Edited version of private advice

Authorisation Number: 1052022533437

Date of advice: 18 August 2022

Ruling

Subject: Proposed share buy-back

Issue 1 - Dividend Component

Question 1

Will the proposed share buy-back by the company constitute a buy-back which is an "off-market purchase" for the purposes of Division 16K of the Income Tax Assessment Act 1936 (ITAA 1936) pursuant to section 159GZZZK of the ITAA 1936?

Answer

Yes.

Question 2

Will the trustee of the trust be taken, for the purposes of subsection 159GZZZP(1) of the ITAA 1936, to have been paid a dividend equal to the difference between the proposed purchase price for the buy-back and the amount debited against amounts standing to the credit of the company's share capital account (ie. the dividend component)?

Answer

Yes.

Question 3

Because the trustee of the trust is a 'qualified person', will the amount of the franking credit on the dividend component be included in the assessable income of the trust under subsections 207-35(1) and (2) of the ITAA 1997 in the income year in which the buy-back occurs, provided:

(a)  the 'related payments rule' is met, and

(b)  none of the anti-manipulation circumstances in paragraphs 207-145(1)(b) to (db) of the ITAA 1997 apply.

Answer

Yes.

Issue 2 - Capital Component

Question 4

Will the difference between the purchase price and the dividend component (ie the capital component) not be a dividend pursuant to subsection 159GZZZP(2) of the ITAA 1936, provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend?

Answer

Yes.

Question 5

Will the trustee of the trust be taken to have received the capital component as the consideration in respect of all the Company shares bought back under the buy-back (sale consideration) on the share buy-back date pursuant to section 159GZZZQ of the ITAA 1936, provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend?

Answer

Yes.

Question 6

Because the company shares are held on capital account by the trustee of the trust:

(a)  will the shares be taken to have been disposed of for Capital Gains Tax (CGT) purposes on the share buy-back date pursuant to section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) (CGT Event A1), and

(b)  will the sale consideration represent the capital proceeds for CGT purposes pursuant to section 116-20 of the ITAA 1997 (provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend), and

(c)   will the trustee of the trust make a capital gain when CGT event A1 happens if the sale consideration exceeds the cost base of the shares or a capital loss if the sale consideration is less than the reduced cost base of the shares?

Answer

Yes.

Issue 3 - Trust Distribution

Question 7

Can the trustee of the trust distribute the franked portion of the share buy-back dividend to the private company under subdivision 207-B of the ITAA 1997 such that the private company can claim a franking offset, provided:

(a)  the 'related payments rule' is met, and

(b)  none of the anti-manipulation circumstances in paragraphs 207-150(1)(b) to (eb) of the ITAA 1997 apply.

Answer

Yes.

This ruling applies for the following periods:

1 July 20XX to 30 June 20XX

1 July 20XX to 30 June 20XX

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Trust

The trust is an Australian resident discretionary trust. The trust was established on XXX.

The individual is a beneficiary of the trust, as are the individual's family companies and other specified entities. The trustee can also nominate other beneficiaries.

A family trust election was made in XXX and the individual is the test individual. The individual is the appointer of the trust.

The trustee of the trust is a corporate trustee and has been trustee since XXX. The individual is the sole shareholder and director of the trustee company.

The trust owns 50% of the shares in the company which it acquired on XXX for $XXX and which have been continuously held by the trustee.

The Company

The company is an Australian proprietary company incorporated on XXX. The company is a private company and its shares are not listed on any stock exchange.

The company is limited by XXX ordinary shares fully paid at $1 each. The trustee of the trust holds 50% of the shares in the company and another corporate trustee holds the other 50% of the shares in the company.

The other corporate trustee is controlled by and operated for the benefit of the family of another individual and is an Australian resident taxpayer.

The current directors of the company are the individual and the other individual (who is not related to the first individual).

As at 30 June 20XX, the company owned X% of the shares in an ASX listed company.

The company purchased the listed company shares over a number of years. The number of shares held in listed company as at 30 June 20XX was XXX. The cost base of these shares was $XXX.

Based on the ASX listed share price as at XXX and the number of shares held as at 30 June 20XX, the value of the company's listed shares is $XXX.

The company is fundamentally a holding entity for the listed shares and does not carry on business other than as manager of its listed company shareholding.

Proposed share buy-back

The individual would like to simplify their affairs for estate planning and simplicity reasons and as part of this, the individual would like to separate their family's joint interest in the listed company by having the company buy-back the trust's shares in the company in consideration for an in-specie distribution of shares in the listed company equal to 50% of the company.

An off-market share buy-back would entail the company buying back its shares from the trust (a selective buy-back) for an agreed price (in the form of an in-specie distribution of the listed company shares). Once the shares are acquired by the company, they would immediately be cancelled and all rights attaching to the shares would be extinguished.

The share buy-back price would be set with reference to the market value of the company at the time of the buy-back, as ascertained by a valuation made in accordance with the ATO market valuation guidelines.

The value of the company is lower than the value of its investment in the listed company shares because the company's value is discounted by its future tax liability on the sale of the listed company shares. Accordingly, the trust would receive less than 50% of the listed company shares as a result of the share buy-back. In order to ensure that the trust only receives 50% of the value of the company, the in-specie distribution of the listed company shares would inherently have to be reduced (ie. weighted proportionately down).

The company will adopt the average cost per share methodology as espoused in Practice Statement Law Administration 2007/9: Share buy-backs (PS LA 2007/9) as being representative of the appropriate capital/profit mix of the share buy-back price.

The price to be paid by the company to the trust under the share buy-back would be debited firstly against 50% of the available paid-up share capital. The remainder is the share buy-back premium, being the excess above the 50% share of the company share capital which would be referable to the trust. The share buy-back premium would be funded out of the company's retained earnings and its asset revaluation reserve and the accounting entries will be:

Dr Share Capital $XXX

Dr Reserves Balance relating to the shares transferred

Dr Retained Earnings Balance

Consequences for the company

The in-specie distribution of the listed company shares to the trust would trigger CGT event A1 for the company. The in-specie distribution would be deemed to occur at market value under the market substitution rule under subsection 116-30(1) of the ITAA 1997. This would crystallise a capital gain for the company which would be taxable at the company's tax rate.

The tax liability would essentially be funded by the company distributing less than 50% of the listed company shares to the trust (and/or, if appropriate, selling some listed company shares for cash or obtaining funds from elsewhere).

Any tax liability resulting from this capital gain would generate more franking credits for the company. It is expected that the company will fully frank the portion of the share buy−back amount that is taken to be a dividend for income tax purposes to the maximum extent possible.

The trust distribution

The trust intends to distribute the listed company shares it receives from the company to private company.

There will be no 'related payments', as defined by former section 160APHN of the ITAA 1936, in relation to the in-specie distribution of the listed company shares to private company.

Private company is an Australian resident tax-paying entity. The individual is the sole shareholder and director of the company.

Clause XXX of the trust deed gives the trustee of the trust the discretion to treat an amount as income or capital.

Clause XXX then gives the trustee of the trust the ability to appoint income to specified eligible beneficiaries, including companies, in such shares or proportions the trustee determines. The appointment may relate to the whole or any part of the income thereof.

There is currently no ability in the trust deed to categorise types of income (for example to divide the income of the trust into categories such as franked dividends and all other income). Accordingly, the trust will make the private company presently entitled to all of the income of the trust in the year in which the share buy-back occurs.

Pursuant to a Deed executed on XXX, the individual's family companies and other beneficiaries (including private company) were added to the list of eligible beneficiaries in Clause XXX of the trust deed.

Timing

Whilst the current private ruling request is for the period from 1 July 20XX to 30 June 20XX, there may be difficulties with proceeding with the proposed share buy-back during this period. However, the proposed buy-back is seriously contemplated, particularly for estate planning purposes. The individual wishes for the new structure to be in place:

• Ensuring security in ownership of investments for estate planning purposes. By having the private company as the direct owner of the listed company shares, it could be guaranteed that the control of these shares is in the hands of the desired beneficiaries.
• Separation of assets and investments from the company so as to simplify the individual's affairs for their future estate.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6

Income Tax Assessment Act 1936 Division 16K

Income Tax Assessment Act 1936 Subsection 45A(2)

Income Tax Assessment Act 1936 Subsection 45B(3)

Income Tax Assessment Act 1936 Section 45C

Income Tax Assessment Act 1936 Section 159GZZZK

Income Tax Assessment Act 1936 Section 159GZZZM

Income Tax Assessment Act 1936 Section 159GZZZP

Income Tax Assessment Act 1936 Section 159GZZZQ

Income Tax Assessment Act 1936 Section 160APHD

Income Tax Assessment Act 1936 Section 160APHG

Income Tax Assessment Act 1936 Section 160APHJ

Income Tax Assessment Act 1936 Section 160APHL

Income Tax Assessment Act 1936 Section 160APHM

Income Tax Assessment Act 1936 Section 160APHN

Income Tax Assessment Act 1936 Section 160APHO

Income Tax Assessment Act 1936 Section 160APHU

Income Tax Assessment Act 1936 Subsection 44(1)

Income Tax Assessment Act 1997 Section 104-10

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

Income Tax Assessment Act 1997 Subdivision 207-B

Income Tax Assessment Act 1997 Subdivision 207-F

Income Tax Assessment Act 1997 Section 207-35

Income Tax Assessment Act 1997 Section 207-45

Income Tax Assessment Act 1997 Section 207-50

Income Tax Assessment Act 1997 Section 207-55

Income Tax Assessment Act 1997 Section 207-57

Income Tax Assessment Act 1997 Section 207-58

Income Tax Assessment Act 1997 Section 207-145

Income Tax Assessment Act 1997 Section 207-150

Income Tax Assessment Act 1997 Subsection 975-300(1)

Reasons for decision

Issue 1 - Dividend Component

Question 1

Summary

The proposed share buy-back by the company will constitute a buy-back which is an "off-market purchase" for the purposes of Division 16K of the Income Tax Assessment Act 1936 (ITAA 1936) and pursuant to section 159GZZZK of the ITAA 1936.

Detailed reasoning

The tax consequences of a share buy-back are set out in sections 159GZZZIA to 159GZZZS of Division 16K of Part III of the ITAA1936 and depend on whether the buy-back concerned is "on-market" or "off-market". Where a company buys back shares in itself from a shareholder in the company, the purchase is a buy-back and the relevant shareholder is the "seller" for the purposes of Division 16K of the ITAA 1936.

An "on-market" buy-back happens if the share is listed on a stock exchange and the buy-back is made in the ordinary course of the business of the stock exchange. Any other buy-back is an "off-market" buy-back under paragraph 159GZZZK(d) of the ITAA 1936.

Application to your circumstances

The trust currently holds 50% of the shares in the company. The company intends to buy-back all of the trust's shares in the company. This would constitute a share buy-back. As the company shares do not trade on a stock exchange, the transaction will not be made in the ordinary course of the business of the stock exchange. Therefore, the proposed buy-back will be an "off-market purchase" for the purposes of Division 16K of the ITAA 1936.

Question 2

Summary

The trust will be taken, for the purposes of subsection 159GZZZP(1) of the ITAA 1936, to have been paid a dividend equal to the difference between the proposed purchase price for the buy-back and the amount debited against amounts standing to the credit of the company's share capital account (ie. the dividend component).

Detailed reasoning

For an "off-market" buy-back, the difference between the "purchase price" and that part of the "purchase price" that is debited against amounts standing to the credit of the "company's share capital account" is treated as a dividend paid to the shareholder out of company profits on the day of the buy-back under subsection 159GZZZP(1) of the ITAA 1936. The deemed dividend is included in the assessable income of the shareholder under subsection 44(1) of the ITAA 1936.

"Purchase price" is described in section 159GZZZM of the ITAA 1936 as meaning:

• The amount of money, or the sum of the amounts of money, a seller receives or is "entitled to receive", as a result of or in respect of a buy-back (paragraph (a)); or
• The market value at the time of the buy-back of any property (other than money) a seller receives, or is "entitled to receive", as a result of or in respect of a buy-back (paragraph (b)); or
• If the seller has received, or is "entitled to receive", both money and property (other than money) as a result of or in respect of the buy-back, the sum of that amount of money and the market value of the property at the time of the buy-back (paragraph (c)).

The expression "company share capital account" is defined in subsection 975-300(1) of the Income Tax Assessment Act 1997 (ITAA 1997) as simply "an account where a company keeps its share capital". Subsection 975-300(2) of the ITAA 1997 provides that if a company has more than one share capital account, the accounts are taken for the purposes of the ITAA 1997 to be a single account.

The dividend/capital split is considered in Practice Statement Law Administration 2007/9: Share buy-backs (PS LA 2007/9). The ATO considers that there are a number of acceptable methodologies for ascertaining the capital/dividend split, however, 'average capital per share' (ACPS) should be applied to share buy-backs unless companies can demonstrate exceptional circumstances for the use of an alternate methodology. ACPS is obtained by dividing a company's ordinary issued capital by the number of shares on issue.

Application to your circumstances

The company intends to buy-back the trust's shares in the company in consideration for an in-specie distribution of shares in the listed company equal to 50% of the company. The "purchase price" of the buy-back will be the market value of the listed shares provided to the trust at the time of the buy-back, representing the market value of the 50% share in the company at the time of the share buy-back, in accordance with paragraph 159GZZZM(b) of the ITAA 1936 (ie. the "purchase price" encompasses both the capital and dividend components of the distribution).

The difference between the market value of the listed company shares provided to the trust at the time of the buy-back and the amount that is debited against amounts standing to the credit of the company's share capital account is a dividend, in accordance with subsection 159GZZZP(1) of the ITAA 1936.

As the company is debiting its share capital account by the amount of share capital which is being bought back by the company, being the trust's total portion, this is in line with the ACPS methodology described in PSLA 2007/9. The company's ordinary issued capital is XXX, divided by the number of shares on issue, XXX shares, which is $1. The company intends to purchase 50% of its shares from the trust for $XXX. Hence, the capital/dividend split is acceptable in this arrangement and the balance of any buy-back price would be a dividend.

Question 3

Summary

Because the trustee of the trust is a 'qualified person', the amount of the franking credit on the dividend component will be included in the assessable income of the trust in the income year in which the buy-back occurs under subsections 207-35(1) and (2) of the ITAA 1997, provided:

(a)  the 'related payments rule' is met, and

(b)  none of the anti-manipulation circumstances in paragraphs 207-145(1)(b) to (db) of the ITAA 1997 apply.

Detailed reasoning

Division 207 outlines the effects of an entity receiving a franked distribution. In particular, Subdivision 207-B outlines the impacts of franked distributions received through partnerships and trusts.

A trustee receiving a franked dividend includes both the amount of the dividend and the franking credit in the trust's assessable income (under subsections 207-35(1) and (2) of the ITAA 1997) when calculating the trust's taxable income or loss.

However, Subdivision 207-F of the ITAA 1997 includes anti-manipulation rules that, where applied, deny franking credit benefits. A trust receiving a franked distribution as a shareholder in a company does not include the franking credit from the distribution in its assessable income under section 207-35 of the ITAA 1997 if any of the anti-manipulation rules in section 207-145 of the ITAA 1997 apply.

Qualified person

The first of the anti-manipulation rules is paragraph 207-145(1)(a) of the ITAA 1997 which removes the franking credit from the assessable income of the trust where the trustee is not a 'qualified person' in relation to the distribution. The qualified person test ensures only the true economic owners of shares benefit from franking credits attached to distributions made from the shares.

Though Part IIIAA of the Income Tax Assessment Act 1936 ceased to have general application from 1 July 2002, it is necessary to have regard to the rules in Division 1A of the former Part IIIAA in determining whether an entity is a 'qualified person' for the purpose of the new rules contained in the Simplified Imputation System in respect of a franked distribution made directly or indirectly to the entity on or after 1 July 2002.

A shareholder generally meets the qualified person test, as defined by former section 160APHO of the ITAA 1936, if they satisfy the:

• holding period rule; and
• where applicable, the related payments rule.

The holding period rule will be satisfied where the shareholder has held their shares, 'at risk', for a continuous period of at least 45 days during the primary qualification period. The primary qualification period begins on the day after the shares were acquired and ends 45 days after the shares become ex-dividend (as defined in former section 160APHD of the ITAA 1936).

If the trustee or an associate of the trustee in relation to the share buy-back makes, is required to make, or is likely to make a 'related payment' in respect of the dividend component, the shares must also be held at risk for a continuous period of at least 45 days during the secondary qualification period (this is known as the 'related payments rule'). The secondary qualification period as defined by former section 160APHD of the ITAA 1936 begins 45 days before the ex-dividend date and ends 45 days after.

A 'related payment' as defined by former section 160APHN of the ITAA 1936 means doing something with the effect of passing the benefit of the dividend to one or more other persons. An actual "payment" is not required. Where a trustee distributes a dividend to a beneficiary of the trust, who is presently entitled to the dividend, this does not constitute the making of a 'related payment' (refer to former subsection 160APHN(5) of the ITAA 1936).

The qualification periods (primary and secondary) do not include the day of acquisition or, if the shares have been disposed of, the day of disposal. Also excluded are days where the financial risk of owning the shares is materially diminished.

A materially diminished risk of loss or opportunity for gain is defined by former section 160APHM of the ITAA 1936 as the circumstance where shares are exposed to less than 30% of risks and opportunities. This exposure requires the 'net position' of the shareholder to be worked out, using the financial concept of a delta: section 160APHJ of the ITAA 1936.The section gives an example where a delta of -0.5 would mean a reduction of risk and opportunity by 50%. Accordingly days where the shares held a delta of less than -0.3 would not be counted in the qualification periods.

In the absence of any positions taken by the trustee to reduce the risk of holding the shares, the only position of the beneficiary would normally be a deemed long position (delta of +1) under former subsection 160APHL(7) of the ITAA 1936. However, if the trustee has not made a family trust election, former subsection 160APHL(10) of the ITAA 1936 provides that there is a deemed short position (eg. a delta of -1). Accordingly, provided the trustee has made a valid family trust election in place at the time it received the dividend, the shares will be deemed to be held under a long position of +1 and those days can be counted towards the qualification periods.

Application to your circumstances

Under the proposed share buy-back, the trustee for the trust will receive a fully franked dividend (if possible to fully frank) equal to the difference between the proposed purchase price for the buy-back and the amount debited against amounts standing to the credit of the company's share capital account.

The trustee for the trust acquired its ordinary shares in the company on XXX and these shares have been continuously held by the trustee. The primary qualification period will be from XXX until 45 days after the share buy-back is deemed to occur (which will occur sometime after this ruling is issued).

As the trust has made a family trust election it is deemed that the shares are being held 'at risk'. By this mechanism the holding period rule would be satisfied as the trust has held the shares at risk for greater than 45 days during the primary qualification period.

The related payments rule may also be relevant. The trust intends to distribute the share buy-back profit to private company. However, private company will be presently entitled to the dividend at the time of the buy-back, and accordingly the distribution of the dividend to private company is not a related payment (former subsection 160APHN(5) of the ITAA 1936).

We are unaware of any other methods that the trustee may use to pass on the benefit of the dividend. However, if the related payments rule is applicable then the trust must hold the shares at risk for 45 days during the secondary qualification period. The date on which the buy-back occurs will affect the start of the secondary qualification period. This period may not have begun at the time of this ruling.

As the trustee of the trust has satisfied the 45 day holding period rule in respect of the shares it holds in the company, the trustee of the trust will be a qualified person in relation to the dividend (provided the related payments rule is also met). Provided none of the remaining anti-manipulation circumstances in paragraphs 207-145(1)(b) to (db) of the ITAA 1997 apply, the trust would include the dividend component, as well as the attached franking credit, in the trust's assessable income in the income year that the share buy-back occurs.

Issue 2 - Capital Component

Question 4

Summary

The difference between the purchase price and the dividend component (i.e. the capital component) will not be a dividend pursuant to subsection 159GZZZP(2) of the ITAA 1936, provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend.

Detailed reasoning

The purchase price paid by the company to the shareholder is the amount of money and/or market value of any property the shareholder receives as a consideration for the buy-back as set out in section 159GZZZM of the ITAA 1936 (as detailed in Question 2 further above).

In an off-market share buy-back, the purchase price paid to a vendor shareholder will generally comprise a return of capital and a dividend. The difference between the purchase price and the part of the purchase price in respect of the buy-back which is debited against the company's share capital account is taken to be a dividend paid by the company to the seller. The amount debited against the company's share capital account is the capital component and is not considered a dividend (section 159GZZZP(2) of the ITAA 1936).

Application to your circumstances

The purchase price received by the trust in relation to the buy-back arrangement will include the amount which the company will debit against amounts standing to the credit of their share capital account. This amount is not a dividend pursuant to section 159GZZZP(2) of the ITAA 1936, provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend.

Question 5

Summary

The trustee of the trust will be taken to have received the sale consideration in respect of the company shares bought back on the share buy-back date pursuant to section 159GZZZQ of the ITAA 1936, provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend.

Detailed reasoning

In the case of off-market share buy-backs, the "consideration" on disposal of the shares exclude the assessable dividend component of the buy-back price.

In respect of the buy-back, the seller is generally taken to have received as "consideration" an amount equal to the "purchase price" in respect of the buy-back (subsection 159GZZZQ(1) of the ITAA1936), which encompasses the capital and dividend components. The amount of the deemed "consideration" is then reduced where there is a reduction amount (subsection 159GZZZQ(3) of the ITAA1936). The reduction amount is any amount taken to be a dividend by section 159GZZZP and which is either included in the seller's assessable income or is an eligible non-capital amount (subsection 159GZZZQ(4) of the ITAA1936).

Subsection 159GZZZQ(2) of the ITAA 1936 operates to increase the deemed "consideration" in respect of an off-market purchase to market value. This section is only applicable where the "purchase price" (the dividend and capital components) in respect of a buy-back is less than the amount that would have been the market value of the share at the time of the buy-back if the buy-back did not occur and was never proposed to occur.

Application to your circumstances

The trust will be taken to have received an amount equal to the purchase price in respect of the buy-back as "consideration" (ie. the total of the dividend and capital components). This amount will then be reduced by the assessable dividend (the "reduction amount") in accordance with section 159GZZZQ(3) ITAA1936.

In this instance, the difference between the purchase price and the dividend component is the amount debited against amounts standing to the credit of the company's share capital account. Hence, the trust will be taken to have received the capital component as the "consideration" in respect of all the company shares bought back under the buy-back on the share buy-back date.

The company intends to purchase its shares back at market value, as ascertained by a valuation that is made in accordance with the ATO market valuation guidelines. This means that the purchase price (the dividend and capital components) is equal to the market value and there is no requirement to increase the deemed consideration. Subsection 159GZZZQ(2) ITAA 1936 will not apply to this arrangement.

Question 6

Summary

Because the company shares are held on capital account:

(a)  the shares will be taken to have been disposed of for CGT purposes on the share buy-back date pursuant to section 104-10 ITAA 1997 (CGT Event A1);

(b)  the sale consideration will represent the capital proceeds for CGT purposes pursuant to section 116-20 (ITAA 1997) (provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend; and

(c)   the trustee of the trust will make a capital gain when CGT event A1 happens if the sale consideration exceeds the cost base of the shares or a capital loss if the sale consideration is less than the reduced cost base of the shares.

Detailed reasoning

CGT Event A1 happens if you dispose of a CGT asset (section 104-10 ITAA 1997). The disposal of shares as part of a share buy-back, is a disposal of a CGT asset. This event occurs when you enter into a contract or, if there is no contract - when the change of ownership occurs (section 104-10(3) ITAA 1997).

As required by section 116-20(1) ITAA 1997, if you dispose of shares in a buy-back, the capital proceeds are worked out under Division 16K of the ITAA 1936. In the case of off-market share buy-backs, the capital proceeds on disposal of the shares exclude the assessable dividend component of the buy-back price (see issue 2, question 2 above).

In accordance with section 104-10(4), you make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Application to your circumstances

When the company buys back its shares from the trustee of the trust, CGT Event A1 happens, as this is the disposal of a CGT asset. This event will occur when the shares in the company change ownership from the trustee for the trust to the company.

The capital proceeds on disposal of the company shares will exclude the dividend component of the buy-back price. Hence, the capital proceeds will be the sale consideration, provided the Commissioner does not make a determination under subsection 45A(2) or 45B(3) that section 45C of the ITAA 1936 will apply to treat the capital component as an unfranked dividend.

As CGT Event A1 happens when the company buys back its shares, section 104-10(4) of the ITAA 1997 applies to calculate whether a capital gain or capital loss has occurred. The trust who is disposing of the company shares will make a capital gain if the capital proceeds from the disposal of the company shares are more than the shares cost base. The trust will make a capital loss if those capital proceeds are less than the shares reduced cost base.

Issue 3 - Trust Distribution

Question 7

Summary

You have advised that the trust will make private company presently entitled to all of the income of the trust in the year in which the share buy-back occurs. Accordingly, the trustee of the trust can distribute the franked portion of the share buy-back dividend to the private company under subdivision 207-B of the ITAA 1997 such that the private company can claim a franking offset, provided:

(a)  the 'related payments rule' is met, and

(b)  none of the anti-manipulation circumstances in paragraphs 207-150(1)(b) to (eb) of the ITAA 1997 apply.

On your facts private company's share of the franked distribution is 100% and the share of franking credits will be 100%. This will be included in private company's tax return for the relevant income year.

Detailed reasoning

A trust's franked distributions can be distributed amongst beneficiaries or streamed to particular beneficiaries by making them specifically entitled to the amounts for tax purposes. The amounts must be capable of being distributed this way under the trust deed to be able to be streamed for tax purposes.

To achieve this result, franked distributions are effectively taken out of the trust rules in Division 6 of the ITAA 1936 and are dealt with under Subdivision 207-B of the ITAA 1997. This allows beneficiaries to get the benefit of any franking credits attached to a franked distribution, subject to integrity rules.

Share of franked distribution and franking credit

When a franked distribution indirectly flows to a beneficiary of a trust, the beneficiary's share of the franked distribution and the franking credit is included in the beneficiary's assessable income by virtue of subsections 207-35(3) and (4) of the ITAA 1997. The meaning of indirectly flows to or through an entity is covered by section 207-50 of the ITAA 1997.

If the beneficiary is a corporate tax entity, it is entitled to a tax offset equal to its share of the franking credit on the franked distribution under section 207-45 of the ITAA 1997.

The references to the beneficiary's share of the franking credit on the franked distribution is a reference to the calculation in section 207-57 of the ITAA 1997 which effectively allocates to the beneficiary their share of the total franking credits based on their proportionate share of the total franked distribution. A beneficiary's share of the franked distribution is in turn calculated under section 207-55 of the ITAA 1997.

Paragraph 207-55(4)(a)(i) of the ITAA 1997 provides that a beneficiary's share of the franked distribution from the trust will be the amount that the beneficiary is specifically entitled to as defined by section 207-58 of the ITAA 1997. However, if no beneficiary is specifically entitled to the franked distribution, then the beneficiary's share of the franked distribution will be the amount of the franked distribution multiplied by the entity's adjusted Division 6 percentage of the income of the trust for the relevant year. For example, if no entity is specifically entitled to the franked distribution, but an entity is presently entitled to 100% of the income of the trust, its Division 6 percentage will be 100%. Their share of the franked distribution will be 100% and their share of the franking credit will also be 100%.

A beneficiary of a trust is specifically entitled to an amount of a franked distribution made to the trust in an income year equal to the amount calculated under the formula in subsection 207-58(1) ITAA 1997. This formula requires the trustee to be able to record the beneficiary's share of the net financial benefit, in its character, as referable to the franked distribution in the accounts or records of the trust (in accordance with the terms under the trust deed). Endowing a beneficiary with an entitlement to unspecified amounts (or shares) - such as "the balance" of trust income, "all of the trust income", "half of the trust income" or "$100 of trust income" is not sufficient to create a specific entitlement because the entitlement would not have been recorded in its character as referable to a franked distribution.

Qualified person

Subdivision 207-F of the ITAA 1997 includes anti-manipulation rules that, where applied, deny franking credit benefits. A company receiving a franked distribution as a beneficiary of a trust is not entitled to a tax offset for its share of the franking credit from the distribution if any of the anti-manipulation rules in section 207-150 of the ITAA 1997 apply.

The first of the anti-manipulation rules is paragraph 207-150(1)(a) of the ITAA 1997 which removes the franking credit tax offset where the corporate beneficiary is not a 'qualified person' in relation to the distribution (for the purposes of Division 1A of former Part IIIAA of the ITAA 1936).

A beneficiary of a trust can only be a qualified person in relation to a distribution if the trustee of the trust is also a qualified person in relation to the distribution (per former subsection 160APHU(1) of the ITAA 1936).

The qualified person test requires the holding period rule and the related payments rule to be satisfied under former section 160APHO of the ITAA 1936. These tests are outlined in detail at Issue 1, Question 3 above.

While a discretionary beneficiary could not be said to hold shares in the underlying company in an ordinary sense, under former subsection 160APHG(3) of the ITAA 1936, a beneficiary of a non-widely held trust is taken to acquire, hold and dispose of an interest in shares held by a trust when the trustee acquires, holds or disposes of shares or an interest in shares. Consequently, a beneficiary of a discretionary trust will be taken to hold an interest in the shares while the trustee holds the shares.

Pursuant to former subsection 160APHL(5) of the ITAA 1936, a beneficiary's interest in shares held by the trustee of a non widely held trust will be determined in proportion to the beneficiary's share of the dividend income derived by the trust.

Similarly to the details outlined in Issue 1, Question 3 above, former subsection 160APHL(7) of the ITAA 1936 deems the beneficiary's interest as a long position with a delta of +1 in relation to itself. Provided the trust has made a family trust election, former subsection 160APHL(10) of the ITAA 1936, will not apply.

Application to your circumstances

The trust deed gives the trustee the discretion to treat an amount as income or capital, in accordance with Clause XXX. Therefore, the share buy-back dividend can be treated as income by the trustee.

Clause XXX then gives the trustee of the trust the ability to appoint income to specified eligible beneficiaries, including the private company, in such shares or proportions the trustee determines. The appointment may relate to the whole or any part of the income thereof.

There is currently no ability in the trust deed to categorise types of income (for example to divide the income of the trust into categories such as franked dividends and all other income). However, the trust will make the private company presently entitled to all of the income of the trust in the year in which the share buy-back occurs. Accordingly, the private company's share of the franked distribution and franking credits will be 100%.

The private company will be deemed to hold the company shares in the same way as the trustee of the trust has held the shares, with an entitlment to 100% of the franked distribution. As the trust has made a family trust election, the private company is deemed to hold the company shares 'at risk'. By this mechanism the private company has held the company shares at risk for greater than 45 days during the primary qualification period.

Provided the related payments rule is met, and none of the anti-manipulation circumstances in paragraphs 207-150(1)(b) to (eb) of the ITAA 1997 apply, the private company will be entitled to:

• Include the total franked distribution and franking credits in its assessable income under subsections 207-35(3) and (4) of the ITAA 1997.
• Claim a tax offset equal to its share of the franking credit on the franked distribution under section 207-45 of the ITAA 1997.