Edited version of private advice

Authorisation Number: 1051926559956

Date of advice: 25 November 2021

Ruling

Subject: Tax consequences of a proposed family law settlement

Question 1

Will the Redeemable Preference Shares (RPS) continue to be treated as equity interests under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the proposed declaration and payment of dividends to the RPS holder trigger tax consequences under Division 725 of the ITAA 1997 and cause CGT event K8 to occur under section 104-250 of the ITAA 1997?

Answer

No.

Question 3

Will the proposed dividends declared in respect of the RPS be frankable distributions as defined in section 202-40 of the ITAA 1997?

Answer

Yes.

Question 4

Will the proposed payment of dividends to the holder of the RPS be considered dividend streaming under Subdivision 204-D of the ITAA 1997?

Answer

No.

Question 5

Will section 207-155 of the ITAA 1997 or section 177E of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the future payment of dividends to the holder of the RPS?

Answer

No.

Question 6

Will section 177EA of the ITAA 1936 apply to the future payment of dividends to the holder of the RPS?

Answer

No.

Question 7

Will the Commissioner make a determination under Part IVA of the ITAA 1936 to the whole, or part, of the arrangement including the proposed transfer of real property from each company?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company A and Company B are Australia resident investment companies.

Mr A holds 100% of the beneficial interests in the shares of Company A.

Company A is the sole shareholder of Company B.

Mr A and Mrs A are directors of Company A and Company B.

Mrs A has no other interests in these companies.

Mr A and Mrs A have separated and are currently negotiating a Family Law settlement which will involve splitting the matrimonial assets between the parties. This will include the assets held by Company A and Company B.

It is Proposed Steps of the proposed arrangement for which orders will be made to the Family Court include:

•         Incorporate a new company (Company C) with 100% of the shares held by Mrs A;

•         Company A and Company B would issue one redeemable preference share (RPS) to Company C, thus making Company C a new shareholder of both Company A and Company B.

•         Company B would transfer the real property valued at $X by way of a loan.

•         Company A would transfer real properties valued at $Y by way of loan.

•         To offset the loans owing by Company C to Company A and Company B, the directors of Company A and Company B will declare a fully franked dividend payable equivalent to the value of real property transferred to the holder of the RPS. The dividends will be paid from retained profits of each company and not from share capital.

•         The RPS issued by Company A and Company B to Company C will be redeemed within 3 years from its issue so Company C will no longer has any interest in these companies.

The Memorandum of articles of both Company A and Company B permits the creation and issue of the RPS to Company C.

The RPS to be issued by to Company C will have the following rights:

a)    No voting rights.

b)    Right to receive a dividend at the discretion of the Directors of Company A and Company B.

c)    the shares shall be automatically redeemed for the subscription price no later than three (3) years following the shares issue.

d)    The class of share is not transferable to another person or entity.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-250

Income Tax Assessment Act 1997 paragraph 149-15(1)(b)

Income Tax Assessment Act 1997 section 202-40

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

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

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

Income Tax Assessment Act 1997 Subdivision 204-D

Income Tax Assessment Act 1997 Division 207

Income Tax Assessment Act 1997 section 207-155

Income Tax Assessment Act 1997 Division 725

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1936 section 177EA

Reasons for decision

Question 1

Will the Redeemable Preference Shares (RPS) continue to be treated as equity interests under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Detailed reasoning

For the RPS to be an equity interest:

• it must satisfy the equity test in subsection 974-75(1); and
• must not pass the debt test in subsection 974-20(1).

A share is an interest in a company as a member or stockholder of that company. Therefore, item 1 of subsection 974-75(1) is satisfied and the RPS pass the test for an equity interest.

Subsection 974-20(1) provides the test for a debt interest. The conditions which must be met for a scheme to satisfy the debt test are:

•         there must be a scheme (subsection 974-20(1));

•         the scheme must be a financing arrangement (paragraph 974-20(1)(a)). However, this condition is not required to be met where the interest is as a member or stockholder of a company;

•         there must be a financial benefit received (paragraph 974-20(1)(b));

•         the issuing entity must have an "effectively non-contingent obligation" to provide a future financial benefit (paragraph 974-20(1)(c)); and

•         it must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to, or exceed the financial benefit received and will not equal nil (paragraphs 974-20(1)(d) and 974-20(1)(e)).

In the present case, the obligation to pay dividends will be entirely at the discretion of the directors of Company A and Company B.

The shares shall be automatically redeemed no later than three (3) years following the shares issue.

In summary, there is no obligation on Company A and Company B to pay dividends to the holder of the RPS. There is thus no effectively non-contingent obligation for Company A and Company B to provide a financial benefit under the scheme. On that basis, the proposed RPS do not meet all the conditions to be a debt interest, and would therefore be an equity interest in Company A and Company B.

Question 2

Will the proposed declaration and payment of dividends to the RPS holder trigger tax consequences under Division 725 of the ITAA 1997 and cause CGT event K8 to occur under section 104-250 of the ITAA 1997?

Answer

No.

Detailed reasoning

Subsection 725-145(1) explains that a direct value shift (DVS) occurs when:

-   there is a decrease in the market value of one or more equity or loan interests in the target entity; and

-   the decrease is reasonably attributable to one or more things done under a scheme, and occurs at or after the time when the thing, or the first of those things is done; and

-   either or both of subsections (2) and (3) of section 725-145 are satisfied.

Subsections 725-145(2) and (3) relevantly require:

-   one or more equity or loan interests in the target entity must be issued at a discount. The decrease in the interest must occur at or after the time of the issue and be reasonably attributable to it.

-   there must be an increase in the market value of one or more equity or loan interests in the target entity. The increase must be reasonably attributable to the decrease in the other interest.

However, section 725-50 relevantly provides that a DVS will only have consequences under Division 725 if section 725-90 does not apply.

Section 725-90 applies if:

-   the one or more things referred to in paragraph 725-145(1)(b) brought about a state of affairs, but for which the direct value shift would not have happened; and

-   as at the time referred to in that paragraph, it is more likely than not that, because of the scheme, that state of affairs will cease to exist within 4 years after that time.

The 'one or more things referred to in section 725-145 that might have brought about a state of affairs but for which the value shift would not have happened' is the issue of the RPS to Company C.

The relevant 'state of affairs' is that the proposed RPS has specific characteristics in the form of discretionary dividend rights which give rise to the potential shift in value.

The RPS are redeemable at the direction of the directors, at any time, for the subscription price. If not redeemed earlier, the shares are automatically redeemable for the subscription price no later than three (3) years following the shares issue.

The removal of these specific characteristics when the RPS are redeemed (which must happen within 3 years of the issue of the RPS) will satisfy the requirements of section 725-90 and hence enliven its operation.

For the above reasons it is not necessary to determine if there is a DVS pursuant to section 725-145 as section 725-90 will apply such that any DVS will not have any consequences under Division 725.

CGT event K8 happens if there is a 'taxing event generating a gain' for a down interest under section 725-245 (subsection 104-250(1)). As there is no DVS that has consequences under Division 725, CGT event K8 will not happen as a result of the proposed transaction.

Question 3

Will the proposed dividends declared in respect of the RPS be frankable distributions as defined in section 202-40 of the ITAA 1997?

Answer

Yes.

Detailed reasoning

Section 202-40 of the ITAA 1997 provides that a distribution is a frankable distribution to the extent that it is not unfrankable under section 202-45.

Section 202-45 provides that the following distributions are unfrankable:

c)    where the purchase price on the buy-back of a share by a company from one of its members is taken to be a dividend under section 159GZZZP of that Act - so much of that purchase price as exceeds what would be the market value (as normally understood) of the share at the time of the buy-back if the buy-back did not take place and were never proposed to take place;

d)    a distribution in respect of a non-equity share;

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

f)     an amount that is taken to be an unfrankable distribution under section 215-10 or 215-15;

g)    an amount that is taken to be a dividend for any purpose under any of the following provisions:

(i)            unless subsection 109RB(6) or 109RC(2) applies in relation to the amount - Division 7A of Part III of that Act (distributions to entities connected with a private company);

(ii)           (Repealed by No 79 of 2007 )

(iii)          section 109 of that Act (excessive payments to shareholders, directors and associates);

(iv)          section 47A of that Act (distribution benefits - CFCs);

h)    an amount that is taken to be an unfranked dividend for any purpose:

(i)            under section 45 of that Act (streaming bonus shares and unfranked dividends);

(ii)           because of a determination of the Commissioner under section 45C of that Act (streaming dividends and capital benefits);

i)      a demerger dividend;

j)      a distribution that section 152-125 or 220-105 says is unfrankable.

In the current circumstances the distribution will not be unfrankable for the following reasons:

• the RPS is not considered a non-equity share;
• the distribution will be from retained profits and not share capital;
• section 215-10 and 215-215 do not apply;
• paragraphs (c), (g), (h), (i) and (j) do not apply.

Therefore, the dividend is a frankable dividend pursuant to section 202-40.

Question 4

Will the proposed payment of dividends to the holder of the RPS be considered dividend streaming under Subdivision 204-D of the ITAA 1997?

Answer

No.

Detailed reasoning

Subdivision 204-D of the ITAA 1997 contains provisions which aim to prevent the streaming of franking credits to one member of a corporate tax entity in preference to another.

Section 204-30 of the ITAA 1997 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, and other members receive lesser imputation or no imputation benefits.

For this section to apply, members to whom distributions are streamed must be in a position to derive a greater benefit from the franking credits than other members.

Subsection 204-30(8) of the ITAA 1997 details examples of when a member of an entity will be taken to have derived a greater benefit from franking credits than another member. These are where the other member:

-   is not an Australian resident;

-   is not entitled to use the tax offset under Division 207 of the ITAA 1997;

-   incurs a tax liability as a result of the distribution that is less than the benefit associated with the tax offset attributable to the distributions;

-   is a corporate tax entity at the time the distribution is made, but no franking credit arises for the entity as a result of the distribution;

-   is a corporate tax entity at the time the distribution is made, but cannot use the franking credits to frank a distribution to its own members because it is not a franking entity or is unable to make a frankable distribution; or

-   is an exempting entity.

In the current circumstances, all parties are residents of Australia for tax purposes. Therefore, from a residency perspective no entity will derive a greater benefit from franking credits than another entity.

The dividends paid to Company C are assessable and none of the other factors listed in subsection 204-30(8) of the ITAA 1997 are applicable. Furthermore, the proposed RPS holder will not derive a greater benefit from franking credits than other Company A and Company B shareholders. Therefore, the Commissioner would not make a determination under Subdivision 204-D of the ITAA 1997.

Question 5

Will section 207-155 of the ITAA 1997 or section 177E of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the future payment of dividends to the holder of the RPS?

Answer

No.

Detailed reasoning

Dividend Stripping - s177E

Direct or indirect recipients of a franked distribution can be denied the benefits of attached franking credits in various situations including if the distribution is made as part of a dividend stripping operation (paragraphs 207-145(1)(d), 207-150(1)(e)).

The notion of dividend stripping operation in this context is defined in section 207-155:

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 same effect of a scheme by way of, or in the nature of, dividend stripping.

Section 177E of the ITAA 1936 applies where:

-   property of a company is disposed of as a result of:

-          a scheme by way of or in the nature of dividend stripping; or

-          a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping; and

-   in the Commissioner's opinion, the disposal of property represents, in whole or in part, a distribution of profits of the company; and

-   if, immediately before the scheme was entered into, the company had paid a dividend equal to the amount of the disposal of property, an amount (referred to as the notional amount) would have been included in the assessable income of a taxpayer of a year of income; and

-   the scheme is entered into after 27 May 1981.

Where all of the above conditions are met, the scheme is taken to be a scheme to which Part IVA of the ITAA 1936 applies, and the taxpayer is taken to have obtained a tax benefit in connection with the scheme equal to the notional amount.

Is the scheme by way of or in the nature of dividend stripping?

'Dividend stripping' is not defined in the ITAA 1936.

As set out in TD 2014/1, dividend stripping involving the issue of a what is known as a Dividend Access Share, has been recognised by the courts as involving the following six common characteristics:

(i)            a target company which has 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.

In the current circumstances the proposed scheme has some of the above characteristics as follows:

• Company A and Company B has substantial undistributed profits which would expose the original shareholder (Mr A) to a potential tax liability if the profits were paid to him as a dividend;
• the proposed RPS will be issued to an entity other than the original shareholder (Mr A) to Company C whose shareholder is Mrs A;
• fully franked dividends are paid by Company A and Company B to Company C out of retained profits;
• Company C and Mrs A do not incur a tax liability in respect of the payment of dividends as the benefit of the franking credits attaching the dividend wholly offsets any tax liability;
• the substance of the scheme results in the profits of Company A and Company B being directed away from the original shareholder (Mr A) to another party (Company C) to satisfy an obligation of Mr A to pay Mrs A without having to pay tax on a dividend;

The sixth characteristic involves the careful planning, with all parties acting in concert, for the sole purpose of avoiding tax on the distribution of dividends.

The purpose of the scheme is to be determined objectively, having regard to the characteristics of the scheme and the circumstances in which it is designed and operated. One of the factors that the Commissioner takes into account in determining whether there is a dominant purpose of avoiding tax in a dividend access share arrangement is the complexity of the arrangement.

As outlined in the Proposed Transaction steps, the purpose of the scheme is for Company A and Company B to pay a dividend to Mrs A who is not a shareholder, to facilitate a family law settlement (subject to Family Court Consent Order) for the division of family assets.

Had it not been for the family law settlement to redistribute assets, the assets would have remained in Company A and Company B.

The effect of the proposed arrangement will transfer Mrs A's share of the assets from a company controlled and owned by Mr A, into a company owned and controlled by Mrs A.

Conclusion

Therefore, when viewed objectively, the Proposed Transactions will not be carried out for the sole purpose of avoiding tax. Absent this core feature, there is no scheme by way of or in the nature of dividend stripping, or a scheme having substantially the effect of a scheme by way of or in the nature of dividend stripping.

Question 6

Will section 177EA of the ITAA 1936 apply to the future payment of dividends to the holder of the RPS?

Answer

No.

Detailed reasoning

Section 177EA of the ITAA 1936 is a general anti avoidance provision that applies where a scheme involving the disposition of shares is entered into with a purpose of enabling a taxpayer to obtain a franking credit benefit. It applies where:

• There is a disposal of shares or interests in shares (s.177EA (3)(a)); and
• A franked dividend is paid or is payable (s.177EA(3)(b) and (c)); and
• The shareholder would, or could reasonably be expected to, receive franking credit benefits from the dividend (s.177EA(3)(d)); and
• Having regard to specified circumstances, it would be concluded that a purpose of at least one of the participants was to obtain a franking credit benefit. It is not necessary that this purpose is the dominant purpose but it is not sufficient that it is merely incidental (s.177EA(3)(e)).

Section 177EA(3)(e) of ITAA 1936 requires the taxpayer to have carried out the scheme (or any part of the scheme) for the purpose of obtaining an imputation benefit and defines this purpose to exclude 'an incidental purpose':

'...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'.

Whilst some characteristics are present, the dominate purpose of the Proposed Transaction is to enable the redistribution of family assets from Company A and Company B, to Company C, a company owned and controlled by Mrs A, to facilitate a family law settlement for the division of family assets.

The franking credit benefits are merely incidental to this primary purpose and follow from the issue of RPS to Company C for to facilitate the above objective.

Therefore, the purpose requirement in paragraph 177EA(3)(e) of ITAA 1936 is not satisfied.

Conclusion

Having regard to the relevant circumstances of the scheme, the conditions in subsection 177EA(3) of the ITAA 1936 have not been satisfied and section 177EA will not apply to any fully franked distribution under the proposed transaction: specifically the Commissioner will not be empowered to make a determination under subsection 177EA(5).

Question 7

Will the Commissioner make a determination under Part IVA of the ITAA 1936 to the whole, or part, of the arrangement including the proposed transfer of real property from each company?

Answer

No.

Detailed reasoning

Having regard to the characteristics and objective purpose of the Proposed Transaction steps, it is accepted that a dominant purpose of obtaining a tax benefit is not present.

Consequently, the arrangement involving the issue of the RPS and the future payment of dividends to the RPS holders is not a scheme to which Part IVA applies.

As section 177D, section 177E and section 177EA of the ITAA 1936 do not apply, a determination would not be made under section 177F or section 177EA(5) of the ITAA 1936 to cancel any tax benefit that may be obtained under the arrangement.