Edited version of your written advice

Authorisation Number: 1012824535366

Ruling

Subject: Retirement planning

Question 1

Are the franked distributions made by the liquidator of the Company to the Fund non-arm's length income of the Fund under section 295-550 of the Income Tax Assessment Act (ITAA 1997)?

Answer

Yes

Question 2

Are the franked distributions made by the liquidator of 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

Are the franked distributions made by the liquidator of the Company to the Fund made as part of a distribution washing operation within the meaning of subsection 207-157(1) of the ITAA 1997?

Answer

No.

Question 4

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 5

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

The scheme commences on

1 July 2014

Relevant facts and circumstances

Taxpayer A and Taxpayer B are spouses (together, the Taxpayers). Taxpayer A and Taxpayer B are both over 55 years of age.

The Taxpayers and their children are the directors of the Company.

The Company's issued shares are fully paid ordinary shares which are owned by the Taxpayers and were acquired on incorporation (prior to 20 September 1983).

As at 30 June 2014, the Company had assets of approximately $X, comprising cash, a related party loan, and an unpaid present entitlement (UPE) of from the Taxpayer's Family Trust.

The UPE is said to be treated as a loan and compliant with Division 7A of the ITAA 1936.

As at 30 June 2014, the Company had a franking account balance of $X.

The Taxpayers and their children are the only members of the Fund. The earnings of the Fund consist of rent from property investments, revenue from property developments and interest from cash deposits and fixed interest securities including bonds.

The trustee of the Fund is private company, with the four members of the Fund being directors of that trustee company. The shareholders of the trustee company are the Taxpayers.

The Taxpayers combined account balances in the Fund as at 30 June 2014 was approximately $X. The Taxpayers are currently each receiving an account based pension from the Fund. The Taxpayers' children's interests in the Fund are not supporting a superannuation income stream; they are in accumulation phase.

The Taxpayers have no current need for and currently do not wish to access the value in the Company. The Taxpayers wish to simplify their affairs (including resolving the outstanding UPE) and begin succession planning by liquidating the Company.

It is intended to implement the following steps:

(a) the UPE of the Company will be cleared by the Taxpayer's Family Trust making a cash payment to the Company in full satisfaction of the UPE;

(b) the loan to the related party of the Company will be repaid;

(c) the Fund will purchase the shares in the Company from the Taxpayers at the stated market value of approximately $X (i.e. equal to the cash assets of the Company). A cash payment for the shares will be made to the Taxpayers and funded from the current pension accounts of the Taxpayers.

(d) at the time when the shares in the Company are purchased by the Fund the only asset of the Company will be cash and it will have no liabilities;

(e) the shares received by the Fund will be recorded in the Fund's accounts at the stated market value;

(f) the current pensions being paid to the Taxpayers will continue, with the shares supporting the pensions;

(g) on receipt of the proceeds from the sale of the shares to the Fund, the Taxpayers will loan those monies to the Taxpayer's Family Trust;

(h) CGT event K6 will not result in a capital gain to the Taxpayers when they sell their shares in the Company to the Fund. Any capital gain or capital loss that the Taxpayers make on the disposal of the shares will be disregarded because the shares were acquired by the Taxpayers prior to 20 September 1985;

(i) after the expiry of 45 days from the purchase of the shares, the Fund will arrange a member's voluntary appointment of a liquidator to the Company;

(j) the liquidator of the Company will pay a liquidator's distribution to the Fund. That liquidator's distribution is expected to be equal to the Company's retained earnings of approximately $X and will be a frankable distribution (the franked distribution) that is fully franked (i.e. with a franking credit attached of approximately $X);

(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 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 proportion is expected to be similar to that in the 2014 income year financial reports. The remainder of the franked distribution is assessable and to the extent it is included in taxable income, subject to tax at 15%;

(l) the Fund is expected to be entitled to a refund of the unused franking credit tax offset arising from a franking credit of approximately $X;

(m) the Fund will not realise a capital loss from the ending of the Fund's shares in the company.

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 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 207-157

Income Tax Assessment Act 1997 section 295-385

Income Tax Assessment Act 1997 section 295-390

Income Tax Assessment Act 1997 section 295-545

Income Tax Assessment Act 1997 section 295-550

Reasons for decision

Question 1

Summary

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 from the Company to the Fund would be non-arm's length income of the Fund under subsection 295-550(2) 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

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'.

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.

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.

Dividends paid to an entity by a private company, along with ordinary or statutory income reasonably attributable to such a dividend (such as the franking credits), are non-arm's length income of the entity unless the amount is consistent with an arm's length dealing (subsection 295-550(2) of the ITAA 1997).

As relevant to this matter, the term 'dividend' is defined in section 995-1 of the ITAA 1997 with reference to the meaning given by subsection 6(1) of the ITAA 1936. Subsection 6(1) states that 'dividend' includes: (a) any distribution made by a company to any of its shareholders, whether in money or other property, but it does not include moneys paid…where the amount of moneys paid…is debited against an amount standing to the credit of the share capital account of the company. Therefore the liquidator's distribution paid to the Fund will be a dividend to the extent that the amount paid exceeds the amount standing to the credit of the share capital account of the Company. Therefore the liquidator's distribution falls for consideration as to whether it is a dividend consistent with an arm's length dealing for the purposes of subsection 295-550(2) of the ITAA 1997.

Subsection 295-550(3) of the ITAA 1997 requires consideration of the following matters when deciding whether an amount is consistent with an arm's length dealing:

(a) the value of shares in the company that are assets of the entity; and

(b) the cost to the entity of the shares on which the dividend was paid; and

(c) the rate of that dividend; and

(d) whether the company has paid a dividend on other shares in the company and, if so, the rate of that dividend; and

(e) whether the company has issued any shares to the entity in satisfaction of a dividend paid by the company (or part of it) and, if so, the circumstances of the issue; and

(f) any other relevant matters.

The Commissioner has issued Taxation Ruling TR 2006/7 Income tax: special income derived by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust in relation to the year of income. This Ruling refers to former section 273 of the ITAA 1936 which concerned 'special income' (now termed non-arm's length income) and continues to provide the ATO view so far as the new provision (section 295-550 of the ITAA 1997) expresses the same ideas as section 273.

In the facts of this case the shares are to be purchased at the stated market value ($X) and reflected at that market value in the members' accounts. This is a relevant consideration under paragraph 295-550(3)(a) of the ITAA 1997 and the acquisition of shares at market value is consistent with an arm's length dealing.

The rate of the dividend (paragraph 295-550(3)(c) of the ITAA 1997) is also relevant and refers to the amount of the dividend (or dividends) paid per share over a period of time (e.g. annually) by a company. In this case the dividend rate reflects the distribution of all of the assets of the company (other than assets represented by the paid up share capital of the Company) over a short period of time (i.e. potentially soon after the 45 day holding period rule is satisfied).

As the Fund is the only shareholder there is no comparison to be made as between the rate of dividends paid to the Fund and the rate of dividends paid to any other shareholder (paragraph 295-550(3)(d) of the ITAA 1997).

Other relevant factors (paragraph 295-550(3)(f) of the ITAA 1997) to consider include the market value of the shares as compared with the dividend rate and the rate of return on investment and also the level of investment risk undertaken by the Fund in relation to the dividend rate and the rate of return.

It is considered that taking into account the acquisition of the shares at the stated market value of $X, the dividend rate, the rate of return, the lack of risk, the timeframe and the certainty that the balance of shareholders' funds after repayment of issued capital of the Company will be paid to the Fund as a fully franked dividend given all parties are related, the dividend income of the Fund is non-arm's length income.

• The Fund has minimal or nil investment risk 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.

• There is no risk that the dividend won't be paid given the non-arm's length relationship that exists between all parties involved.

• During the relatively short period of time the shares are held by the Fund it will, for minimal or nil investment risk, realise all of the assets of the Company giving it a return of 100% based on the stated market value of the shares (in total) being $X and an after tax return in excess of 100% (i.e. with the refund of the unused franking credit tax offset).

• The market value of the shares 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 the Fund as a result of the transactions.

Therefore, subsection 295-550(2) of the ITAA 1997 would apply to the Fund with respect to its receipt of the franked distribution from the Company. The franked distribution would not be exempt current pension income of the Fund (under subsection 295-385(1) or 295-390(1) of the ITAA 1997).

Question 2

Summary

The franked distribution 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. As a consequence the amount of the franking credit on the distribution 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 a tax offset under Subdivision 207-F because of the distribution (paragraphs 207-145(e) and (f) of the ITAA 1997).

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997

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.

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.

If the franked distribution from the Company to the Fund would be a distribution 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 of the ITAA 1997.

Dividend stripping operations

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. 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]; Lawrence v. Federal Commissioner of Taxation [2009] FCAFC 29; (2009) 175 FCR 277 (Lawrence v. FCT) at [42] - [43].

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].

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 from the Company to the Fund be a distribution made as part of a dividend stripping operation?

The payment of the franked distribution from the Company 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 of a scheme 'by way of or in the nature of dividend stripping' will be present. For the reasons below, each of the central characteristics of a scheme by way of or in the nature of dividend stripping identified in paragraph 30 above are satisfied.

First element: The Company has substantial undistributed profits. The Company's sole asset is cash of $X attributable to retained earnings (other than to the extent $4 stands to the credit of the share capital account). Accordingly, the element of a 'dividend stripping operation' identified in paragraph 30(a) above is satisfied.

Second element: The Taxpayers will transfer their shares in the Company to the Fund by way of sale. Accordingly, the element of a 'dividend stripping operation' in paragraph 30(b) above is satisfied.

Third element: The Company will pay a franked distribution to the Fund which is substantially equal to the value of its retained earnings. Accordingly, the element of a 'dividend stripping operation' in paragraph 30(c) above is satisfied.

Fourth element: On the assumption that the franked distribution is 'consistent with an arm's length dealing' within the meaning of subsection 295-550(2) of the ITAA 1997, and therefore is not 'non-arm's length income' of the Fund within the meaning of paragraph 295-390(2)(a) of the ITAA 1997, a proportion (as worked out under subsection 295-390(3) of the ITAA 1997) of that income, which would otherwise be assessable income of the Fund, is exempt from income tax under subsection 295-390(1) of the ITAA 1997. In addition, the remainder of the franked distribution is assessable income of the Fund and subject to 15% tax to the extent it is included in the Fund's taxable income. 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 (arising from a franking credit of approximately $X) in relation to the franked distribution. Accordingly, the element of a 'dividend stripping operation' in paragraph 30(d) above is satisfied.

Fifth element: The Taxpayers will receive a capital sum of approximately $X for their shares in the Company, which will be the same as or very close to the amount of the franked distribution. Accordingly, the element of a 'dividend stripping operation' in paragraph 30(e) above is satisfied.

Sixth element: The arrangement proposed and described at paragraph 11 above is carefully planned. It involves all the parties acting in concert for a predominant purpose. The objective purpose of the parties is to obtain:

(a) the exemption in subsection 295-390(1) of the ITAA 1997, and the concessional rate of tax to the extent each applies to the franked distribution to the Fund and subsequently the refund of the unused franking credit tax offset (arising from a franking credit of approximately $X) thus increasing the amount available for subsequent tax free distribution as superannuation benefits to the members of the Fund; and

(b) the substitution of a capital amount for the disposal of the shares instead of a franked distribution, with a resultant nil incidence of tax (under the applicable capital gains tax provisions) for the Taxpayers: see Lawrence v. FCT at [44].

There are no other rational explanations for the implementation of the arrangement.

It is no answer to say that the arrangement is undertaken for the purposes of retirement planning and simplification of the Taxpayers' affairs rather than for the purposes 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. This is because, on an objective assessment, the substantial aspect of the arrangement that makes it desirable retirement planning for the Taxpayers and gives rise to the enhanced value is the tax benefits obtained through the channelling of the franked distribution through the Fund, namely, the replacement of an assessable distribution with a capital amount that is not included in the assessable income of the Taxpayers as well as a refund of the unused franking credit tax offset arising from a franking credit of approximately $X (see paragraphs 11(j), (k) and (l) above).

Question 3

Summary

The franked distributions from the Company to the Fund are not made as part of a distribution washing operation within the meaning of subsection 207-157(1) of the ITAA 1997.

Detailed reasoning

Section 207-157 of the ITAA 1997 applies to a franked distribution received by a member of a corporate tax entity on a membership interest (the washed interest) if:

(a) the washed interest was acquired after the member, or a *connected entity of the member, disposed of a substantially identical membership interest; and

(b) a corresponding franked distribution is made to the member, or the connected entity, on the substantially identical interest.

A membership interest is substantially identical to the washed interest if it is any one or more of the following:

(a) fungible with, or economically equivalent to, the washed interest;

(b) a membership interest in the same *corporate tax entity as the washed interest and of a class that is the same as, or not materially different from, the washed interest;

(c) a membership interest in the same corporate tax entity as the washed interest and of a class that is exchangeable at a fixed rate for an interest of the same class as the washed interest;

(d) a membership interest in another corporate tax entity that holds predominantly membership interests that are covered by any of the preceding paragraphs; or

(e) a membership interest in another corporate tax entity that is exchangeable at a fixed rate for interests that are covered by any one or more of paragraphs (a) to (c).

If the conditions in section 207-157 of the ITAA 1997 are met, a member will not be entitled to a franking credit gross-up and offset on the distribution.

The provision contemplates the payment of franked distribution on the washed interest and the payment of a franked distribution on a substantially identical interest. Under the proposal, there will be no dividend distribution declared or payable prior to the proposed sale of the shares to the Fund. That is, there is only the liquidator's distribution to the Fund. Accordingly, section 207-157 of the ITAA 1997 will not apply to the proposed liquidation distribution.

Question 4

Summary

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 of the ITAA 1936 that has the effect of cancelling the tax benefit.

Detailed reasoning

Section 177E of Part IVA of the ITAA 1936

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'. This has the result that the Commissioner is empowered to issue a determination cancelling a tax benefit under section 177F of the ITAA 1936.

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].

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 from the Company to the Fund?

For the following reasons, each of the conditions in paragraphs 177E(1)(a) to (d) of the ITAA 1936 referred to in paragraph 48 above are satisfied.

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 matters in paragraph 11 above clearly constitute a scheme within the meaning of subsection 177A(1) of the ITAA 1936.

Moreover, the 'scheme' described in paragraph 11 above is plainly a 'scheme that is in relation to a company'; namely, the Company.

For this reason, the first condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 48(a) above is satisfied.

Second condition: For the reasons given above in paragraphs 33 to 40, the 'scheme' is one 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 48(b) above is satisfied.

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.

The scheme involves the payment by the Company of a franked distribution to the Fund equal to the value of the Company's retained earnings 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 11(j) above).

Accordingly, the third condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 48(c) above is satisfied.

Fourth condition: As noted above in paragraph 11(j), the franked distribution to be paid represents all or substantially all of 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 48(d) above is satisfied.

Fifth condition: If, before the scheme described in paragraph 11 above was entered into, the Company paid a franked distribution of the amount of retained earnings to its then shareholders, being the Taxpayers, it is reasonable to expect that an amount would have been included in each of their assessable incomes. For this reason, the fifth condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 48(e) above is satisfied.

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 48(f) above is satisfied.

For those reasons, if the scheme in paragraph 11 above is entered into, it will be taken to be a scheme to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e) of the ITAA 1936) and the Taxpayers will be taken to have obtained a tax benefit in connection with the scheme, being the amount which, had the Company paid a franked distribution of the amount of the retained earnings of the Company prior to entering into the scheme, would have formed part of their assessable incomes (paragraphs 177E(1)(f) and (g)).

Question 5

Summary

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

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.

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)'.

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 (subparagraph 177EA(3)(b)(i); subparagraph 177EA(3)(b)(ii) being presently irrelevant);

(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)).

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.

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

It is clear that the 'jurisdictional facts' in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 and described in paragraphs 65(a) to (e) above are satisfied. This is because:

(a) there is a 'scheme for the disposition of membership interests' because the relevant scheme involves the transfer of shares in the Company from the Taxpayers to the Fund (see paragraph 11 above). Accordingly, the jurisdictional fact in paragraph 177EA(3)(a) is satisfied;

(b) it is expected that the distribution to the Fund will be a frankable distribution to the extent that it is not a return of share capital and to that extent it is expected to be a franked distribution. Accordingly, the jurisdictional facts in subparagraph 177EA(3)(b)(i) 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.

Accordingly, the question as to whether the power to make a determination under subsection 177EA(5) of the ITAA 1936 will arise 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?

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]).

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 paragraphs 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].

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. The consideration of $X 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)). The franked distribution does not appear to be equivalent to receipt of an amount in the nature of interest (cf., paragraph 177EA(17)(h)). The franked distribution, to the extent it is not a return of share capital, appears to be paid from taxed and not untaxed profits (cf., paragraph 177EA(17)(ga)). The Fund will not realise a capital loss from the ending of the Fund's shares in the company (cf., paragraph 17EA(17)(g)). These matters, to the extent that they bear probative weight, point against the relevant conclusion as to purpose.

However, the period of time the Fund will hold the shares in the Company prior to the payment of the franked distribution is short and the Company will be thereafter be deregistered. The Company will conduct no trading activities in that period and its assets are 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 (cf., paragraphs 177EA(17)(a) and (i)). This points towards the existence of the relevant conclusion as to purpose.

Further, 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 all connected with the Taxpayers, being the Taxpayers themselves or the Trustee of the Fund as well as the Company which they control and are interested in (cf., paragraph 177D(2)(h));

(b) the scheme's form involves a transfer of the shares in the Company to the Fund and payment of a franked distribution 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 the ultimate economic owners (the Taxpayers) through the Fund (cf., paragraph 177D(2)(b));

(c) the scheme is to be implemented over a short period of time (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:

(i) the Fund will pay out the amount of $X and will receive the distribution (or distributions in total) equal to that amount and franked to the extent of approximately $X. The Fund expects a refund of the unused franking credit tax offset as the franked distribution is exempt income pursuant to section 295-390 of the ITAA 1997 or subject to a lower rate of tax (15%) to the extent the franked distribution is reflected in the Fund's taxable income.. The net effect will be an increase in the value of the Fund arising from the unused franking credit tax offset amount (cf., paragraph 177D(2)(d)). With respect to the payment and subsequent receipt of an amount of $X, 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;

(ii) the Taxpayers will receive a capital amount for the sale of their shares in the Company but will not have any amount referrable to a capital gain included in their assessable incomes because their shares are pre-CGT assets. However a substantial amount would be included in their assessable incomes if the franked distribution had been paid directly to them. (cf., paragraph 177D(2)(e)); and

(iii) the Taxpayers will receive the benefit of pension incomes tax free (as they are 60 years of age or older) from the Fund supported by the franked distribution and the refund of the unused franking credit tax offset whereas without the scheme they would not have the benefit of the full value of the franked distribution and a franking credit. Instead the Taxpayers would have the benefit of a lesser amount. That is, the dividend amount reduced by tax payable ('top-up tax') to the extent that their marginal tax rate exceeds the company tax rate. (cf., paragraph 177D(2)(f)).

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 explanation for the implementation of the scheme other than to ensure that the profits of the Company and the attached franking credits of the Company are channelled to their ultimate economic owners (the Taxpayers) through the Fund and thus with the benefit of the exemption in section 295-390 of the ITAA 1997 or a lesser rate of tax which gives rise to the consequent refund of the franking credit tax offset. As observed above, this is the net effect of the scheme.

It is no answer to say that the main purpose of the scheme is the maximising 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 maximisation of wealth in retirement over that which would otherwise be achieved (see paragraph 40 above).