Edited version of your written advice

Authorisation Number: 1012879929665

Date of advice: 18 September 2015

Ruling

Subject: Retirement planning

Question 1

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

Answer

Yes

Question 2

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

Answer

Yes

Question 3

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

Answer

Yes

This ruling applies for the following periods:

1 July 2015 to 30 June 2016

1 July 2016 to 30 June 2017

1 July 2017 to 30 June 2018

1 July 2018 to 30 June 2019

1 July 2019 to 30 June 2020

The scheme commences on:

1 July 2015

Relevant facts and circumstances

1. Taxpayer 1 and Taxpayer 2 are both over 55 years of age. They are both currently planning for their retirement.

2. Taxpayer 1 and Taxpayer 2 are currently the only directors and only shareholders of the Company. They each hold X ordinary shares in the Company.

3. The total assets of the Company at 30 June 2014 equal $X. This comprises cash, unsecured shareholder loans, property, plant and equipment. As at 30 June 2014 the Company had current liabilities of $X, reserves of $X and retained earnings of $X.

4. As at 30 June 2014 there was $X standing to the credit of the Company's franking account.

5. The Company ceased operating a business in over 12 months ago.

6. The Company currently derives rental income from the residential rental property that it owns. There is no intention to deregister the Company in the foreseeable future.

7. Taxpayer 1 and Taxpayer 2 are the individual trustees of the Fund.

8. Taxpayer 1 and Taxpayer 2 are the only members of the Fund. They are both currently drawing an account based pension from the Fund.

9. Taxpayer 1 and Taxpayer 2 do not have any income tax carried forward losses. Nor do they have any capital losses available.

10. It is intended that the following steps will be implemented:

(a) Taxpayer 1 and Taxpayer 2 will borrow from an unrelated third party a total of approximately $X against the equity in their home to repay the shareholder loan to the Company of $Y and to lend approximately $Z to the Fund;

(b) the residential rental property held by the Company will be revalued at its market value. The Company will then have total assets of approximately $X being cash and a residential rental property represented by reserves and retained earnings totalling approximately $X;

(c) Taxpayer 1 and Taxpayer 2 will sell their shares in the Company to the Fund at market value, which is stated to be approximately $X (i.e. equal to the cash and residential rental property of the Company). Upon the sale of the shares to the Fund, Taxpayer 1 and Taxpayer 2 will each crystallise a capital gain which is said will be reduced to nil after applying the small business 15 year exemption contained in subdivision 152-B of the ITAA 1997;

(d) the Fund will purchase all the shares from Taxpayer 1 and Taxpayer 2 using $X borrowed from Taxpayer 1 and Taxpayer 2 and $X cash already held in the Fund;

(e) the 20 shares purchased by the Fund will be recorded in the Fund's accounts at the stated market value of $X;

(f) Taxpayer 1 and Taxpayer 2 will use the $X received as proceeds from the sale of the shares to the Fund to repay the loan referred to, at paragraph (a). The drawdown and repayment of the loan will occur over no more than two weeks;

(g) the borrowing by the Fund from Taxpayer 1 and Taxpayer 2 of $X would be made under a limited recourse borrowing arrangement (LRBA). The loan would have a fifteen year term with the first five years being interest only repayments and the following ten years being interest and principle repayments;

(h) franked distributions (including any attached franking credits) are to be paid to the Fund and are said to be exempt income for the Fund. A proportion (as worked out under subsection 295-390(3) of the ITAA 1997) of the franked distribution which would otherwise be assessable income of the Fund will be 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 refunds of the unused franking credit tax offset (arising from the franking credits attached to the dividends);

(i) the Company will only conduct an investment operation. The income generated by its assets (at least initially being cash and the residential rental property) will be paid as dividends to the Fund. The level of dividends to be paid going into the future will depend on the underlying risk and investment portfolio of the Company and market conditions at the time The dividends initially paid will be in the range of $X to $Y per year;

(j) the investments of the Company will be diversified into higher yield assets to increase returns. With less conservative investments the dividends paid would be in the range of $X to $Y per year.

(k) The Fund will make at least the minimum pension payments each year to Taxpayer 1 and Taxpayer 2.

11. If the steps outlined in paragraph 10 above are not implemented, Taxpayer 1 and Taxpayer 2 will continue to be the shareholders of the Company and be in receipt of dividends from the Company.

Assumptions

12. All the terms of the loan from Taxpayer 1 and Taxpayer 2 to the Fund under the LRBA will be equivalent to the terms were a similar loan to be made to the Fund from an arm's length commercial lender, including the interest rate, term of the loan, timing and amount of repayment of principle and interest, security, costs and loan to value ratio.

13. The shares in the Company are purchased by the Fund under a LRBA where the lenders are Taxpayer 1 and Taxpayer 2 and the LRBA meets the requirements of section 67A of the Superannuation Industry (Supervision) Act 1993 (SISA).

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

15. The Company will continue to meet the requirements of subregulation 13.22C of the SISA while ever the Fund is a shareholder thereby ensuring that the Fund's investment in the Company does not exceed the 5% in-house asset limit (see Part 8 of the SISA).

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 295-545

Income Tax Assessment Act 1997 section 295-550

Reasons for decision

Question 1

Summary

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

Detailed reasoning

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

18. The note to subsection 295-545(1) of the ITAA 1997 explains that a concessional rate (15%) of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal tax rate (45% or 47% for the 2014-15, 2015-16 and 2016-17 financial years). These rates are set out in the Income Tax Rates Act 1986.

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

20. 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.

21. Given the assumption that the Fund holds a fixed entitlement to the income of the holding trust, subsection 295-550(5) of the ITAA 1997 is relevant. It provides that:

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

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

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

Fixed entitlement

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

Entitlement acquired or income derived under a scheme

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

(a) any *arrangement; or

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

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

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

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

Whether parties are not dealing with each other at arm's length and the income is more than it might otherwise have been

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

28. It is clear that the parties in the present case are not at arm's length. Taxpayer 1 and Taxpayer 2, are the vendor shareholders and lenders under the LRBA. Taxpayer 1 and Taxpayer 2 are also directors of the Company that is paying the dividend to the Fund and Taxpayer 1 and Taxpayer 2 are also the members and trustees of the Fund. The scheme therefore involves persons who are all connected being Taxpayer 1 and Taxpayer 2 themselves or entities which they control or are interested in.

29. As to whether or not they are dealing at arm's length, in Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 (Axa) Dowsett J (at [26]) summarised propositions, which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' (or similar) have been considered, as follows:

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

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

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

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

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

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

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

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

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

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

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

33. In this case, it is consistent with Allen to consider the arrangement holistically to determine if income of the Fund is non-arm's length income. The arrangement is one effectively carried out by Taxpayer 1 and Taxpayer 2 in their various capacities as the shareholders and directors, members or trustees of the parties to the arrangement. The holistic approach recognises that the purchase of the shares by the Fund from Taxpayer 1 and Taxpayer 2 is financed by them with the LRBA holding trust relevant only because there is a borrowing which would otherwise be prohibited under subsection 67(1) of the SISA. If the focus were limited only to the LRBA holding trust and Fund, it might more readily lead to a conclusion that subsection 295-550(5) of the ITAA 1997 applies because looking only at this part of the arrangement it would appear that the Fund acquired its (fixed) interest in the LRBA holding trust for nil consideration.

34. In determining if the parties are not dealing with each other at arm's length such that the income derived by the Fund (through holding a fixed entitlement to the income of the LRBA holding trust) is more than the amount that the Fund might have expected to derive if the parties had been dealing with each other at arm's length it is appropriate to consider the market value of the shares as compared with the dividend rate and the rate of return on investment and the level of investment risk undertaken by the Fund.

35. In the circumstances of this case:

• the Fund has minimal or nil investment risk as owner of the shares as the only assets of the Company are cash and residential rental property, the Company has no liabilities and there are no trading activities being conducted by the Company;

• given the non-arm's length relationship that exists between all parties involved there is also no risk to the Fund that dividends won't be paid. Additionally, as the Fund owns 100% of the shares in the Company and it is a related party of the Fund, the Company could at any time choose to pay out dividends that equate to the capital sums paid to Taxpayer 1 and Taxpayer 2;

• the purchase price of the shares is stated to be approximately $X (i.e. commensurate with its cash and residential rental property assets) which takes no account of the statutory right to the franking credit tax offsets and the subsequent franking credit refunds that are conferred on the Fund as a result of the transactions.

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

37. In summary, subsection 295-550(5) of the ITAA 1997 would apply to the Fund with respect to its receipt of the franked distributions from the Company. The franked distributions 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

38. The 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. Consequently the amount of the franking credit on each of the distributions 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 (paragraphs 207-145(e) and (f) of the ITAA 1997).

Detailed reasoning

Subsection 207-145(1) of the ITAA 1997

39. 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.

40. 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.

41. If the 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 the 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

42. 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].

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].

44. 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' can lie 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?

45. The payment of the franked distributions 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 (identified in paragraph 42 above) of a scheme 'by way of, or in the nature of, dividend stripping' will be present.

46. First element: The Company has substantial undistributed profits. Its only assets will be cash and a residential rental property. This creates a potential tax liability for Taxpayer 1 and Taxpayer 2 in relation to the retained earnings and reserves of the Company as the current shareholders and recipients of the loan from the Company. If the profits of the Company were paid to Taxpayer 1 and Taxpayer 2 by way of franked distributions, under subparagraph 44(1)(a)(i) of the ITAA 1936, they would be assessed on an amount reflecting the franked distributions. Accordingly, the element of a dividend stripping operation identified in paragraph 42(a) above is satisfied.

47. Second element: There will be a sale or allotment of shares in the target co to another party. Taxpayer 1 and Taxpayer 2 will sell all of the shares in the Company to the Fund. Taxpayer 1 and Taxpayer 2 will each receive a capital sum for those shares

48. 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 42(b) above is satisfied.

49. Third element: The Company will pay franked distributions to the Fund. The fact that franked distributions are paid to the Fund over several years and not as a 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 42(c) above is satisfied.

50. Fourth element: On the assumption that the franked distributions are not non-arm's length income of the Fund (within the meaning of section 295-550 of the ITAA 1997) the franked distributions are said to be exempt income of the Fund under section 295-390 of the ITAA 1997. In the result, absent the application of subsection 207-145(1) of the ITAA 1997 the Fund will obtain refunds of the unused franking credit tax offsets in relation to the franked distributions.

51. The reference in FCT v. CPH (FFC) at [136] to various different means by which tax can be escaped (including application of an inter-company dividend rebate) was not an exhaustive description of the means by which tax can relevantly be escaped on the dividend by a dividend stripping operation. Accordingly, the element of a dividend stripping operation in paragraph 42(d) above is satisfied.

52. Fifth element: Taxpayer 1 and Taxpayer 2 will each receive a capital sum for the sale of the shares in the Company to the Fund. Dividend amounts are being paid out to the Fund from the Company. Further, as the Fund owns 100% of the shares in the Company and it is a related party of the Fund, the Company could at any time choose to pay out dividends that equate to the capital sums received by Taxpayer 1 and Taxpayer 2. Accordingly, the element of a "dividend stripping operation" in paragraph 42(e) above is satisfied. It is not significant that the payments are spread over a number of dividends, rather than paid at once. This is no more than a "variation on the paradigm" which does not remove the scheme from one satisfying the central characteristics of a "dividend stripping operation".

53. Sixth element: The sixth element of a dividend stripping operation identified in paragraph 42 above is satisfied for the following reasons:

(a) The arrangement proposed and described at paragraph 10 above is carefully planned. It involves all the parties acting in concert. The parties are all related, being Taxpayer 1 and Taxpayer 2, or entities controlled by them.

(b) From the point of view of the Fund, the principal or predominant economic effect of the arrangement proposed and described at paragraph 10 above is obtaining tax benefits: namely, the attraction of the exemption in subsection 295-390(1) of the ITAA 1997 to the franked distributions and generating refunds of the unused franking credit tax offsets. 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.

(c) From the point of view of the vendor shareholders (Taxpayer 1 and Taxpayer 2), 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 stated resultant nil 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 Taxpayer 1 and Taxpayer 2 could expect to incur a tax liability. However, in the hands of the Fund, the dividend and franking credit tax offset refund amounts are available for subsequent tax free distribution as superannuation benefits to Taxpayer 1 and Taxpayer 2.

(d) 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 Taxpayer 1 and Taxpayer 2 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 cash flow planning for Taxpayer 1 and Taxpayer 2 is the tax benefits obtained through the channeling of the franked distributions through the Fund: namely, the exemption of the franked distributions and the refund of the franking credit tax offsets referred to in paragraph 10(h) above. The only additional cash added to the Fund is through the refund of any franking credit tax offsets since the Fund has to initially purchase the shares with existing cash assets of the Fund and a borrowing from Taxpayer 1 and Taxpayer 2 along with the incurring of interest expenses.

(e) The cashflow objective could be more simply achieved by the Company continuing to pay franked distributions to Taxpayer 1 and Taxpayer 2. The relevant difference being the tax effects achieved by the arrangement proposed and described at paragraph 10 above would not be achieved.

Question 3

Summary

54. 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

55. 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.

56. 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].

57. 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?

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

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

60. The scheme described in paragraph 10 above is plainly a 'scheme that is in relation to a company'.

61. For this reason, the first condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 56(a) above is satisfied.

62. Second condition: For the reasons given above in paragraphs 42 to 53 the steps set out in paragraph 10 above involve 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 56(b) is satisfied.

63. 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.

64. The scheme, involves the payment by the Company of 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 paragraph 10(h) above).

65. Accordingly, the third condition in subsection 177E(1) of the ITAA 1936 referred to in paragraph 56(c) above is satisfied.

66. Fourth condition: As noted above in paragraph 10, the Company will pay franked distributions to the Fund. 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 56(d) above is satisfied.

67. Fifth condition: If, before the scheme described in paragraph 10 above was entered into, the Company paid a franked distribution out of profits to its then shareholders being Taxpayer 1 and Taxpayer 2, it is reasonable to expect that an additional amount would have been included in their assessable incomes 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 56(e) above is satisfied

68. 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 56(f) above is satisfied.

69. For those reasons, if the scheme in paragraph 10 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, Taxpayer 1 and Taxpayer 2 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 formed part of their assessable incomes (paragraph 177E(1)(f) and (g)).