Edited version of your written advice

Authorisation Number: 1012765692791

Ruling

Subject: Proposed dividend payment and share issue by an Australian proprietary company limited by shares (Company X)

Question 1

Does section 177E of the Income Tax Assessment Act 1936 (Cth) ('ITAA 1936') apply to the scheme?

Answer

No.

Question 2

Does Division 725 of the Income Tax Assessment Act 1997 (Cth) ('ITAA 1997') apply in relation to the shares held in Company X?

Answer

No.

Question 3

Do the employee share scheme ('ESS') provisions contained in Division 83A of the ITAA 1997 apply to the director of Company X ('Director A')?

Answer

No.

Question 4

Having regard to the matters in subsection 177D(2) of the ITAA 1936, would the Commissioner make a determination under section 177F of the ITAA 1936 to cancel any tax benefits that may be obtained under the proposed restructure?

Answer

No.

This ruling applies for the following periods:

Income tax year ended 30 June 2015.

Relevant facts and circumstances

Background

1. Company X is an Australian proprietary company limited by shares. Its directors, Director A and Director B are related.

2. Company Y is also an Australian proprietary company limited by shares. Its directors are Director B and Director B's spouse, who each hold one of its two ordinary shares.

3. Company Y in its capacity as trustee for Family Trust B owns all of the existing shares in Company X. Approximately half of the shares were acquired by initial subscription after 20 September 1985. The remaining shares were acquired from Company Z several years later.

4. The business conducted by Company X, together with its shares, are post-CGT assets.

5. Company X has an exclusive agreement with other companies to promote and distribute a range of products within Australia.

6. Company X employs staff. Its business premises are owned by related parties and leased to the business.

7. Director B established the business and has controlled it since its inception. Director B currently serves as the Chair, while Director A controls the day to day operations.

8. The family have agreed that Director A should have a significant equity interest in the business and should not wait for inheritance to acquire this.

9. As such, the family have agreed a strategy to facilitate an investment in Company X by Director A.

10. One of the companies that Company X contracts with places importance on succession planning and it is anticipated that the proposed restructure would strengthen the parties' relationship.

11. In Company X's statement of financial position during the relevant income year, they reported substantial amounts of retained earnings (millions), issued capital and net assets (millions).

12. In its income tax return for the 20XX income tax year, Company X disclosed a franking account balance greater than $X million.

13. The investment in Company X by Director A will be held by Family Trust A, either directly or via an interposed entity (Company A). Alternatively, Director A may elect to settle a second trust and have each trust make equal subscriptions in Company X for estate planning purposes.

14. Family Trust A will make a family trust election. Both Family Trust A, the second trust (if elected) and Company A will make interposed entity elections, prior to Director A's investment in Company X.

15. The new share issue (see 23 below) is to be at market value. In order to determine the current market value of the shares in Company X and the trading businesses, the relevant taxpayers will obtain an independent valuation.

Dividend one

16. Director B will incorporate a new company (Company B). All the shares in Company B will be held by Family Trust B or another trust controlled by the same parties.

17. Company X will pay a fully franked dividend greater than $5 million to the trustee for the Family Trust ('dividend 1').

18. Family Trust B will distribute dividend 1 to Company B.

19. Company B will use the income from dividend 1 to make other investments.

Dividend two

20. Company X will pay a fully franked dividend to Family Trust A ('dividend 2') being half the market value of Company X.

21. Family Trust B will distribute an amount attributable to dividend 2 to Family Trust A.

22. Family Trust A will distribute an amount attributable to dividend 2 to Company A, which will be wholly owned by Family Trust A.

Share issue

23. Company X will issue new shares at market value to which Company A will subscribe, using the proceeds from Dividend 2.

24. The trustee for Family Trust A will then be an equal shareholder with the trustee for Family Trust B.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 177E,

Income Tax Assessment Act 1997 Division 725,

Income Tax Assessment Act 1997 Division 83A,

Income Tax Assessment Act 1936 Section 177D, and

Income Tax Assessment Act 1997 Section 177F.

Reasons for decision

Question 1

Summary

Certain necessary characteristics of a dividend stripping arrangement are not present. Section 177E of the ITAA 1936 does not apply.

Detailed reasoning

Section 177E of the ITAA 1936 applies, by virtue of s 177E(1)(a), to a scheme that is, in relation to a company:

a) By way of or in the nature of dividend stripping (subparagraph 177E(1)(a)(i)), or

b) Having substantially the effect of a scheme by way of or in the nature of dividend stripping (subparagraph 177E(1)(a)(ii)).

The payment of dividend 2 and share issue amounts to a 'scheme' for the purposes of section 177E of the ITAA 1936 ('the scheme').

There is no statutory or technical legal meaning of the term "dividend stripping".

However, the High Court in FC of T v Consolidated Press Holdings 2001 ATC 4343 agreed with the definition of dividend stripping adopted by the Full Federal Court. The Full Federal Court referred to earlier dividend stripping cases in concluding that dividend stripping entailed the following steps:

1) A target company has substantial undistributed profits which will generate a potential tax liability for the existing shareholders if distributed as dividends.

2) There is a sale or allotment of shares in the company to new shareholders.

3) The payment of dividends to the new shareholders.

4) The new shareholders escape Australian tax upon the dividends.

5) The vendor of the shares receives a capital sum which is substantially the same as the total of the dividends received by the new shareholder(s).

6) Such schemes were generally orchestrated with the sole or dominant purpose of enabling the original shareholders to escape taxation with respect to any distribution of profits.

In Lawrence v FC of T [2008] FCA 1497 [at 81] it was said that the requisite objective sole or dominant purpose of avoiding tax on dividends applies equally to both subparagraphs 177E(1)(a)(i) and 177E(1)(a)(ii) of the ITAA 1936.

Whilst some of the elements of a 'dividend stripping' arrangement are present, there does not appear to be an objective sole or dominant purpose of avoiding tax on dividends. Importantly, both dividends will be paid directly to the original shareholder. Further, the arrangement facilitates Director A's investment in Company X. As the requisite purpose is not present, section 177E of the ITAA 1936 does not apply to the scheme.

Question 2

Summary

The scheme will not result in a direct value shift affecting interests in Company X. The direct value shifting rules in Division 725 of the ITAA 1997 do not apply.

Detailed reasoning

Division 725 of the ITAA 1997 applies to:

a) Modify the adjustable values of affected interests to take account of material changes in their market value attributable to a direct value shift; and

b) Treat the value shift as a partial realisation to the extent that value is shifted between interests held by different owners, and in some other cases.

However, it does so only for interests that are owned by entities involved in the value shift.

The income tax consequences depend on whether the interest is characterised as a capital asset, revenue asset or trading stock (Section 725-205 of the ITAA 1997).   

Division 725 of the ITAA 1997 can only apply to a scheme if there is a direct value shift as defined by section 725-145 of the ITAA 1997.

A direct value shift will occur when:

a) There is a decrease in the market value of one or more equity or loan interests in a target entity (subsection 725-145(1) of the ITAA 1997), and:

i. One or more equity or loan interests are issued at a discount (subsection 725-145(2) of the ITAA 1997); or

ii. There is an increase in the market value of one or more equity or loan interests, in the same target entity (subsection 725-145(3) of the ITAA 1997); and

b) The decrease in market value and the issue of equity or loan interests or increase in market value are reasonably attributable to things done under the scheme (Section 725-145 the ITAA 1997).

The shares in Company X will be issued at market value and will not cause:

a) A decrease in the market value of any equity or loan interests in Company X, or

b) An increase in the market value of any equity interests or the issue at a discount of one or more equity or loan interests, in Company X.

As a consequence, there is not a direct value shift affecting interests in Company X.

Question 3

Summary

Director A is not acquiring an interest in Company X at a discount. Division 83A of the ITAA 1997 does not apply.

Detailed reasoning

Division 83A of the ITAA 1997 includes in your assessable income 'discounts on shares, rights and stapled securities you (or your associate) acquire under an ESS (section 83A-1 of the ITAA 1997).

Any discount that the employee receives by acquiring an ESS interest below the market price is a benefit relating to employment, similar to salary or wages and so would usually be considered income of the employee. At a general level, Division 83A of the ITAA 1997 taxes the value of that discount, to ensure employees are taxed consistently regardless of the form of remuneration they receive.

Section 83A-305 of the ITAA 1997 treats ESS interests provided to associates of employees, in relation to an employee's employment, as though the interest was in fact acquired by the employee rather than the associate. Company A is an associate of Director A (see section 318 of the ITAA 1936).

Company A will acquire its shares in Company X at market value when issued, as determined by an appropriate market valuation. To the contrary, the employee share scheme rules only apply to ESS interests acquired at a discount (subsections 83A-20(1) and 83A-105(1) of the ITA 1997).

Division 83A of the ITAA 1997 does not apply.

Question 4

Summary

Having regard to the matters in subsection 177D(2) of the ITAA 1936, the arrangement does not amount to a scheme for the purpose of enabling a taxpayer to obtain a tax benefit. The Commissioner would not make a determination under section 177F of the ITAA 1936 to cancel any tax benefits that may be obtained under the scheme.

Detailed reasoning

Subsection 177D(1) of the ITAA 1936 provides that Part IVA applies to a scheme in connection with which a taxpayer has obtained a tax benefit if, after having regard to the eight factors in subsection 177D(2), it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the purpose of enabling the taxpayer to obtain the tax benefit.

The payment of dividend 2 and share issue amounts to a 'scheme' for the purposes of section 177D ('the scheme').

The reference in section 177D to 'the purpose' of the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme includes the dominant purpose where there are two or more purposes (subsection 177A(5)). The person need not be the taxpayer.

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

The eight factors the Commissioner must have regard to include:

a) The manner in which the scheme was entered into or carried out (paragraph 177D(2)(a)):

The scheme will be entered into as a result of a family agreement that Director A should have a significant investment in Company X and that investment should essentially be funded by way of a gift. The overall purpose of the scheme is to facilitate Director A's investment in Company X.

In this regard, Director A will subscribe for the new shares in Company X at market value to match the existing shareholding, putting to use the funds made available to Director A's associated entity. Director A's investment in Company X will accord with an independent market valuation.

As a consequence of Director A's investment in Company X, the existing shareholders will relinquish Y% of their control of the company and its associated businesses to Director A.

b) The form and substance of the scheme (paragraph 177D(2)(b)):

The form and substance of the scheme are congruent. Significantly, Director A's investment in Company X will be at market value determined by an independent market valuation. Director A's parents, via the Family Trust, will relinquish Y% of their control of the company and its associated business to Director A as a result of the scheme.

The steps to be undertaken in the proposed restructure do not suggest contrivance or artificiality, provided they are carried out in the manner described to the Commissioner.

c) The time at which the scheme was entered into and the length of the period during which the scheme was carried out (paragraph 177D(2)(c)):

There is no indication that the scheme is being entered into at a tax preferential time. However, the scheme is being carried out at a time when succession planning is important to both Company X and Director B. The commercial consequences of the scheme will be enduring.

d) The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme (paragraph 177D(2)(d)):

The respective dividends will be assessed to the recipient trusts or the beneficiaries presently entitled to the net income of the trusts.

e) Any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme (paragraph 177D(2)(e)):

The financial position of Family Trust B will change as a result of the payment of dividend 2 and issue of new shares in Company X.

f) Any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme (paragraph 177D(2)(f)):

As a result of the payment of dividend 1 and the scheme:

i) Company X's retained earnings will reduce by an amount equal to dividends 1 and 2;

ii) Company X's share capital will increase by an amount equal to the market value of the new shares issued to Director A;

iii) Company X's franking account balance will reduce by an amount equal to the maximum frankable amount of dividends 1 and 2;

iv) Company X's cash balance will diminish by an amount equal to dividend 1;

v) Company B will ultimately receive a substantial amount of cash and pay no further tax on this amount, since it will receive an amount attributable to a fully franked dividend;

vi) Company A will ultimately receive dividend 2 and pay no further tax on this amount, since it will receive an amount attributable to a fully franked dividend;

vii) Director A will become a Y% equity holder in Company X through Company A;

viii) Director B and Director B's spouse will relinquish Y% of the control of Company X and its associated businesses to Director A.

g) Any other consequence for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out (paragraph 177D(2)(g)):

Not applicable

h) The nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f) (paragraph 177D(2)(h)):

The persons who are affected by the scheme are the family members. In substance, Director A will benefit from ultimately attaining a Y% investment in Company X to the detriment of Director A's parents. In this instance, the family relationship coupled with the constituent transfer of ownership interests to Director A point towards a purpose other than enabling a taxpayer to obtain the tax benefit.

It is evident that the dominant purpose of the scheme is to facilitate A's investment in Company X. The scheme was not entered into for the purpose of enabling a taxpayer to obtain a tax benefit in connection with the scheme.