Edited version of your written advice

Authorisation Number: 1012783283925

Ruling

Subject: Retirement planning proposal

Question 1

Are any of the franked distributions from the Company to a self-managed superannuation fund (the Fund) made as part of a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the Income Tax Assessment Act (ITAA 1997)?

Answer

Yes

Question 2

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 3

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 2015

Year of income ended 30 June 2016

Year of income ended 30 June 2017

Year of income ended 30 June 2018

Year of income ended 30 June 2019

Year of income ended 30 June 2020

Year of income ended 30 June 2021

Year of income ended 30 June 2022

The scheme commences on:

1 July 2014

Relevant facts and circumstances

1. The Taxpayer has not yet reached retirement age.

2. The Taxpayer is currently the sole director of the Company.

3. The sole shareholder of the Company is the corporate trustee for the X Trust (the Trust), a discretionary trust.

4. The Taxpayer is the sole director and shareholder of the corporate trustee.

5. The Taxpayer and members of their family are beneficiaries of the Trust.

6. At 30 June 20XX the Company's sole asset was cash of approximately $X, invested in interest bearing cash accounts and term deposits represented by retained earnings of the same amount. The Company has no liabilities.

7. At 30 June 20XX there was $X standing to the credit of the Company's franking account.

8. At 30 June 20XX the Company had carried forward tax losses of approximately $X from the 20XX financial year.

9. It is advised that the market value of the shares in the Company is estimated to be approximately $X (i.e. equal to the cash assets of the company).

10. The Taxpayer currently has approximately $X in a retail superannuation fund.

11. The Fund was established on dd/mm/yyyy. The Fund is a complying self-managed superannuation fund.

12. The Taxpayer is the sole director and shareholder of the corporate trustee of the Fund.

13. The Taxpayer is the sole member of the Fund.

14. The Fund will commence paying a pension to the Taxpayer after they reache 60 years of age.

15. It is intended that the following steps will be implemented during the year ended 30 June 20YY:

(a) an amount of approximately $X will be rolled over to the Fund from the Taxpayer's retail superannuation fund;

(b) the Taxpayer will make a non-concessional contribution and a concessional contribution to the Fund;

(c) the Company 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;

(d) all of the Company shares will be purchased by the Fund from the corporate trustee (in its capacity as trustee for the Trust). The purchase will be funded with the cash available in the Fund (approximately $X) and the remainder (approximately $X) will be borrowed by the Fund from the Taxpayer under a limited recourse borrowing arrangement (LRBA) described further below;

(e) the amount required by the Taxpayer to lend to the Fund under the LRBA will be borrowed from the corporate trustee (in its capacity as trustee for the Trust) at the same interest rates as for the loan under the LRBA.

(f) the total purchase price of the Company shares is expected to be approximately $X and the corporate trustee will receive a capital sum in that amount;

(g) 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));

(h) the corporate trustee in its capacity as trustee for the Trust will make a gross capital gain of approximately $X,000,000 on the disposal of the Company shares;

(i) the acquisition of the Company shares by the Fund will be consistent with the Fund's investment strategy;

16. The key features of the LRBA will be as follows:

(i) the loan amount under the LRBA will be approximately $X;

(ii) the interest rate is expected to be benchmarked against market interest rates charged by commercial financial institutions and lenders;

(iii) the term of the loan is expected to be no less than seven years;

(iv) repayments will be made at least annually;

(v) the repayments will be interest only in the first year, and then comprise interest and principal amounts;

(vi) there will not be an amount outstanding under the LRBA at a time when the value of the Company shares is nil. The terms of the LRBA will require the Fund to repay the loan sufficiently to maintain the agreed loan to value ratio at a certain level being equivalent to that of a similar product offered by a major Australian bank; and

(vii) there will be no forgiveness of the loan amount;

(viii) it is expected that the LRBA will be fully repaid at the conclusion of the seven year period, when it is expected that the Company will be wound up.

17. Following the transfer of the Company shares to the Fund, the Company will continue to invest in interest bearing cash and term deposits for a period of seven years. This investment is expected to generate interest income of approximately $X per annum. It is expected that the Company will have an annual tax liability during this period of approximately $X per annum.

18. It is anticipated that the Company will pay yearly, fully-franked distributions to the Fund for a minimum of seven years. Whether or not distributions are paid (and the value of any such distributions) will be determined by the director of the Company at the relevant time with consideration of a range of relevant factors. However, the cash flow forecasts for the Company are based on projected interest income of $X per annum and a fully franked dividend to be paid of $X with $X franking credits attached over the next six years up to and including the year ending 30 June 2021.

19. During the year ending 30 June 2022 the Taxpayer will commence receiving an account based pension from the Fund.

20. During the year ending 30 June 2022, and after the Taxpayer has commenced receiving a pension from the Fund, it is anticipated that a final franked distribution of approximately $X with approximately $X franking credits attached will be paid to the Fund following which the Company will be wound up.

21. Any distributions from the Company received by the Fund prior to the Taxpayer commencing a pension from the Fund will be included in the Fund's assessable income and taxed accordingly.

22. The franked distribution, including the franking credit on that distribution, referred to in paragraph 20 above, 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 and the franking credit on that distribution which would otherwise be assessable income of the Fund is treated as exempt from income tax under subsection 295-390(1) of the ITAA 1997. The relevant proportion is expected to be 100%. The Fund is expected to be entitled to a refund of the unused franking credit tax offset (which arises from a franking credit of approximately $X).

23. During the period from 1 July 20YY until 30 June 2022 the Taxpayer will make concessional contributions of $X per year to the Fund.

24. For the Fund, in general terms the deductible interest expense on the loan under the LRBA will offset the assessable income from the yearly distribution from the Company and the Fund will receive a refund of approximately $X as a result of the unused franking credit tax offset. This refund will be used to repay the principal of the loan. During the year ending 30 June 2022 the final distribution from the Company will be partially used to repay the loan under the LRBA. Overall by the end of the 7 years of the arrangement, the value of the Fund will increase due to the amount rolled over from the Taxpayer's retail superannuation fund, the contributions made by the Taxpayer initially and each year and the annual refund of the unused franking credit tax offsets.

25. The Taxpayer is wanting to undertake the proposed arrangement for the purposes of retirement planning and to generate investment income for the Fund.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1997 section 207-20

Income Tax Assessment Act 1997 section 207-35

Income Tax Assessment Act 1997 section 207-145

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 section 295-390

Reasons for decision

Question 1

Summary

26. The franked distributions from the Company to the Fund to the extent that they are made from the retained earnings held in the Company at the time the Fund acquires beneficial ownership of the Company shares are 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 credits on those distributions (or part thereof) is not included in the assessable income of the Fund under section 207-20 of the ITAA 1997 and the Fund is not entitled to tax offsets under Subdivision 207-F because of the distributions (or part thereof) (paragraphs 207-145(e) and (f) of the ITAA 1997). The franked distributions from the Company to the Fund to the extent that they are made from profits made while the Fund holds the beneficial ownership of the Company shares will not be made as part of a dividend stripping operation, thus the franking credit on those distributions (or part thereof) will be included in the assessable income of the Fund and the Fund will be entitled to tax offsets because of those distributions (or part thereof).

Detailed reasoning

27. 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; and

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

28. 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.

29. If franked distributions from the Company to the Fund are 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 those distributions will not be included in the assessable income of the Fund and the Fund will not be entitled to tax offsets under Subdivision 207-F of the ITAA 1997.

Dividend stripping operations

30. 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].

31. 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].

32. 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 franked distributions from the Company to the Fund be distributions made as part of a dividend stripping operation?

33. The payment of the franked distributions from the Company to the Fund to the extent that they are made from the retained earnings held in the Company at the time the Fund acquires beneficial ownership of the Company shares 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 30 above) of a scheme 'by way of, or in the nature of, dividend stripping' will be present.

34. First element: the Company has substantial undistributed profits. Its only asset is cash represented by retained earnings of approximately $X. This creates a potential tax liability for either the corporate trustee and/or the Taxpayer and/or other beneficiaries of the Trust in relation to those retained earnings. If the franked distributions were paid to the corporate trustee, under subparagraph 44(1)(a)(i) of the ITAA 1936, either the corporate trustee and/or a beneficiary, or beneficiaries of the Trust would be assessed on an amount reflecting the retained earnings. Accordingly, the element of a dividend stripping operation identified in paragraph 30(a) above is satisfied.

35. Second element: There will be a sale or allotment of shares in the target co to another party. The corporate trustee will sell all of the shares in the Company to the Fund and the corporate trustee will receive a capital sum for those shares.

36. 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 or transfer 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 30(b) above is satisfied.

37. Third element: the Company will pay franked distributions to the Fund in part, equal to the value of the Company's retained earnings at the time the Fund acquires beneficial ownership of the Company shares, namely $X. The fact that the franked distributions are paid to the Fund over several years or after several years and not as an immediate single distribution is merely a "variation on the paradigm" which will not remove the scheme from satisfying the central characteristics of a "dividend stripping operation": FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45]. Alternatively, the scheme will have "substantially the effect" of a scheme "by way of or in the nature of dividend stripping". Accordingly, the element of a dividend stripping operation in paragraph 30(c) above is satisfied.

38. Fourth element: On the assumption that none of the franked distributions are non-arm's length income of the Fund (within the meaning of section 295-550 of the ITAA 1997) the franked distributions will be either assessable or exempt income of the Fund and subject to either a concessional rate of tax at 15% or nil. In the result, absent the application of subsection 207-145(1) of the ITAA 1997 the Fund will obtain refunds of the unused franking credit tax offsets (arising from franking credits of approximately $X potentially available at the time the Fund acquires beneficial ownership of the Company shares) in relation to the franked distributions. If the franked distributions were made to the corporate trustee as trustee of the Trust, then the corporate trustee or the beneficiaries of the Trust would be subject to a higher incidence of tax as a result of the distributions. 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 distributions flow to the Fund with the consequence that the LRBA holding trust is not subject to tax on the franked distributions and the Fund is either not subject to tax or is subject to a concessional rate of tax on the franked distributions.

39. 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. A lower amount of tax may also amount to tax being escaped. Accordingly, the element of a dividend stripping operation in paragraph 30(d) above is satisfied.

40. Fifth element: the corporate trustee will receive a capital sum of approximately $X for the sale of the shares in the Company to the Fund. That capital sum is included in the dividend amounts that will be paid out by the Company to the Fund during the seven years of the arrangement. Accordingly, the element of a "dividend stripping operation" in paragraph 30(e) above is satisfied. It is not significant that the payments are spread over a number of dividends, rather than paid at once. It is not significant that payments which are not part of a dividend stripping operation are also made during the 7 years of the arrangement. It does not detract from this conclusion that the capital sum is, in part, initially recognised as a loan amount due to the Taxpayer by the Fund, and that the loaned amount will be paid to the Taxpayer over a period of time from funds received from the franked distributions paid by the Company. These are all no more than "variations on the paradigm" which does not remove the scheme from one satisfying the central characteristics of a "dividend stripping operation".

41. Sixth element: The sixth element of a dividend stripping operation identified in paragraph 30(f) above is satisfied for the following reasons:

(a) The arrangement proposed and described at paragraphs 15 to 24 above is carefully planned. It involves all the parties acting in concert. The parties are all related, being the Taxpayer and his family members, 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 paragraphs 15 to 24 above is obtaining tax benefits: namely, the attraction of the exemption in subsection 295-390(1) of the ITAA 1997 to the final franked distribution and generating a refund of the unused franking credit tax offset of $X in the year ending 30 June 2022. Those tax benefits overwhelmingly provide the explanation for the increase in the cash flow and value of the Fund as a result of the arrangement other than the contributions made by the Taxpayer and the initial amount rolled over from the Taxpayer's retail superannuation fund. In the years ending 30 June 2016 to 30 June 2021, the unused franking credit tax offset is used to repay the loan under the LRBA to the Taxpayer and thus has no other economic effect. In the year ending 30 June 2022 the distribution from the Company received by the Fund is used to repay the remaining balance of the loan under the LRBA and thus also has no economic effect.

(c) A further tax effect for the Fund (although of lesser significance once it moves to 'pension phase') is the generation of a capital loss which might be used if the Fund ceases to be entirely in pension phase or another member is admitted to the Fund.

(d) From the point of view of the vendor shareholder (the corporate trustee), the principal or predominant effect of the proposed arrangement is the substitution of a capital amount for the disposal of the shares instead of franked distributions with a resultant lower incidence of tax (under the applicable capital gains tax provisions): see Lawrence v. FCT at [44]. If the retained earnings of the Company were paid as franked distributions by the Company, then the Trust (and/or a beneficiary, or beneficiaries, of the Trust) could expect to incur a larger tax liability.

(e) It is no answer to say that the arrangement is undertaken for the purposes of providing cash flow to pay for the superannuation benefits for the Taxpayer 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 for cashflow and retirement planning for the Taxpayer is the tax benefits obtained through the channelling of the franked distributions through the Fund: namely, the exemption of the final franked distribution and the refund of the franking credit tax offsets referred to in paragraph 22 above. The increase in the Fund's assets over the seven year period comes from the initial contributions to be made by the Taxpayer, the rollover to be received from the Taxpayer's retail superannuation fund and the yearly concessional contributions to be made by the Taxpayer and the refund of the unused franking credit tax offset for the final dividend paid in the year ended 30 June 2022.

(f) The cashflow objective could be more simply achieved by the Fund investing the initial contributions and rollover amounts. The receipt of the yearly franked distribution is not being retained in the Fund to increase the wealth of the Fund, but rather to provide the cashflow to make the payments of interest and principal on the loan from the Taxpayer under the LRBA. The relevant difference being the tax effects achieved by the arrangement proposed and described at paragraphs 15 to 24 above would not be achieved.

(g) Furthermore, the fact that the corporate trustee or the beneficiaries of the Trust may be assessed on a net capital gain made in respect of the disposal of the shares in the Company to the Fund does not mean that a 'dividend stripping operation' cannot arise. In Lawrence v. FCT, the Full Court of the Federal Court observed at [44] that 'notwithstanding the advent of comprehensive taxation of capital gains, this characteristic remains relevant because the methods of calculating capital gains invariably lead to a lower amount of tax'.

Question 2

Summary

42. 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

43. 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.

44. 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].

45. 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 distributions from the Company to the Fund?

46. For the following reasons, each of the conditions in paragraphs 177E(1)(a) to (d) of the ITAA 1936 referred to in paragraph 44 above is satisfied.

47. 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'. The steps in paragraphs 15 to 24 above clearly constitute a scheme within the meaning of subsection 177A(1) of the ITAA 1936.

48. The scheme described in paragraphs 15 to 24 above is plainly a 'scheme that is in relation to a company' (the Company).

49. For this reason, the first condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 44 above is satisfied.

50. Second condition: For the reasons given above in paragraphs 33 to 41 the steps set out in paragraphs 15 to 24 above involves a 'scheme' by way of or in the nature of dividend stripping. For this reason, the second condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 44(b) above is satisfied.

51. 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.

52. The scheme, involves the payment by the Company of the franked distributions 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 paragraphs 18 and 20 above).

53. Accordingly, the third condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 44(c) above is satisfied.

54. Fourth condition: As noted above in paragraph 20, the final franked distribution is to be paid in an amount totaling approximately $X which represents the Company's current retained earnings, and that year's interest income of the Company. In addition a franked distribution is to be paid each year for the duration of the arrangement. Therefore, the Commissioner has formed the view that the franked distributions 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 44(d) above is satisfied.

55. Fifth condition: If, before the scheme described in paragraphs 15 to 24 above was entered into, the Company paid a franked distribution out of profits to its then shareholder being the corporate trustee, it is reasonable to expect that an additional amount would have been included in the corporate trustee's, or one or more of the beneficiaries of the Trust's assessable income equal to the value of the (grossed up) franked distributions. For this reason, the fifth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 44(e) above is satisfied

56. 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 44(f) above is satisfied.

57. For those reasons, if the scheme in paragraphs 15 to 24 above is 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 corporate trustee and/or a beneficiary, or beneficiaries, of the Trust, will be taken to have obtained a tax benefit in connection with the scheme, being the amount which, had the Company paid franked distributions prior to entering into the scheme, would have been assessed to the corporate trustee or an amount reflecting the franked distribution would have been assessed to a beneficiary, or beneficiaries, of the Trust, (paragraph 177E(1)(f) and (g)).

Question 3

Summary

58. 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 those distributions.

Detailed reasoning

Section 177EA of the ITAA 1936

59. 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.

60. 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)'.

61. 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)).

62. 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.

63. 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

64. It is clear that the 'jurisdictional facts' in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 and described in paragraphs 61(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 corporate trustee to the Fund (see paragraph 15(d) above). Accordingly, the jurisdictional fact in paragraph 177EA(3)(a) is satisfied;

(b) it is expected that the distributions to the Fund will be frankable distributions and they are expected to be franked distributions (see paragraphs 18 and 20 above). Accordingly, the jurisdictional fact in subparagraph 177EA(3)(b)(i) and paragraph 177EA(3)(c) is satisfied:

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

65. 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 imputation benefits?

66. 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]).

67. 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 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].

68. 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 paid by the Fund for the shares in the Company does not appear to have been calculated by reference to any imputation benefits (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 distributions do not appear to be equivalent to receipts of amounts in the nature of interest (cf., paragraph 177EA(17)(h));

(c) the franked distributions appear 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.

69. 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 first franked distribution is short. The Company will conduct no trading activities in the period the Fund holds the shares and its asset is wholly cash. 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. During years one to six the payment of franked distributions will represent current year interest income of the Company, resulting in the Company maintaining the same level of cash assets until it is eventually wound up in year seven. The Fund was not the economic owner of the shares when the Company generated the franking credits that will exist at the time the Fund becomes the beneficial owner of the shares and will not bear any significant risk in the 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) if the Company is subsequently deregistered or the shares are otherwise disposed of by the Fund once all retained earnings are paid out, this will give rise to a capital loss for the Fund thus incurring a capital loss in connection with the distributions being made (cf., paragraph 177EA(17)(g)). However, as any such capital loss cannot be utilised while the Fund is entirely in pension phase, this factor would be of limited weight.

70. 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 Taxpayer (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 franked distributions 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 owner(s) (the Taxpayer (and family members)) through the Fund in order to generate a refund of the unused franking credits (cf., paragraph 177D(2)(b));

(c) the scheme is to be implemented over a number of years, which is determined by the number of years before the Fund commences paying the Taxpayer a tax free pension with the result that the final and largest distribution being made to the Fund is expected to be exempt income of the Fund (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 distributions ($X per annum in the years from 1 July 20XX until 30 June 2021). In each of these years the Fund will receive a partial refund of the franking credits attached to the distributions on the basis that the income tax rate for the Fund is only 15%. The Fund will also receive a final franked distribution of $X in the year ending 30 June 2022 as well as a refund of the franking credit tax offset on the basis that the franked distribution in that year is exempt income pursuant to section 295-390 of the ITAA 1997. The Fund will also incur a liability under the LRBA, and will utilize an amount equivalent to the amount rolled over into the Fund and the concessional and non-concessional contributions, less tax payable by the Fund, made by the Taxpayer prior to 30 June 20YY. 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 franking credit tax offsets in the year ending 30 June 2022. (cf., paragraph 177D(2)(d)). 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 corporate trustee will receive a capital amount for the sale of the shares and thus will have an amount, referable to the net capital gain made upon disposal of the shares in the Company included in its assessable income and or the assessable income of the beneficiaries of the Trust and, because of the method of calculating net capital gains, this will be a lesser amount than would be included if the franked distributions were paid directly to it. (cf., paragraph 177D(2)(d)); and

(iii) once the Taxpayer commences drawing a pension from the Fund (during the year ending 30 June 2022) they will receive the benefit of a pension in a tax free form from the Fund - supported by the franked distributions and the refunds of the franking credit tax offsets received by the Fund. In the absence of the scheme the Taxpayer, or another beneficiary or beneficiaries of the Trust would otherwise reasonably expect to receive franked distributions from the Company and could reasonably expect to incur a taxation liability in respect of that income. (cf., paragraph 177D(2)(e)).

71. 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 each year and particularly in the year ending 30 June 2022. 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 channelled to their ultimate economic owner (the Taxpayer and family) through the Fund with the benefit of either a concessional rate of tax of 15% or 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 Taxpayer's retirement income. A further taxation benefit is the conversion of the Company's funds on which the corporate trustee and/or the Taxpayer, or another beneficiary and/or beneficiaries of the Trust could reasonably expect to incur a taxation liability to a capital sum with a lower taxation liability.

72. It is no answer to say that the main purpose of the scheme is to provide cash flow for the Taxpayer's 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 additional cash flow than that which would otherwise be achieved.