Edited version of your written advice

Authorisation Number: 1013029270383

Date of advice: 15 June 2016

Ruling

Subject: Proposed distributions by Head Company

Question 1

It is proposed that Company B will elect to adopt AASB 9 in its separate financial statements in respect of the income year ended 30 September 20XX onwards and adopt a FV measurement for Company C. The change in FV of Company B's investment in Company C between xx xx xxxx and xx xx xxxx will be reflected in the profit and loss account of Company B. In accordance with AASB 9, Company B will be required to revalue its investment in Company C on an annual basis.

Will this income be assessable income, in accordance with sections 6-5 or 6-10 of the ITAA 1997, in the consolidated income tax return for the XXXXX income tax consolidated group?

Answer

No

Question 2

Will the potential distributions made to Company A's shareholders out of retained earnings created following the dividend distribution from Company B be dividends paid out of profits derived by the company for the purposes of section 44 of the ITAA 1936?

Answer

Yes

Question 3

Will the potential distributions made to Company A's shareholders out of retained earnings created following the dividend distribution from Company B be frankable distributions for the purposes of subsection 202-40 (1) of the ITAA 1997?

Answer

Yes

Question 4

Will section 177EA if the ITAA 1936 apply to prevent the payment of franked distributions?

Answer

No

This ruling applies for the following period

xx xx xxxx to xx xx xxxx

The scheme commences on:

Xx xx xxxx

Relevant facts and circumstances

Company A is an Australian company listed on the ASX.

Company B is a wholly owned subsidiary of Company A and is a member of the XXXXX income tax consolidated group of which Company A is the head company.

Company B has one wholly owned direct subsidiary Company C. Company C is also a member of the XXXXX income tax consolidated group.

Company B proposes to make an accounting policy choice under AASB 127 to measure its subsidiaries at fair value (FV) under AASB 9 Financial Instruments (AASB 9).

However, Company A will continue to carry its investment in Company B and other subsidiaries at 'cost' under AASB 127.10.

Upon transition to AASB 9, a substantial material uplift is expected to occur in respect of the value of Company B's subsidiary - Company C.

The increase in FV of Company B's investment in Company C will be reflected as a FV gain in the separate profit and loss account of Company B in the year ended xx xx xxxx.

The FV gain expected to arise in Company is an accounting entry only. No receipt will arise in the hands of Company B upon the revaluation of Company C.

The journal entries that Company B would record for accounting purposes in respect of its investment in Company C on adoption of the option in AASB 127 to measure investments in subsidiaries at fair value in accordance with AASB 9 will have no impact on the XXXXX consolidated financial statements as the re-measurement of Company B's investment in Company C to FV and the associated profits that result will be eliminated in full against the carrying amount of the investment (AASB10.B86).

At some point in the future, Company B may be required to pay a dividend to Company A.

If Company B declares a dividend, it would be treated as dividend income in the Company A's separate financial statements when Company A's right to receive the dividend is established (AASB 127.12).

The potential distribution to be made to Company A by Company B will be sourced from its retained earnings account consisting of the FV uplift described above, together with other profits received from its foreign operations and dividends from Company C.

Company A, may then declare, in accordance with its dividend policy dividends to its shareholders which will be sourced from Company A's retained accounts.

Company B's retained earnings accounts are not share capital accounts.

Company A's retained earnings account is not an account that Company A keeps of its share capital. Equally, Company A's retained earnings account is not an account that was first credited with an amount of share capital.

The share capital account of Company A is not 'tainted' as defined in Division 197 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 section 44

Income Tax Assessment Act 1936 subsection 44(1)

Income Tax Assessment Act 1936 subsection 44(1A)

Income Tax Assessment Act 1936 section 177EA

Income Tax Assessment Act 1936 subsection 177EA(3)

Income Tax Assessment Act 1936 paragraph 177EA(3)(a)

Income Tax Assessment Act 1936 paragraph 177EA(3)(b)

Income Tax Assessment Act 1936 subsection 177EA(14)

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 Division 197

Income Tax Assessment Act 1997 subsection 197-50(1)

Income Tax Assessment Act 1997 section 202-5

Income Tax Assessment Act 1997 paragraph 202-5(a)

Income Tax Assessment Act 1997 paragraph 202-5(b)

Income Tax Assessment Act 1997 section 202-15

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 subsection 202-40(1)

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 paragraph 202-45(e)

Income Tax Assessment Act 1997 section 701-1

Income Tax Assessment Act 1997 section 975-300

Reasons for decision

Question 1

Summary

The change in FV of Company B's investment in Company C between xx xx xxxx and xx xx xxxx as reflected in the profit and loss account of Company B does not constitute income as at the present time no gain has 'come home' or been derived by the consolidated group. Therefore, there is no income assessable under either section 6-5 or section 6-10 of the ITAA 1997.

The proposed dividend payment by Company B to Company A (out of Company B's retained earnings after the above change in FV of Company B's investment in Company C between xx xx xxxx and xx xx xxxx) will not form part of the assessable income in accordance with sections 6-5 and 6-10 of the ITAA 1997 in the consolidated income tax return of the tax consolidated group due to the application of section 701-1 of the ITAA 1997.

Detailed reasoning

In 1985, Professor Ross Parsons identified some propositions which provide the hallmarks of income according to ordinary concepts. Parsons noted that the concept of income denotes two components. First, there must be a gain for the taxpayer. Second, once a 'gain' has been established, there must be something that comes in. The second component relates to the concept of derivation. The principles which determine the derivation of an item express a general concept of realisation as essential to income derivation.

In Read v The Commonwealth (1988) 167 CLR 57 Mason CJ, Deane and Gaudron JJ said:

'In our opinion a mere increase in the value of an asset does not amount to a capital profit. A profit connotes an actual gain and not mere potential to achieve a gain. Until a gain is realized it is not 'earned, derived or received'. A capital gain is realized when an item of capital which has increased in value is ventured, either in whole or in part, in a transaction which returns that increase in value.'

Dixon J's observed, in Commissioner of Taxation (South Australia) v. Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108 that:

'...the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer's true income. Speaking generally, in the assessment of income the object is to discover what gains have during the period of account come home to the taxpayer in a realised or immediately realisable form.'

This principle was endorsed in, amongst other cases, Arthur Murray (NSW) Pty Ltd v. Federal Commissioner of Taxation (1965) 114 CLR 314; 14 ATD 98; (1965) 9 AITR 673 ( Arthur Murray ) and Country Magazine Pty Ltd v. Federal Commissioner of Taxation (1968) 117 CLR 162; 15 ATD 86; (1968) 10 AITR 573 ( Country Magazine).

Paragraph 40 of TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1) provides that:

'In relation to non-trading income, the general rule is that there must be a receipt; ' ... there must be something 'coming in'; that is, for income tax purposes, receivability without receipt is nothing' (from Law of Income Tax , Sir Houldsworth Shaw and Mr Baker, quoted by Dixon J in Carden's case, and by Rich ACJ in Permanent Trustee Co (NSW) v. FC of T ).'

The change in FV of Company B's investment in Company C between xx xx xxxx and xx xx xxxx as reflected in the profit and loss account of Company B is an accounting gain only. Company B has not really derived any receipt upon the revaluation of Company C. Company B has merely brought to account an unrealised gain which may or may not eventuate in the future. No gains have come home to Company B in a realised or immediately realisable form. There has been no transaction that has the effect of crystallising the uplift in FV of Company B's investment in Company C such as a sale of the Company B's shares in Company C.

Accordingly, as the uplift in the FV of Company B's investment in Company C is yet to be realised, no assessable income has been derived by Company B under section 6-5 of the ITAA 1997 in respect of the change in FV of Company B's investment in Company C. There are no provisions that will bring this amount attributable to the revaluation of Company B's shares in Company C as statutory income under section 6-10.

Application of the Single Entity Rule

Section 701-1 of the ITAA 1997 is a key provision of the consolidation regime. It is the means by which the members of a consolidated group are treated as a single entity (being the head company) for income tax purposes. For income tax purposes the single entity rule in section 701-1 of the ITAA 1997 deems subsidiary members to be parts of the, head company, rather than separate entities during the period that they are members of the consolidated group. As a consequence, the single entity rule has the effect that dealings that are solely between members of the same consolidated group (intra-group dealings) will not result in ordinary or statutory income (under sections 6-5 or 6-10 of the ITAA 1997) of the group's head company.

An example of an intra-group dealing is the payment of a dividend from one member of a consolidated group to another group member. For income tax purposes this transaction is treated as a movement of funds between two parts of the same entity (the head company), rather than the payment of a dividend. The members of the group paying and receiving the dividend are not seen as separate entities for income tax purposes.

This principle is specifically recognised in the Taxation Ruling TR 2014/11 (TR 2004/11) dealing with the application of the single entity rule. In TR 2004/11, it is stated as follows at para 10:

'Another example is the payment of a dividend from one member of a consolidated group to another group member. For income tax purposes this transaction is treated as a movement of funds between two parts of the same entity (the head company), rather than the payment of a dividend. The members of the group paying and receiving the dividend are not seen as separate entities for income tax purposes.'

This is further expanded at para 32 of TR 2004/11 as follows:

'Transaction between members of a consolidated group will be ignored for income tax purposes. For example, payment of management fees between group members will not be deductible or assessable for income tax purposes. In addition, intra-group dividends will not be assessable or subject to the franking regime.'

Company A is the head company of the tax consolidated group. Company B is a wholly owned subsidiary member of the tax consolidated group. Any dividend payment made by Company B to Company A will be an intra-group dealing that will be eliminated under the single entity rule. Consequently, there will be no impact to the assessable income of the tax consolidated group in respect of the dividend payment made by Company B to Company A.

Therefore, the proposed dividend payment by Company B to Company A will not form part of the assessable income in accordance with sections 6-5 and 6-10 of the ITAA 1997 in the consolidated income tax return of the tax consolidated group due to the application of section 701-1 of the ITAA 1997.

Question 2

Summary

The potential distributions made to Company A's shareholders out of retained earnings created following the dividend distribution from Company B (potential distributions) will be dividends paid out of profits derived by the company for the purposes of section 44 of the ITAA 1936.

Detailed reasoning

Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends paid to the shareholder out of profits derived by the company from any source (if the shareholder is a resident of Australia) or from an Australian source (if the shareholder is a non-resident of Australia).

Subsection 44(1A) of ITAA 1936 confirms that a dividend paid out of amounts other than 'profits' is deemed to be paid out of profits.

Subsection 6(1) of the ITAA 1936 defines 'dividend' as any distribution made by the company to any of its shareholders whether in money or property except where the distribution is debited against an amount standing to the credit of the share capital account of the company (paragraphs (a) and (d) of the definition).

The potential distributions will be a payment or the crediting of money or other property to Company A's shareholders, within the meaning of subsection 6(1) of the ITAA 1936.

The Commissioner has considered the definition of 'profits' for income tax purposes in Taxation Ruling 2012/5 'Income Tax: section 254T of the Corporations Act 2001 and the assessment and franking of dividends paid from 28 June 2010' (TR 2012/5). Relevantly, the Commissioner stated, at paragraph 2 that 'profits' include:

'(i) revenue profits from ordinary business and trading activities, dividends received from other companies, and realised capital profits recognised in the statement of financial performance in a company's accounts; and

(ii) unrealised capital profits of a permanent character recognised in a company's accounts.'

The amounts credited to Company A's retained earnings account are the company's profits from ordinary activities including dividends received from Company B paid out of Company B's retained earnings account (which in turn is credited with Company B's profits including the FV gains arising on the re-measurement of its investment in Company C, other profits received from its operations and dividends from Company C).

In Dimbula Valley (Ceylon) Tea Co Ltd v Laurie (supra), Buckley J held that a reserve resulting from revaluation of unrealised fixed assets, made in good faith by competent valuers and unlikely to be liable to short term fluctuations might be distributed legally as dividend when the regulations of the company so permitted.

Whilst the FV uplift arising in the financial statements of Company B as a result of the re-measurement of Company C is an unrealised amount, the FV movement is nevertheless considered to be of a permanent character out of which a dividend can be paid.

Accordingly, the requirement in subsection 44(1) of ITAA 1936 that a dividend paid to the shareholder be out of 'profits' is satisfied.

However, paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936 excludes from the definition of 'dividend' any:

'moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company...'

The term 'share capital account' is defined in subsection 975-300(1) of the ITAA 1997 as 'an account that the company keeps of its share capital' or 'any other account…[where] the first amount credited to the account was an amount of share capital'.

Subsection 975-300(3) of the ITAA 1997 states that an account is taken not to be a share capital account if it is tainted. Subsection 197-50(1) of the ITAA 1997 states that a share capital account is tainted if an amount to which Division 197 of the ITAA 1997 applies, is transferred to the account and the account is not already tainted. Company A's share capital account is not tainted.

The potential distributions will be sourced entirely from its retained earnings and will not be debited against its share capital account. Therefore, the exclusion in paragraph (d) of will not apply.

The potential distributions made by Company A to its shareholders out of its retained earnings will therefore be dividends as defined in subsection 6(1) of the ITAA 1936 paid out of profits derived by Company A for the purposes of section 44 of the ITAA 1936.

Question 3

Summary

The potential distributions made to Company A's shareholders out of retained earnings created following the dividend distribution from Company B (potential distributions) will be frankable distributions for the purposes of subsection 202-40(1) of the ITAA 1997.

Detailed reasoning

An entity can frank a distribution if certain conditions set out in section 202-5 of the ITAA 1997 are satisfied. This section states:

'An entity franks a distribution if:

(a) the entity is a franking entity that satisfies the residency requirement when the distribution is made; and

(b) the distribution is a frankable distribution; and

(c) the entity allocates a franking credit to the distribution.'

A 'franking entity' is defined in section 202-15 of the ITAA 1997 to include a 'corporate tax entity'. A 'corporate tax entity', pursuant to section 960-115 of the ITAA 1997, includes a company. Being a company incorporated in Australia and an Australian resident for tax purposes, Company A will be a franking entity for the purposes of paragraph 202-5(a) of the ITAA 1997.

The potential distributions also need to be a frankable distribution (paragraph 202-5(b) of the ITAA 1997). The kinds of distributions that can be franked are defined in section 202-40 of the ITAA 1997 as distributions and non-share dividends, unless it is specified that they are unfrankable under section 202-45 of the ITAA 1997.

A 'distribution' that is made by a company, as referred to in section 202-40 of the ITAA 1997 is defined in section 960-120 of the ITAA 1997 as:

'a dividend, or something that is taken to be a dividend, under this Act.'

Subsection 202-40(1) of the ITAA 1997 states that:

'A *distribution is a frankable distribution, to the extent that it is not unfrankable under section 202-45.'

Paragraph 202-45(e) of the ITAA 1997 specifically makes the following unfrankable:

'a distribution that is sourced, directly or indirectly, from a company's *share capital account'

Accordingly, the potential distributions will be frankable to the extent that they are not 'sourced, directly or indirectly, from Company A's share capital account'. The question of whether a distribution is 'sourced, directly or indirectly, from a company's share capital account' is one based in fact and law.

Company A has advised that the company will satisfy all the requirements in section 254T of the Corporations Act for the declaration and payment of the potential distributions.

The amounts credited to Company A's retained earnings account are the company's profits from ordinary activities, including dividends received from Company B. The potential distributions will be sourced entirely from Company A's retained earnings and will not be sourced directly or indirectly from the share capital account of Company A.

Accordingly, the potential distributions will not be unfrankable pursuant to paragraph 202-45(e) of the ITAA 1997. Therefore, the potential distributions made to Company A's shareholders out of its retained earnings created following the dividend distribution from Company B will be frankable distributions for the purposes of subsection 202-40 (1) of the ITAA 1997.

Question 4

Summary

Section 177EA of the ITAA 1936 will not apply to prevent the payment of franked distributions.

Detailed reasoning

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies to a wide range of schemes to obtain a tax advantage in relation to imputation benefits. In essence, it applies to schemes for the disposition of shares or an interest in shares where a franked distribution is paid or payable in respect of the shares or an interest in shares. This would include a capital reduction with a franked dividend component. Section 177EA will apply if the conditions in subsection 177EA(3) are satisfied.

Section 177EA will apply if the conditions in subsection 177EA(3) are satisfied. The conditions are:

'(a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and

(b) either:

(i) a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests; or

(ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in membership interests, as the case may be; and

(c) the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d) except for this section, the person (the relevant taxpayer) would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

(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.'

In order to satisfy the condition in paragraph 177EA(3)(a), there has to be a scheme for a disposition of membership interests. Scheme for the disposition of membership interest is defined in subsection 177EA(14) to include:

• Issuing the membership interests or creating the interest in membership interest;

• Entering into any contract, arrangement, transaction or dealing that changes or otherwise affects the legal or equitable ownership of the membership interest or interest in membership interests;

• Creating, varying or revoking a trust in relation to the membership interests or interest in membership interests;

• Creating, altering or extinguishing a right, power, or liability attaching to, or otherwise relating to, the membership interests or interest in membership interests;

• Substantially altering or extinguishing a right, power or liability attaching to, or otherwise relating to, the membership interests or interest in membership interests;

• Substantially altering any of the risks of loss, or opportunities for profit or gain, involved in holding or owning the membership interest or having the interest in membership interests;

• The membership interests or interest in membership interests beginning to be included, or ceasing to be included, in any of the insurance funds of a life assurance company.

Under the current circumstances none of these prescribed circumstances are satisfied.

Although subsection 177EA(14) is a non-exhaustive list, it is difficult to conclude that a scheme for the disposition of membership interest was meant to include the mere receipt of a dividend. Receipt of a dividend is a natural consequence of holding membership interest. Moreover, if it were to read to include the mere receipt of dividends, there would be no need to have the condition in paragraph 177EA(3)(b) requiring for a frankable distribution to be paid.

Accordingly, the condition in paragraph 177EA(3)(a) that there be a scheme for disposition of membership interests is not satisfied. Section 177EA will therefore not apply as the requirement for disposition of a membership interests in paragraph 177EA(3)(a) is not satisfied.