Edited version of private advice

Authorisation Number: 1051586123830

Date of advice: 28 October 2019

Ruling

Subject: Distribution of profits, imputation benefit dividend stripping and franking credit scheme

Question 1

Does section 207-20 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to Shareholder 1 (SH1) to:

(a)       include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year; and

(b)       allow entitlement to a tax offset equal to the amount of the relevant franking credits?

Answer

(a)       Yes

(b)       Yes

Question 2

Does subsection 207-35(1) of the ITAA 1997 apply to Trustee Co as trustee for Shareholder 2 (SH2) to include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year?

Answer

Yes

Question 3

Does subsection 207-35(4) and section 207-45 of the ITAA 1997 apply to Beneficiary Co to:

(a)       include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year; and

(b)       allow entitlement to a tax offset equal to the amount of the relevant franking credits?

Answer

(a)       Yes

(b)       Yes

Question 4

Will SH2 and Beneficiary Co be qualified persons under former Division 1A of Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936) in relation to the Type 1 Dividend and the Type 2 Dividend?

Answer

Yes

Question 5

Will the Type 1 Dividend and the Type 2 Dividend form part of the capital proceeds received by SH1 and SH2 on the sale of their shares in H Co?

Answer

Yes

Question 6

Will section 118-20 of the ITAA 1997 apply to reduce the amount of any capital gain made by SH1 and SH2 on the disposal of their shares in H Co by the amount of the Type 1 Dividend and the Type 2 Dividend that are included in each respective entity's assessable income under subsection 44(1) of the ITAA 1936?

Answer

Yes

Question 7

Will SH2 be able to treat the capital gain on the disposal of its H Co shares as a discount capital gain pursuant to Division 115 of the ITAA 1997?

Answer

Yes

Question 8

Will the Commissioner make a determination under paragraph 204-30(3)(c) of the ITAA 1997 regarding streaming distributions, to deny the whole, or any part, of the imputation benefit received in relation to the Type 1 Dividend and the Type 2 Dividend?

Answer

No

Question 9

Will the Commissioner make a determination under paragraphs 177EA(5)(a) or 177EA(5)(b) of the ITAA 1936, to debit H Co's franking account or deny the whole, or any part, of the imputation benefit received in relation to the Type 1 Dividend and the Type 2 Dividend?

Answer

No

Question 10

Will section 177E of the ITAA 1936 apply in relation to the sale of shares in H Co and the payment of the Type 1 Dividend and the Type 2 Dividend?

Answer

No

Question 11

Will section 207-145 or 207-150 of the ITAA 1997 apply to the whole, or any part of the Type 1 Dividend and the Type 2 Dividend?

Answer

No

This ruling applies for the following period:

1 July 20XX to 30 June 20YY

The scheme commences on:

The scheme commenced on 1 July 20XX.

Relevant facts and circumstances

H Co

H Co is an Australian resident company.

H Co is the head company of a tax consolidated group (H Co Group) in Australia with a number of wholly-owned subsidiaries.

The H Co Group has two shareholders, SH1 and SH2:

·                     SH1 is an Australian resident company wholly-owned 100 percent by XYZ Co (XYZ). It acquired its entire shareholding before 1 July 19XX.

·                     SH2 is a discretionary trust

·                     SH2 is an Australian resident trust

·                     Beneficiary Co is a general beneficiary of SH2.

·                     a family trust election was made in 2002.

·                     Not all of the shares owned by SH2 were acquired before 1 July 1997

Sale transaction

SH1 and SH2 entered into a Contract for the sale of 75% of their shareholdings in H Co to a subsidiary of Foreign Co, Purchaser.

Pursuant to the Contract, the consideration payable in respect of the transaction is based on a formula involving a Base Purchase Amount that is adjusted for various items including loans owed by H Co to SH1 and SH2 as a result of the Type 1 Dividend and the Type 2 Dividend.

Payment of dividends

Prior to the sale occurring, H Co resolved to pay a fully franked Type 1 Dividend and a fully franked Type 2 Dividend to SH1 and SH2. The eligibility for these dividends was determined on the record date which was 23 July 20XX. It follows that the ex-dividend date was 24 July 20XX.

·                     Type 1 dividend

-                    H Co has a policy of paying dividends equal to 30 per cent of its net profit after tax which in recent years it has departed from. This dividend was being paid to account for lower dividends paid in prior income years due to funds being retained for capital expenditure on expanding operations:

-                    payment of the dividend was conditional on this ruling being favourable and the entire dividend was sourced from retained earnings.

·                     Type 2 dividend - these dividends were conditional upon the shareholders entering into a binding agreement with the subsidiary of Foreign Co to dispose of 75 percent of their H Co shares:

-                    payment of these dividends was also conditional on this ruling being favourable and the entire dividend was sourced from retained earnings.

Funding the dividends

Both types of dividends were funded by crediting each shareholder's loan account.

The Foreign Co lent 75 percent of the outstanding shareholder loan amounts to H Co around the time of completion of the sale. These funds were used to repay part of the loans owing to SH1 and SH2.

Each shareholder entered into a loan agreement with H Co.

Purchaser lending to H Co

The Contract obligated the Purchaser to lend to H Co and to procure H Co to pay this amount to SH2 and SH1 (to partly pay out H Co's loans caused by H Co's declaration of the Type 1 Dividend and the Type 2 Dividend).

You advised the commercial reasons for paying these dividends to SH1 and SH2 was to reduce their 'at risk' equity going forward given they were to become minority shareholders.

Flow of dividends and capital proceeds

SH2 distributed 100 percent of both types of dividends received under this arrangement, including franking credits, to Beneficiary Co. This has been done as an unpaid present entitlement for the year ended 30 June 20XX.

This unpaid present entitlement will be satisfied by distributing to Beneficiary Co, cash received by SH2 from the loan repayment made by H Co.

Beneficiary Co

Beneficiary Co is an Australian resident company and a general beneficiary of SH2.

Historically all dividends received by SH2 have been distributed to Beneficiary Co. The Beneficiary Co's policy is that it only makes dividend payments to members of the family group.

Any franking credits sourced from the H Co Type 1 Dividend and Type 2 Dividend that are credited to Beneficiary Co's franking account will only be distributed (via Beneficiary Co's shareholders who are trusts) to individuals in the family group and be taxable in their hands.

None of the Beneficiary Co shares are currently held by superannuation funds, nor do any of the family trusts distribute to superannuation funds as beneficiaries.

None of Beneficiary Co's shareholders will transfer any of their shares in Beneficiary Co to an associate superannuation fund, company or trust to allow the franking credits sourced from the H Co dividend to be paid to these entities.

SH1 paid the dividends to its 100 per cent shareholder - XYZ

XYZ

The franking credits attached to the H Co Type 1 Dividend and Type 2 Dividend were credited firstly to SH1's franking account and then later to the franking account of XYZ. All franking credits sourced from the H Co Type 1 Dividend and Type 2 Dividend will eventually only be paid as part of dividends to the individual shareholders of XYZ.

Neither SH1 nor any of the individual shareholders of XYZ will transfer any of their shares to an associate superannuation fund, company or trust to allow the franking credits sourced from the H Co dividend to be paid to these entities.

Relevant legislative provisions

Income Tax Assessment Act 1997, Section 104-5

Income Tax Assessment Act 1997, Paragraph 115-10(c)

Income Tax Assessment Act 1997, Section 115-15

Income Tax Assessment Act 1997, Subsection 115-25(1)

Income Tax Assessment Act 1997, Subsection 116-20(1)

Income Tax Assessment Act 1997, Section 118-20

Income Tax Assessment Act 1997, Section 204-30

Income Tax Assessment Act 1997, Subsection 204-30(3)

Income Tax Assessment Act 1997, Paragraph 204-30(3)(c)

Income Tax Assessment Act 1997, Subsection 204-30(6)

Income Tax Assessment Act 1997, Section 207-20

Income Tax Assessment Act 1997, Subsection 207-35(1)

Income Tax Assessment Act 1997, Subsection 207-35(3)

Income Tax Assessment Act 1997, Subsection 207-35(4)

Income Tax Assessment Act 1997, Section 207-45

Income Tax Assessment Act 1997, Section 207-50

Income Tax Assessment Act 1997, Subsection 207-50(3)

Income Tax Assessment Act 1997, Section 207-75

Income Tax Assessment Act 1997, Section 207-140

Income Tax Assessment Act 1997, Section 207-145

Income Tax Assessment Act 1997, Paragraph 207-145(1)(a)

Income Tax Assessment Act 1997, Section 207-150

Income Tax Assessment Act 1997, Paragraph 207-150(1)(a)

Income Tax Assessment Act 1997, Section 207-155

Income Tax Assessment Act 1936, Subsection 6(1)

Income Tax Assessment Act 1936, Subsection 44(1)

Income Tax Assessment Act 1936, Paragraph 97(1)(a)

Income Tax Assessment Act 1936, Division 1A of former Part IIIA

Income Tax Assessment Act 1936, Section 160APHD

Income Tax Assessment Act 1936, Subsection 160APHE(1)

Income Tax Assessment Act 1936, Section 160APHH

Income Tax Assessment Act 1936, Section 160APHL

Income Tax Assessment Act 1936, Subsection 160APHN(2)

Income Tax Assessment Act 1936, Subsection 160APHN(3)

Income Tax Assessment Act 1936, Subsection 160APHN(4)

Income Tax Assessment Act 1936, Paragraph 160APHN(3)(f)

Income Tax Assessment Act 1936, Paragraph 160APHN(4)(c)

Income Tax Assessment Act 1936, Paragraph 160APHN(4)(f)

Income Tax Assessment Act 1936, Paragraph 160APHO(1)(a)

Income Tax Assessment Act 1936, Subsection 160APHO(1)(b)

Income Tax Assessment Act 1936, Subsection 160APHO(3)

Income Tax Assessment Act 1936, Section 177E

Income Tax Assessment Act 1936, Section 177EA

Income Tax Assessment Act 1936, Subsection 177EA(3)

Income Tax Assessment Act 1936, Paragraph 177EA(5)(a)

Income Tax Assessment Act 1936, Paragraph 177EA(5)(b)

Income Tax Assessment Act 1936, Subsection 177EA(14)

Income Tax Assessment Act 1936, Paragraph 177EA(14)(b)

Income Tax Assessment Act 1936, Subsection 177EA(17)

Reasons for Decisions

Question 1

Does section 207-20 of the ITAA 1997 apply to SH1 to:

(a)       include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year; and

(b)       allow entitlement to a tax offset equal to the amount of the relevant franking credits?

Summary

SH1 satisfies the residence requirement and the holding period rule in relation to the Type 1 Dividend and the Type 2 Dividend. Section 207-20 will therefore apply and requires SH1 to include the amount of the franking credits attached to its share of the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year.

SH1 is also entitled to a tax offset equal to the amount of the franking credits attached to the Dividends.

Detailed reasoning

Dividend is defined to include any distribution paid or credited by a company to its shareholders (whether in money or other property) but does not include any distribution made from the company's share capital account.

Dividends paid out of profits by a company to its shareholders are generally required to be included in the shareholder's assessable income.

The Type 1 Dividend and the Type 2 Dividend were declared prior to the completion date of the Contract between SH2 and SH1 (vendor shareholders) and Purchaser (a subsidiary of Foreign Co). The Type 1 Dividend and the Type 2 Dividend were funded by crediting each shareholder's loan in the accounts of H Co.

At or around the completion date of the Contract, Foreign Co agreed to loan 75 percent of any outstanding shareholder loan amounts to H Co. These funds would be used to repay part of the loans owing to the shareholders.A loan agreement was entered into between H Co and each shareholder in respect of the remaining outstanding loan amounts.

The term 'paid' in the definition of 'dividend' at subsection 6(1) of the ITAA 1936 includes credited or distributed. The crediting of a dividend to an account in the name of a shareholder in the accounts of the company comes within the meaning of 'paid' in the definition of dividend.Therefore, the Type 1 Dividend and the Type 2 Dividend constitute a dividend for the purposes of subsection 44(1) of the ITAA 1936.

Where a company makes a franked distribution, the general rule under section 207-20 requires the entity receiving the franked distribution to include the amount of the franking credits on the distribution in their assessable income in addition to the amount of the franked distribution. The entity is also entitled to a tax offset for the income year equal to the franking credits on the distribution (tax offset component). The general rule is subject to the entity satisfying the residency requirement and the 'qualified person' requirement under Division 1A of former Pt IIIAA being of the ITAA 1936 at the time the dividend is made.

A taxpayer is considered a qualified person if the taxpayer satisfies the holding period rule. This rule, broadly, requires the shares in the entity to be held at risk for more than 45 days. These rules apply to shares acquired on or after 1 July 1997.

SH1 is an Australian resident entity. On the basis SH1 acquired all of its shares in H Co before 1 July 1997, the holding period requirement would not apply to deny a tax offset equal to the amount of franking credits attached to its share of the Type 1 Dividend and the Type 2 Dividend.

Pursuant to section 207-20, SH1 is required to include the franking credits attached to its share of the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year. However, SH1 is also entitled to a tax offset equal to the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend.

Question 2

Does subsection 207-35(1) of the ITAA 1997 apply to Trustee Co as trustee for Shareholder 2 (SH2) to include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year?

Summary

SH2 held its H Co shares at risk continuously for the required period during both the primary and secondary qualification period. SH2 is therefore considered a qualified person for the purpose of the former Division 1A of Part IIIA of the ITAA 1936.

Subsection 207-35(1) will therefore apply to include the amount of the franking credits attached to SH2's share of the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year.

Detailed reasoning

The consequence of franked distribution received through an entity that is a partnership or a trustee of a trust is outlined in subdivision 207-B. Specifically, subsection 207-35(1) provides that where a franked distribution is made to a partnership or a trustee of a trust (but not a corporate tax entity or a complying superannuation entity) in an income year, the assessable income of the partnership or trust for that income year includes the franking credit on the franked distribution.

In applying the rule in section 207-35(1), the partnership or the trustee of the trust must satisfy the qualified person rule.

Therefore, subject to satisfying the qualified person rule, SH2 will be required to include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year.

Qualified person

In relation to shares acquired on or after 1 July 1997, a taxpayer must be a 'qualified person' in relation to a dividend in order to be entitled to a tax offset in respect of the franking credits attached to dividends.

A taxpayer is a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936 if they satisfy the holding period rule and/or the related payments rule.

Holding period rule

The holding period rule requires a taxpayer to hold their shares 'at risk' for a continuous period (excluding the day of acquisition and the day of disposal, if they are disposed) of at least 45 days (or 90 days for preference shares) during the relevant qualification period in order to qualify for a franking benefit.

The primary qualification period is the relevant test period if no related payments were made in relation to the relevant dividend/distribution.

If the taxpayer is under an obligation to make a related payment in relation to a distribution, they will have to satisfy the secondary qualification period.

Related payments

The term 'related payment' is broadly defined in former section 160APHN of the ITAA 1936. Notably, an actual payment by the taxpayer or an associate is not required. The taxpayer or associate is taken to have made a related payment if the taxpayer or associate is under an obligation to or may reasonably be expected to pass the benefit of a dividend or distribution to other persons.

Former subsection 160APHN of the ITAA 1936 gives examples of, but does not limit, what constitutes the making of a related payment, for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.

Former subsection 160APHN(3) of the ITAA 1936 states:

Without limiting subsection (2), the doing of any of the following by the taxpayer or an associate of the taxpayer in the circumstances mentioned in subsection (4) may have the effect of passing the benefit of the dividend or distribution to one or more other persons:

(i)            causing a payment or payments to be made to, or in accordance with the directions of, the other person or other persons; or

(ii)           causing an amount or amounts to be credited to, or applied for the benefit of, the other person or the other persons; or

(iii)          causing services to be provided to, or in accordance with the directions of, the other person or other persons; or

(iv)         causing property to be transferred to, or in accordance with directions of, the other person or other persons; or

(v)          allowing any property or money to be used by the other person or other persons or by someone nominated by the other person or other persons; or

(vi)         causing an amount or amounts to be set off against, or to be otherwise applied in reduction of, a debt or debts owed by the other person or other persons; or

(vii)        agreeing to treat an amount or amounts owed to the other person or other persons by the taxpayer or associate as having been increased.

Former subsection 160APHN(4) of the ITAA 1936 states:

The circumstances referred to in subsection (3), are where:

(a)          the amount or the sum of the amounts paid, credited or applied; or

(b)          the value or the sum of the values of the services provided, of the property transferred or of the use of the property or money; or

(c)          the amount or the sum of the amounts of the set-offs, reductions or increases;

as the case may be:

(d)          is, or may reasonably be expected to be, equal to; or

(e)          approximates or may reasonably be expected to approximate; or

(f)           is calculated by reference to;

the amount of the dividend or distribution.

In the present case, the fact that the proceeds of sale of the H Co shares will be discounted by an amount equal to 75 percent of the Type 1 Dividend and the Type 2 Dividend means that under the arrangement, SH2 could be taken to have made a related payment in respect of the Type 1 Dividend and the Type 2 Dividend. In particular, the discount on the Purchase Price for the sale of the H Co shares could fall within the former paragraphs 160APHN(3)(f), 160APHN(4)(c) and (f) of the ITAA 1936.

As such, SH2 is considered to have made a related payment in respect of the Type 1 Dividend and the Type 2 Dividend. Consequently, SH2 will need to satisfy the holding period requirement within the secondary qualification period.

Secondary qualification period

The secondary qualification period applies where the taxpayer or associate is under an obligation to make, or is likely to make, a related payment, i.e. any method of passing the benefit of the dividend to another person could qualify as a related payment.

The secondary qualification period begins 45 days before the ex-dividend date and ends 45 days after (or 90 days for preference shares). In calculating the number of days, the following days are not counted:

·                     the day on which the taxpayer acquired the shares or interest

·                     if the taxpayer had disposed of the shares or interest, the day of disposal, and

·                     any days on which the taxpayer had materially diminished risks of loss or opportunities for gain in respect of the shares or interest. However, the exclusion of those days did not break the continuity of the holding period.

A share or interest (other than an interest as a beneficiary of a widely held trust) becomes ex-dividend on the day after the last day on which the shares or interest can be acquired so as to become entitled to the dividend or distribution on the shares or interest.

The eligibility for both the Type 1 Dividend and the Type 2 Dividend is determined on the record date. This is the last day on which H Co shares can be acquired which will be entitled an investor to receive the dividends. Accordingly, the ex-dividend date for the purposes of former subsection 160APHE(1) of the ITAA 1936.

The secondary qualification period for the purposes of Division 1A of former Part IIIAA of the ITAA 1936 in respect to both dividends would therefore run from 45 days before ex-dividend date to 45 days after the ex-dividend date.

When working out the number of days for the qualification period, the day of the disposal of shares is excluded as mentioned above. This is because the shares are no longer considered to be held at risk. Under former section 160APHH of the ITAA 1936, a shareholder is treated as having disposed of shares at a time the contract was entered into for the disposal of shares.

The period from the day the contract was entered into would be excluded in determining the number of days the shares were held at risk for the purpose of the secondary qualification period.

Family trust

Under former section 160APHL of the ITAA 1936, the rules for determining a beneficiary's interest in shares held by a trust were such that dividends received as part of a discretionary trust distribution generally would not qualify for franking credits. This is because shares owned by a discretionary trust are generally deemed not to be held at risk unless the trust makes a valid family trust election (or the discretionary trust had acquired the shares or interests in shares before 3 pm ACT time on 31 December 1997). Therefore, in order for SH2 to pass on the benefit of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend, SH2 is required to have a valid family trust election in place.

Conclusion

SH2 made a valid family trust election and has held each parcel of their shares since the time they were acquired. This means that SH2 would have held its shares for the required period for the purpose of both the primary and secondary qualification period. SH2 is therefore considered to be a qualified person for the purpose of Division 1A of former Part IIIAA of the ITAA 1936.

Pursuant to subsection 207-35(1), SH2 will be required to include the amount of the franking credit attached to its share of the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year.

Question 3

Does subsection 207-35(4) and section 207-45 of the ITAA 1997 apply to Beneficiary Co to:

(a)       include the amount of the franking credits attached to the Type 1 Dividend and the Type 2 Dividend in its assessable income for the 20XX income year; and

(b)       allow entitlement to a tax offset equal to the amount of the relevant franking credits?

Summary

Beneficiary Co will need to include so much of the franking credit amount as is equal to its share of the franking credits on the distribution in its assessable income for the 20XX income year.

On the basis there is a valid family trust election in place, Beneficiary Co, as a beneficiary of SH2, will be considered a qualified person pursuant to former section 160APHL of the ITAA 1936 and be entitled to a tax offset equal to the amount of the relevant franking credits.

Detailed reasoning

Beneficiary Co is an Australian resident company and a general beneficiary of SH2.

Historically all dividends received by SH2 have been distributed to Beneficiary Co. The Beneficiary Co's policy is that it only makes dividend payments to members of the family group.

Where a franked distribution is made in an income year to an entity that is a trustee of a trust (but not a corporate tax entity or a complying superannuation entity), then the assessable income of the trust for that income year includes the amount of the franking credits on the distribution.

If all or a part of this amount of assessable income is then distributed, or flows indirectly, to an entity that is a beneficiary or the trustee of a trust and this entity has an amount of assessable income for that year that is attributable to all or a part of the distribution then, in accordance with subsection 207-35(3), the entity's assessable income for that year also includes so much of the franking credits as is equal to its share of the franking credits on the distribution.

The circumstances in which a franked distribution is taken to 'flow indirectly through' to a beneficiary of a trust are set out in subsection 207-50(3).

Pursuant paragraph 97(1)(a) of the ITAA 1936 in respect to the 20XX income year, SH2 will distribute 100 percent of both the Type 1 Dividend and the Type 2 Dividend, including franking credits, to Beneficiary Co. Accordingly, Beneficiary Co will be taken under section 207-50 to have received the distributions indirectly through SH2.

Accordingly, pursuant to subsection 207-35(4), Beneficiary Co will need to include so much of the franking credits as is equal to its share of the franking credits on the distribution in its assessable income for the 20XX income year.

Beneficiary Co will also be entitled to a tax offset in respect to the franking credits subject to it also satisfying the qualified person test for the purpose of paragraph 207-150(1)(a). As there is a valid family trust election in place, Beneficiary Co as a beneficiary of SH2 will be taken to be a qualified person pursuant to the former section 160APHL of the ITAA 1936.

Question 4

Will SH2 and Beneficiary Co be qualified persons under former Division 1A of Part IIIAA of the ITAA 1936 in relation to the Type 1 Dividend and the Type 2 Dividend?

Detailed reasoning

With reference to the analysis in the preceding questions, SH2 and Beneficiary Co are considered to be qualified persons for the purpose of Division 1A of former Part IIIAA of the ITAA 1936.

Question 5

Will the Type 1 Dividend and the Type 2 Dividend form part of the capital proceeds received by SH1 and SH2 on the sale of their shares in H Co?

Summary

The Type 1 Dividend and Type 2 Dividend are paid in respect of the disposal of H Co shares and form part of the capital proceeds receive by SH1 and SH2.

Detailed reasoning

The capital proceeds received by SH2 and SH1 for the sale of their H Co shares (the CGT event) comprises the money and the market value of any property received or entitled to be received in respect of the event happening. The capital proceeds amount is worked out at the time of the event happening under CGT event A1.

Under Taxation Ruling 2010/4 (TR 2010/4), a dividend declared or paid by a company (the target company) to a shareholder who has disposed of shares in that company (the vendor shareholder) under a contract of sale will be treated as capital proceeds of the vendor shareholder in relation to the disposal of the shares.

Further, TR 2010/4 states that a dividend paid by a company will be included in the capital proceeds received by a shareholder who disposes of shares in the company under a contract, if the shareholder has bargained for the receipt of the dividend (whether or not in addition to other consideration) in return for the transfer of the shares.

However, a dividend declared and paid independently of the contract for the sale of shares is not included in the capital proceeds merely because payment of the dividend is contingent on the sale proceeding. This will not be the case if the purchaser of the shares or its associate participates in arrangements in respect of the dividend that are collateral to the contract for the sale of the shares.

In the present case, the Contract permits and contemplates payment of the Type 1 Dividend, meaning the consideration paid for the shares will be reduced by 75 percent of the amount of the dividend payments. Therefore, the Type 1 Dividend is considered to be collateral to the contract for the sale of H Co shares.

With regard to the Type 2 Dividend, the payment of the dividend is not independent of the sale of the H Co shares.

The dividends are therefore paid in respect of the disposal of the H Co shares. Accordingly, the dividends will form part of the capital proceeds which SH1 and SH2 will receive in respect of the disposal of their shares in H Co.

Question 6

Will section 118-20 of the ITAA 1997 apply to reduce the amount of any capital gain made by SH1 and SH2 on the disposal of their shares in H Co by the amount of the Type 1 Dividend and the Type 2 Dividend that is included in each respective entity's assessable income under subsection 44(1) of the ITAA 1936?

Summary

SH2 and SH1 are required to include the Type 1 Dividend and the Type 2 Dividend in their respective assessable incomes. However, section 118-20 will apply to reduce the capital gain on the basis the dividends are considered assessable income.

Detailed reasoning

In cases where the happening of a CGT event gives rise not only to a capital gain under the CGT provisions but also to an amount assessable under another provision, section 118-20 may apply to prevent double taxation by reducing or eliminating the amount of the capital gain.

In the present case, the inclusion of the Type 1 Dividend and the Type 2 Dividend in the capital proceeds received by SH2 and SH1 increases the capital gains from the sale of the H Co shares. On the basis the dividends are already included in each respective entity's assessable income; section 118-20 will apply to reduce the capital gain to the extent of the double inclusion.

Question 7

Will SH2 be able to treat the capital gain on the disposal of its H Co shares as a discount capital gain pursuant to Division 115 of the ITAA 1997?

Summary

SH2 will be eligible to treat the capital gain as a discount capital gain under subdivision 115-A.

Detailed reasoning

The CGT discount is generally available in relation to capital gains made by a trust if the capital gain resulted from CGT event A1 happening to a CGT asset that has been owned by the taxpayer for at least 12 months.

The date for the availability of the discount is 11.45 am legal time in the ACT on 21 September 1999, there is also the requirement that a discount capital gain must be a capital gain that results from a CGT event happening after that time.

SH2 held all of its shares in H Co prior to 2002. The CGT event in respect of the share sale is happening after 21 September 1999 and will result in a capital gain. On this basis SH2 will be eligible to treat the capital gain as a discount capital gain under subdivision 115-A.

Question 8

Will the Commissioner make a determination under paragraph 204-30(3)(c) of the ITAA 1997 regarding streaming distributions, to deny the whole, or any part, of the imputation benefit received in relation to the Type 1 Dividend and the Type 2 Dividend?

Summary

The Commissioner has concluded that the requisite element of streaming does not exist in relation to the Type 1 Dividend and the Type 2 Dividend. Accordingly the Commissioner will not make a determination under paragraph 204-30(3)(c) to deny the whole, or any part, of the imputation benefits that are attached to the Type 1 Dividend and the Type 2 Dividend.

Detailed reasoning

The Commissioner may make a determination under subdivision 204-D where a distribution with attached imputation benefits are disproportionately streamed to a member of a corporate tax entity in preference to another member.

Imputation benefit is defined in subsection 204-30(6) and includes, for example, a member entitlement to a tax offset under Division 207 or an amount is included in a member's assessable income because of section 207-35.

Section 204-30 applies where an entity streams one or more distributions in such a way that the franking credits attaching to the distribution are received by those members of the entity who derive a greater benefit from them (favoured member); and other members receive lesser imputation or no imputation benefits (disadvantaged member). The favoured members to whom distributions are streamed must be in a position to derive a greater benefit from the franking credits than the disadvantaged members.

'Streaming' is not defined for the purposes of Subdivision 204-D. However, paragraph 3.28 of the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2002 provides that it is 'selectively directing the flow of franked distributions to those members who can most benefit from the imputation credits'.

If section 204-30 applies, the Commissioner is vested with a discretion under subsection 204-30(3) to make a determination in writing:

(a)          that a specified franking debit arises in the franking account of the entity, for a specified distribution or other benefit to a disadvantaged member,[1] and/or

(b)          that no imputation benefit is to arise in respect of any streamed distribution made to a favoured member and specified in the determination.[2]

The Type 1 Dividend and the Type 2 Dividend will be included in the assessable income of SH1 and Beneficiary Co which are both Australian resident corporate tax entities.

The Type 1 Dividend and the Type 2 Dividend will be paid on all shares and will be fully franked regardless of the tax profiles of the shareholders. The distribution of franking credits will be a function of the shareholder owning H Co shares, rather than any action taken by H Co to selectively direct franking credits to particular shareholders.

Based on the information provided, the Commissioner can conclude that the requisite element of streaming does not exist in relation to the Type 1 Dividend and the Type 2 Dividend. Accordingly the Commissioner will not make a determination under paragraph 204-30(3)(c) to deny the whole, or any part, of the imputation benefits that are attached to the Type 1 Dividend and the Type 2 Dividend.

Question 9

Will the Commissioner make a determination under paragraph 177EA(5)(a) or 177EA(5)(b) of the ITAA 1936, to debit H Co's franking account or deny the whole, or any part, of the imputation benefit received in relation to the Type 1 Dividend and the Type 2 Dividend?

Summary

The factors considered in relation to the share sale transaction do no support the requisite purpose of obtaining an imputation benefit with respect to the payment of the Type 1 Dividend and the Type 2 Dividend. Therefore, the Commissioner will not make a determination under paragraphs 177EA(5)(a) and 177EA(5)(b) of the ITAA 1936 to deny imputation benefits in relation to the Type 1 Dividend and the Type 2 Dividend.

Detailed reasoning

Where section 177EA of the ITAA 1936 applies, the Commissioner may make a determination to deny imputation benefits where it may be concluded that a party to a scheme participated in the scheme or some part of the scheme for a purpose, other than an incidental purpose, of enabling a taxpayer to obtain an imputation benefit.

The purpose of section 177EA of the ITAA 1936 is to protect the imputation system from abuse and ensure that the benefits of the imputation system flow to the economic owner of the share which is the source of the franked distribution. Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 3) 1998 that introduced section 177EA states:

8.5 Two of the underlying principles of the imputation system are, firstly, that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves...

Subsection 177EA(3) of the ITAA 1936 provides that section 177EA of the ITAA 1936 applies if:

(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 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 section 177EA of the ITAA 1936, a 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.

The term 'scheme for a disposition' is defined in subsection 177EA(14) of the ITAA 1936. The term is given an inclusive meaning, but is not limited, by reference to a scheme that involves any of the matters set out in paragraphs 177EA(14)(a) to 177EA(14)(f) of the ITAA 1936. In particular, paragraph 177EA(14)(b) includes a scheme that involves entering into any contract, arrangement, transaction or dealing that changes or otherwise affects the legal or equitable ownership of the membership interests or interest in membership interests.

In the present case, the conditions in paragraphs 177EA(3)(a) to 177EA(3)(d) of the ITAA 1936 are satisfied by the fact that fully franked Type 1 Dividend and a fully franked Type 2 Dividend are payable under a scheme for the disposition of the H Co shares.

The question that remains to be considered is whether H Co, its shareholders or any other relevant party entered into or carried out the scheme for a purpose that was other than an incidental purpose of enabling the relevant taxpayer to obtain an imputation benefit. This purpose does not have to be a sole or dominant purpose of any party.

In arriving at a conclusion the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17) of the ITAA 1936, including the factors listed in subsection 177D(2) of the ITAA 1936. The relevant circumstances may individually or collectively indicate the requisite purpose.

In the present case the primary purpose of the scheme is the commercial disposition of a majority shareholding in H Co. The payment of the Type 1 Dividend and the Type 2 Dividend were to redress the lower dividends paid in prior years when retained earnings were used to fund the expansion of the company, as well as allowing H Co shareholders to share in the profits generated during the period of their ownership of the company.

With a new shareholder acquiring a majority ownership in the company, the shareholders is also seeking reduce their risk in relation to their remaining minority equity ownership. This is supported by the fact that the Type 2 Dividend was conditional upon securing a binding agreement for the disposition of the H Co shares and no conditions attached to the payment of the Type 1 Dividends other than a favourable ruling from the Commissioner.

As established earlier, SH1 and SH2 are considered to have held their shares in H Co at risk for a significant period of time under the 'qualified person' rule. The Type 1 Dividend and the Type 2 Dividend were paid out of profits accrued while they were shareholders of the company. The return on their investment as such is tied to the fortunes of the company.

Beneficiary Co is an Australian resident company and a general beneficiary of SH2. Historically, all dividends received by SH2 have been distributed to Beneficiary Co.

SH2 distributed 100 percent of the dividends received under the scheme, including franking credits, to Beneficiary Co. This will initially be done as an unpaid present entitlement for the year ended 30 June 20XX.

The Applicants have confirmed that:

·                     the franking credits sourced from H Co's Type 1 Dividend and the Type 2 Dividend that are credited to Beneficiary Co's franking account will only be distributed, via Beneficiary Co's shareholders who are trusts, to individual members of the Family Group (and not superannuation funds, companies or other trusts) and will be taxable in the hands of those individuals;

·                     the Beneficiary Co shares are not currently held by superannuation funds and the family trusts who are members of Beneficiary Co will not distribute to superannuation funds as beneficiaries;

·                     the Beneficiary Co shareholders will not transfer any of their shares in Beneficiary Co to a superannuation fund or any associate superannuation fund, company or trust to allow the franking credits sourced from the H Co dividends to benefit these entities.

SH1 will pay the dividends to its 100 per cent shareholder - XYZ.

The franking credits attached to H Co Type 1 Dividend and the Type 2 Dividend were credited firstly to SH1's franking account and then later to the franking account of XYZ. All franking credits sourced from H Co Type 1 Dividend and the Type 2 Dividend will eventually only be paid as part of dividends to the individual shareholders of XYZ and taxed at their respective marginal tax rates.

The Applicants have confirmed that neither SH1 nor any of the individual shareholders of XYZ will transfer any of their shares to an associate superannuation fund, company or trust to allow the franking credits sourced from the H Co dividend to be paid to these entities.

Having regard to the relevant circumstances of the scheme, the Commissioner has come to the view that:

·                     no member, who is holding shares in H Co or an interest in shares in H Co, is likely to receive, whether directly or indirectly, a greater benefit from the franking credits attached to the Type 1 Dividend and the Type 2 Dividend.

·                     the benefit from the franking credits is not passed or is expected to be passed on to any entity that is outside the Family Group.

·                     the primary purpose of the scheme is for the disposition of the H Co shares which is undertaken for commercial purposes. The provision of the imputation benefits to the shareholders is considered to be incidental to the purpose of disposing of the shares in H Co.

Therefore, it may be concluded that in this case the facts do not support a finding that the requisite purpose of enabling the shareholders to obtain imputation benefits is present.

Accordingly, the Commissioner will not make a determination under paragraphs 177EA(5)(a) and 177EA(5)(b) of the ITAA 1936 to deny imputation benefits in relation to the Type 1 Dividend and the Type 2 Dividend.

Question 10

Will section 177E of the ITAA 1936 apply in relation to the sale of shares in H Co and the payment of the Type 1 Dividend and the Type 2 Dividend?

Summary

The factors considered in this case do not support that the arrangement is being carried out with the dominant purpose of extracting profit out of H Co, whether by the shareholders or the purchaser, by way of or in the nature of dividend stripping to which section 177E of the ITAA 1936 would apply.

Detailed reasoning

Section 177E of the ITAA 1936 is an anti-avoidance provision that is designed to prevent tax benefits being obtained as part of a dividend stripping scheme or a scheme with substantially the same effect as a dividend stripping scheme.

A dividend stripping scheme is defined in section 207-155 as a distribution that is made to a member of a corporate tax entity that arises out of, or is made in the course of, a scheme that was by way of, or in the nature of, dividend stripping or has substantially the effect of a scheme, by way of dividend stripping. The language used in section 207-155 is largely similar to that of section 177E of the ITAA 1936.

The concept of dividend stripping is also considered in paragraphs 9 and 10 of Taxation Ruling IT 2627 Income Tax: Application of Part IVA to Dividend Stripping Arrangements, which states:

9. However, it can be said that in its traditional sense a dividend stripping scheme would include one where a vehicle entity (the stripper) purchases shares in a target company that has accumulated or current years' profits that are represented by cash or other readily-realisable assets. The stripper pays the vendor shareholders a capital sum that reflects those profits and then draws off the profits by having paid to it a dividend (or a liquidation distribution) from the target company.

10. No exhaustive list of other examples can be given of what might constitute a dividend stripping scheme for the purposes of section 177E. Having regard to the overall scope and purpose of the section, an important element to be looked at will be any release of profits of a company to its shareholders in a non-taxable form, regardless of the different methods that might be used to achieve this result.

The High Court, in Federal Commissioner of Taxation v Consolidated Press Holdings 2001 ATC 4343, identified six factors which assist in identifying whether a dividend stripping arrangement exists. The six factors include:

(i).           a target company with substantial undistributed profits creating a potential tax liability, either for the company or its shareholders;

(ii).          the sale or allotment of shares in the target company to another party;

(iii).         the payment of a dividend to the purchaser or allottee of the shares out of the target company's profits;

(iv).        the purchaser or allottee escaping Australian income tax on the dividend so declared;

(v).         the vendor shareholders receiving a capital sum for the shares in an amount the same as or very close to the dividends paid to the purchasers (there being no capital gains tax at the relevant times); and

(vi).        the scheme being carefully planned, with all the parties acting in concert, for the predominant if not the sole purpose of the vendor shareholders, in particular, avoiding tax on a distribution of dividends by the target company.

From the six factors, the question as to whether a dividend stripping exists hinges largely on the last factor being whether 'the scheme being carefully planned, with all the parties acting in concert, for the predominant if not the sole purpose of the vendor shareholders, in particular, avoiding tax on a distribution of dividends by the target company'.

Therefore, for a dividend stripping scheme to exist, the taxpayer must have a sole or dominant purpose to obtain a tax benefit from entering into such arrangement.

As with Part IVA, the test of whether a taxpayer entered into a scheme for the dominant purpose of achieving a tax benefit is an objective one. The Commissioner will look at the entirety of the scheme and attempt to gain an understanding of the intention of the taxpayer.

In the present case, the arrangement involves the Purchaser acquiring the majority of the shares in the target company - H Co, with Type 1 Dividend and a Type 2 Dividend being paid to the vendor shareholders as part of the sale transaction. The purpose of the Type 1 Dividend and Type 2 Dividend was to enable the shareholders to share in the profit of the company that was retained over the period of their ownership as well as to enable them to reduce their risk in relation to their minority interest.

Under the sale transaction, no dividend was proposed to be paid or flow to the purchaser. The sale of shares was based on commercial reasons and does not result in the liberation of H Co's profits by the purchaser as part of the transaction or after the transaction in a tax effective manner.

The factors considered in this case do not support that the arrangement is being carried out with the dominant purpose of extracting profit out of H Co, whether by the shareholders or the purchaser, by way of or in the nature of dividend stripping to which section 177E would apply.

Question 11

Will sections 207-145 or 207-150 of the ITAA 1997 apply to the whole, or any part of the Type 1 Dividend and Type 2 Dividend?

Summary

Based on the facts of the present case, it cannot be established that any of the circumstances in subsections 207-145(1) and 207-150(1) arises in relation to the payment of the Type 1 Dividend and the Type 2 Dividend. Accordingly, neither sections 207-145 nor 207-150 will apply in this case to the whole, or any part of the Type 1 Dividend and the Type 2 Dividend.

Detailed reasoning

Generally, subject to meeting certain requirements in subdivision 207-A and 207-B, an entity receiving a franked distribution will be entitled to gross up their assessable income for the franking credit and obtain a tax offset equal to the franking credit received.

However, integrity measures contained in subdivision 207-F may operate to deny the effect of any franking credit gross up or applicable tax offset on distributions where the entity concerned has manipulated the imputation system in a manner not permitted under the income tax law. Specifically, under both sections 207-145 and 207-150, the grossing up of the an entity's assessable income to include the franked distribution and the tax offset will be denied where the franked distribution is made in the following circumstances:

(a)          the entity is not a qualified person in relation to the distribution for the purposes of Division 1A of former Part IIIAA of the ITAA 1936;

(b)          the Commissioner has made a determination under paragraph 177EA(5)(b) of the ITAA 1936 that no imputation benefit (within the meaning of that section) is to arise in respect of the distribution for the entity;

(c)          the Commissioner has made a determination under paragraph 204-30(3)(c) that no imputation benefit is to arise in respect of the distribution for the entity;

(d)          the distribution is made as part of a dividend stripping operation;

(e)          the distribution is one to which section 207-157 (which is about distribution washing) applies;

Having regard to the nature of the transaction and the Commissioner's view in relation to the other questions addressed above, it cannot be established that any of the circumstances in subsections 207-145(1) and 207-150(1) arises in relation to the payment of the Type 1 Dividend and the Type 2 Dividend. Accordingly, neither section 207-145 nor 207-150 will apply in this case to the whole, or any part of the Type 1 Dividend and the Type 2 Dividend.

[1] Paragraph 204-30(3)(a) of the ITAA 1997

[2] Paragraph 204-30(3)(c) of the ITAA 1997