Edited version of your written advice

Authorisation Number: 1012727538881

Advice

Subject: Franked dividends to companies

Question 1

Will the Commissioner make a determination under section 204-30 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the intended payment of a franked dividend to the companies?

Advice

No.

Question 2

Will the Commissioner make a determination under paragraph 177EA(5)(a) of the Income Tax Assessment Act 1936 (ITAA 1936) that a franking debit will arise in the companies' franking accounts?

Advice

No.

Question 3

Will section 177E of Part IVA of the ITAA 1936 apply to the arrangement?

Advice

No.

This advice applies for the following period<s>:

Year ending 30 June 2015

The arrangement commences on:

1 July 2014

Relevant facts and circumstances

The current shareholders have owned the total number of issued shares in XXX Pty Ltd (XXX) (one ordinary share each) since after 19 September 1985.

The current shareholders are Australian residents, over 55 and currently undertaking retirement and estate planning. They wish to separate their investments due to estate and family needs.

The current shareholders intend to create two new companies, so that one of the shareholders will hold 100% of the issued shares in one of the companies, and the other shareholder will hold 100% of the issued shares in the other company. Once created, the companies will be private companies. The shareholders intend to interpose the companies between themselves and XXX.

The companies will be Australian residents for tax purposes and not tax exempt entities.

The companies will not hold any other assets at the time of acquiring the XXX shares.

The current shareholders will exchange their one ordinary share in XXX for one ordinary share in their new company. Subsequent to this transaction, each shareholder will continue to own 100% of the shares in their new company.

After the restructure a significant portion of retained profits in XXX will be paid by way of fully franked dividend to each of the companies. As each of the companies will hold an equal shareholding in XXX, they will be entitled to the same distribution and attached franking credits.

The current shareholders will be indirectly entitled to the distribution of profits of XXX via their shareholding in the new companies.

Eventually XXX will be wound up, but this may take a few years.

Relevant legislative provisions

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 1936 Part IVA

Income Tax Assessment Act 1997 section 204-30

Income Tax Assessment Act 1997 subdivision 204-D

Reasons for decision

Section 204-30 of the ITAA 1997

Subdivision 204-D of the ITAA 1997 was introduced as a specific anti-avoidance provision. It is intended to apply where a company streams dividends so as to provide franking credit benefits to shareholders who benefit most from these credits, in preference to shareholders who would gain either no benefit, or a lesser benefit, from a franked dividend payment.

As stated in paragraph 3.2 of the Explanatory Memorandum (EM) to New Business Tax System (Imputation) Bill 2002, the anti-streaming provisions are intended to ensure that '…over time, the benefit of franking credits is spread more or less evenly across members in proportion to their ownership interest in the entity.' The general intent '…is that credits for tax paid on behalf of all members should flow to all members and not to only some of them.' By encouraging the distribution of franked dividends to shareholders who might not be able to take full advantage of imputation credits, it was expected that the 'intended wastage' envisaged at the time of introduction of the imputation credit regime would be achieved.

Section 204-30 of the ITAA 1997 is the key provision. Subsection 204-30(1) of the ITAA 1997 states that:

This section empowers the Commissioner to make determinations if an entity streams one or more distributions (or one or more distributions and the giving of other benefits), whether in a single franking period or in a number of franking periods, in such a way that:

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

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

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

The member that derives the greater benefit from franking credits is the favoured member. The member that receives the lesser imputation benefits is the disadvantaged member.

Subsection 204-30(2) of the ITAA 1997 then states that:

These are examples of the giving of other benefits:

(a) issuing bonus shares;

(b) returning paid-up share capital;

(c) forgiving a debt;

(d) the entity or another entity making a payment of any kind, or giving any property, to a member or to another person on a member's behalf.

In part, subsection 204-30(6) of the ITAA 1997 states that:

A member of an entity receives an imputation benefit as a result of a distribution if:

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

….

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

As subsections 204-30(7) and 204-30(8) of the ITAA 1997 are headed: 'When does a favoured member derive greater benefit from franking credits?' These subsections are directly relevant to the application of paragraph 204-30(1)(b) of the ITAA 1997.

Subsection 204-30(7) of the ITAA 1997 states that:

The following subsection lists some of the cases in which a member of an entity derives a greater benefit from franking credits than another member of the entity. It is not an exhaustive list.

A member of an entity derives a greater benefit from franking credits than another member of the entity if any of the following circumstances exist in relation to the other member in the income year in which the distribution giving rise to the benefit is made, and not in relation to the first member:

(a) the other member is a foreign resident;

(b) the other member would not be entitled to any tax offset under Division 207 because of the distribution;

(c) the amount of income tax that, apart from this Division, would be payable by the other member because of the distribution is less than the tax offset to which the other member would be entitled;

(d) the other member is a corporate tax entity at the time the distribution is made, but no franking credit arises for the entity as a result of the distribution;

(e) the other member is a corporate tax entity at the time the distribution is made, but cannot use franking credits received on the distribution to frank distributions to its own members because:

it is not a franking entity; or

(ii) it is unable to make frankable distributions;

(f) the other member is an exempting entity.

10) of the ITAA 1997 are also relevant to determining if dividend streaming has occurred, but are not relevant in this case, as the distribution will not be made by an exempting entity, and the distributions are not franked with an exempting credit or venture capital credit.

Application to the taxpayer's circumstances

Section 204-30 of the ITAA 1997 is concerned with whether the other shareholders/ members would have received a lesser benefit, or no benefit, from the franked dividend which was distributed.

XXX intends to distribute a significant portion of its retained profits to the companies who will hold 100% of the shares in XXX after the restructure. As both the companies will be corporate tax entities, resident of Australia for tax purposes and not tax exempt bodies, they will both be subject to the same benefits from franking credits. Accordingly, neither company would have received a lesser benefit than the other from franked dividends when they are distributed.

Subsection 204-30(1) of the ITAA 1997

The three paragraphs of subsection 204-30(1) of the ITAA 1997 are key to the making of any determination in relation to dividend streaming.

Paragraph 204-30(1)(a) of the ITAA 1997

As it is intended that the dividend distribution to be made to the companies in the income year will be franked, a 'member' of XXX will be entitled to an 'imputation benefit' for the purposes of paragraph 204-30(1)(a), being the imputation credit and franking credit. Thus, the requirement of paragraph 204-30(1)(a) of the ITAA 1997 is met.

Paragraph 204-30(1)(b) of the ITAA 1997

As the companies (who after the restructure will own 100% of the shares in XXX and will both receive distributions) are Australian residents, corporate tax entities and not tax exempt bodies, neither will derive a greater benefit from franking credits than the other in any franking period and so paragraph 204-30(1)(b) of the ITAA 1997 will not apply in this case.

Paragraph 204-30(1)(c) of the ITAA 1997

In your case, both the companies will be entitled to the same distribution and attached franking credits, therefore paragraph 204-30(1)(c) of the ITAA 1997 will not apply.

Section 204-30 of the ITAA 1997 will only apply where each of paragraphs (a), (b) and (c) of subsection 204-30(1) of the ITAA 1997 apply. As paragraphs 204-30(b) and (c) of the ITAA 1997 do not apply, the requirements of section 204-30(1) of the ITAA 1997 have not been met.

Therefore, the Commissioner will not make a determination under section 204-30 of the ITAA 1997 in relation to the intended payment of a franked dividend to the companies.

Part IVA of the ITAA 1936

Part IVA of the ITAA 1936 is a general anti-avoidance provision.

Part IVA of the ITAA 1936 gives the Commissioner the discretion to cancel 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 Part IVA of the ITAA 1936 applies.

In general, Part IVA of the ITAA 1936 will only apply to an arrangement where:

• the taxpayer obtained a tax benefit from a scheme a benefit that would not have been available if the scheme had not been entered into, and

• it could be objectively concluded that the taxpayer entered the scheme for the sole or dominant purpose of obtaining the tax benefit.

For Part IVA of the ITAA 1936 to apply, there must be a tax benefit which, in order to be identified, consideration must be given to an alternate postulate as to what might reasonably have occurred.

A reasonable expectation requires more than a possibility but a reasonable hypothesis as to what would have taken place.

It is possible for different conclusions to be reached as to what might reasonably be expected if the particular scheme had not been entered into or carried out.

PS LA 2005/24: Application of General Anti-Avoidance Rules suggests that in applying the reasonable expectation test it is useful to consider such issues as:

• the most straightforward and usual way of achieving the practical outcome of the scheme (disregarding the tax benefit)

• behaviour of relevant parties before/after the scheme compared with the period of operation of the scheme, and

• actual cash flow.

Section 177EA of the ITAA 1936

If section 177EA of the ITAA 1936 operates in relation to a scheme for a disposition of membership interests in a corporate tax entity, the Commissioner may make a determination that:

• a franking debit arises in a corporate tax entity that is party to the scheme in respect of a distribution made to a relevant taxpayer or that flows indirectly to a relevant taxpayer, or

• no imputation benefit is to arise in respect of a distribution that is made, or flows indirectly to a relevant taxpayer.

Section 177EA operates where five pre-conditions, set out in paragraphs 177EA(3)(a)-(e) of Part IVA are satisfied.

Paragraph 177EA(3)(e) requires that, having regard to the relevant circumstances of the scheme, it would be concluded that the person (the relevant taxpayer in receipt of the frankable distribution), or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose of enabling the relevant taxpayer to obtain an imputation benefit.

Paragraph 177EA(4) states that it is not to be concluded for the purposes of paragraph 177EA(3)(e) that a person entered into or carried out a scheme for a purpose mentioned in that paragraph (ie, a purpose of enabling a relevant taxpayer to obtain an imputation benefit), merely because the person acquired membership interests, or an interest in membership interests, in the corporate entity.

Subsection 204-30(6) states that a member of an entity receives an imputation benefit as a result of a distribution if the member is entitled to a tax offset under Division 207 as a result of the distribution. Under Division 207, as a general rule, if a member of an entity receives a franked distribution the member is entitled to a tax offset equal to the franking credit on the distribution.

In this case, XXX intends to pay dividends to the companies, and it is intended that they subsequently pay dividends to the current shareholders.

The dividends paid by XXX to the companies, and the dividends paid by the companies to the current shareholders will all be assessable to the recipients of the dividends. On receipt of the dividends, both the companies and the current shareholders will be entitled to claim tax offsets for the attached franking credits, ie they will receive an imputation benefit.

However, if in the alternate, XXX were to pay dividends directly to the current shareholders, they would be entitled to franking benefits equal to the benefits they are entitled to under the proposed scheme.

As the current shareholders would not be entitled to any 'additional' imputation benefits by entering into the proposed arrangement, it cannot be said for the purposes of paragraph 177EA(3)(e) of the ITAA 1936 that the taxpayers would, under the proposed arrangement, be entering into a scheme for the purpose of enabling them to obtain an imputation benefit.

Accordingly, section 177EA of Part IVA of the ITAA 1936 will not apply to deny any franking credits on dividends paid by the companies to the current shareholders after the restructure has been effected.

Section 177E of the ITAA 1936

In the Explanatory Memorandum to the bill introducing Part IVA of the ITAA 1936 in 1981, it states that section 177E of the ITAA 1936 was designed to operate as a self-contained code within Part IVA for dealing with so called dividend stripping schemes which might not otherwise have come within the general ambit of sections 177C and 177D of the ITAA 1936, particularly because of perceived difficulties in identifying a "tax benefit".

Where section 177E of the ITAA 1936 operates, it deems the scheme to be one to which Part IVA applies (paragraph 177E(1)(e)). This makes it unnecessary to consider the operation of section 177D of the ITAA 1936 and whether an entrant into the scheme did so for the purpose of obtaining a tax benefit. Section 177E of the ITAA 1936 also deems the taxpayer to have obtained a tax benefit, being the non-inclusion in assessable income of the amount that would have been included if the company had paid the dividend described by paragraph 177E(1)(c) (paragraphs 177E(1)(f) and (g)). This makes it unnecessary to consider the operation of section 177C of the ITAA 1936.

If section 177E of the ITAA 1936 operates in a particular case, the Commissioner may apply section 177F of the ITAA 1936 to determine precisely what adjustments should be made in the assessments of the vendor shareholders and of other taxpayers affected by the scheme.

The appropriate determination under subsection 177F(1) of the ITAA 1936 in dividend stripping cases is the inclusion in the assessable income of vendor shareholders of the full amount of the tax benefit obtained in connection with the scheme, as calculated for the purposes of section 177E of the ITAA 1936.

Subsection 177F(1) of the ITAA 1936 uses the word "may". This gives the Commissioner a discretion whether or not to make a determination (Fletcher v. F.C. of T. 88 ATC 4834). A determination will usually be made where the Commissioner believes the provisions of Part IVA are satisfied. However, the discretion will not be exercised if cases arise where the view is formed that there is no real avoidance of tax (Taxation Ruling IT 2627 Income Tax: application of Part IVA to dividend stripping arrangements [IT 2627], at paragraph 31).

This can be particularly relevant to the application of section 177E of the ITAA 1936, where there need not be a tax benefit or a tax avoidance purpose before the section applies.

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

Paragraph 177E(1)(a) is the first of the four pre-conditions that needs to be satisfied for section 177E to operate. Paragraph 177E(1)(a) requires that:

as a result of a scheme that is, in relation to a company:

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

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

any property of the company is disposed of.

IT 2627, at paragraph 10, states the Commissioner's view that in determining what might constitute a dividend stripping scheme for the purposes of section 177E, an important element to be looked at will be any release of profits of a company to its shareholders in a non-taxable form.

In your case, XXX intends to actually pay dividends to the companies, and it is intended that they subsequently pay dividends to the current shareholders.

The dividends paid by XXX to the companies, and the dividends paid by the companies to the current shareholders will all be assessable to the recipients of the dividends.

Under the arrangement, the payment of fully franked dividends by XXX to the companies will be 'tax neutral,' as the two companies will be required to include the 'grossed up' amount of the dividends in their assessable income, and be entitled to a tax offset for the attached franking credits for an amount equal to the tax that they are liable to pay on the distribution. On the subsequent payment of franked dividends by the two companies to the current shareholders, the current shareholders will be required to include the 'grossed up' amount of the dividends in their assessable income, which will be taxed at their marginal tax rates, and will be entitled to a tax offset for the attached franking credits. This is the same net tax result for the current shareholders as would result if XXX were to pay the dividends directly to them. Therefore, there will not be any 'release of profits of a company to its shareholders in a non-taxable form', and no 'real avoidance of tax' as a result of the proposed arrangement being entered into.

As there will not be any release of profits of a company to its shareholders in a non-taxable form under the proposed arrangement, it is considered that there will be no scheme by way of or in the nature of dividend stripping, or scheme having substantially the effect of a scheme by way or in the nature of a dividend stripping. Therefore, the requirements of paragraph 177E(1)(a) of the ITAA 1936 will not be satisfied, and accordingly 177E of the ITAA 1936 will not apply.

Furthermore, it is considered that even if it was determined that section 177E of the ITAA 1936 did operate in relation to the arrangement, given that the arrangement does not involve any 'real avoidance of tax', the Commissioner would not exercise his discretion under section 177F(1) of the ITAA 1936 to make a determination to include any amounts in the assessable income of the taxpayers involved - in accordance with paragraph 31 of IT 2627.

Accordingly, section 177E of Part IVA of the ITAA 1936 will not apply to the arrangement.