Edited version of private advice

Authorisation Number: 1051996698004

Date of advice: 24 June 2022

Ruling

Subject: Sale of shares to employees

Issues

Question 1

Will the non-recourse loans from Holdco to the Executives be treated as dividends in the hand of the Executives for the 20XX income year under section 109D of Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

As the Executives are not shareholders (or associates of shareholders) at the time the loans are made, the loan arrangements will fall outside section 109D of the ITAA 1936 and Holdco will not be taken to pay dividends to the Executives

Question 2

a) Does the non-recourse loan provided to an executive employee (to enable them to participate in the Transaction) constitute a loan benefit for the purposes of subsection 136(1) of the Fringe benefits Tax Assessment Act 1986 (FBTAA)?

Answer

Yes. A non-recourse loan provided to an employee of an entity is a loan fringe benefit.

b) Does the non-recourse loan provided to an executive employee (to enable them to participate in the Transaction) constitute an exempt loan benefit for the purposes of section 17 of the FBTAA?

Answer

No.

c) Can the taxable value of the loan fringe benefit provided to an executive employee to enable them to participate in the Transaction be reduced by the otherwise deductible rule under section 19 of the FBTAA?

Answer

Yes.

Question 3

Will any amount forgiven under the loans to the Executives be treated as a dividend in the hand of the Executives at the end of the income year in which any such debt forgiveness occurs under section 109F of ITAA 1936?

Answer

No - where there is an outstanding balance of a loan owed by an Executive to HoldCo, in accordance with the terms of the Participation Deed and HoldCo, it is reasonable to conclude that Holdco will release, waive, etc. any obligation of the Executive to pay that outstanding balance, and when it does so it will not be considered debt forgiveness for the purposes of section 109F of the ITAA 1936 in the circumstances of the Executives and the terms of the Participation Deed.

Question 4

Can a 'debt waiver benefit' as defined in subsection 136(1) of the FBTAA arise if Holdco waives the obligation imposed on an Executive to repay the loan arising as a result of entering into the Transaction (subject to the minor benefit rule)?

Answer

Yes. If Division 7A of the ITAA 1936 were not to apply in these circumstances, there will be a debt waiver for fringe benefit tax purposes where Holdco waives an Executive from the obligation to pay or repay that outstanding amount.

Question 5

Will any amount forgiven under the loans to the Executives be subject to the commercial debt forgiveness rules?

Answer

To the extent any amount is not in the debtor's assessable income as a deemed dividend under Division 7A of the ITAA 1936 or the amount waived is not debt waiver fringe benefit or a minor benefit for FBTAA purposes, Division 245 of the ITAA 1997 may apply.

Question 6

Whether section 177D of the ITAA 1936 will apply to the transaction?

Answer

No.

Question 7

Whether section 177E of the ITAA 1936 will apply to the transaction?

Answer

No.

This ruling applies for the following period: XXXX

Relevant facts and circumstances

Holdco is the group head - Company A and Company B are subsidiaries.

The former and current directors of Holdco are the Individual A and Individual B (Individuals) and their adult children.

Prior to the Transaction

The Individuals were the shareholders of Holdco

a) they each owned X ordinary shares;

b) they jointly owned X ordinary shares; and

c) they jointly owned 1 X Class share.

Dividend History

Fully franked dividends have been paid by HoldCo to its shareholders as follows:

•         20XX $X

•         20XX $X

•         20XX $X

•         20XX $X

•         20XX $X

Acquisition by employees of shares in Holdco

As part of the Transaction, the Individuals sold 15% of their Holdco shares to certain members of the Executive management team and Holdco advanced funds to those Executive management team members on an interest free non-recourse basis in order for them to acquire the shares from the Individuals.

The purchase price of the shares under the Transaction is the market value of the shares.

The Executives pay the Individuals the full amount of the purchase price by way of payment direction to Holdco:

(a) The Executives each pay 1% of their respective purchase price by cash.

(b) The balance is funded by way of a non-recourse interest-free loan by Holdco to the Executives (the loan is made in X income year).

The Executive's rights with respect to dividends

Dividend Entitlement

The Executive is entitled pro-rata to all dividends declared and paid on Shares in the proportion that the number of the Executive's Participation Shares bear to the total number of Shares on issue at the time the dividend is declared by the Board.

Minimum Dividend

It is anticipated that the Board will from time to time resolve to pay a minimum percentage of EBITDA as a dividend each year. The Company and the Executive will have good faith discussions to agree a percentage to be recommended to the Board prior to the commencement of each financial year.

The Executive's rights and obligations with respect to the disposal of the shares

The controlling shareholders can buy the shares back at their discretion at any point in the first twelve months. After that point the employees can otherwise only sell the shares in the following circumstances:

a) The employee leaves the company (willingly or otherwise) in which case the employee sells their shares back to the controlling shareholder.

b) The controlling shareholder decides to sell the company in entirety to a new owner (in which case the employee sells their shares to the new owner).

The proceeds from this transaction must be applied against any balance outstanding under the terms of the loan.

The taxpayer defends the legitimacy of the arrangement on the basis that they will be subject to CGT (although the shares may well be pre-CGT) and that the arrangement will serve to incentivise the executives to continue the growth of the company's business of property construction (and enable the executives to share in the spoils of any eventual sale of the company).

Relevant legislative provisions

Income Tax Assessment Act 1936 section 109D

Income Tax Assessment Act 1936 section 109F

Income Tax Assessment Act 1936 section 177D

Income Tax Assessment Act 1936 section 177E

Income Tax Assessment Act 1997 section 245-40

Income Tax Assessment Act 1997 section 245-60

Income Tax Assessment Act 1997 section 245-65

Fringe benefits Tax Assessment Act 1986 section 17

Fringe benefits Tax Assessment Act 1986 section 19

Fringe benefits Tax Assessment Act 1986 section 136

Reasons for decision

Question 1

Summary

As the Executives are not shareholders (or associates of shareholders) at the time the loans are made, the loan arrangements will fall outside section 109D of the ITAA 1936 and Holdco will not be taken to pay dividends to the Executives.

Discussion

Division 7A deemed dividend

Division 7A of the ITAA 1936 is an integrity measure aimed at preventing private companies from making tax-free distributions of profits to shareholders (or their associates). In particular, advances, loans and other payments or credits to shareholders (or their associates) are, unless they come within specified exclusions, treated as assessable dividends to the extent that the private company has a distributable surplus.

Section 109D of the ITAA 1936

Subsection 109D(1) of the ITAA 1936 provides that a private company is taken to pay a dividend to an entity at the end of one of the private company's years of income if:

a) the private company makes a loan to the entity during the year; and

b) the loan is not fully repaid before the lodgment day for the year; and

c) Subdivision D does not apply to prevent the company from being taken to pay a dividend because of the loan at the end of the year; and

d) either:

(i) the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or

(ii) a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time.

Section 109NB of the ITAA 1936

Section 109NB of the ITAA 1936 provides that a private company is not taken under section 109D of the ITAA 1936 to pay a dividend because of a loan made solely for the purpose of enabling the shareholder, or an associate of the shareholder, to acquire an ESS interest under an employee share scheme to which certain provisions of Division 83A of the Income Tax Act 1997 (ITAA 1997) would apply.

Section 109N of the ITAA 1936

Section 109N of Subdivision D of the ITAA 1936 prevents a private company from being taken to pay a dividend under section 109D of the ITAA 1936 if the loan is put under a written agreement before the private company's lodgment day for the income year in which the loan is made, the rate of interest payable on the loan equals or exceeds the benchmark interest rate, and the term of the loan does not exceed seven years for unsecured loans or 25 years for secured loans.

A loan agreement that does not allow for interest to be charged and/or does not specify a maximum loan term, would not meet the requirements of section 109N of the ITAA 1936 - in which circumstances the company would normally be taken to pay a dividend to the borrower.

Application in these circumstances

The Executives are not shareholders (or associates of shareholders) of Holdco and are being offered loans, as employees of Company A and Company B, to acquire initial shareholdings in Holdco.

In circumstances such as these, it is the Commissioner's view that where the borrower is not a shareholder (or an associate of a shareholder) at the time the loan is made, the loan arrangement will fall outside section 109D of the ITAA 1936 and Holdco will not be taken to pay a dividend to the borrower.

However, any subsequent loans to the Executives to purchase additional shares in Holdco will be subject to section 109D of the ITAA 1936 and the requirements of section 109N of the ITAA 1936.

Question 2

Discussion

Does the non-recourse loan provided to an executive employee (to enable them to participate in the Transaction) constitute a loan benefit for the purposes of subsection 136(1) of the FBTAA?

Fringe benefit

Pursuant to section 66 of the Fringe benefits Tax Assessment Act 1986 (FBTAA) an employer is liable to pay fringe benefits tax on the employer's fringe benefits taxable amount as calculated under section 5B and section 5C of the FBTAA.

Relevantly, a 'fringe benefit' is defined as follows in subsection 136(1) of the FBTAA:

fringe benefit, in relation to an employee, in relation to the employer of the employee, in relation to a year of tax, means a benefit:

(a) provided at any time during the year of tax; or

(b) provided in respect of the year of tax;

being a benefit provided to the employee or to an associate of the employee by:

(c) the employer; or

(d) an associate of the employer: or

...

in respect of the employment of the employee, but does not include:

(f) a payment of salary or wages or a payment that would be salary or wages if salary or wages included exempt income for the purposes of the Income Tax Assessment Act 1936; or

(g) a benefit that is an exempt benefit in relation to the year of tax; or

(h) ...

Relevantly, there must be a benefit provided to an employee or an associate of an employee by the employer or an associate of the employer.

Benefit provided to an employee or an associate of an employee

The term 'employee' is defined under subsection 136(1) of the FBTAA as:

(a) a current employee;

(b) a future employee; or

(c) a former employee.

In this case, each member of the Holdco Executive team satisfies the definition of employee.

Benefit provided by an employer

The term 'employer' is defined under subsection 136(1) of the FBTAA as:

(a) a current employer;

(b) a future employer; or

(c) a former employer....

'Associate' in this context has the meaning given by section 318 of the ITAA 1936. Relevantly, subsection 318(2) of the ITAA 1936 specifies who will be an associate of a company (other than a company in the capacity of trustee). These are as follows:

• a partner of the company or a partnership in which the company is a partner (paragraph (2)(a));
• where the partner of a company is a natural person - that person's spouse or child (paragraph (2)(b));
• where the company, or an entity that is an associate of the company because of paragraph (2)(a), (b), (d), (e) or (f), benefits under a trust (see notes on paragraph 318(6)(a)) - the trustee of the trust (paragraph (2)(c));
• another entity that, acting alone or with another entity or entities, sufficiently influences the company (subparagraph (2)(d)(i));
• an entity that, either alone or together with associates, holds a majority voting interest in the company (subparagraph (2)(d)(ii));
• a second company that is sufficiently influenced by:

o   the company (sub-subparagraph (2)(e)(i)(A));

o   an entity that is an associate of the company because of paragraph (2)(a), (b), (c), (d) or (f) (sub-subparagraph (2)(e)(i)(B));

o   a third company that is an associate of the company because of sub-subparagraph (2)(e)(i)(A), (B) or (D) or subparagraph (2)(e)(ii) (sub-subparagraph (2)(e)(i)(C)); or

o   two or more entities that are associates of the company because of sub-subparagraph (2)(e)(i)(A), (B) or (C) (sub-subparagraph (2) (e)(i)(D));

• a second company in which a majority voting interest is held by:

o   the company (sub-subparagraph (2)(e)(ii)(A));

o   entities that are associates of the company because of subparagraph (2)(e)(i) and paragraphs (2)(a), (b), (c), (d) and (f) (sub-subparagraph (2)(e)(ii)(B)); or

o   both the company and entities that are associates of the company because of subparagraph (2)(e)(i) and paragraphs (2)(a), (b), (c), (d) and (f) (sub-subparagraph (2)(e)(ii)(C)); and

• an associate of an entity that is an associate of the company because of paragraph (2)(d) (paragraph (2)(f)).

In this case Holdco satisfies the meaning of an associate of Company A and Company B - i.e. the employer of the Executives.

In respect of the employment

For a benefit to be a 'fringe benefit' it must be provided to the employee (or their associate) 'in respect of the employment of the employee'.

Subsection 136(1) of the FBTAA defines 'In respect of' defined as:

.... in relation to the employment of an employee, includes by reason of, by virtue of, or for or in relation directly or indirectly to, that employment.

[emphasis added]

Subsection 148(1) of the FBTAA, also provides that a reference in the FBTAA to the provision of a benefit to a person in respect of the employment of an employee is a reference to the provision of such a benefit (having the requisite connection with employment):

(a) whether or not the benefit is also provided in respect of, by reason of, by virtue of, or for or in relation directly or indirectly to, any other matter or thing;

.....

(g) whether or not the provision of the benefit is, or is ion the nature of, income; and

(h) whether or not the benefit is provided as a reward for services rendered, or to be rendered, by the employee.

A benefit will be considered to be in respect of employment if there is a sufficient or material connection between the benefit and the employment: i.e. if the employment explains why the benefit is provided (Smith v. FCT 87 ATC 4883, J& G Knowles & Associates Pty Ltd v. FC of T 2000 ATC 4151 and Starrim Pty Ltd v Federal Commissioner of Taxation [2000] FCA 952). Further, the benefit is not required to constitute remuneration for the employment activity - it will be sufficient if the benefit is found to have a material connection to the employment relationship, in total, rather than a specific connection to the activities that generate the income for the employee (Smith v. FCT 87 ATC 4883).

The loans are provided to the Executives in respect of their employment.

Provision of a benefit

The definition of the term 'benefit' in subsection 136(1) of the FBTAA provides that a benefit includes:

any right (including a right in relation to, and an interest in, real or personal property), privilege, service or facility and, without limiting the generality of the foregoing, includes a right, benefit, privilege, service or facility that is, or is to be, provided under:

(a) an arrangement for or in relation to:

(i) the performance of work (including work of a professional nature), whether with or without the provision of property;

(ii) the provision of, or of the use of facilities for, entertainment, recreation or instruction; or

(iii) the conferring of rights, benefits or privileges for which remuneration is payable in the form of a royalty, tribute, levy or similar exaction;

(b) a contract of insurance; or

(c) an arrangement for or in relation to the lending of money.

A loan fringe benefit is defined in subsection 136(1) of the FBTAA as 'a fringe benefit that is a loan benefit.' Subsection 136(1) of the FBTAA states that a 'loan benefit means a benefit referred to in subsection 16(1)', which provides:

16(1) [Recipient under obligation to repay loan] Where a person (in this subsection referred to as the provider) makes a loan to another person (in this subsection referred to as the recipient), the making of the loan shall be taken to constitute a benefit provided by the provider to the recipient and that benefit shall be taken to be provided in respect of each year of tax during the whole or a part of which the recipient is under an obligation to repay the whole or any part of the loan.

Note: A loan benefit is taken to be provided in respect of a year of tax may not be provided as a fringe benefit if:

a)    the loan was made in the year of tax or a previous year of tax, and

b)    A dividend is not taken to be paid under section 109D of the Income Tax Assessment Act 1936 in relation to the loan, because of section 109N of that Act.

See paragraph (s) of the definition of fringe benefit in subsection 136(1) of this Act.

The definition of the term 'loan' is defined in subsection 136(1) of the FBTAA as including:

(a)  an advance of money;

(b)  the provision of credit or any other form of financial accommodation;

(c)   the payment of an amount for, on account of, on behalf of or at the request of a person where there is an obligation (whether expressed or implied) to repay the amount; and

(d)  a transition (where its terms or form) which in substance effects a loan of money.

The loan provided by Holdco to employee participants (Executives) meets the definition of 'loan benefit'.

It must also satisfy the definition of a fringe benefit to be a loan fringe benefit. Subsection 136(1) of the FBTAA relevantly provides that a fringe benefit includes benefits provided to an employee by their employer in respect of their employment but does not include certain loans within the meaning of section 109D of the ITAA 1936. As discussed above, the loans are not considered dividends under section 109D of the ITAA 1936. Therefore, each loan benefit is a fringe benefit.

As the benefit qualifies as a loan fringe benefit, section 18 of the FBTAA provides that:

... the taxable value, in relation to a year of tax, of a loan fringe benefit provided in respect of the year of tax is the amount (if any) by which the notional amount of interest in relation to the loan in respect of the year of tax exceeds the amount of interest that has accrued on the loan in respect of the year of tax.

In this case, this would be the entirety of the notional amount of interest (i.e. the applicable arm's length/commercial interest rate), as no interest has or will accrued on the loan as the terms of the loan include that it is interest free.

Does the non-recourse loan provided to an executive employee (to enable them to participate in the Transaction) constitute an exempt loan benefit for the purposes of section 17 of the FBTAA?

Section 17 of the FBTAA sets out loans that are exempt loan benefits. However, this loan benefit is not described in that section and therefore is not an exempt loan benefit.

Can the taxable value of the loan fringe benefit provided to an executive employee to enable them to participate in the Transaction be reduced by the otherwise deductible rule under section 19 of the FBTAA?

Under section 19 of the FBTAA, the taxable value of a loan fringe benefit is reduced by the amount that the employee would have been able to claim as a once-only income tax deduction under the ITAA 1936 or the ITAA 1997, had they actually incurred interest on the loan. This is referred to as the otherwise deductible rule.

Subsection 19(1) of the FBTAA relevantly provides that the taxable value may be reduced where:

19(1) Where:

(a) the recipient of a loan fringe benefit in relation to an employer in relation to a year of tax is an employee of the employer; and

(b) if the recipient had, on the last day of the period (in this subsection called the loan period) during the year of tax when the recipient was under an obligation to repay the whole or any part of the loan, incurred and paid unreimbursed interest (in this subsection called the gross interest), in respect of the loan, in respect of the loan period, equal to the notional amount of interest in relation to the loan in relation to the year of tax - a once-only deduction (in this subsection called the gross deduction) would, or would if not for section 82A of the ITAA 1936, and Divisions 28 and 900 of the Income Tax Assessment Act 1997, have been allowable to the recipient under either of those Acts in respect of the gross interest; ...

Deductions for interest

Under section 8-1 of the ITAA 1997, interest is deductible to the extent that it is incurred in gaining or producing the taxpayer's assessable income or in carrying on a business for that purpose and is not of a capital, private or domestic nature.

Whether the requisite connection exists is a question of fact and degree, determined by reference to the circumstances of the particular case.

In determining the deductibility of interest, the courts and tribunals have looked at the purpose of the borrowing and the use to which the borrowed moneys have been put (Fletcher & Ors v FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v FC of T 99 ATC 4242; (1999) 41 ATR 139). Using the borrowed money for the purpose of gaining assessable income connects the interest paid on the borrowed money to the income derived from its use.

Firth v. FC of T 2001 ATC 4615 confirms that with respect to non-recourse loans, interest expenses would be deductible where money is borrowed for the purposes of gaining assessable income.

Paragraph 16 of Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities highlights that although the concepts of the use to which funds are put and of subjective purpose are useful tools in determining the deductibility of interest, the statutory issue is whether the interest outgoing was incurred in (i.e. in the course of) the income producing activity. (see Hill J in Kidston Goldmines Ltd v Federal Commissioner of Taxation 91 ATC 4538; (1991) 22 ATR 168; and FC of T v JD Roberts 92 ATC 4380 (1992); 23 ATR 494)

Expenditure incurred prior to assessable income

A loss or outgoing may be deductible under section 8-1 of the ITAA 1997 even though it produces assessable income in a year of income later than the year in which the loss or outgoing was incurred.

In Ronpibon Tin NL v FC of T (1949) 8 ATD 431 at 436; (1949) 78 CLR 47 at page 57, Latham CJ, Rich, Dixon, McTiernan and Webb JJ said:

[I]t is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income

However, expenditure incurred before the commencement of an income-generating activity may be excluded from deductibility under section 8-1 of the ITAA 1997 where it lacks the necessary nexus.

In FC of T v Total Holdings (Australia) Pty Ltd (1979) 24 ALR 401 at 406; 79 ATC 4279 at 4283, Lockhart J stated:

... [ I]f a taxpayer incurs a recurrent liability for interest for the purpose of furthering his present or prospective income-producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction under s 51 [now section 8-1]...

I say 'generally' as some qualification may be necessary in appropriate cases, for instance, where interest is paid by a taxpayer as a prelude to his being in a position whereby he may commence to derive income. In such cases the requirement that the expenditure be incidental and relevant to the derivation of income may not be satisfied.

Paragraph 9 of Taxation Ruling IT 2606 Income tax: Deductions For Interest on Borrowings to Fund Share Acquisitions explains:

As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) [now paragraph 8-1(1)(a)] where it is expected that dividends or some other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility; there must be a prospect of dividends or other assessable income being received.

The expectation of dividends is not a mere theoretical possibility: there is a prospect dividends will be received

Interest incurred on a loan to purchase shares will generally have the required connection to assessable income where there is a reasonable prospect of dividends being received.

Accordingly, any interest on the loans provided by Holdco to the employee participants (the Executives) would be able to be claimed as once-only income tax deductions under the ITAA 1936 or the ITAA 1997 and therefore satisfy the requirements of paragraph 19(1)(b) of the FBTAA.

This means that the taxable value of the interest on the loan fringe benefit is reduced by the amount the Executive would hypothetically have been entitled to claim as an income tax deduction for interest as if the employee had incurred expenditure in respect of the provision of the benefit.

Paragraph 19(1)(ba) of the FBTAA 1986 provides the method for calculating the notional deduction allowable as:

(ba) the amount (in this subsection called the notional deduction) calculated in accordance with the formula:

GD - RD

Where:

GD is the gross deduction; and

RD is:

(i) if no interest accrued on the loan in respect of the loan period - nil; or

(ii) if interest accrued on the loan in respect of the loan period - the amount (if any) that would, or that would but for section 82A of the Income Tax Assessment Act 1936, and Divisions 28 and 900 of the Income Tax Assessment Act 1997, have been allowable as a once-only deduction to the recipient under the Income Tax Assessment Act 1936 or the Income Tax Assessment Act 1997 in respect of that interest if that interest had been incurred and paid by the recipient on the last day of the loan period;

exceeds nil;

Provided that the substantiation requirements are met, the otherwise deductible rule in section 19 of the FBTAA will apply.

Paragraph 19(1)(c) of the FBTAA requires that the recipient gives a declaration to the extent that the interest would have been otherwise deductible except where the fringe benefit is an employee credit loan or 'employee share loan fringe benefit', Paragraph 19(1)(c) of the FBTAA states:

(c) except where the fringe benefit is:

(i) an employee credit loan benefit in relation to the year of tax; or

(ii) an employee share loan benefit in relation to the year of tax;

the recipient gives to the employer, before the declaration date, a declaration, in a form approved by the Commissioner, in respect of the loan concerned; and

Sub-paragraph 19(1)(c)(ii) of the FBTAA is relevant.

An employee share loan benefit is defined in subsection 136(1) of the FBTAA as:

employee share loan benefit , in relation to a year of tax, means a loan fringe benefit in relation to an employee in relation to an employer in relation to the year of tax where:

(c) the sole purpose of the making of the loan is to enable the employee to acquire shares, or rights to acquire shares, in a company, being:

(i) the employer; or

(j) an associate of the employer; and

(d) the shares or rights were beneficially owned by the employee at all times during the period during the year of tax when the employee was under an obligation to repay the whole any part of the loan.

The terms of the Executive Share Participation and Loan Deed provide that the sole purpose of the loan is to enable the employees (the Executives) to purchase shares in Holdco (an associate of their employer).

In relation to the beneficial ownership, after the sale, the shares are owned by the employees. According to the Executive Share Participation and Loan Deed, upon purchase of the shares by the employees all title, rights and risks associated with the shares pass to the employees (the Executives). Therefore, the employees (the Executives) will be the beneficial owners of the shares while under an obligation to repay the loan.

As such, the loan is an employee share loan benefit and there is no need for the employee to provide a declaration for the purpose of section 19 of the FBTAA.

Section 19 of the FBTAA will apply to reduce the taxable value of the loan benefit to nil.

Question 3

Summary

Where there is an outstanding balance of a loan owed by an Executive to HoldCo, after the application of any loan repayments, dividends applied directly and the application of proceeds from required disposals as determined in accordance with the terms of the Participation Deed and HoldCo then releases, waives, etc. any obligation of the Executive to pay or repay that outstanding balance or if, having regard to all of the circumstances, it is reasonable to conclude that Holdco will not insist on repayment of the debt, that action will not be considered debt forgiveness for the purposes of section 109F of the ITAA 1936 in the circumstances of the Executives and the terms of the Participation Deed.

Discussion

Subsection 109F(1) of the ITAA 1936 provides that a private company is taken to pay a dividend to an entity at the end of the private company's year of income if all or part of a debt the entity owed the private company is forgiven in that year and either:

a. the amount is forgiven when the entity is a shareholder in the private company, or an associate of such a shareholder; or

b. a reasonable person would conclude (having regard to all the circumstances) that the amount is forgiven because the entity has been such a shareholder or associate at some time.

The amount is forgiven when the Executive is no longer a shareholder.

Taxation Determination TD 2008/14 Income tax: Division 7A of Part III of the Income Tax Assessment Act 1936 - what is the meaning of 'because' in the context of the expression 'because the entity has been such a shareholder or associate at some time' in relation to payments, loans and debt forgiveness made by a private company to the entity? confirms that paragraph 109F(1)(b) of the ITAA 1936 has broad application, such that where the debt was forgiven when the entity was not a shareholder or associate, the forgiveness can still give rise to a dividend if a reasonable person would conclude, having regard to all the circumstances, that the forgiveness occurred because the entity had been such a shareholder or associate at some time:

1. In this context 'because' means by reason that. The reason must be a real and substantial reason for the payment, loan or debt forgiveness concerned,¹ even if it is not the only reason or not the main reason for the transaction.

....

22. Paragraph 109C(1)(b) does require a causal relationship. The word 'because' is not defined in the Income Tax Assessment Act 1936. It is defined in The Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne as 'for the reason that; since'. This directs attention to the question of whether the fact that the entity was in the past a shareholder or associate is a reason for the payment being made.

23. However, the Commissioner considers that to be a cause of the payment, a reason must be real and substantial and not merely remote or insignificant. Whether a reason is real and substantial is a question of fact and degree determined on balance, according to the facts and circumstances.

24. In some cases it may be reasonable to conclude that there is more than one reason for the payment being made. The Commissioner considers that, as a matter of ordinary language, an event may occur because of a particular circumstance even if it also occurs because of one or more other circumstances.

26. Paragraph 109C(1)(b) prevents the operation of the primary rule in paragraph 109C(1)(a) from being avoided simply by ending the relevant shareholding or association before making a payment. Given the breadth of paragraph 109C(1)(a), which as mentioned above requires no causal relationship between the making of the payment and the entity's status, the Commissioner considers it appropriate to take a broad view of the rule in paragraph 109C(1)(b) that is intended to support its operation. In particular, it would tend to make paragraph 109C(1)(b) ineffective if the existence of some other reason for a payment were enough to prevent the paragraph from applying. In other words, because paragraph 109C(1)(b) is there to stop people contriving ways to avoid paragraph 109C(1)(a), paragraph 109C(1)(b) in turn should be interpreted in a way that makes it relatively difficult to avoid, including by means of further contrivances.

27. In conclusion therefore, the existence of multiple reasons for a transaction does not prevent a reasonable person from concluding that the payment, loan or debt forgiveness occurred because the entity has been a shareholder or associate at some time. For the purposes of paragraph 109C(1)(b), subparagraphs 109D(1)(d)(ii) and 109D(1A)(d)(ii) and paragraph 109F(1)(b) it is sufficient that a reasonable person would conclude (having regard to all the circumstances) that a real and substantial reason for a transaction occurring is that the entity was a shareholder, or an associate of a shareholder, at some time.

In this case, the only circumstance an amount forgiven under the loan arrangement between the Executives and will arise is where there is an outstanding balance of a loan owed by an Executive to HoldCo, after the application of any loan repayments, dividends applied directly and the proceeds from a required disposal of shares do not exceed the loan balance. This is determined in accordance with the terms of the Participation Deed where HoldCo will then not insist that Executive pays or repays that outstanding balance as the loan was made on a non-recourse basis under the agreement.

However, the loan was extended prior to the Executive becoming a shareholder and the terms of the loan were offered as an inducement to Executive members to incentivise them to acquire the shares, stay with the company and work towards its economic goals. The loan was the means or cause by which the Executive became a shareholder, rather than the other way around as contemplated in the 'causal relationship' discussed in paragraph 22 of TD 2008/14. Although the participation in the arrangement means that the Executives are shareholders until the required disposal occurs, the amount will be forgiven due to the Executive entering into the Participation Deed prior to the Executive becoming a shareholder and not by the holding of the shares. Prior to the entering into the Participation Deed, the shares were held by the Individuals, who had no such arrangement in place, where their shares were sold. As such the shareholding may be a reason for the forgiveness, but not a 'real or substantial' reason as contemplated by paragraph 23 of TD 2008/14.

The Commissioner considers that the purposes of paragraphs 109C(1)(a) and 109C(1)(b) of the ITAA 1997 are not made ineffective by this conclusion in the circumstances of the applicants. The Commissioner considers that a reasonable person would not conclude that a forgiveness of an amount owed by the Executives, in the circumstances described above, would be considered to have been made because the Executives were shareholders at some time, but rather it was because of the incentive scheme arrangement offered through the Participation Deed to encourage the Executives (employees) to become shareholders.

Question 4

Summary

If Division 7A of the ITAA 1936 were not to apply in these circumstances, there will be a debt waiver for fringe benefit tax purposes where Holdco waives an Executive from the obligation to pay or repay that outstanding amount.

Discussion

Interaction between Division 7A and FBTAA

Where Division 7A of the ITAA 1936 applies in respect of a debt forgiveness, it excludes the operation of the FBTAA, (subsection 109ZB(2) of the ITAA 1936).

Debt Waiver

A 'debt waiver benefit' is defined in subsection 136(1) of the FBTAA to mean a benefit referred to in section 14.

Section 14 of the FBTAA states that:

14 Where, at a particular time, a person (in this section referred to as the provider) waives the obligation of another person (in this section referred to as the recipient) to pay or repay to the provider an amount, the waiver shall be taken to constitute a benefit provided at that time by the provider to the recipient.

The word 'waive' is defined in the FBTAA at subsection 136(1) as: 'includes release'.

The word 'waive' has also been considered by the courts. In Banning v Wright (1972) 2 All ER 987 it was held to mean the giving up or abandoning of some right.

Under the terms of the Participation Deed the Executive (employee) is required to repay the outstanding loan balance and the loan is a non-recourse loan. This can be distinguished from the circumstances set out in ATO Interpretative Decision ATO ID 2003/317 Fringe Benefits Tax Debt waiver benefits: benefit upon discharge of limited recourse loan - where the terms of the loan agreement provided that the employee may elect to transfer the shares to the lender in full and final satisfaction of the loan balance. Consequently, where, under the terms of a loan agreement, the lender accepts a transfer of shares in full satisfaction of the loan balance, there is no release or waiver of any obligation to pay or repay an amount: the discharge of a loan through the transfer of shares to the lender, where the shares have a lesser value than the loan balance, is not considered to give rise to a debt waiver benefit.

A debt waiver fringe benefit arises where an employer waives or forgives an employee's debt and encompasses circumstances where money is still owed on the debt after the collateral is sold and the debtor (employee) avails themself of the limited recourse provision such that they do not have to pay the shortfall/outstanding amount: this is effectively a waiving of the employee's debt by the creditor (employer).

To the extent that the loan is not fully repaid by the Executives (the borrowers) pursuant to the terms of the Participation Deeds, Holdco (the lender) has limited recourse against the borrower to recover that outstanding amount. Notwithstanding, each Executive has an obligation to pay that amount unless there is a waiver or release from obligation to do so by Holdco. A debt waiver benefit arises at the time the Executive avails themself of the limited recourse provision such that the Executive's obligation to pay or repay an amount is waived by Holdco.

The taxable value in relation to an FBT year of a debt waiver fringe benefit provided in that year is the amount the repayment of which is waived: section 15 of the FBTAA.

Minor benefit rule

The taxable value in relation to an FBT year of a debt waiver fringe benefit provided in that year is the amount the repayment of which is waived: section 15 of the FBTAA.

However, where a benefit has a notional taxable value of less than $300 it will be a minor benefit, and may be an exempt benefit, if it would be unreasonable to treat the minor benefit as a fringe benefit considering the criteria stated in paragraph 58P(1)(f) of the FBTAA.

In broad terms, the benefit that arises from the provision of a debt waiver by the employer will be an exempt minor benefit if:

(i) the notional taxable value of the benefit is less than $300; and

(ii) it can be concluded on the basis of the factors listed in paragraph 58P(1)(f) of the FBTAA that it would be unreasonable to treat the benefits as a fringe benefit.

Guidance on the application of these requirements are set out in Taxation Ruling TR 2007/12 Fringe benefits tax: minor benefits (TR 2007/12).

Question 5

Summary

To the extent any amount is not in the debtor's assessable income as a deemed dividend under Division 7A of the ITAA 1936 or the amount waived is not debt waiver fringe benefit or a minor benefit for FBTAA purposes, Division 245 of the ITAA 1997 may apply.

Discussion

Interaction between Division 7A and commercial debt forgiveness

Relevantly, section 245-40 of the ITAA 1997 provides that the forgiveness of a debt is not caught by Division 245 of the 1997 where:

(i) a forgiveness of a debt that is a fringe benefit; or

(ii) a debt that has been or will be included in the debtor's assessable income (e.g. a loan that is a deemed dividend), or

(iii)......

That is, Division 7A of the ITAA 1936 and FBTAA take precedence over and affect the application of Division 245 of the ITAA 1997.

Where the debt forgiveness gives rise to a deemed dividend under Division 7A of the ITAA 1936 or the amount the repayment of which is waived is a debt waiver fringe benefit under the FBTAA, there will be no additional implications under the commercial debt forgiveness rules.

An amount which is included in the assessable income under Division 7A will no longer be a debt for debt forgiveness purposes. However, where part of the debt forgiveness amount is not included in the assessable income of the taxpayer (e.g. it is a lesser amount based on the distributable surplus rules in Division 7A of the ITAA 1936), the commercial debt forgiveness provisions may apply to the amount of the debt forgiven that was not included in the taxpayer's assessable income.

Commercial debt forgiveness

Commercial debt

Section 245-10 of the ITAA 1997 states (in part) that a debt will be considered to be a commercial debt if:

• the whole or any part of the interest payable in respect of the debt can be deducted by the borrower, or
• where interest is not payable, but had interest been payable, the whole or any part of the interest payable would have been deductible to the borrower.

In this case, an interest free loan has been provided to the Executives to facilitate the purchase of shares in Holdco that are expected to generate dividend income. Accordingly, if interest had been payable on the loan, it would have been deductible to the borrower (the Executive). Therefore, the loan from Holdco to each Executive constitutes a commercial debt.

Forgiveness of a debt

A debt is forgiven if and when the debtor's obligation to pay the debt is released, waived, or is otherwise extinguished other than by repaying the debt in full (paragraph 245-35(a) of the ITAA 1997).

As discussed above, in these circumstances, the debt will not be considered to be extinguished other than by repayment of the debt in full. Where money is still owed on the debt after the collateral (the shares) is sold and the Executive avails themself of the limited recourse provision and the creditor ceases to be entitled to recover the debt, there will be a debt forgiveness for the purposes of paragraph 245-35(a) of the ITAA 1997.

In this case, Holdco, as lender, in accordance with the terms of the Participation Deed would need to take some action to release the Executive from their liability with respect to any outstanding amount following the required disposal of the shares such that the debt will be forgiven.

Gross forgiven amount

Subdivision 245-C of the ITAA 1997 sets out the 2 steps for determining the amount of forgiveness (the gross forgiven amount):

(a) The value of the debt when it was forgiven is worked out on the basis that the debtor was solvent both then and when the debtor incurred the debt; and

(b) The value of the debt is then offset by any consideration given for the forgiveness of the debt.

The difference between the value of the debt and the amount offset is the gross forgiven amount.

Value of the debt

There is a general rule for working out the value of a debt; however, there are special rules in section 245-60 of the ITAA 1997 for working out the value of a non-recourse debt.

The rules cover debts including those incurred to finance the acquisition of property where the creditor's rights against the borrower in the event of default in the payment of the debt or interest were, just before the debt was forgiven, limited to rights (including the right to money payable) in relation to:

a.the property or the use of the property;

b.goods produced, supplied, carried, transmitted or delivered by means of the property;

c.services provided by means of the property;

d.the loss or disposal of the whole or a part of the property or of your interest in the property (subsections 245-60(2) and (3) of the ITAA 1997).

In broad terms, a non-recourse loan refers to a loan arrangement where a lender has no recourse beyond a specified security of the borrower. The borrower is not otherwise personally at risk to repay the loan (see e.g. Taxation Ruling TR 2000/8 Income tax: investment schemes). The loans to the Executives are non-recourse debts for the purposes of Division 245 of the ITAA 1997. There is a limited recourse debt that becomes a non-recourse debt upon the required disposal of the shares - where money is still owed on the debt after the collateral (the shares) is sold and the Executive avails themself of the limited recourse provision and the creditor ceases to be entitled to recover the debt.

Subsection 245-60(1) of the ITAA 1997 states that the value of a debt when it is forgiven is the lesser of:

a.    the market value at that time of the creditor's rights.

b.    the amount of the debt outstanding at that time; and

Under the Participation Deed, the proceeds from the required disposal must be applied against the outstanding balance of the loan. This would equate to the market value of Holdco's rights, as a creditor, at the relevant time.

Amount offset against amount of debt

The rules to determine the amount that can be offset against the value of a debt (consideration) are set out in section 245-65 of the ITAA 1997. In broad terms, section 245-65 of the ITAA 1997 sets out the rules to determine the consideration given by the debtor to the creditor in respect of the forgiveness of a debt, which reduces the value of the debt (determined here under section 245-60 of the ITAA 1997) to arrive at the gross forgiven amount of the debt.

Under the Participation Deed, amongst other things, the proceeds from the required disposal must be applied against the outstanding balance of the loan - this is an amount that the Executive is required to pay with respect to the loan.

Relevantly, where there is a non-money lending debt, under Item 2 the consideration is the sum of each amount the debtor has paid or is required to pay and the market value, when the debt is forgiven, of any property given or that is required to be given in respect of the debt forgiveness. Item 3 would not apply as there is an amount or property that is consideration for these purposes.

To the extent that the market value of the Holdco's rights is lesser than the amount of the debt outstanding, there may be no net forgiven amount because the consideration given by the Executive (the debtor) to Holdco (the creditor) for the purposes of section 245-65 of the ITAA 1997 being the value of the creditors' rights, would be equal to the market value of the debt.

Question 6

Summary

In these circumstances, there is an absence a tax benefit or where there is a tax benefit (incidental or otherwise), it would not lead to the conclusion that the arrangement was entered into for the sole or dominant purpose of obtaining a tax benefit.

Detailed reasoning

GENERAL ANTI-AVOIDANCE

Part IVA of the ITAA 1936 (Part IVA) is a general anti-avoidance provision. Broadly, it allows the Commissioner the discretion to cancel a tax benefit obtained by a taxpayer in relation to a scheme where the sole or dominant purpose of the scheme was to obtain a tax benefit.

Scheme

Part IVA requires the consideration of a 'scheme', which is defined in subsection 177A(1) of the ITAA 1936 as:

a.any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable by legal process; and

b.any scheme, plan, proposal, action, course of action or course of conduct.

Guidance of the meaning of the term 'scheme' can be found in case law. In Federal Commissioner of Taxation v. Hart (2004) 55 ATR 712 (Hart), per Gummow and Hayne JJ:

[43] [The] definition is very broad. It encompasses not only a series of steps which together can be said to constitute a "scheme" or a "plan" but also (by its reference to "action" in the singular) the taking of but one step.

Tax Benefit

There must be a tax benefit obtained by the taxpayer in order for Part IVA to potentially apply. Section 177C of the ITAA 1936 broadly provides that a tax benefit in relation to a scheme relates to:

a.amounts not being included in assessable income that would otherwise have been included in assessable income

b,amounts included as an allowable deduction that would otherwise not have been included as an allowable deduction

c.capital losses incurred that would otherwise not have been incurred

foreign income tax offsets being allowable that would otherwise not have been allowable, and

d.no liability to withholding tax on an amount that would otherwise have had a liability.

Dominant purpose

Part IVA also requires consideration of the purpose for which the scheme was entered into. Specifically, section 177D of the ITAA 1936 refers to the purpose of the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme. The person need not be the taxpayer.

The meaning of the purpose is clarified by subsection 177A(5) of the ITAA 1936, which explains that, where there are two or more purposes, the purpose includes the dominant purpose:

A reference in this Part to a scheme or a part of a scheme being entered into or carried out by a person for a particular purpose shall be read as including a reference to the scheme or the part of the scheme being entered into or carried out by the person for 2 or more purposes of which that particular purpose is the dominant purpose.

When determining whether the purpose of the scheme was to enable a tax benefit, the Commissioner must also have regard to the following eight factors specified in subsection 177D(2) of the ITAA 1936:

a. the manner in which the scheme was entered into or carried out

b. the form and substance of the scheme

c. the time the scheme was entered into and the length of time during which the scheme was carried out

d. the result that, but for the operation of Part IVA, would be achieved by the scheme

e. any change (being a change that has resulted from, will result of or may reasonably be expected to result from, the scheme). in the financial position of the relevant taxpayer that has resulted, or will result from, the scheme

f. any change (being a change that has resulted from, will result of or may reasonably be expected to result from, the scheme)in the financial position of any person who has, or has had, any connection with the relevant taxpayer

g. any other consequence for the relevant taxpayer, or for any person referred to in paragraph of the scheme having been entered into or carried out, and

h. the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph(f).

Focussing on the various elements of Part IVA should not obscure the way in which the Part as a whole is intended to operate. What constitutes a scheme is ultimately meaningful only in relation to the tax benefit that has been obtained since the tax benefit must be obtained in connection with the scheme. Likewise, the dominant purpose of a person in entering into or carrying out the scheme, and the existence of the tax benefit, must be considered against a comparison with reasonable alternative schemes capable of carrying out the commercial objectives of the arrangement.

In summary, section 177D of the ITAA 1936 provides that Part IVA applies to a scheme in connection with which a taxpayer has obtained a tax benefit if, after having regard to the eight specified factors, it would be concluded that any person who entered into or carried out the scheme, or any part of it, did so for the dominant purpose of enabling the relevant taxpayer to obtain the tax benefit.

The identification of a tax benefit requires consideration of the tax consequences of a 'counterfactual', or alternative hypothesis, that would have resulted had the scheme not been entered into. As stated by Gummow and Hayne JJ Hart:

[66] When [section 177C(1)] is read in conjunction with [former] s177D(b) it becomes apparent that the inquiry directed by Pt IVA requires comparison between the scheme in question and an alternative postulate. To draw a conclusion about purpose from the eight matters identified in [former] s177D(b) will require consideration of what other possibilities existed.

Guidance for identifying the counterfactuals of the scheme can be found in Practice Statement PS LA 2005/24: Application of the General Anti-Avoidance Rules (PS LA 2005/24). In particular, paragraph 74 lists the following considerations for determining the counterfactuals:

a. the most straightforward way of achieving the commercial and practical outcomes

b. commercial norms, such as standard industry behaviour

c. social norms, such as family obligations

d. behaviour of the parties around the time of the scheme compared with the period of the e. scheme's operation, and

f. actual cash flow.

PSLA 2005/24 further explains that if:

a)    the scheme had no effect other than obtaining the tax benefit, it is reasonable to assume that nothing would have happened if it was not carried out (paragraph 75), and

b)    a tax benefit is obtained in connection with the scheme which also achieves a wider commercial objective, then it would be reasonable to expect that in absence of the scheme the wider commercial objectives would have been pursued by an alternative arrangement (paragraph 76).

In Peabody v Federal Commissioner of Taxation (1993) 40 FCR 531 the Court explained that although the Commissioner has to consider each of the factors provided by former subsection 177D(b), this doesn't mean that each of the factors must point to the dominant purpose, stating that:

Some of the matters may point in one direction and others may point in another direction. It is the evaluation of these matters, alone or in combination, some for, some against that [former] s177D requires in order to reach the conclusion to which 177D refers.

The Commissioner's support of this view is provided in PS LA 2005/24 which states at paragraph 88 that all factors of subsection 177D(2) of the ITAA 1936 need to be taken into account with regard to the relevant evidence, and weighed together, to identify the dominant purpose of the scheme.

Cancellation of tax benefit

Where the Commissioner has made a determination under paragraph 177F(1)(a) of the ITAA 1936 that an amount is to be included in a taxpayer's assessable income, subsection 177F(2) provides that this amount shall be deemed to be included in the taxpayer's assessable income.

Application to your circumstances

The proposed arrangement (i.e. the transaction) would satisfy the requirements for a scheme pursuant to subsection 177A(1) of the ITAA 1936.

Tax benefit

To establish whether there is a tax benefit associated with the proposed arrangement, it is necessary to consider what is reasonably expected to occur, including the tax outcomes, if the scheme is not entered into. Taking into account the factors listed in paragraph 74 of PS LA 2005/24, a counterfactual to your proposed scheme, would be to issue new shares to the Executives.

Arguably, one of the tax benefits to be obtained may be from the application of capital gains tax concessions to amounts that may otherwise have been assessable dividends in the hands of the Individuals.

It is noted the fact that a taxpayer pays less tax if one form of the transaction rather than another is adopted, does not by itself demonstrate that Part IVA applies (paragraph 109 of PS LA 2005/24).

Dominant purpose

Whether your purpose in entering into the arrangement is to obtain a tax benefit, is determined with reference to the eight factors specified in subsection 177D(2) of the ITAA 1936:

                 i.         The manner in which the scheme is entered into or carried out

                ii.        The form and substance of the scheme

               iii.        The time at which the scheme was entered into and the length of the period during which the scheme will be carried out

               iv.        The result in relation to the operation of this Act, but for this part, would be achieved by the scheme

                v.         Any change in the financial position of the relevant taxpayer that has resulted, will result, or may be reasonably expected to result, from the scheme

               vi.        Any change in the financial position of any person who has, or has had, any connection with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme

              vii.        Any other consequences for the relevant taxpayer or person connected

             viii.        The nature of any connection between the relevant taxpayer and any person referred to in subparagraph (vi)

Conclusion

Based on the available information and having regard to the eight factors in section 177D of the ITAA 1936, a reasonable person would more likely than not conclude that there are 'tax benefits' in entering into this scheme.

To the extent any amount is not in the debtor's assessable income as a deemed dividend under Division 7A of the ITAA 1936 or the amount waived is not debt waiver fringe benefit or a minor benefit for FBTAA purposes, Division 245 of the ITAA 1997 may apply.

As such, there is no tax benefit to the Executives or Holdco as contemplated for the purposes of section 177D of the ITAA 1936 as fringe benefits tax or the commercial debt forgiveness rules would apply in the circumstances.

There is no tax benefit to the Individuals as the transaction is conducted on arm's length basis (at market value) for capital gains tax purposes.

Consequently, Part IVA of the ITAA 1936 will not apply to the scheme.

Question 7

Whether section 177E of the ITAA 1936 will apply to the transaction?

Summary

The transaction will not constitute a 'dividend stripping scheme' (or a scheme having substantially that effect) for the purposes of section 177E of the ITAA 1936 because the ordinary characteristics of a 'dividend stripping' scheme will not be apparent if the Individuals dispose of their shares for market value.

Detailed reasoning

DIVIDEND STRIPPING

Section 177E of the ITAA 1936contains an anti-avoidance provision regarding a scheme to reduce income tax through stripping of company profits.

The definition of 'scheme' is contained in section 177A of the ITAA 1936 and includes any plan, proposal, action, course of action or course of conduct. Given the broad definition, it is considered that the proposed transaction will constitute a scheme for the purposes of the anti-avoidance provisions.

The pre-conditions to the operation of the dividend stripping rules are contained in paragraphs 177E(1)(a)-(d), which state the provisions have effect where:

(a) as a result of a scheme that is, in relation to a company:

(i) a scheme by way of or in the nature of dividend stripping; or

(ii) a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping;

any property of the company is disposed of;

(b) in the opinion of the Commissioner, the disposal of that property represents, in whole or in part, a distribution (whether to a shareholder or another person) of profits of the company (whether of the accounting period in which the disposal occurred or of any earlier or later accounting period);

(c) if, immediately before the scheme was entered into, the company had paid a dividend out of profits of an amount equal to the amount determined by the Commissioner to be the amount of profits the distribution of which is, in his or her opinion, represented by the disposal of the property referred to in paragraph (a), an amount (in this subsection referred to as the notional amount ) would have been included, or might reasonably be expected to have been included, by reason of the payment of that dividend, in the assessable income of a taxpayer of a year of income; and

(d) the scheme has been or is entered into after 27 May 1981, whether in Australia or outside Australia.

A)   The four pre-conditions

The Commissioner's view on the nature of dividend stripping schemes is contained in Taxation Ruling IT 2627. The Commissioner identified four pre-conditions that must be satisfied in paragraphs 177E(1)(a)-(d) above, which are:

(a) As a result of a dividend stripping scheme or scheme having substantially the same effect, any property of the company is disposed of (paragraphs 6 to 21).

(b) The disposal of property represents, in whole or in part, a distribution of profits of the company, regardless of whether the profits existed at the time the property was disposed of (paragraph 22).

(c) If the profits had been paid as a dividend immediately before the scheme was entered into an amount would, or might reasonably be expected to, have been included in the taxpayer's assessable income (paragraph 24 to 25).

(d) The scheme was entered into after 27 May 1981, whether inside or outside Australia.

B)   Two limbs of the first pre-Condition

There are two limbs to the application of this the first pre-condition, the difference between them being the method by which profits of the target company are distributed. As stated by the Full Federal Court in Lawrence v Commissioner of Taxation [2009] FCAFC 29 ('Lawrence'):

[52] The first limb is concerned with schemes which are by way of or in the nature of dividend stripping; the second limb is concerned with other schemes, that is, schemes that are not by way of or in the nature of dividend stripping but which are schemes having substantially the same effect.

The Commissioner's view in IT 2627 is that in order for a scheme to fall within the second limb 'it would require at a minimum that company profits are effectively distributed to shareholders.' The profits do not need to be distributed specifically to the shareholder, as long as it can be determined that the payment has been made for the benefit of the shareholder or their associate.

It was noted by the Full Federal Court in Lawrence that:

[48] The reference to 'having substantially the effect of' a dividend stripping scheme is to a scheme that would be within the first limb, except for the fact that the distribution by the target company is not by way of dividend or deemed dividend.

Therefore, in order to determine whether the first pre-condition is satisfied, the common characteristics of a dividend stripping scheme must be identified. If the common characteristics exist then the manner in which the profits of the target company are distributed required examination to determine which limb the scheme falls within.

C)   Common characteristics of a dividend stripping scheme

The High Court in Commissioner of Taxation v Consolidated Press Holdings & Anor [2001] HCA 32 ('Consolidation Press') applied the following common characteristics of dividend stripping that had been identified by the Full Court of the Federal Court:

A target company with substantial undistributed profits

The sale or allotment of share to another party

The payment of a dividend to the purchaser or allottee

The purchaser escapes Australian tax on the dividends declared

The vendor receives a capital sum for their shares in an amount the same or very close to the dividends paid to the purchasers; and

The scheme was carefully planned for the predominant if not sole purpose of the vendor shareholders avoiding tax.

It is noted that many of these characteristics are consistent with the description of a dividend stripping scheme provided in Taxation Ruling IT 2627.

In the Federal Court, Hill J held that:

[A] scheme will only be a dividend stripping scheme if it would be predicated of it that it would only have taken place to avoid the shareholders in the target company becoming liable to pay tax on dividends out of the accumulated profits of the target company. It is that matter which distinguishes a dividend stripping scheme from a mere reorganisation.

Therefore, in order to determine whether a scheme will possess the ordinary characteristics of a dividend stripping scheme, it must be determined whether it would only have taken place to avoid the shareholders becoming liable to tax on dividends that they otherwise would have. This requires a consideration of the amount of tax, and the quantum of dividends, that would ordinarily have resulted.

Dominant purpose

Although a plain reading of the words contained in section 177E of the ITAA 1936 do not require determining the purpose for which the scheme was entered, the High Court has held that to constitute dividend stripping the scheme must have as its dominant purpose the avoidance of tax on the distributions of dividends by the target company (see Lawrence v Commissioner of Taxation [2009] FCAFC 29, [33] (Ryan, Stone, Edmonds JJ).

The tax avoidance purpose is ordinarily that of enabling the shareholders to receive profits of the company in a substantially tax-free form(see Commissioner of Taxation v Consolidated Press Holdings & Anor [2001] HCA 32, [129] (Gleeson CJ, Gaudron, Gummow, Hayne, Callinan JJ). Determining the purpose of an arrangement depends upon objective facts and is not concerned with the subjective motivation of the taxpayer. It is the dominant purpose of a person who entered into or carried out the scheme that must be determined in this manner(see Commissioner of Taxation v Consolidated Press Holdings & Anor [2001] HCA 32, [129] (Gleeson CJ, Gaudron, Gummow, Hayne, Callinan JJ)).

Application to your circumstances

The Commissioner accepts that the transaction is unlikely to constitute a scheme that demonstrates the common characteristics of a dividend stripping scheme as:

•         The shares are sold for market value.

•         The Individuals account for CGT obligations regarding the disposal of the shares.

•         The Executives are unrelated to the Individuals.

•         The Executives are receiving shares with reference to their years of service/level of responsibilities or same number of shares.

•         The Executives will hold the shares in their own right rather than tax effective structures.

•         The Executives will receive the same dividends and any franking that Individuals do for these ordinary shares.

•         The Executives will receive the capital proceeds from the sale of the shares (notwithstanding amounts may be applied against their outstanding loan balance).

As discussed, the Commissioner considers that in these circumstances it is reasonable to accept that any tax benefits (incidental or otherwise) would not lead to the conclusion that the arrangement was entered into for the sole or dominant purpose of obtaining a tax benefit.