Edited version of private advice

Authorisation Number: 1051921896925

Date of advice: 29 November 2021

Ruling

Subject: Dividend stripping

Question 1

Is the receipt of fully franked dividends by the Fund from Company B, a dividend stripping operation within the meaning of paragraph 207-145(1)(d) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is there a scheme by way of or in the nature of, or substantially the effect of, dividend stripping to which section 177E of the Income Tax Assessment Act 1936 (ITAA 1936) applies?

Answer

No.

Question 3

Is there a scheme to obtain imputation credits to which section 177EA of the ITAA 1936 applies?

Answer

No.

Question 4

Does the Fund's direct and indirect ownership of shares in Company B, the Fund's receipt of fully franked dividends from Company B and resulting refund of franking credits result in non-arm's length income of the Fund under section 295-550 of the ITAA 1997?

Answer

No.

This ruling applies for the following periods:

1 July 20XX to 30 June 20XX

Relevant facts and circumstances

The Fund is a self managed superannuation fund.

The Fund made an investment in the Group.

Company A was the head company of the Group.

A party left the Group, and the value of Company A was agreed.

Company A obtained funding from third parties, including associates and a bank loan facility.

The funding to Company A included money provided by the Fund.

Two holding trusts were established by the Fund for the purposes of acquiring direct and indirect shareholdings in Company A under limited recourse borrowing arrangements (LRBAs), with trust deeds dated 20XX:

•                Holding Trust No 1

•                Holding Trust No 2

The LRBA loans from a related Trust both had 10 year terms with interest at the Bank Bill Swap Rate (BBSW) + x%. Repayments were interest only. Repayment schedules and interest calculations were provided

No written document from the company for the issue of shares existed until several month later.

In 20XX, the directors of Company A declared a dividend of $xx payable to all existing shareholders.

Company A issued ordinary shares at $xx per share. The issue price for the new shares was determined by reference to the agreed value.

As part of this new share issue, the third parties that contributed funding, including Holding Holding Trust No 2, acquired ordinary shares in Company A.

The Fund subsequently obtained direct and indirect shareholdings in Company B after a restructure.

After PCG 2016/5 was released on 6 April 2016, the Fund trustee took steps to comply with the guideline in respect of the LRBA loans from the related trust. The loans were repaid in full in 20YY, the interest rate was revised upwards to be consistent with the guidelines and the additional interest was charged from 20ZZ until the full repayment of the loan.

Due to a Court Order, a subsidiary of Company B is required to declare a fully franked dividend in favour of Company B.

Company B, in turn, will declare a fully franked dividend in favour of its shareholders, including the Fund, of equal value.

The Fund will be entitled to $xx in fully franked dividends via its holdings in Company B.

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 207-145

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 section 295-390

Income Tax Assessment Act 1997 section 295-545

Income Tax Assessment Act 1997 section 295-550

Superannuation Industry (Supervision) Act 1993 section 67

Superannuation Industry (Supervision) Act 1993 section 67A

Other relevant documents

TD 2016/16: Income tax: will the ordinary or statutory income of a self-managed superannuation fund be non-arm's length income under subsection 295-550(1) of the Income Tax Assessment Act 1997 (ITAA 1997) when the parties to a scheme have entered into a limited recourse borrowing arrangement on terms which are not at arm's length?

PCG 2016/5 Income tax - arm's length terms for Limited Recourse Borrowing Arrangements established by self managed superannuation funds.

Reasons for Decision

QUESTION 1

Franked distribution

As a general rule, section 207-20 of the ITAA 1997 requires the recipient of a franked distribution to include in their assessable income the amount of the franking credit on the distribution. This is in addition to any other amount included in the recipient's assessable income in relation to the distribution itself. The recipient is also entitled to a tax offset equal to the franking credit.

Where a franked distribution is made to an entity as part of a dividend stripping operation, as per paragraph 207-145(1)(d) of the ITAA 1997, then the following applies:

•                the amount of the franking credit on the distribution is not included in the assessable income of the entity under sections 207-20 or 207-35 (paragraph 207-145(1)(e)); and

•                the entity is not entitled to a tax offset because of the distribution (paragraph 207-145(1)(f)).

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) as follows:

A distribution made to a *member of a *corporate tax entity is taken to be made as part of a dividend stripping operation if, and only if, the making of the distribution arose out of, or was made in the course of, a *scheme that:

(a) was by way of, or in the nature of, dividend stripping; or

(b) had substantially the effect of a scheme by way of, or in the nature of, dividend stripping.

If the franked distributions from Company B to the Fund would be distributions 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.

Dividend stripping operations

A 'dividend stripping operation' has been recognised by the Courts as having the following characteristics[1]:

1)    a company with substantial undistributed profits (target company);

2)    a sale or allotment of shares in target company to another party;

3)    the payment of a dividend to the purchaser or allottee of shares by target company;

4)    the acquirer escaping Australian income tax on the dividend so declared;

5)    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

6)    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.

A scheme may still be a 'dividend stripping operation' because the making of a distribution was 'by way of or in the nature of dividend stripping' even if it contains features which vary from the paradigm case of dividend stripping, so long as it retains the central characteristics of a dividend stripping scheme: FCT v. CPH (FFC) at [156], Lawrence v. FCT at [45].

A difference between a scheme 'by way of or in the nature of dividend stripping' and a scheme which has 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping' lies in the means adopted to distribute the profits of the target company. Where the means adopted do not involve a distribution, but some other step (such as the purchase by the target company of near worthless assets or assets later rendered near worthless by the target company) this involves a scheme having 'substantially the effect' of a scheme 'by way of or in the nature of dividend stripping': Lawrence v. FCT at [47] - [52].

Will the franked distributions from Company B to the Fund be distributions made as part ofa dividend stripping operation?

The payment of the franked distributions from Company B to the Fund will not be made as part of a 'dividend stripping operation' within the meaning of paragraph 207-145(1)(d) of the ITAA 1997 because each of the elements of a scheme 'by way of, or in the nature of, dividend stripping' will not be present. For the reasons below, all of the central characteristics of a scheme by way of or in the nature of dividend stripping identified above are not satisfied.

First element: A subsidiary company is to pay a $xx fully franked dividend to Company B, which will then be distributed equally among its shareholders that include the Fund. The undistributed profits in the targeted company are substantial - condition is satisfied.

Second element: There was an allotment of direct and indirect shareholdings in Company B to the Fund's two holding trusts in 20XX. Although this was several years prior to the distribution of the franked dividend - condition is satisfied.

Third element: Company B will pay franked distributions to the Fund as a beneficial holder of the shareholding interests in Company B - satisfied.

Fourth element: The Fund will report the franked dividend as a low tax component under subsection 295-545(3) of the ITAA 1997 in the year it is received. The low tax component is concessionally tax at 15%. There is no information provided that indicates the Fund is trying to evade income tax on the franked dividend. The Fund is not paying a pension so is not eligible for the income to be exempt - not satisfied.

Fifth element: There are no shares being sold or issued to the Fund immediately prior to the distribution - not satisfied.

Sixth element: The primary reason for paying the franked dividend was to comply with a Court Order. The dividends will be taxable to the Fund and there will be no avoidance of tax - not satisfied.

Conclusion

The franked distributions from Company B to the Fund are not 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 included in the assessable income of the Fund under subsection 207-20(1) with the Fund being entitled to tax offsets as per subsection 207-20(2).

QUESTION 2

Section 177E of Part IVA of the ITAA 1936 - stripping of company profits

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.

The conditions in subsection 177E(1) of the ITAA 1936 are to the following effect:

1)    there is a 'scheme' of the kind defined in subsection 177A(1) of the ITAA 1936 that is in relation to the company (target company);

2)    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;

3)    a result of the scheme is that property of the target company is disposed of;

4)    the Commissioner forms the opinion that the disposal of property by the target company represents in whole or in part a distribution whether to a shareholder (called the vendor shareholder) or another person of profits of the target company;

5)    had the target company, immediately before the scheme was entered into, paid a dividend out of profits equal to the amount of profits represented by the target company'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

6)    the scheme was entered into after 27 May 1981.

See FCT v. CPH (FFC) at [118] - [123].

As noted above, if those conditions are satisfied, the scheme is taken to be one to which Part IVA of the ITAA 1936 applies (paragraph 177E(1)(e)), and the taxpayer shall be taken to have obtained a tax benefit referable to the notional amount not being included in the assessable income of the taxpayer in the year of income: FCT v. CPH (FFC) at [124] - [127].

Will the conditions of subsection 177E(1) of the ITAA 1936 be satisfied in relation to the franked distributions from Company B to the Fund?

For the following reasons, not all of the conditions in paragraphs 177E(1)(a) to (d) of the ITAA 1936 are satisfied.

First condition: The breadth of the definition of 'scheme' in section 177A of the ITAA 1936 has been judicially noted: British American Tobacco Australia Services Ltd v. Federal Commissioner of Taxation [2010] FCAFC 130; (2010) 189 FCR 151 at [30]. It includes any 'scheme, plan, proposal, action, course of conduct, or course of action'. The steps taken in this case clearly constitute a scheme within the meaning of subsection 177A(1).

The scheme described above is plainly a 'scheme that is in relation to a company', namely Company B. For this reason, the first condition in subsection 177E(1) of the ITAA 1936 is satisfied.

Second condition: For the reasons given above in question 1 the steps set out in the facts do not involve a 'scheme' by way of or in the nature of dividend stripping. For this reason, the second condition as per paragraph 177E(1)(a) of the ITAA 1936 is not satisfied.

Third condition: Subsection 177E(2) of the ITAA 1936 provides as follows:

Without limiting the generality of subsection (1), a reference in that subsection to the disposal of property of a company shall be read as including a reference to:

(a) the payment of a dividend by the company;

(b) the making of a loan by the company (whether or not it is intended or likely that the loan will be repaid);

(c) a bailment of property by the company; and

(d) any transaction having the effect, directly or indirectly, of diminishing the value of any property of the company.

The scheme, involves the payment by Company B of franked distributions to the Fund and other shareholders, 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 - condition is satisfied.

Fourth condition: A subsidiary company is to pay a fully franked dividend to Company B, which will then distribute the dividend equally among its shareholders that include the Fund - condition is satisfied.

Fifth condition: If, before the scheme was entered into, Company B paid a franked distribution out of profits to its shareholders, it is reasonable to expect that an additional amount would have been included in their assessable income equal to the value of the franked distributions - condition is satisfied

Sixth condition: The scheme is to be entered into after 27 May 1981 - condition is satisfied.

Conclusion

Company B's payment of franked dividends to the Fund will not satisfy all the conditions in paragraphs 177E(1)(a)-(d) of the ITAA 1936, subsequently there will not be a scheme to which Part IVA applies as per paragraph 177E(1)(e).

QUESTION 3

Section 177EA of the ITAA 1936

Subsection 177EA(5) of the ITAA 1936 gives the Commissioner the power to determine that no imputation benefit is to arise in respect of a distribution or specified part of a distribution that is made, or that flows indirectly to the relevant taxpayer.

In Mills v. Federal Commissioner of Taxation [2012] HCA 51; (2012) 87 ALJR 53 (Mills v. FCT) at [59], it was pointed out that subsection 177EA(3) of the ITAA 1936:

is an exhaustive statement of the jurisdictional facts that are necessary and sufficient for

s177EA to apply so as to found an exercise of power by the Commissioner to deny a franking

credit under s177EA(5)(b)'.

Specifically, section 177EA of the ITAA 1936 applies if the following conditions, set-out in subsection 177EA(3) of the ITAA 1936 are satisfied:

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:

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

iii. 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; and

d)    except for this section, the person 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 one of those 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 that person to obtain an imputation benefit.

The 'relevant circumstances' in paragraph 177EA(3)(e) of the ITAA 1936 are defined in subsection 177EA(17) to include 11 matters.

In accordance with subsection 177EA(14) of the ITAA 1936 a scheme for a disposition of membership interests or an interest in membership interests includes, but is not limited to, a scheme that involves any of the following:

a)    issuing the membership interests or creating the interest in membership interests;

b)    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;

c)    creating, varying or revoking a trust in relation to the membership interests or interest in membership interests;

d)    creating, altering or extinguishing a right, power or liability attaching to, or otherwise relating to, the membership interests or interest in membership interests;

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

f)     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.

Application of paragraphs 177EA(3)(a) - (d) of the ITAA 1936

It is considered that not all of the conditions in paragraphs 177EA(3)(a) to (d) of the ITAA 1936 are satisfied. This is because:

a)    there is not a 'scheme for the disposition of membership interests' as the relevant scheme of distributing the franking dividends did not involve the transfer of shares in Company B to the Fund that would invoke subsection 177EA(14) of the ITAA 1936. The Fund acquired its shares in 20XX which was not linked to the purpose of the franking distribution. Accordingly, subparagraph 177EA(3)(a) is not satisfied;

b)    frankable distributions are expected to be payable to the holder of the Company B shares - satisfied

c)    the distribution is expected to be a franked distribution - satisfied;

d)    except for section 177EA, the Fund could reasonably be expected to receive an imputation benefit as a result of the franked distributions - satisfied.

As not all of the above conditions have been met, it is not necessary to consider the 'relevant circumstances' of the scheme in determining whether it could 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 the purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

However, as discussed above, the Fund's Company B shareholding interests were acquired several years ago. The primary reason for paying the franked dividend was to comply with a Court Order. Therefore, the proposed transaction is not being carried out for a more than an incidental purpose of enabling taxpayers to obtain an imputation benefit.

Conclusion

Based on the facts, the conditions in 177EA(3) of the ITAA 1936 have not been satisfied. Therefore, the Commissioner is not required to determine under subsection 177EA(5) that an imputation benefit does not arise for the Fund in respect of that distribution.

QUESTION 4

Non-arm's Length Income

Section 295-545 of the ITAA 1997 provides that the taxable income of a complying superannuation fund is split into a non-arm's length component and a low tax rate component. The note to subsection 295-545(1) explains that a concessional rate of tax applies to the low tax component, while the non-arm's length component is taxed at the highest marginal rate.

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.

As a result of a Court Order, the Fund is receiving a franked dividend from its shareholding interests in Company B.

The issue raised is whether dividends paid by Company B to the Fund as a result of transactions that have occurred to give effect to a Court Order are NALI under section 295-550 of the ITAA 1997.

Section 295-550 of the ITAA 1997 states:

1)    An amount of *ordinary income or *statutory income is non-arm's length income of a *complying superannuation entity if, as a result of a *scheme the parties to which were not dealing with each other at *arm ' s length in relation to the scheme, one or more of the following applies:

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

(b)  in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm ' s length in relation to the scheme;

(c)   in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm ' s length in relation to the scheme.

This subsection does not apply to an amount to which subsection (2) applies or an amount *derived by the entity in the capacity of beneficiary of a trust.

2)    An amount of *ordinary income or *statutory income is also non-arm's length income of the entity if it is:

(a)  a *dividend paid to the entity by a *private company; or

(b)  ordinary income or statutory income that is reasonably attributable to such a dividend;

unless the amount is consistent with an *arm ' s length dealing.

3)    In deciding whether an amount is consistent with an *arm ' s length dealing under subsection (2), have regard to:

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

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

(c)   the rate of that dividend; and

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

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

(f)    any other relevant matters.

In deciding whether subsection 295-550(2) of the ITAA 1997 applies, the factors in subsection 295-550(3) are to be considered to determine whether the amount is consistent with arm's length dealings.

The Fund acquired its Company B shareholding interests as part of a scrip for scrip arrangement in respect of its Company A shares when the head company of the Group had changed. As such, the cost of the Company A shares to the Fund and also the circumstances of its acquisition are relevant factors to determining whether the arrangement is consistent with an arm's length dealing under subsection 295-550(3) of the ITAA 1997.

The consideration for the issue of the Company A shares derived from a value that was arrived at by parties bargaining on arm's length terms. The transaction under which there was agreement to issue the Company A shares was between arm's length parties. The dividend was paid to all shareholders at the same rate.

These factors point to the amount of the dividend ultimately paid on the shares being an amount which is consistent with arm's length dealings.

On the other hand, regarding the direct shareholding, Company A did not enter into a written agreement to issue the shares at the time the funding was provided. Further, the provision of the funding would appear to give rise to a regulatory breach, in so far as what was acquired does not appear to be a single acquirable asset under section 67A of the Superannuation Industry (Supervision) Act 1993 (SISA). These factors point towards the amount not being consistent with arm's length dealings.

When weighing all the above factors (including the nature of the SISA contravention), on balance, we have concluded that NALI should not apply under subsection 295-550(2) of the ITAA 1997.

The statutory language in relation to subsection 295-550(1) is not identical, however, it is considered that the same conclusion applies.

[1] See Taxation Determination 2014/1: Income tax: is the 'dividend access share' arrangement of the type described in this Taxation Determination a scheme 'by way of or in the nature of dividend stripping' within the meaning of section 177E of Part IVA of the Income Tax Assessment Act 1936?