Edited version of private advice

Authorisation Number: 1052009487967

Date of advice: 19 July 2022

Ruling

Subject: CGT - rollover and related tax issues

Question 1

Will the capital gain on the transfer of shares in the trading company (from Person A and Person B to the holding company) be disregarded under Division 615 of the ITAA 1997?

Answer

Yes

Question 2

Will the first element of the cost base of each of Person A and Person B's new shares in the holding company be equal to the cost bases of their shares in the trading company?

Answer

Yes

Question 3

Did the trading company's business goodwill maintain its status as a pre-CGT asset until the trading company issued dividend access shares on date C?

Answer

Yes

Question 4

Was the pre-CGT goodwill in the trading company deemed to be acquired when dividend access shares were issued by the trading company on date C under Division 149?

Answer

Yes

Question 5

Is the cost base of the goodwill in the trading company its prevailing market value when dividend access shares were issued in the trading company on date C under Division 149?

Answer

Yes

Question 6

Are the holding company's shares in the trading company all post-CGT on the basis that all of the trading company's assets are post-CGT?

Answer

Yes

Question 7

Is the cost base of the holding company's post-CGT shares in the trading company the cost bases of the trading company's post-CGT assets less its related liabilities at the rollover date?

Answer

Yes

Question 8

Is the cost base which is attributable to the trading company's work in progress and its debtors the face value of these assets?

Answer

No

Question 9

Do the liabilities of the trading company refer to legal liabilities (ie. presently existing pecuniary obligations) including the provision for income tax, rather than non-incurred amounts and non-legal liabilities like deferred tax liabilities and right of use liabilities?

Answer

Yes

Question 10

Will the holding company be entitled to a tax offset in respect of franked dividends which are paid to the holding company out of the trading company's post-interposition profits?

Answer

Yes

Question 11

Do sections 177E and 177F of the ITAA 1936 apply?

Answer

No

Question 12

Will the arrangement be considered part of a dividend stripping operation for the purposes of section 207-155 of the ITAA 1997?

Answer

No

Question 13

Will the Commissioner seek to apply Part IVA of the ITAA 1936 to the scheme comprised of the steps described in the 'relevant facts and circumstances' section of this ruling which results in the interposition of the holding company above the trading company?

Answer

No

This ruling applies for the following period:

Redacted for this edited version

The scheme commences on:

Redacted for this edited version

Relevant facts and circumstances

Overview

1.         The D family group is proposing to interpose a new head company over an existing trading company. The current shareholders will transfer their shares in the trading company to the new company. The D family seek a private ruling addressing 13 questions about the tax consequences of this arrangement.

2.         We describe the relevant entities in Table 1.

Table 1: entities relevant to this private ruling

Ownership changes

3.         Person A and Person B formed a partnership some years before 20 September 1985. The partnership operated a business in Industry I, with Person A and Person B holding their partnership interests beneficially (not on trust). Person A and Person B were equal partners in the partnership (50% interests each).

4.         The trading company was incorporated on a date after 20 September 1985. It was a shelf company, created with two ordinary shares. Person A and Person B acquired one share each in the trading company shortly after the incorporation date. There were two unrelated original subscribing shareholders, but the original subscription shares were redeemed when Person A and Person B were issued with their shares. Person A and Person B held their shares in the trading company beneficially, not on trust for the benefit of others.

5.         The partnership formed by Person A and Person B transferred its business goodwill to the trading company shortly after incorporation. As consideration, the trading company issued an instrument to Person A and Person B. That instrument required the trading company to pay $X to Person A and Person B (each would receive half of $X). The trading company recorded the instrument in its accounts as a loan payable owed to Person A and Person B. For tax purposes, the parties claimed a rollover for the transfer under the former section 160ZZN of the Income Tax Assessment Act 1936. Rollover consequences (including deemed acquisition time) didn't extend to Person A and Person B's shares in the trading company, because they weren't issued with shares as part of the business transfer. The parties made an election to apply the rollover for the goodwill transfer at the time.

6.         Person A and Person B:

•                were the only beneficial owners of all the trading company's shares immediately after the goodwill was transferred to the trading company

•                are currently the only shareholders in the trading company, holding one ordinary share each.

7.         However, the trading company has had other classes of shares on issue in its history. All other share classes were non-voting but had rights to dividends at the board's discretion. The shares were held by Person A, Person B, Person E, Person F, Person G, and the H Investment Trust. The client describes the classes held by:

•                Person A, Person B, and the H Investment Trust as redeemable preference shares (RPS for short)

•                Person E, Person F, and Person G as dividend access shares (DAS for short).

8.         We detail the trading company's share history (while held by the D family) in Table 2.

Table 2: the trading company's share history (while the trading company was held by the D family)

9.         All shares listed in Table 2, apart from the ordinary and K class shares, were cancelled on date J. The trading company and the relevant shareholders entered a shareholders' agreement shortly before date J. The shares were cancelled with the trading company paying the shareholders $1 for each share. The client's advisers determined that this was the market value, taking the view that the RPS and DAS had limited value: without attached voting rights, shareholders only received dividends at the board's discretion. The shares were cancelled under the agreement on date J.

10.      The shareholders' agreement happened after discussions between Person A, Person B, the trading company's Chief Financial Officer, and the family's professional (accounting and legal) advisers. Person A and Person B wished to simplify their life, partly as a precursor to semi-retiring, and partly for estate planning. The trading company's accounting and tax advisers recommended cancellation because:

•         the RPS and DAS were surplus to the family's needs and needlessly complicated the trading company's shareholding structure

•         it would be consistent with the ATO's views on dividend access shares in Taxpayer Alert 2012/4 and TD 2014/1.

11.      The K Class shares were part of a scheme proposed by the group's former tax advisers.

•         Those former advisers recommended and implemented the transaction to limit the group's commercial liability.

•         The trading company issued X K Class redeemable preference shares to the H Investment Trust. (The issue date has been redacted for the purposes of this edited version.)

•         The K Class redeemable shares had the following rights. They had a paid-up capital amount of $X per share. They were non-voting shares, but carried a right to non-cumulative dividends at the directors' discretion. The shares ranked in priority to all other shares on winding up or capital reduction, but only to return the paid-up capital amount. They didn't have any other right to participate in surplus profits or assets on winding up.

•         The trading company paid a $X franked dividend to the H Investment Trust.

•         The H Investment Trust distributed that dividend to a corporate beneficiary in the family group. That distribution wasn't paid, so the distribution created an unpaid present entitlement.

•         Some time later, the trading company redeemed the K Class shares for their issue price ($X each, or $X in total).

Succession plans

12.      Person A and Person B's succession plan for the business is for Person E and Person G to own and manage the business. Person A and Person B are nearing retirement. Person A and Person B intend:

•         to hold their shares in the trading company until their death

•         for Person E and Person G to inherit the trading company shares when Person A and Person B die.

13.      Person A and Person B are gradually stepping back as Person E and Person G take on more responsibilities, with Person A and Person B having more of a strategic support role. Person G and Person E are employees with managing responsibilities. They are both heavily involved in running the business day-to-day. The family plans that Person E and Person G will continue in their current roles and run the business after Person A and Person B die.

Dividend history

14.      The trading company has paid dividends on all its share classes. All dividends were fully franked. the trading company's dividend history is described in Table 3.

(Table 3 has been substantially redacted for the purpose of this edited version.)

Table 3: the trading company's dividend history

Tax events

15.      The ATO had some interactions with the D family about the $X dividend paid on the K Class shares. Details have been redacted for the purposes of this edited version. The ATO raised issues about the correct tax treatment for dividends paid on the K Class redeemable shares.

16.      The ATO and the D family agreed to resolve the dispute through an agreement.

17.      The ATO review didn't raise Person A and Person B's RPS, or the DAS, as tax risks.

18.      This paragraph has been redacted for the purposes of this edited version.

19.      After engaging new tax advisers, the D family has had a 'RAP' (reasonably arguable position) file for some years. That RAP file identifies and forms positions on possible tax risks. The D family has had recently introduced a documented tax governance framework.

Business changes

20.      The business (which Person A and Person B started as a partnership sometime before 20 September 1985) specialised in Industry I. Active subcontracting work stopped after a few years. From that point, the business was a contract management business, which employed some workers. However, it engaged mainly subcontractors to do the physical work.

21.      For some years, the business activities only related to Subcategory K within Industry I.

22.      Sometime before 20 September 1985, the business started expanding into Subcategory L within Industry I, and stopped Subcategory K work soon after. Before 20 September 1985, the business:

•         received its first Subcategory L contract

•         completed the last Subcategory K project

•         was doing 100% Subcategory L work

•         won its first government project (with Department/Agency M)

•         transitioned to Subcategory L because that work had higher demand and was more profitable.

23.      Before 20 September 1985, the business:

•         the business had less than X employees

•         was managed by Person A and Person B

•         used Person A and Person B's personal residence as the office.

24.      Sometime after 20 September 1985, the business' office moved out of Person A and Person B's residence into premises elsewhere.

25.      Table 4 compares some information about the business between 1985 and Date C.

Table 4: comparing the business between 1985 and Date C

26.      The trading company started Industry N work some years after date C, and there was some degree of separation between the Industry I and Industry N divisions. The trading company appointed a general manager for each division. Each division had separate trading names, but used the same accounting, quality assurance, and safety systems. The trading company moves staff between areas, so some staff in each division have worked in the other division before. There's considerable overlap in customers: the trading company has performed both Industry I and Industry N work for many government clients.

27.      Today, the trading company employs thousands of staff across both divisions.

28.      The trading company has been providing its financial statements to customers for many years. At first, this was mainly to government customers. Now, many of its private sector customers also require financial statements. Tender submissions usually require between two and three years of audited financial statements. The trading company also needs to provide financial statements to financial assessment companies during a tender process. The trading company provides financial statements annually to its long-term contract customers. The trading company also provides financial statements to insurers.

Related party loans

29.      The trading company has made loans to related parties in the D family's group. The trading company has non-current loans totalling about $X, mostly to entities connected with the D family. About $X was lent to a related company which receives a higher interest rate. The remaining loans were mostly made for related entities to acquire, improve, or develop real property.

30.      While the D family has no fixed plans, it expects the trading company to make similar loans to related parties for similar purposes.

Proposed interposition

31.      The applicant's group is planning to interpose a head company over the trading company through the following steps. Step 1 has already taken place.

•         Step 1: Person A and Person B have acquired the holding company as a shelf company. the holding company was registered a short time before the ruling period. Person A and Person B acquired one ordinary share each, on the same day. They each hold one ordinary share in the trading company. The holding company is a dormant company. It hasn't undertaken any activities or held any assets so far, and won't before the planned interposition.

•         Step 2: the holding company will acquire all the trading company's shares from Person A and Person B.

•         Step 3: As consideration for receiving the trading company's shares from Person A and Person B under Step 2, the holding company will issue two further shares to Person A and Person B (one each).

32.      The trading company doesn't currently propose to pay any dividend either before or after the interposition.

33.      The holding company's shares aren't and won't be redeemable shares.

34.      The applicant is not proposing any other transactions which will take place during, before, or after the interposition.

Justifications (related party loans, tax governance)

35.      The applicant submits that it has two objectives for the proposed interposition.

•                First, to limit the trading company's ongoing trading liability, while retaining sufficient assets in the holding company so that it has a strong balance sheet for operational efficiency and customer perceptions

•                Second, to relocate loans to related parties from the trading company to the holding company, so that the trading company's customers have no visibility over them.

36.      The applicant submits that cancelling the RPS and DAS on date J was unrelated to the proposed interposition. Rather, the cancellation was done because the share structure was unnecessarily complicated and produced no additional benefit to family members. They submit:

•                the RPS provided Person A and Person B with no additional benefit because they held all the ordinary shares

•                the DAS provided Person E, Person G, and Person F with no additional benefit because they were discretionary beneficiaries of the H Investment Trust, so they could request distributions from that source instead

•                cancelling the shares simplified the share structure and allowed Person A and Person B to leave their ordinary shares to Person E and Person G, who would then have 100% control of the trading company

•                removing the RPS and DAS was consistent with the ATO's views on DAS in Taxpayer Alert 2012/4 and TD 2014/1.

Other points

37.      Person A, Person B, the trading company, the holding company, Person E, Person F, and Person G are all Australian tax residents, and have always been Australian tax residents. (Just to confirm, Person A and Person B were Australian tax residents on the date when the partnership transferred its business goodwill to the trading company.) Tax residency isn't expected to change for any entities after the interposition.

38.      The trading company isn't a tax consolidated group, and the trading company has never been the head company of a tax consolidated group).

39.      The trading company has substantial retained earnings and a substantial (positive) franking credit balance.

40.      Redacted for the purposes of this edited version.

41.      Redacted for the purposes of this edited version.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 8-1

Section 104-10

Section 104-35

Section 104-230

Section 109-5

Section 110-25

Section 110-45

Section 112-20

Section 124-10

Section 149-10

Section 149-15

Section 149-30

Section 149-35

Section 152-20

Section 204-30

Section 207-20

Section 207-145

Section 207-155

Section 207-157

Section 615-5

Section 615-10

Section 615-15

Section 615-20

Section 615-25

Section 615-40

Section 615-65

Section 960-115

Section 960-130

Section 960-135

Section 995-1

Income Tax Assessment Act 1936

Former section 82KZC

Former section 160APHO

Former section 160M

Former section 160ZZN

Former section 160ZZRR

Former Section 160ZZRS

Former section 160ZZRT

Former section 160ZZS

Section 177A

Section 177C

Section 177CB

Section 177D

Section 177E

Section 177EA

Income Tax Rates Act 1986

Section 23

Section 23AA

Section 23AB

Reasons for decision

In these reasons for decision, where a specific Act isn't mentioned, references to:

•         hyphenated section numbers (eg, section 615-5) mean the Income Tax Assessment Act 1997

•         un-hyphenated section numbers (eg, section 177A) mean the Income Tax Assessment Act 1936

•         Division 615 mean Division 615 of the Income Tax Assessment Act 1997

•         Part IVA mean Part IVA of the Income Tax Assessment Act 1936.

Question 1

Will the capital gain on the transfer of shares in the trading company (from Person A and Person B to the trading company) be disregarded under Division 615 (ITAA 1997)?

Summary

42.      Yes. The proposed interposition of the holding company as a holding company above the trading company will qualify for rollover relief under Division 615.

Explanation

Overview of conditions for Division 615 rollover relief: each original shareholder must exchange their shares in the original company for an equivalent ratio of ordinary shares in the interposed company.

43.      Division 615 allows rollover relief for shareholders meeting relevant eligibility conditions if they surrender shares in a company in exchange for shares in an interposed head company. Broadly, the eligibility conditions include that the shareholders' economic ownership is maintained, and they receive nothing else under the relevant scheme for reorganising. If shareholders qualify for relief, gains and losses from the transaction are disregarded. The tax characteristics of their original shares (cost base and pre/post-CGT status) transfer to their replacement shares in the interposed company.

44.      Broadly, Division 615 rollover relief is available if seven conditions are met. We loosely summarise them.

•                Under a scheme for reorganising the target company's affairs, exchanging members either dispose of all their shares, or alternatively have them cancelled, in exchange for shares in the interposed company: paragraph 615-5(c); subsection 615-10(1).

•                Exchanging members receive nothing else under that scheme: paragraphs 615-5(c) and 615-10(1)(e).

•                The interposed company must own all shares in the original company immediately after the completion time: section 615-15.

•                Each exchanging member must own same percentage of shares, and the same market value ratio in the interposed company, as they had in the original company: subsections 615-20(1) and (2).

•                The exchanging members must either be Australian residents, or the shares in both companies must be taxable Australian property: subsection 615-20(3).

•                Shares in the interposed company mustn't be redeemable: subsection 615-25(1).

•                Immediately after the scheme, the exchanging members must own all[1] the shares in the interposed company: subsections 615-25(2) and (3).

Which steps are included in the 'scheme for reorganising'?

45.      Determining the scope of the relevant scheme is important when applying the conditions in Division 615. Some conditions apply to things done 'under a scheme for reorganising its [the company or unit trust's] affairs'. Most conditions will normally be met if the scheme for reorganising is limited to the interposition of a head company. However, some conditions might be failed where other surrounding events (before, during, or after the interposition) are characterised as forming part of the scheme.

46.      Whether the D Group qualify for rollover relief may depend on whether the scheme is limited to the interposition of the holding company. All conditions will be met if the scheme for reorganising is limited to Person A and Person B exchanging their the trading company shares for the holding company shares. However, some conditions could be failed if the scheme includes cancelling RPS and DAS, assuming the same ending structure proposed in this ruling application. (In other words, we've assumed that Person A and Person B will end up holding the only ordinary shares in the holding company.)

•                First, they may have failed the ratio requirements for the number and market value of shares.

•                Second, they would have received 'something else' under the scheme, being the redemption price for their RPS.

47.      How do we determine which steps form part of the scheme? There's no ATO view directly on point, but ATO documents address two similar provisions.

•                TR 97/18[2] was about predecessor provisions (in the Income Tax Assessment Act 1936) which used the phrase 'scheme for the reorganisation of the affairs' (of a unit trust or company).

•                TD 2020/6[3] is about the restructuring of a demerger group.

48.      Broadly, both documents suggest that the relevant reorganisation or restructuring can include steps before and after a transaction which, taken alone, would meet the rollover requirements.

49.      We think we should take a similar approach when determining the scope of a reorganisation for the Division 615 rollover. We think whether transactions form part of the reorganisation of the company's affairs is a question of fact, to be determined objectively. The reorganisation could include steps before, during, and after, if there are objective circumstances suggesting they are connected. Time is a factor, but just because there's a significant time lag doesn't necessarily mean two transactions aren't connected.

Balancing several considerations, we think the scheme for reorganising should be limited to the interposition step. It won't extend to the earlier cancellation of RPS and DAS because that step has a compelling independent explanation.

50.      We've identified five points which we think are relevant to determining whether cancelling the RPS and DAS is part of this scheme for reorganising the trading company's affairs. Those factors are:

•                the time between the cancellation and the interposition

•                whether the transactions were contingent upon each other

•                the applicant's justifications for the two events

•                the extent to which the cancellation facilitated eligibility for the rollover

•                other tax considerations, such as general tax governance and ATO compliance action.

51.      Here, we've placed significant weight on the fourth and fifth factors when we balance them. In other words, we think the tax related factors are particularly important here. Cancelling the RPS and DAS was essential for the interposition to be a practical option for the client. Similarly, cancelling them arguably removed a substantial tax risk for the client, and reduced the risk of future tax disputes with the ATO. The other factors seem less important.

•                We're not convinced that there were compelling reasons to simplify the group structure for estate planning reasons. Two of the DAS holders (Person E and Person G) are expected to inherit shares in the trading company anyway.

•                The existing DAS don't seem redundant. Dividends were regularly paid to Person F on their DAS. Even if family members could have received income from alternative sources, the existing structure allows flexibility to pay franked dividends on the DAS.

•                While the cancellation is formally separate and there's no evidence the agreement was contingent on a future interposition happening, that doesn't mean the two events can't be connected in a practical or planning sense.

•                Finally, a gap of a couple of years between steps isn't inconceivable for a significant business restructure.

52.      On balance, we think that cancelling the RPS and DAS isn't part of the scheme for reorganising the trading company. We see two objectively compelling reasons why the RPS and DAS were cancelled. Eligibility for rollover relief is one, improving tax governance is another. We think that the cancellation improved rollover eligibility prospects, and that's a strong reason to link the two events. But equally, we think it makes sense that a large private group which was previously audited over RPS tax issues would later cancel RPS and DAS to reduce its tax risk. Therefore, we don't think it should be treated as merely a preliminary step towards the proposed interposition.

53.      Given our conclusion, it follows that the proposed interposition will qualify for rollover relief under Division 615. Since we've concluded that cancelling the RPS and DAS aren't part of the scheme for reorganising, that preliminary step won't cause the 'nothing else' and (number and market value) ratio conditions to be failed. See Table 5.

Table 5 - Division 615 conditions

Conclusion on Question 1: eligible for rollover relief.

54.      The proposed interposition will qualify for rollover relief under Division 615.

Question 2

Will the first element of the cost base of each of Person A and Person B's new shares in the holding company be equal to the cost bases of their shares in the trading company?

Summary

55.      Yes. The first element of the cost base of Person A and Person B's new shares in the holding company will equal the cost bases of the trading company shares they transfer to the holding company under the interposition.

Explanation

Relevant law: cost base consequences for a Division 615 rollover

56.      Broadly, replacement shares under a Division 615 rollover inherit the CGT characteristics of the original shares. Section 615-40 says that the consequences in Subdivision 124-A also apply to a rollover under Division 615 as if it were a rollover covered by Division 124. Those consequences include:

•                capital gains and capital losses from the original asset are disregarded: subsection 124-10(2)

•                new assets acquire the cost base of (post-CGT) original assets under a formula in subsection 124-10(3)

•                if the original assets were pre-CGT assets, the new assets will also be deemed to be pre-CGT assets: subsection 124-10(4).

57.      Subsection 124-10(1) says the consequences in section 124-10 apply when:

•                your ownership of a CGT asset (known as an original asset) ends, and

•                you acquire one or more CGT assets (known as new assets) in a situation "covered by this Division". Read with section 615-40, this includes a rollover covered by Division 615.

58.      Broadly, Division 149 says something is a pre-CGT asset if you last acquired it after the CGT came into effect (20 September 1985). See our explanation in Questions 3 and 4.

59.      Subsection 109-5(1) says in general, you acquire a CGT asset when you become its owner. There's a list of specific rules for certain CGT events in subsection 109-5(2).

Applied to Person A and Person B: their replacement shares in the holding company will inherit the cost base of their former ordinary the trading company shares

60.      Person A and Person B's CGT consequences will be determined under section 124-10.

•                We decided in Question 1 that Person A and Person B are eligible for rollover relief under Division 615.

•                Under the scheme, Person A and Person B's ownership of their the trading company shares will end when they transfer them to the holding company. The trading company shares are 'original assets'.

•                Person A and Person B will acquire shares in the holding company when the holding company issues them, because they will become owners of those shares once issued.[6] The holding company shares are 'new assets'.

•                It follows that Person A and Person B have had their ownership of original assets end, and have acquired new assets, in a circumstance covered by Division 615.

61.      Person A and Person B can disregard any capital gain or loss on transferring the trading company shares to the holding company will be disregarded under subsection 124-10(2).

62.      Person A and Person B's the trading company shares are post-CGT assets because they first acquired their shares in 1988.

63.      Since Person A and Person B's the trading company shares are post-CGT assets, their replacement the holding company shares will inherit the trading company share cost base under the formula in subsection 124-10(3).

Question 3

Did the trading company's business goodwill maintain its status as a pre-CGT asset until the trading company issued dividend access shares on date C?

Summary

64.      Yes. We accept that first Person A and Person B in partnership, and then the trading company, carried on the same business between 20 September 1985 to date C. We also accept that these parties were eligible to apply a rollover under tax legislation in force at the relevant time. It follows that the business goodwill remained a single, pre-CGT asset for that period.

Explanation

Brief overview about the rules about preserving and losing pre-CGT asset status

65.      Division 149 is about pre-CGT assets.

66.      The effect of section 149-10 is that a CGT asset will be pre-CGT if its current owner last acquired it before the CGT was introduced, and it hasn't lost pre-CGT status. Division 149 has rules about losing pre-CGT status. Former section 160ZZS of the ITAA 1936 had similar rules.

67.      The trading company acquired the business goodwill from Person A and Person B sometime after 20 September 1985. Person A and B were in partnership together at that time.

68.      Therefore, the trading company's business goodwill would have been treated as a post-CGT asset (in the trading company's hands) from acquisition unless it was deemed to be acquired earlier by another provision.

69.      Rollovers are one example where an asset could be treated as having been acquired at an earlier time.

Section 160ZZN rollover: the taxpayer must dispose of an asset to a company, as consideration for shares or securities in that company

70.      Broadly, former section 160ZZN gave rollover relief to taxpayers who disposed of assets to a company under certain conditions. If the original taxpayer acquired the asset before 20 September, the company was deemed to have acquired the asset before that date: see paragraph 160ZZN(2)(e). There were two alternative subsections which listed eligibility conditions. Broadly, subsection (2) applied to non-trustees, and (4) applied to trustees. As in force at the relevant date,[7] there were five relevant conditions applying to non-trustees. We list and apply them in Table 6.

(We've ignored subsection 160ZZN(4) because Person A and Person B didn't hold their business goodwill on trust.)

Table 6: conditions in former subsection 160ZZN(2)

Can a partnership apply a section 160ZZN rollover?

71.      Paragraph 160ZZN(2)(a) requires that a (non-trustee) taxpayer disposes of an asset to a company.

72.      Broadly, a taxpayer disposes of an asset when ownership changes to another entity. Former section 160M was about when a disposal and acquisition had happened. Subsection 160M(1) said that a change in ownership is deemed to be a disposal by the person who owned it immediately before, and an acquisition by the person who owned it immediately after. Subsection 160M(1A) said that a change in legal ownership doesn't constitute a change in ownership unless beneficial ownership also changed.[9]

73.      We think there's two indications that a partnership should be treated as a disposing taxpayer under former section 160ZZN rollover. First, there were two references in section 160ZZN to partnerships. Paragraph (2)(ca) and subsection (6) applied where the 'taxpayer is a partnership'. Those provisions would be meaningless if a partnership couldn't be a disposing taxpayer. Second, the Explanatory Memorandum introducing section 160ZZN suggested the rollover would be available to partnerships:[10]

Section 160ZZN... contains measures to provide rollover relief where an individual, partnership or trust transfers an asset (other than a personal-use asset) to a company solely in exchange for stock or securities of the company and immediately after the transfer ... in the case of a partnership, the partners beneficially own shares in the company in the same proportion as their interests in the partnership immediately before the disposal....

Relevant principles about business goodwill: business goodwill will remain a single pre-CGT asset if the same business continues to be carried on.

74.      TR 1999/16[11] is the ATO's view about the CGT consequences for transactions affecting business goodwill. We paraphrase a few points made in TR 1999/16.

•                Business goodwill is a single CGT asset. [paragraph 16]

•                Goodwill for a pre-CGT business remains a pre-CGT asset if the same business continues to be carried on. [17]

•                If an old business ceases and a new business commences, the old goodwill asset ceases to exist and a new goodwill asset is acquired [18]

•                Whether the same business is being carried on is a question of fact and degree and depends on the circumstances. [20]

•                The same entity can have multiple businesses, each with their own business goodwill asset. This test is different to the 'same business test' which treats an entity as having a single business.[12] [20 and 73].

75.      TR 1999/16 approach is to test whether the business' 'essential nature or character' has changed.

•                The business doesn't need to be identical. It can expand, contract, or change while still being the same business. Examples of (permissible) organic growth, expansion or diversification might be adopting new compatible operations, servicing different clients, or offering improved products or services. [21]

•                However, the business won't be the same if it changes its essential character through planned/systemic change or sudden and dramatic change by acquiring or shedding activities on a considerable scale. [24]

76.      TR 1999/16 says whether an increase is a mere expansion or a separate business depends on several factors. At paragraph 62, it suggests these factors include:

•                the nature of new business operation

•                types of customers that the business operation or activity attracts

•                the extent to which business operation is subject to same integrated management and control

•                whether each operation are treated separately for banking and accounting purposes

•                whether the business uses one or more different trading names.

Applying TR 1999/16 to the trading company's business goodwill

77.      We've focused our discussion on whether any changes between 1985 and date C caused a fundamental change to the business. We don't need to consider whether the trading company's Industry N division represented a change of business, or commenced a separate business for the trading company. The trading company lost the pre-CGT status of its business goodwill in date C: see our explanation about Question 4. Similarly, we don't need to consider whether any changes before 1985 represented a change of business: the business goodwill would still be a pre-CGT asset (until date C) in either event.

78.      We summarise what we think are the important factors here.

•                By 1985, the business did purely Subcategory L projects. Person A and Person B's business had stopped Subcategory K work.

•                In 1985, the Person A and Person B ran the office out of their garage. They moved premises later, moving from a garage to an office, and stayed there until after date C.

•                Clients changed in the period between 1985 and date C. They began taking on government clients and larger Subcategory L projects.

•                They expanded from less than X employees to a few more employees in the same period.

•                Revenue also expanded somewhat.

•                The business name changed when the partnership switched to a company.

•                Person A and Person B managed the business throughout that period. That only changed after date C when each division engaged a general manager.

79.      We think these changes are consistent with being the same business throughout the period from 1985 and date C. The business carried on first by Person A and Person B, and then the trading company, is best characterised as a single Subcategory L project management business. The work was exclusively Subcategory L, and the managers didn't change. The business gradually shifted to larger clients, projects, engaged more employees, switched premises, and increased their revenue. We don't characterise any of those changes as a fundamental departure from previous practices, or a change to the business' essential character. Rather, they're consistent with natural growth and expansion. Following the approach in TR 1999/16, we think the business goodwill remained a single CGT asset for that period.

80.      It follows that the changes in the business between 1985 and date C didn't cause the business to stop being a single, pre-CGT asset.

Conclusion: the trading company's business goodwill remained a single, pre-CGT asset until date C

81.      The trading company's business goodwill remained a single, pre-CGT asset between 1985 and date C. It inherited the pre-CGT status from Person A and Person B when applying the former section 160ZZN rollover at the relevant date. It didn't lose that status because of any changes in the business between 1985 and date C.

Question 4

Was the pre-CGT goodwill in the trading company deemed to be acquired when dividend access shares were issued by the trading company on date C under Division 149?

Summary

82.      Yes. the trading company's business goodwill stopped being a pre-CGT asset when the trading company issued dividend access shares. the trading company will be deemed to have acquired the business goodwill on date C.

Explanation

Background principles about pre-CGT assets: the original owners need to maintain at least a 50% beneficial interest in the assets and income.

83.      Division 149 is about when an asset is, or ceases to be, a pre-CGT asset.

84.      Section 149-10 says an asset is a pre-CGT asset if several conditions are met. These include:

•                the entity must have last acquired the asset before 20 September 1985

•                the asset hasn't stopped being a pre-CGT asset for the entity under Division 149

•                the entity wasn't (immediately before the start of the 1999 income year) taken under former subsection 160ZZS or subdivision C of Division 20 of former Part IIIA of the ITAA 1936[13] to have acquired the asset after 20 September 1985.

85.      Broadly, Division 149 deems pre-CGT assets to be post-CGT assets where the majority underlying interests in the assets have changed.

•                Subsection 149-30(1) says an asset stops being a pre-CGT asset at the earliest time when majority underlying interests in the asset were not had by ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985.

•                The effect of subsection 149-30(2) is that there'll be no change in majority underlying interests where the Commissioner thinks it reasonable to assume that there's been no change.

•                Subsection 149-15(1) says majority underlying interests in a CGT asset consists of more than 50% of the beneficial interests that ultimate owners have in the asset, or in any ordinary income that may be derived from the asset.

•                Subsection 149-15(3) says ultimate owners includes individuals.

86.      Former section 160ZZS (as in force in date C)[14] had a similar effect to Division 149.

•                Under subsection 160ZZS(1), pre-CGT assets were deemed to have be post-CGT assets unless the Commissioner was satisfied that the same natural persons continued to hold majority underlying interests in them since before the CGT started.

•                When an asset stopped being a pre-CGT asset, it was taken to have been acquired at that time, for its market value: see subsection (1A).

•                Former section 82KZC[15] said 'majority underlying interests' meant more than half of the beneficial interests held by natural persons (directly or through interposed entities) in:

o      the property, and

o      any income that may be derived from it.

87.      Section 160ZZS was the law in effect about when an asset ceased to be a pre-CGT asset at date C.[16]

88.      Two ATO IDs illustrate how Division 149 applies to shares carrying discretionary dividend rights. Shares carrying discretionary dividend rights were issued in both scenarios.

•                In ATO ID 2011/101[17], the original (pre-CGT) shareholders continued to hold all shares on issue: no new shareholders acquired shares.

•                However, in ATO ID 2011/107[18], new shares with discretionary rights to dividends were issued to a new shareholder.

•                In the first ATOID - 2011/101 - the majority underlying interests were maintained because the original owners, collectively, would still receive 100% of any dividend paid.

•                In the second ATOID - 2011/107 - majority underlying interests weren't maintained because the discretionary dividend rights could cause the original owners to receive less than 50% of any dividend.

89.      Since section 160ZZS and Division 149 had similar effect, we think ATO guidance on Division 149 would also apply to section 160ZZS.

90.      In this context, individuals can have a beneficial interest in assets held by interposed companies.

•                The term 'beneficial interest' wasn't defined at the relevant time. Sections 160ZZRR, 160ZZRS, and 160ZZRT defined relevant terms,[19] but those sections were introduced in 1997 and weren't in force in date C.[20]

•                In Case Y59, the AAT rejected the taxpayer's argument that a shareholder had no beneficial interest in assets held by a company for the purposes of section 160ZZS.[21]

•                An ATO officer confirmed this was the ATO view in a meeting of the Losses and CGT Sub-committee in December 1993.[22]

Applying these principles

91.      We'll restate some relevant facts for convenience.

•                Here, Person A and Person B ran the business through a partnership (in equal partnership with 50% interests each) until the relevant date.

•                On that date, they transferred the business to the trading company. They each held one ordinary share in the trading company. There were no other shares on issue: Person A and Person B were the only beneficial owners of the trading company's shares, holding 50% each.

•                The parties claimed a section 160ZZN rollover. We concluded at Question 3 that the parties were eligible to claim that rollover. The trading company was deemed to have acquired the business goodwill before 20 September 1985 under paragraph 160ZZN(2)(e).

•                Some years later, the trading company issued redeemable shares with discretionary dividend rights each to Person A and Person B.

•                On date C, the trading company issued E Class shares to Person E, and F Class shares to Person G. Each class carried discretionary dividend rights.

92.      If the business goodwill was the same pre-CGT asset, it became a post-CGT asset on date C. The majority underlying interests in business goodwill were maintained up until then.

•                Person A and Person B were the two individuals holding the business assets when it was run by the partnership, with direct rights to share in the business income.

•                After the goodwill was transferred, Person A and Person B were the sole individual shareholder in the trading company. They had effective economic ownership of the business assets, through the company. They had sole rights to receive income derived from the business, as dividends through the company, up until date C.

•                Issuing redeemable discretionary shares some years later didn't change that: Person A and Person B were the only shareholders. Regardless of whether dividends were paid on the redeemable or ordinary shares, between them they would receive 100% of any dividend if declared.

•                However, majority underlying interests changed when the trading company issued E Class and F Class shares with discretionary dividend rights to Person E and Person G in date C. The discretionary dividend rights mean it was possible that dividends could be paid on the class shares, but not on the ordinary or redeemable. From that point, Person E and Person G could have received more than 50% of any dividends declared. The original owners - Person A and Person B - could have received less than 50% of any dividends declared. They no longer held majority underlying interests.

Conclusion on Question 4: the business goodwill became a post-CGT asset when the trading company issued DAS because Person A and Person B stopped holding majority underlying interests.

93.      It follows that the business goodwill is a post-CGT asset. When DAS were issued to Person E and Person G, Person A and Person B would have ceased to hold majority underlying interests in the goodwill. Section 160ZZS would have applied on date C. It follows that the trading company had already been taken under former subsection 160ZZS(1) to have acquired the asset on or after 20 September 1985. The business goodwill isn't a pre-CGT asset under paragraph 149-10(b).

Question 5

Is the cost base of the goodwill in the trading company its prevailing market value when dividend access shares were issued in the trading company on date C under Division 149?

Summary

Yes. Under both current law, and the CGT rules in force in date C, the cost base of assets losing their pre-CGT status is their market value at that time.

Explanation

94.      Under both the current and former law, when a pre-CGT asset loses its pre-CGT status, the first element of cost base is its market value at that time.

•                Section 149-35 says the first element of cost base when it stops being a pre-CGT asset is the asset's market value at the time referred to in subsection 149-30(1).

•                Subsection 149-30(1) refers to the earliest time when majority underlying interests in the asset were not had by ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985.

•                As in force in date C,[23] subsection 160ZZS(1A) said where assets are deemed under subsection (1) to be post-CGT:

o      the taxpayer is taken to have acquired the asset at the time when the natural persons who held majority underlying interests before 20 September 1985 first ceased to hold those interests, and

o      the taxpayer is taken to have acquired the asset for consideration equal to the market value of the asset at that time.

•                Subsection 110-25(2) says the first element of cost base is the money paid, and market value of property given, to acquire the asset.

95.      Here, the cost base of the trading company's business goodwill will be its market value on date C. The business goodwill was taken to be a post-CGT asset on date C under both subsection 149-30(1) and 160ZZS(1). Subsection 160ZZS(1A) and section 149-35 produce the same outcome: the trading company was deemed to acquire the asset for market value at that date. First element of cost base will be that market value amount under subsection 110-25(2).

Question 6

Are the holding company's shares in the trading company all post-CGT on the basis that all of the trading company's assets are post-CGT?

Summary

96.      Yes. the holding company's shares in the trading company will all be treated as post-CGT assets. the trading company has no pre-CGT assets.

Explanation

97.      Section 615-65 is about the CGT consequences for an interposed company where the Division 615 rollover is available.

98.      One effect of section 615-65 is that the pre or post-CGT status of the interposed company's shares in the original entity derives from the status of the original entity's assets.

•                Subsection 615-65(2) says a number of the interposed company's shares in the original entity are taken to be acquired before 20 September 1985 if any of the original assets were acquired by it before that day.

•                That number is the greatest possible whole number that doesn't exceed the market value of the original entity's assets acquired before that date, less its liabilities in respect of those assets: subsection 615-65(3).

•                For the remaining shares, the first element of cost base is the total cost base of the original entity's post-CGT assets: subsection 615-65(4).

99.      Division 149 is about when an asset is a pre-CGT asset. Section 149-10 says an asset is a pre-CGT asset if several conditions are met. These include:

•                the entity must have last acquired the asset before 20 September 1985

•                the asset hasn't stopped being a pre-CGT asset for the entity under Division 149

•                the entity wasn't (immediately before the start of the 1999 income year) taken under former subsection 160ZZS or subdivision C of Division 20 of former Part IIIA of the ITAA 1936 to have acquired the asset after 20 September 1985.

100.    Section 109-5 is about when you acquire a CGT asset. Subsection 109-5(1) says in general, you acquire a CGT asset when you become its owner. Item 1 in the table in subsection 109-5(2) says where an entity disposes of a CGT asset to you under CGT Event A1, you acquire the asset when the disposal contract is entered into. If there's no disposal contract, you acquire it when the entity stops being the asset's owner. Broadly, section 104-10 says a CGT Event A1 disposal happens when a change of (beneficial) ownership occurs.

101.    Despite section 109-5, assets are sometimes deemed to have been acquired at other dates, including where rollovers are available. See section 109-55 for a list of provisions under the current law.

102.    Here, the holding company will acquire shares from the trading company. Under section 615-65, their status as pre or post-CGT assets depends on whether the trading company had any pre-CGT assets.

103.    Here, none of the trading company's assets will be pre-CGT when the interposition happens. The trading company was registered and first acquired all its assets after 20 September 1985. Person A and Person B transferred the business goodwill to the trading company after 20 September 1985, and claimed the section 160ZZN rollover. the trading company was deemed to have acquired the business goodwill before 20 September 1985: see Question 3. However, the business goodwill lost that pre-CGT status on date C: see Question 4. We aren't aware of any other assets which could have been pre-CGT in the trading company's hands.

104.    Since the trading company had no pre-CGT assets, none of the holding company's shares in the trading company will be treated as pre-CGT assets under section 615-65.

Question 7

Is the cost base of the holding company's post-CGT shares in the trading company the cost bases of the trading company's post-CGT assets less its related liabilities at the rollover date?

Summary

105.    Yes. The cost base of the holding company's shares in the trading company will be worked out as the cost bases of the trading company's assets, less its related liabilities at the interposition date.

Explanation

106.    Under section 615-65, the cost base of the original company's post-CGT assets transfers to the interposed company's post-CGT shares. Subsection 615-65(4) says:

The first element of the *cost base of the interposed company's *shares or units in the original entity that are not taken to have been *acquired before 20 September 1985 is:

(a)  the total of the cost bases (as at the completion time) of the original entity ' s assets that it acquired on or after that day; less

(b)  its liabilities (if any) in respect of those assets.

107.    All of the holding company's shares in the trading company will be post-CGT. Their cost base will be determined under subsection 615-65(4).

Question 8

Is the cost base attributable to the trading company's work in progress and trade debts the face value of those assets?

Summary

108.    No. The face value of work in progress and trade debts includes amounts which aren't included in cost base under the general CGT rules. We don't think those rules can be ignored or modified under a Division 615 rollover.

Explanation

109.    Cost base is determined under rules in Divisions 110 and 112. Broadly, section 110-25 says cost base consists of five elements. The first element is money paid or property given to acquire the CGT asset. Generally, expenditure is excluded to the extent it's deductible. Division 112 has special rules modifying the general rules. One of them is a 'market value substitution' rule in section 112-20.

General cost base rules: cost base generally includes money and property paid to acquire an asset.

110.    To elaborate on the first element of cost, subsection 110-25(2) says the first element of cost base is the total of:

•                the money you paid, or are required to pay, in respect of acquiring it; and

•                the market value of any other property you gave, or are required to give, in respect of acquiring it (worked out at the acquisition time).

111.    There's some ATO guidance relevant to whether the value of services can be included in the first element of cost base. TD 60[24] says that the value of the taxpayer's labour can't be included in cost base for assets constructed or created by the taxpayer. ATO ID 2005/211 (W)[25] and ATO ID 2008/110 (W)[26] concluded that for debts created by providing services, the first element of cost base is nil. While both ATO ID's are withdrawn, the withdrawal notices suggests guidance is available elsewhere and don't say the decisions or reasoning are incorrect.

112.    Subsection 110-45(2) says expenditure doesn't form part of the cost base to the extent that you have deducted it, or can deduct it. There are exceptions where the expenditure is reversed or where the deduction is under Division 243.[27]

Applying the general cost base rules: the face value of WIP and trade debts isn't money or property paid to acquire assets.

113.    The relevant CGT assets are WIP and trade debts. Broadly, WIP represents the value of services performed under a contract which haven't progressed to the point they can be billed to clients. In contrast, trade debts represent billed work which haven't been paid. the trading company didn't pay money or give property to acquire WIP or trade debts. It incurred expenses through labour costs.

The market value substitution rule: cost base is market value in some circumstances.

114.    Section 112-20 is a market value substitution rule which applies in specified circumstances. Under this rule, where you acquire an asset from another entity, and any of three extra conditions apply, the first element of cost base is its market value. However, there are exceptions where the rule doesn't apply. The three conditions:

•                you didn't incur expenditure to acquire it (unless created by CGT event D1 or without a CGT event)

•                some of the expenditure can't be valued.

•                you didn't deal at arm's length to acquire it.

115.    If you didn't deal at arm's length to acquire the asset, market value is only substituted if you paid more than market value: subsection 112-20(2).

116.    Exceptions listed in subsection 112-20(3) include contractual or other legal or equitable rights resulting from CGT event D1. Broadly, CGT Event D1 happens if you create a contractual right or other legal or equitable right in another entity: subsection 104-35(1). However, CGT Event D1 doesn't happen if exclusions listed in subsection 104-35(5) apply. Paragraph 104-35(5)(a) says CGT event D1 doesn't happen if you created the right by borrowing money or obtaining credit from another entity.

117.    ATO ID 2005/211 (W) concluded that the market value substitution rule wouldn't apply to a debt arising from the provision of services for the following reasons.

•                Allina[28] held that an acquisition can encompass a case where another person creates an asset which at the same time comes into the acquirer's possession.

•                This reasoning applies where a debt is created in the creditor.

•                However, the market value substitution rule doesn't apply where the acquisition resulted from CGT event D1, or another entity doing something that isn't a CGT event. This means the first exception didn't apply.

•                CGT event D1 doesn't happen from a debt arising from the provision of services: the provider is giving credit to the debtor.

•                The agreement to pay is doing something that isn't a CGT event, so the second exception applies.

118.    While the withdrawal didn't necessarily signal a change in the ATO view, ATO ID 2005/211 has been withdrawn and is no longer an authoritative source of the ATO view.

Applying these principles: the market value substitution rule won't apply. Even if the trading company acquired the WIP and trade debts from another entity, that results either from CGT Event D1, or without a CGT Event.

119.    We think the market value substitution rule won't apply.

•                First, in this case, there seems to be some doubt about whether the trading company has acquired the WIP from another entity. the trading company had to perform services under the contract before the WIP was created. The WIP was at least partly created by the trading company itself: they weren't unilaterally created in the trading company by its customer.

•                Second, even if the trading company has acquired the assets from another party, following ATO ID 2005/211, the WIP or trade debt rights would be created either with CGT event D1 happening, or without any CGT event happening. In either event, the market value substitution rule still wouldn't apply.

120.    We also note in passing that it's possible that any labour costs relevant to WIP or trade debts could be excluded from cost base for being deductible expenses (for example, under section 8-1). We can't rule on deductibility without knowing the details and circumstances. However, any costs which qualified for deductions would be excluded from the asset's cost base under subsection 110-45(2).

Question 9

Do the liabilities of the trading company refer to legal liabilities (ie. presently existing pecuniary obligations) including the provision for income tax, rather than non-incurred amounts and non-legal liabilities like deferred tax liabilities and right of use liabilities?

Summary

121.    Yes. We think 'liabilities' in the context of Division 615 means present legal obligations, and would exclude other provisions.

Explanation

Relevant law and ATO guidance: the meaning of 'liabilities' varies, but generally means a present legal obligation

122.    The reference to 'liabilities' in subsections 615-65(5) isn't explained or defined, so we look to ordinary usage, context, and ATO guidance to determine its meaning.

•                The Macquarie Dictionary[29] gives a meaning of liability as 'an obligation, especially for payment; debt or pecuniary obligations'.

•                ATO guidance suggests the meaning of liability in tax legislation varies according to the context. The ATO view is that 'liabilities' means present legal obligation when used in provisions about CGT Event K6 (see TR 2004/18 at paragraph 99[30]) and the CGT small business concessions (see TD 2007/14 at paragraph 1[31] and TR 2015/4 at paragraph 38[32]). However, it takes its accounting meaning in consolidation (see TR 2004/14[33] and TR 2006/6[34]) and thin capitalisation provisions (see TR 2002/20).[35]

123.    We think 'liabilities' means present legal obligations in the context of Division 615.

•                The ordinary meaning of liability usually refers to legal obligations to make a payment.

•                CGT Event K6 and the small business CGT concessions are both about CGT, and the ATO view was that liability had its legal meaning in those contexts. Both those sections were about reducing asset market values by liabilities and specified provisions. Section 615-65 is similar in that the taxpayer is reducing asset cost base by liabilities. Similar reasoning should apply here.

•                Different considerations apply to consolidation and thin capitalisation. The relevant consolidation provisions specifically refer to accounting standards, and there are specific exclusions for certain provisions.

124.    There's ATO guidance on the phrase 'present legal obligation'. TD 2007/28[36] and TD 2012/10[37] are about what 'present legal obligation' means when determining distributable surplus in Division 7A of the Income Tax Assessment Act 1936.

•                Broadly, a present legal obligation is an immediate obligation binding at law, but it doesn't necessarily need to be immediately payable and enforceable: see TD 2007/28 at paragraphs 1 and 10.

•                For example, income tax obligations exist at the end of the relevant income year, even if a notice of assessment hasn't issued yet. The obligation exists, even though the debt isn't payable or enforceable until after the Commissioner issues and serves an assessment. While it's contingent in a sense, that contingency doesn't disqualify it as a present legal obligation: see TD 2007/28 at paragraph 10A, and TD 2012/10 at paragraph 34.

•                Income tax liabilities which have been determined, but aren't payable until a later date are also present legal obligations for similar reasons: see TD 2012/10 at paragraph 2.

•                However, it doesn't follow that all contingencies can be present legal obligations. There must be an obligation, a legal requirement to settle it, and the amount must be reliably determined: TD 2007/28 at paragraph 10B.

Applying these principles: tax liabilities are generally present legal obligations, but provisions generally wouldn't be.

125.    We've concluded that for Division 615 purposes, 'liabilities' means present legal obligations. Therefore, Division 615 liabilities would include all the entity's outstanding existing obligations, which are enforceable and payable either immediately or at a future time.

126.    Income tax liabilities are liabilities which are properly owing under taxation law at the relevant time. It doesn't matter whether an assessment had issued or the Commissioner was able to enforce payment. Therefore, they would include income tax provisions to the extent those reflect amounts the entity will be obliged to pay (for periods which have already elapsed) assuming tax law is applied correctly. However, it wouldn't necessarily cover all provisions connected with tax. For example:

•                any provisions for income tax based on expected future events (such as for tax periods which haven't passed yet) wouldn't be present obligations

•                provisions for deferred tax liabilities.

127.    Other contingencies recorded as liabilities for accounting purposes which aren't legally enforceable aren't included (right of use liabilities might be an example).

Question 10

Will the holding company be entitled to a tax offset in respect of franked dividends which are paid to the holding company out of the trading company's post-interposition profits?

Question 11

Do sections 177E and 177F of the ITAA 1936 apply?

Question 12

Will the arrangement be considered part of a dividend stripping operation for the purposes of section 207-155 of the ITAA 1997?

Summary for Questions 10, 11, and 12

128.    Yes to Question 10: the holding company will be entitled to a tax offset for franked dividends the trading company pays to it out of its post-interposition profits. The distribution won't be unfrankable under section 207-145 because it doesn't trigger any conditions in that section.

129.    No to Questions 11 and 12: the arrangement won't be a dividend stripping operation, so sections 177E and 207-155 won't apply.

Explanation for Questions 10, 11, and 12

Will franking credits and offsets be denied?

130.    Section 207-20 of the ITAA 1997 says that if an entity makes a franked distribution to another entity, the receiving entity:

•         includes the franking credit in its assessable income, and

•         is entitled to a tax offset equal to the franking credit.

131.    However, section 207-145 denies franking credits and tax offsets where they are received from distributions which trigger any of six integrity rules. We summarise and apply these rules in Table 7.

Table 7: section 207-145

Section 177EA: this is an integrity rule applying to schemes to distribute membership interests for the purpose of obtaining imputation benefits.

132.    Section 177EA is an integrity rule which applies to schemes for the distribution of membership interests entered for the purpose of obtaining imputation benefits. It applies if five conditions in subsection 177EA(3) are met: we list them in Table 8. Where it applies, the Commissioner can make determinations to create franking debits or deny imputation benefits.

133.    We apply these conditions to the interposition in Table 8.

Table 8: conditions in subsection 177EA(3)

134.    Subsection 177EA(17) lists relevant circumstances for determining purpose. Without listing those circumstances in full, they broadly include:

•                the extent and duration of risks and opportunities from holding membership interests

•                whether relevant entities would derive greater benefits from franking credits compared to other members

•                whether benefits or dividends would have flowed to other entities but for the scheme.

Section 177EA won't apply: we don't think the interposition scheme will be carried out for anyone to benefit from franking credits.

135.    Considering the relevant factors, we don't see anything in the scheme to suggest that the purpose of the scheme is for anyone to benefit from franking credits. Person A and Person B are the effective economic owners of the trading company, and will remain the effective economic owners after the holding company is interposed. They are Australian residents and are entitled to any franking credits flowing from the trading company dividends. Their entitlement to dividends and franking credits will be exactly the same if the holding company is interposed and the holding company on-pays dividends (with attached franking credits) to them.

Section 204-30 is an integrity rule applying where entities stream distributions which can benefit from imputation benefits.

136.    Section 204-30 is another integrity rule which allows the Commissioner to cancel franking credits or create franking debits where an entity streams distributions to entities that would benefit more from imputation benefits.

137.    Broadly, section 204-30 will apply if four requirements are met. We'll summarise them:

•                an entity streams distributions or gives other benefits[42] (in such a way that)

•                an imputation benefit[43] is received by a member

•                the 'favoured' member derives a greater benefit from franking credits[44] than another member

•                the 'disadvantaged' member receives lesser imputation benefits than the favoured member.

138.    We'll elaborate on some of these concepts.

•                The relevant Explanatory Memorandum[45] at paragraph 3.31 suggests streaming is a strategy directed to avoid wastage of imputation benefits by directing franked distributions to members who can benefit most from them.

•                An imputation benefit includes entitlement to a tax offset under Division 207: subsection 204-30(6).

•                Very broadly, a member will derive a greater benefit from franking credits than another member if the other member is a foreign resident, or isn't entitled to a tax offset: subsection 204-30(8). Other examples include where the first entity will receive an exempting credit or distributions will be franked with venture capital credits: subsections 204-30(9) and (10).

Section 204-30 won't apply: no entities can benefit more from franking credits under the scheme.

139.    Section 204-30 won't apply. There can't be advantaged or disadvantaged members. Even if the former shareholders were considered members, paying dividends to them wouldn't cause any franking credit wastage. All relevant entities are Australian residents, and all would be entitled to franking credits.

Section 177E applies to 'dividend stripping' arrangements entered for the purpose of avoiding tax on a dividend.

140.    Section 177E is an integrity provision which applies to dividend stripping arrangements. If it applies, the relevant taxpayer is deemed to have obtained a tax benefit for the purposes of Part IVA. Very broadly, section 177E applies where:

•                there is a scheme by way of, or having substantially the effect of, dividend stripping

•                a company disposes of property (including dividends)

•                the property represents a distribution of company profits

•                if the company paid those profits as dividends, it would have been included in the taxpayer's assessable income.

141.    Broadly, section 207-155 simply says that a distribution will be made under a dividend stripping operation if the scheme was by way of, in the nature of, or having substantially the effect of dividend stripping. That definition resembles the wording used in section 177E.

142.    TD 2014/1[46] is an ATO view document explaining section 177E. It applies section 177E to 'dividend access share' arrangements. At paragraph 17, it states some propositions, relying on case law, about common characteristics of dividend stripping schemes. We summarise and apply these propositions in Table 9. One essential characteristic is that the scheme is planned for the purpose of 'vendor shareholders' avoiding tax on dividends.

Section 177E won't apply: we don't think the arrangement has the purpose of avoiding tax on a dividend.

143.    We don't think this scenario creates a dividend stripping scheme because it doesn't seem to have been planned to avoid tax on a dividend.

Table 9: applying characteristics of dividend stripping schemes

Section 207-157 applies to 'dividend washing' arrangements entered to obtain multiple franking benefits from the same underlying interests.

144.    Broadly, section 207-157 applies to franked distributions received by members on a membership interest. The washed interest must be acquired after the member (or a connected entity) disposed of a substantially identical membership interest, and they must receive a corresponding franked distribution on the substantially identical interest. The Explanatory Memorandum[48] explained the provision this way at paragraph 3.2:

Broadly, dividend washing (or 'distribution washing') is a type of scheme by which a taxpayer can obtain multiple franking credits in respect of a single economic interest by selling an interest after an entitlement to a franked distribution has accrued and then immediately purchasing an equivalent interest with a further entitlement to a corresponding franked distribution.

145.    Paragraph 3.68 of the Explanatory Memorandum says a dividend can be corresponding if it's paid from the same act by an interposed company.

Section 207-157 won't apply: the scenario won't create multiple franking benefits.

146.    Section 207-157 won't apply. While the wording is very broad, the Explanatory Memorandum suggests dividend washing is meant to catch arrangements where a taxpayer receives a dividend, sells shares ex-dividend, then acquires replacement shares which are cum-dividend. No dividend is proposed to be paid either before or after the interposition. Therefore, Person A and Person B won't have disposed of their trading company shares 'ex dividend' and acquired the holding company shares 'cum dividend. Therefore, there won't be any distribution washing.

Conclusion on Questions 11, 12, and 13: the dividends will be frankable because none of the integrity rules will apply.

147.    We conclude that dividends from the trading company out of post-interposition profits will be frankable distributions. They won't be made unfrankable under section 207-145. The scheme won't be a dividend stripping operation, so sections 177E and 207-155 won't apply either.

Question 13

Will the Commissioner seek to apply Part IVA of the ITAA 1936 to the scheme comprised of the steps described in the 'relevant facts and circumstances' section of this ruling which results in the interposition of the holding company above the trading company?

Summary

148.    The Commissioner won't seek to apply Part IVA to the steps in the scheme which interpose the holding company above the trading company. We don't think these steps have been carried out for the dominant purpose of obtaining a tax benefit.

Explanation

General principles about Part IVA: it applies to schemes entered for the dominant purpose of obtaining a tax benefit.

149.    The Part IVA general anti-avoidance rules deny tax benefits from schemes entered for the sole or dominant purpose of obtaining those benefits.

•                Subsection 177D(1) says Part IVA applies to a scheme if it would be concluded that a relevant entity entered into or carried it out for the purpose of obtaining a tax benefit.

•                Scheme is broadly defined. It includes agreements, arrangements, understandings, promises, undertakings, plans, proposals, actions, course of actions, and courses of conduct. See section 177A.

•                Tax benefits include amounts not being included in assessable income, which either would have, or would be reasonably expected to be included: paragraph 177C(1)(a).However, they exclude amounts which are excluded because of a specific choice allowed under tax laws, unless the scheme had the purpose of enabling that choice to be made: subsection 177C(2). When working out whether an expectation is reasonable, tax consequences are disregarded: paragraph 177CB(4)(b).

•                Subsection 177D(2) lists relevant matters to consider when determining purpose. These include the manner in which the scheme was carried out, its form and substance, time, result but for Part IVA, change in financial position, connections between parties.

•                Where a scheme has multiple purposes, the tax purpose must be the dominant purpose: subsection 177A(5).

•                If Part IVA applies, section 177F cancels tax benefits.

150.    We'll highlight a couple of points about the ATO's approach to interpreting and applying Part IVA. PS LA 2005/24[49] gives guidance to internal staff about Part IVA. We won't discuss that practice statement in detail. For present purposes, we'll just highlight a few points:

•                Part IVA must be construed as a whole. What constitutes a scheme is only meaningful in relation the tax benefit that has been obtained. Dominant purpose and the existence of the tax benefit must both be compared against a comparison with an alternative. [54]

•                The Commissioner may advance alternative schemes (including a narrower scheme within a wider scheme) in support of a Part IVA determination. [58]

•                Part IVA will apply to a scheme if a person carries out only part of the scheme for the dominant purpose of obtaining a tax benefit. [60]

•                The tax benefit must be identified by comparing the tax consequences of the scheme (but for Part IVA), to an alternative scheme. That alternative scheme is sometimes called a hypothesis, postulate, or counterfactual. This is what would have happened, or might reasonably be expected to have happened, if the scheme hadn't happened. [75]

•                Identifying a tax benefit requires identifying reasonable alternatives to the scheme that might reasonably have achieved the same commercial (non-tax) outcomes. Tax consequences can't be considered in determining whether the alternative is reasonable. [83, 93]

Part IVA won't apply to the scheme as defined by the ruling question, but we're not ruling about broader or narrower schemes.

151.    Here, we have briefly considered the possibility that steps in the broader scenario could create tax benefits. For example, conceivably cancelling DAS and RPS some years before interposing a head company could improve eligibility prospects for the Division 615 rollover. That could be characterised as a scheme designed to allow a Division 615 choice to be made, and therefore, a tax benefit. Also, interposing a head company may create tax benefits in combination with future transactions or events. Determining whether Part IVA could apply to an interposition would always require the decision maker to:

•                to closely examine those circumstances to identify tax benefits

•                decide whether any steps in a broader or narrower scheme had the sole or purpose of obtaining those tax benefits.

152.    Here, the question limits the scope of the scheme to interposing a holding company for the trading company, through Person A and Person B transferring their shares to the holding company. We haven't identified any tax benefits arising solely from that transaction, considered in isolation. We don't need to decide whether Part IVA could apply to a broader or narrower scheme which could include other surrounding events.

153.    It follows that the Commissioner won't seek to apply Part IVA to the scheme comprised of the steps that interpose the holding company above the trading company.

154.    This ruling shouldn't be interpreted as forming any view about whether Part IVA would or wouldn't apply to a broader or narrower scheme which includes other surrounding events.

[1] There's an exception where other entities own no more than 5 shares and it's reasonable to disregard them: see paragraph 615-25(3)(b).

[2] Taxation Ruling TR 97/18 Income tax: capital gains: rollover relief following reorganisation of the affairs of a unit trust or company - sections 160ZZPA, 160ZZPB, 160ZZPC and 160ZZPD.

[3] Taxation Determination TD 2020/6 Income tax: what is a 'restructuring' for the purposes of subsection 125-70(1) of the Income Tax Assessment Act 1997?

[4] This is a shorthand summary. It isn't an exhaustive description of the conditions.

[5] Taxable Australian property is explained in section 855-15. The concept isn't relevant here because the exchanging members are Australian residents.

[6] For completeness, there wouldn't necessarily be a disposal under CGT Event A1: Holding company wouldn't own the shares before issuing them.

[7] We've used the original provision introduced by section 19 of the Income Tax Assessment Amendment (Capital Gains) Act 1986 (No. 52 of 1986), updated for amendments made by Part IV, section 34 of the Taxation Laws Amendment Act 1988 (No. 11 of 1988), and Part III, section 47 of the Taxation Laws Amendment Act 1989 (No. 11 of 1989). See the Annexure to this private ruling.

[8] The law in force at the relevant date about disposing of CGT assets was effectively the same as the current law. Under former subsection 160M(1), a disposal was deemed to happen when there was a change in ownership of an asset. Subsection 160M(1A) said that there must be a change in beneficial ownership, not just legal ownership. While subsection 160M(1A) was introduced in 1990, subsection 160M(1A) applied retrospectively from 20 September 1985. See subsection 38(8) of the Taxation Laws Amendment Act 1990 (No. 35 of 1990), read with paragraph 14(a), which introduced subsection 160M(1A).

[9] While subsection 160M(1A) was introduced in 1990, subsection 160M(1A) applied retrospectively from 20 September 1985. See subsection 38(8) of the Taxation Laws Amendment Act 1990 (No. 35 of 1990).

[10] Explanatory Memorandum (House of Representatives) to the Income Tax Assessment Amendment (Capital Gains) Bill 1986, see Notes on Clauses at Clause 19: Capital gains and capital losses, under section 160ZZN: transfer of asset to wholly-owned company.

[11] Taxation Ruling TR 1999/16 Income tax: capital gains: goodwill of a business.

[12] Compare Taxation Ruling TR 1999/9 Income tax: the operation of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132, at paragraphs 12 and 28.

[13] Subdivision C of Division 20 of the former Part IIIA of the ITAA 1936 was about changes in majority underlying interests for public entities: this isn't relevant because the entity is a private company.

[14] Subsections 160ZZS(1), (2), and (3) as introduced by section 19 of the Income Tax Assessment Amendment (Capital Gains) Act 1986 (No. 52 of 1986). Subsections 160ZZ(1A) and (2A) as introduced by Part II, section 50 of the Taxation Laws Amendment Act (No. 2) 1992 (No. 80 of 1992).

[15] Introduced by Part II, section 11 of the Taxation Laws Amendment Act 1986 (No. 46 of 1986). Commenced on Royal Assent (24 June 1986): see section 2.

[16] Introduced by section 19 of the Income Tax Assessment Amendment (Capital Gains) Act 1986 (No. 52 of 1986), which commenced on the Royal Assent date of 24 June 1986. Amended by section 40 of the Taxation Laws Amendment Act (No. 2) 1992 (No. 80 of 1992), which commenced on the Royal Assent date of 30 June 1992.

[17] ATO Interpretative Decision ATO ID 2011/101 Income Tax Capital Gains Tax: Division 149 majority underlying interests - no new shareholders.

[18] ATO Interpretative Decision ATO ID 2011/107 Income Tax Capital Gains Tax: Division 149 majority underlying interests - new shareholder.

[19] Section 160ZZRR defined 'majority underlying interests', section 160ZZRS defined 'indirect beneficial interest in an asset', section 160ZZRT defined 'indirect beneficial interest in income derived from an asset'. Very broadly, these correspond to subsections 149-15(1), (4) and (5).

[20] Inserted by Schedule 4 to the Taxation Laws Amendment Act (No 1) 1997 (No. 122 of 1997). The Act received royal assent on 8 July 1997, but Schedule 4 had a retrospective effect to 20 January 1997. See section 2.

[21] Case Y59, (1991) 91 ATC 502 at 505 [9], (1991) 22 ATR 3532 at 3535 [9] per BJ McMahon, DP.

[22] ATO Liaison Group Minutes, Losses and CGT Sub-committee (1 December date C), at Agenda item 13. Comments attributed to Mr J Burge.

[23] See the Annexure. Subsections 160ZZS(1), (2) and (3) as introduced by section 19 of the Income Tax Assessment Amendment (Capital Gains) Act 1986 (No. 52 of 1986), which commenced on the Royal Assent date of 24 June 1986. Subsections 160ZZS(1A) and (2A) introduced by section 40 of the Taxation Laws Amendment Act (No. 2) 1992 (No. 80 of 1992), which commenced on the Royal Assent date of 30 June 1992.

[24] CGT Determination Number 60 TD 60 Capital Gains: Can the value of a taxpayer's labour be included in the cost base of an asset constructed or created by the taxpayer?

[25] ATO Interpretative Decision ATO ID 2005/211 (Withdrawn) Income tax: Capital gains tax - cost base/reduced cost base - debt (withdrawn 19 December 2018, because guidance can be found on the ATO website).

[26] ATO Interpretive Decision ATO ID 2008/110 (Withdrawn) Income Tax: Capital Gains Tax: debt arising from the provision of services - whether the same amount can be both ordinary income and a capital gain (withdrawn 23 February 2018, because guidance can be found in Taxation Determination TD 2 and the ATO website).

[27] Broadly, Division 243 is about limited recourse debt deductions.

[28] Allina Pty Limited v Commissioner of Taxation (1991) 28 FCR 203.

[29] Macquarie Dictionary Publishers (2022) The Macquarie Dictionary online, accessed at https://www.macquariedictionary.com.au/features/word/search/?search_word_type=Dictionary&word=liability on 24 March 2022

[30] Taxation Ruling TR 2004/18 Income tax: capital gains: application of CGT event K6 (about pre-CGT shares and pre-CGT trust interests) in section 104-230 of the Income Tax Assessment Act 1997.

[31] Taxation Determination TD 2007/14 Income tax: capital gains: small business concessions: what 'liabilities' are included in the calculation of the 'net value of the CGT assets' of an entity in the context of subsection 152-20(1) of the Income Tax Assessment Act 1997?

[32] Taxation Ruling TR 2015/4 Income tax: CGT small business concessions: unpaid present entitlements and the maximum net asset value test.

[33] Taxation Ruling TR 2004/14 Income tax: consolidation: recognising and measuring the liabilities of a joining entity under subsection 705-70(1) of the Income Tax Assessment Act 1997 where the entity becomes a subsidiary member of a consolidated group in a financial reporting period of the entity not beginning on or after 1 January 2005.

[34] Taxation Ruling TR 2006/6 Income tax: consolidation: recognising and measuring the liabilities of a joining entity under subsection 705-70(1) of the Income Tax Assessment Act 1997 where the joining time occurs in a financial reporting period of the joining entity beginning on or after 1 January 2005.

[35] Taxation Ruling TR 2002/20 Income tax: Thin Capitalisation - Definition of assets and liabilities for the purposes of Division 820.

[36] Taxation Determination TD 2007/28 Income tax: what is a 'present legal obligation' of a private company for the purposes of subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936?

[37] Taxation Determination TD 2012/10 Income tax: when is income tax of a private company a 'present legal obligation' for the purposes of the distributable surplus calculation under subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936?

[38] Very broadly, a qualified person had to have held shares in a company for 45 days, or 90 days for preference shares: former section 160APHO.

[39] Section 207-155 says a distribution 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 was by way of, or in the nature of, or had substantially the effect of, dividend stripping.

[40] Section 995-1 says membership interest in an entity has the meaning given by section 960-135. Section 960-135 says each interest or set of interests in an entity, or each right or set of rights in relation to an entity, by virtue of which you are a member of the entity, is a membership interest of yours. Item 1 of subsection 960-130(1) says that a member of a company includes a member of the company or a stockholder in the company.

[41] Section 960-115 says an entity is a corporate tax entity if it is a company at that time: see paragraph (a).

[42] Examples of other benefits include issuing bonus shares, returning paid-up share capital, forgiving debts, making payments or giving property: subsection 204-30(2).

[43] An imputation benefit includes entitlement to a tax offset under Division 207: subsection 204-30(6).

[44] Very broadly, a member will derive a greater benefit from franking credits than another member if the other member is a foreign resident, or isn't entitled to a tax offset: subsection 204-30(8). Other examples include where the first entity will receive an exempting credit or distributions will be franked with venture capital credits: subsections 204-30(9) and (10).

[45] Explanatory Memorandum (House of Representatives) to the New Business Tax System (Imputation) Bill 2002.

[46] Taxation Determination TD 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?

[47] Subsection 23(2) of the Income Tax Rates Act 1986 sets the rate at 30% unless the company is a base rate entity. Section 23AA says an entity is a base rate entity if no more than 80% of its income is base rate entity passive income. Section 23AB says base rate passive income includes distributions from corporate tax entities, franking credits, interest, rent, and capital gains.

[48] Explanatory Memorandum (House of Representatives) to the Tax and Superannuation Laws Amendment (2014 Measures No. 2) Bill 2014.

[49] Law Administration Practice Statement PS LA 2005/24 Application of General Anti-Avoidance Rules.