be a franked distribution (see paragraph 10(k) above). Accordingly, the jurisdictional facts in subparagraph 177EA(3)(b)(i) or (ii) and paragraph 177EA(3)(c) are satisfied.

(c) except for section 177EA, the Fund could reasonably be expected to receive an imputation benefit as a result of the franked distribution. Accordingly, the jurisdictional fact in paragraph 177EA(3)(d) is satisfied.

76. Accordingly, the question as to whether the Commissioner has the power to make a determination under subsection 177EA(5) of the ITAA 1936 then turns on whether the relevant purpose in paragraph 177EA(3)(e) is present.

Is it more than an incidental purpose of the scheme to enable the Fund to obtain an imputation benefit?

77. As was observed in Mills v. FCT, the relevance of each of the factors in subsection 177EA(17) of the ITAA 1936 and the probative weight they bear will differ in each case (at [61]).

78. Some of the 'relevant circumstances' in subsection 177EA(17) of the ITAA 1936 can be put aside as irrelevant. Because the Fund will be the sole beneficial shareholder in the Company, there is no question of it deriving a 'greater benefit' than other persons who hold membership interests. Thus, the circumstances in paragraphs 177EA(17)(b), (c) and (d) can be put to one side. Equally, the scheme does not involve the issue of non-share equity and so the matter in paragraph 177EA(17)(e) can be put to one side. These matters are generally concerned with 'dividend streaming' arrangements: see Mills v. Federal Commissioner of Taxation [2011] FCAFC 158; 198 FCR 89 at [43].

79. Some of the 'relevant circumstances' in subsection 177EA(17) of the ITAA 1936 point, at least to some extent, against the existence of the relevant purpose:

(a) the consideration to be paid to the Taxpayers as trustees of the Trust for the shares in the Company does not appear to have been calculated by reference to any imputation benefits (it appears to have been calculated by reference to the sum of the value of the Company's retained earnings but not including the franking credits) (cf., paragraph 177EA(17)(f)). However, given the close relationship of all parties to the scheme, the fact that the scheme involves circular payments as between those related parties and the fact that the tax effect of the scheme is not dependent on the dividend being calculated by reference to the franking credits, the weight of this factor is slight;

(b) the franked distribution does not appear to be equivalent to the receipt of an amount in the nature of interest (cf., paragraph 177EA(17)(h));

(c) the franked distribution appears to be paid from taxed and not untaxed profits (cf., paragraph 177EA(17)(ga)).

These matters, to the extent that they bear probative weight, point against the relevant conclusion.

80. The following matters in subsection 177EA(17) of the ITAA 1936 point to the existence of the relevant purpose:

(a) the period of time the Fund will hold the shares in the Company prior to the payment of the franked distribution is short and following payment of the franked distribution the Company will be deregistered. It appears that the Company will conduct no trading activities in that period and its assets are wholly cash assets. The extent and duration of the risk of loss the Fund will bear as a result of its holding of the shares in the Company will be minimal. After payment of the franked distribution, the Company will be worthless. The Fund was not the economic owner of the shares when the Company generated the franking credits and will not bear any significant risk in the short period of its holding of the shares in the Company. This undermines the principles of the imputation system: Explanatory Memorandum to the Taxation Laws (Amendment) Bill (No 3) at [8.5] (cf., paragraphs 177EA(17)(a) and (i));

(b) the subsequent deregistration of the Company will give rise to a capital loss for the Fund thus incurring a capital loss in connection with the distribution (cf., paragraph 177EA(17)(g)). However, since it is not anticipated that most of this capital loss will be used while the Fund is almost entirely in pension phase, this factor is of limited weight.

81. Turning to the matters in paragraphs 177D(2)(a) to (h) of the ITAA 1936 which are picked up by paragraph 177EA(17)(j) of the ITAA 1936, the following are relevant:

(a) the scheme involves a carefully orchestrated and interlinked series of transactions (cf., paragraph 177D(2)(a)) between persons who are, or who are all connected with, the Taxpayers (cf., paragraph 177D(2)(h));

(b) the scheme's form involves a sale of the shares in the Company to the Fund and payment of a franked distribution that flows to it. The substance of the scheme (that is, 'what in fact [the relevant person] may achieve by carrying it out': Mills v. FCT at [71]) is the channelling of the distribution of the profits and the franking credits of the Company to its ultimate economic owners (the Taxpayers) through the Fund in order to generate a refund of the franking credits (see paragraph 49(b) above) (cf., paragraph 177D(2)(b));

(c) the scheme is to be implemented over a short period of time. The length of the scheme is no longer than is necessary to cause the Company to pay the franked distribution that flows to the Fund and to thereby enable the Fund to repay the loan from the Trust under the LRBA and permit the Company to be put in a position to be deregistered (cf., paragraph 177D(2)(c));

(d) the effects of the scheme (that is, the financial position of the relevant persons with and without the scheme: Mills v. FCT at [70]) will be as follows(cf., paragraphs 177D(2)(d) - (f)):

(i) the Fund will receive the franked distribution as well as a refund of the unused franking credit tax offset on the basis that X% of the franked distribution is exempt income under section 295-390 of the ITAA 1997; and a capital loss on the Company's deregistration. The Fund will incur a liability under the LRBA, and will utilize some existing assets to acquire the shares with the amount paid for the shares equal to the quantum of the franked distribution. The difference in the economic position of the Fund with and without the scheme is overwhelmingly due to the effect of the refund of the unused franking credit tax offset (paragraph 49(b) above) and the non-concessional contributions made by the Taxpayers as one of the final steps in the scheme to reimburse the Fund for the withdrawal made to repay the related party debit loans. The existence of circular or 'round robin' payments is a matter which has been accepted as pointing towards a tax avoidance purpose: Commissioner of Taxation v. Sleight [2004] FCAFC 94; (2004) 136 FCR 211 at [77] per Hill J (cf., paragraph 177D(2)(d));

(ii) The Taxpayers as trustees of the Trust will receive a capital amount equal to the value of the retained earnings of the Company (see paragraph 50(d) above). In the absence of the scheme the Taxpayers as trustees of the Trust would otherwise reasonably expect to receive a franked distribution from the Company and either the Taxpayers and/or a beneficiary, or beneficiaries, of the Trust could reasonably expect to incur a greater taxation liability in respect of that income (see paragraph 44 above) (cf., paragraph 177D(2)(d)); and

(iii) the Taxpayers will receive the benefit of pensions in a tax free form from the Fund - supported by the franked distribution (to the extent it is not used to pay the loan under the LRBA) and the refund of the unused franking credit tax offset received by the Fund. In the absence of the scheme the Taxpayers as trustees of the Trust would otherwise reasonably expect to receive a franked distribution from the Company and either the Taxpayers as trustee of the Trust and/or a beneficiary, or beneficiaries, of the Trust could reasonably expect to incur a taxation liability in respect of that income (see paragraph 44 above) (cf., paragraph 177D(2)(e)).

82. Overall, the balance of matters points towards a conclusion that a more than incidental purpose of the scheme is to enable the Fund to gain an imputation benefit. The critical factor in an assessment of purpose is the absence of any substantial explanation for the implementation of the scheme other than to ensure that the Company's franking credits are channeled to their ultimate economic owners (the Taxpayers) through the Fund with the benefit of the exemption in section 295-390 of the ITAA 1997. This has the effect of converting the franking account of the Company to cash which is then used to support the Taxpayers' retirement income. A further taxation benefit is the conversion of the Company's funds on which the Taxpayers as trustee of the Trust or the beneficiaries of the Trust could reasonably expect to incur a taxation liability to a capital sum with a lower incidence of tax.

83. It is no answer to say that the main purpose of the scheme is the maximising or maintenance of the Taxpayers' wealth in retirement. That draws the same false dichotomy as was rejected in FCT v. Spotless. This is because it is the tax effect referred to above which achieves the maintenance of wealth in retirement over that which would otherwise be achieved. The suggested explanations of minimizing the compliance costs of maintaining the related party debit loans and simplifying the Taxpayers' wealth structure have inadequate probative weight for the reasons given in paragraph 50(e) and (f) above.