Edited version of private advice

Authorisation Number: 1052031759067

Date of advice: 8 September 2022

Ruling

Subject: Tax consequences for interposing a head company

Question 1

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 pre-interposition profits?

Answer

Yes.

Question 2

Will sections 177E and 177F of the ITAA 1936 apply to franked dividends which are paid to the holding company out of the trading company's pre-interposition profits?

Answer

No.

Question 3

Will the payment of franked dividends to the holding company out of the trading company's pre-interposition profits be considered part of a dividend stripping operation for the purposes of section 207-155 of the ITAA 1997?

Answer

No.

Question 4

Do the trading company's unearned income liabilities constitute liabilities under subsection 615-65(4) of the ITAA 1997?

Answer

No.

Question 5

If the interposition of the holding company above the trading company happens before the end of the trading company's income year, will the trading company's tax provision calculated at the interposition date, net of instalments, constitute a liability under subsection 615-65(4) of the ITAA 1997?

Answer

No.

This ruling applies for the following period:

1 July XXXX to 30 June XXXX

The scheme commences on:

1 July XXXX

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 5 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.         Person A and Person B acquired their shares in the trading company many years ago, shortly after it was incorporated. 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 some 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 $1 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 ($1 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.

42.      There's no intention for the trading company to pay any dividends to the holding company at this stage. However, it's possible that decisions could be made at future times that franked dividends would be paid to the holding company by the trading company out of the profits which the trading company will generate after the interposition of the holding company (post-interposition profits) and out of profits which have been generated before the interposition of the holding company (pre-interposition profits).

43.      The trading company may receive amounts in advance of goods being provided or work being done, where goods/services are required to be provided in the future ('unearned income'). These amounts are shown as liabilities in the trading company's financial statements.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 204-30

Section 207-20

Section 207-145

Section 207-155

Section 207-157

Section 615-65

Income Tax Assessment Act 1936

Section 177E

Section 177EA

Reasons for decision

In these reasons for decision, where another act isn't mentioned, references to:

• hyphenated section numbers (eg, section 615-65) mean the Income Tax Assessment Act 1997
• un-hyphenated section numbers (eg, section 177E) mean the Income Tax Assessment Act 1936
• Division 615 mean Division 615 of Part 3-80 of the Income Tax Assessment Act 1997
• Part IVA mean Part IVA of the Income Tax Assessment Act 1936
• Division 7A means Division 7A of Part III of the Income Tax Assessment Act 1936.

Question 1: 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 pre-interposition profits?

Summary

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

Will franking credits and offsets be denied?

45.      Section 207-20 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.

46.      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 5.

Table 5: section 207-145

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

47.      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 6. Where it applies, the Commissioner can make determinations to create franking debits or deny imputation benefits.

48.      We apply these conditions to the interposition in Table 6.

Table 6: conditions in subsection 177EA(3)

49.      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.

50.      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.

51.      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.

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

•                an entity streams distributions or gives other benefits[5] (in such a way that)

•                an imputation benefit[6] is received by a member

•                the 'favoured' member derives a greater benefit from franking credits[7] than another member

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

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

•                The relevant Explanatory Memorandum[8] 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.

54.      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.

55.      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.

56.      Broadly, section 207-155simply 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.

57.      TD 2014/1[9] 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 7. 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.

58.      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 7: 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.

59.      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[11] 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.

60.      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.

61.      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 the trading company shares ex-dividend and acquired the holding company shares cum-dividend. Therefore, there won't be any distribution washing.

Conclusion on Question 1: dividends from the trading company will be frankable distributions.

62.      We conclude that dividends from the trading company out of pre-interposition profits will be frankable distributions. They won't be made unfrankable under section 207-145.

63.      For completeness, we think dividends from the trading company out of post-interposition profits would also be frankable for the same reason.

Question 2: Will sections 177E and 177F of the ITAA 1936 apply to franked dividends which are paid to the holding company out of the trading company's pre-interposition profits?

Explanation

64.      No. Section 177E won't apply to franked dividends paid to the holding company out of the trading company's pre-interposition profits because we don't think the arrangement involves dividend stripping. See our explanation at paragraph 58 and Table 7.

Question 3: Will the payment of franked dividends to the holding company out of the trading company's pre-interposition profits be considered part of a dividend stripping operation for the purposes of section 207-155 of the ITAA 1997?

Explanation

65.      No. Paying franked dividends paid to the holding company out of the trading company's pre-interposition profits won't be a dividend stripping operation. See our explanation at paragraph 58 and Table 7.

Question 4: Do the trading company's unearned income liabilities constitute liabilities under subsection 615-65(4) of the ITAA 1997?

Summary

66.      No. the trading company's unearned income liabilities aren't liabilities under subsection 615-65(4). Broadly, we think 'liabilities' takes its ordinary meaning in this context. That meaning is present legal obligations to pay monetary amounts. Unearned income represents obligations to perform, which we don't think is covered by the ordinary meaning of 'liability'.

Explanation

The cost base for the original company's post-CGT assets transfers to the interposed company's shares in the original company under a formula in subsection 615-65(4).

67.      Section 615-65 is about the tax consequences for an interposed company under the Division 615 rollover. We'll summarise these consequences in general terms.

•                The interposed company must make a choice that section 615-65 applies (within certain periods after the completion time: see section 615-30).

•                Subsection 615-65(2) says that where some of the original entity's assets were pre-CGT assets, some of the interposed company's shares (units) in the original entity are taken to be pre-CGT assets. Subsection 615-65(3) sets a formula for working out the number of shares taken to be pre-CGT assets. That formula is based on the market value of the original entity's pre-CGT assets, less its liabilities in respect of those assets, expressed as a percentage of the market value of all the entity's assets less all of its liabilities.

•                Subsection 615-65(4) is about working out the cost base of the interposed company's shares (units) in the original entity which are taken to be post-CGT. The formula resembles the formula for working out the number of pre-CGT shares (units) in subsection 615-65(3). The first element of cost base is the total of the original entity's post-CGT assets, less the liabilities in respect of those assets.

•                A liability of the original entity that isn't in respect of a specific asset or assets is taken to be in respect of all the original entity's assets: subsection 615-65(5).

•                Subsection 615-65(6) says that if a liability is 'in respect of 2 or more assets' the proportion in respect of any one of those assets is worked out under another formula. It's equal to the asset's market value, divided by the total market value of 'all the assets that the liability is in respect of'.

Ordinary usage and analogous ATO guidance suggests 'liabilities' means present legal obligations to pay monetary amounts, while accounting and legal usage may be broader.

68.      The reference to 'liabilities' in subsections 615-65(3), (4), (5), and (6) isn't explained or defined, so we look to ordinary usage, context, and analogous ATO guidance to determine its meaning.

69.      Dictionaries generally suggest liabilities are obligations to pay.

•                The Macquarie Dictionary[12] gives a meaning of liability as 'an obligation, especially for payment; debt or pecuniary obligations'.

•                The Australian Oxford Dictionary[13] gives one meaning as being liable for 'debts or pecuniary obligations'.

•                Other meanings given by these dictionaries include something disadvantageous, a troublesome responsibility, or a handicap.

70.      Some legal dictionaries suggest 'liability' can have a broader or narrower meaning than the ordinary meaning.

•                The Australian Law Dictionary gives the accounting meaning: present obligations arising from past events, where settling them is expected to result in outflows of economic benefits.[14] (The same definition is given by the Australian Accounting Standards Board.[15])

•                The Encyclopaedic Australian Legal Dictionary[16] says a liability is the result of incurring a legal obligation, or the legal obligation itself. It gives many examples of legal responsibilities, duties, or obligations (eg, criminal liability, tort liability, or contractual liability).

•                A Dictionary of Law says that 'liability' can include a legal duty or obligation. However, it also gives 'an amount owed' as one meaning.[17]

71.      'Liabilities' are used in subsection 615-65(4) to reduce cost base, and cost base excludes the value of services. Cost base generally has a meaning given by section 110-25. The first element of cost base is money paid and the market value of property given to acquire an asset. Very broadly, market value usually means the price likely to be agreed between willing and knowledgeable but not anxious buyers and sellers: see (for example) TR 2004/18[18] at paragraph 156. The other elements of cost base include incidental costs, some ownership costs, and some capital expenditure. TD 60 says that a taxpayer can't include the value of their labour in the cost base of assets they construct or create.[19] Withdrawn ATO guidance also suggests that the value of services can't be included in cost base: see ATO ID 2005/211 (W).[20] There's also a tribunal decision where a member remarked that services aren't money or property.[21]

72.      Some ATO guidance suggests 'liability' generally takes its ordinary meaning, but that can vary according to the context. We'll discuss a few examples.

•                In the CGT small business concession context, the ATO view is that 'liabilities' has its ordinary meaning. To briefly explain that context, section 152-20 - relevant to calculating the net value of CGT assets - reduces the market value of those assets by liabilities and listed provisions. TD 2007/14[22] (at paragraph 1) elaborates that the meaning of liability extends to 'legally enforceable debts due for payment, and presently existing obligations to pay either a sum certain or ascertainable sums'. That meaning doesn't extend to 'future obligations, expectancies or liabilities that are uncertain as both a theoretical and a practical matter...'

•                The ATO took a similar view in another CGT context. TR 2004/18, at paragraphs 97 to 99, gave a meaning which is almost identical to TD 2007/14. TR 2004/18 is about the meaning of liabilities in section 104-230, which is about CGT event K6. Very loosely, CGT event K6 happens when more than 75% of the value of pre-CGT shares or units is attributable to post-CGT assets.

•                However, the ATO view was that liabilities had an accounting meaning in consolidation (see TR 2004/14[23] and TR 2006/6[24], interpreting the phrase 'accounting liabilities') and thin capitalisation provisions (see TR 2002/20 at paragraph 5).[25]

73.      The ATO has guidance about the phrase 'present legal obligation' in another tax context.

•                TD 2007/28[26] and TD 2012/10[27] are about the meaning of 'present legal obligation' in section 109Y of Division 7A (of the Income Tax Assessment Act 1936). [28]

•                As context (speaking very broadly), Division 7A deems some payments, loans, or debt forgiveness by private companies to be deemed dividends to shareholders. Section 109Y limits dividend amounts to the company's distributable surplus. The phrase 'present legal obligations' is an element in determining distributable surplus.

•                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.

•                Contingencies might not 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.

We think liabilities takes its ordinary meaning in Division 615: it covers present legal obligations to pay, but not legal obligations to perform.

74.      We think 'liabilities', in the context of Division 615, means present legal obligations to pay a monetary amount, but doesn't extend to obligations to perform.

•                We think 'liabilities' would usually take its ordinary meaning, rather than its accounting or legal meanings, unless the context suggested otherwise. The ordinary meaning of liability usually refers to legal obligations to make a payment.

•                We don't see anything in the context to suggest accounting or legal meanings should displace the ordinary meaning here. In this context, liabilities reduce cost base. The first element of cost base is about money paid or the market value of property given to acquire assets. It doesn't extend to the cost of labour or services. If 'liabilities' covered obligations to perform, there would be a mismatch. Non-monetary obligations to perform services would reduce cost base, but the value of any corresponding services wouldn't be included in cost base. While the market value of property isn't money, market value is based on what arms' length parties would be prepared to pay. Why should 'liabilities' extend to (non-monetary) obligations to perform services, when cost base doesn't include the value of services?

•                We think it's implicit in the ATO guidance about 'present legal obligations' that the relevant obligations are to pay money. While arguably some of the wording in TD 2012/10 and TD 2007/28 is broad enough to cover non-monetary obligations, the examples are about obligations to pay money debts. Further, the cases discussed in those TDs were also about obligations to pay money amounts.[29]

•                We think 'liabilities' should have a similar meaning across the other CGT contexts we've discussed. CGT event K6 and the small business CGT concessions are both about CGT, and the ATO view was that liability had its ordinary meaning in those contexts. Section 152-20, about the small business CGT concessions, is 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. (Like CGT event K6, it's also relevant to distinguishing between pre and post-CGT assets.) The same reasoning should apply to Division 615.

•                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.

Applying these principles: unearned income amounts aren't liabilities under subsection 615-65(4).

75.      We've concluded that for Division 615 purposes, 'liabilities' means present legal obligations to pay. 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.

76.      We don't think unearned income can be treated as a liability for Division 615 purposes. We think it's implicit that 'liabilities' means liabilities to pay. Unearned income is a present obligation to perform a contract by supplying goods or services. However, the obligation to perform isn't an obligation to pay any monetary amount. The trading company will only be obliged to return the money (or pay damages) if it fails to perform that obligation. That's a contingency when the unearned income is received: the obligation to pay will only arise if the trading company fails to perform.

77.      We can see an alternative argument that the trading company's unearned income represents a present legal obligation. If 'liability' simply meant present legal obligations - either to pay or perform - then unearned income would qualify. The trading company must either provide the goods or services, or alternatively, return the money. The trading company can't retain the money without providing those goods or services. If the trading company did that, the customer would presumably have a right to sue under the contract. The trading company can't escape the obligation. That obligation isn't theoretically or practically uncertain - only the form it will take is uncertain.

78.      However, we don't accept this alternative argument because we don't think the meaning of 'liability' extends to obligations to perform. See paragraphs 74 and 76 for our reasons.

79.      Therefore, the trading company's amounts received in advance of goods being provided or work being performed aren't treated as 'liabilities' under subsection 615-65(4).

Question 5: If the interposition of the holding company above the trading company happens before the end of the trading company's income year, will the trading company's tax provision calculated at the interposition date, net of instalments, constitute a liability under subsection 615-65(4)?

Summary

80.      No. the trading company's tax provision calculated at the interposition date, net of tax income tax instalments, is not a liability under subsection 615-65(4). Applying the principles discussed in Question 4, tax provisions are estimates, not binding obligations to pay. Tax instalment obligations will become liabilities when they arise at the end of the relevant instalment period. The entity's crystalised tax instalment obligations would reduce the significance of this exclusion.

Explanation

Liabilities include income tax liabilities and income tax instalments: both arise at the end of the relevant period, and not before.

81.      Paragraphs 68 to 74 (in the explanation to Question 4 about the meaning of 'liability') are also relevant to this question.

82.      We'll supplement those paragraphs with comments from ATO guidance. To repeat, TD 2007/28 and TD 2012/10 made comments about when tax-related liabilities are 'present legal obligations' when working out distributable surplus in section 109Y.

83.      The obligation to pay income tax arises under taxation legislation at the end of the income year. The obligation isn't created by the assessment, which is just a mechanism to allow the Commissioner to recover the liability. The obligation exists at the end of the income year, 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.

84.      Income tax instalments can also be present legal obligations. TD 2012/10 at paragraphs 1 and 4 says that unpaid tax instalments are present legal obligations for the distributable surplus calculation. Paragraph 28 says the liability arises at the end of the relevant instalment period, not the due date for payment. For a quarterly payer, the liability arises at the end of the quarter; for a monthly payer, it arises at the end of the month.

Applying these principles: tax provisions aren't liabilities under subsection 615-65(4), but instalments are.

85.      Applying the principles in TD 2007/28 and TD 2012/10, tax provisions calculated at the interposition date, net of instalments, won't be liabilities under subsection 615-65(4). Apart from instalment liabilities, tax liabilities are determined at the end of the income year. If the interposition date happens before the end of the income year, the trading company's tax liability can't be determined. While the trading company might be able to estimate its likely tax obligations, future events (such as unexpected income or deductions before the end of the year) could change that. There would be no legal obligation to make a payment. Any provisional tax liability would be an estimate, contingent upon accurate projections for the remainder of the income year. It wouldn't become an inescapable legal obligation to pay until the end of the income year.

86.      The entity's crystalised tax instalment obligations would reduce the significance of this exclusion. For example, if the interposition happened in May, for a monthly payer, the tax provision would be up to one month after the April instalment.

[1] 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.

[2] 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.

[3] 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.

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

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

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

[7] 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).

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

[9] 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?

[10] 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, and its aggregated turnover is less than $50 million. For the purposes of this edited version, we'll just say we think the trading company is likely to have aggregated turnover exceeding $50 million in the relevant years. The holding company would include the trading company's turnover in its aggregated turnover, because the holding company owns all the trading company's shares: see section 328-125 read with section 328-115. For completeness, 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 (excluding non-portfolio dividends), franking credits, and capital gains. Very broadly, non-portfolio dividends are dividends paid to entities which own more than 10% of the shares in the company paying the dividend: see sections 317 and 334A of the Income Tax Assessment Act 1936, with a few exceptions relevant to finance shares. We expect dividends would be non-portfolio dividends because the holding company will own all the trading company's shares, and we see no reason to suggest the exceptions would be relevant here.

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

[12] 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 22 August 2022

[13] Oxford University Press (2004) Australian Oxford Dictionary, 2^nd edition, accessed at https://www.oxfordreference.com/view/10.1093/acref/9780195517965.001.0001/m-en_au-msdict-00001-0031168?rskey=edP8hh&result=1 on 22 August 2022.

[14] Mann T (ed) (2017) Australian Law Dictionary, Oxford University Press, accessed at https://www.oxfordreference.com/view/10.1093/acref/9780190304737.001.0001/acref-9780190304737-e-2341?rskey=mWGPDO&result=1 on 22 August 2022.

[15] Australian Accounting Standards Board (2022) Conceptual Framework for Financial Reporting, at paragraph 4.26; Australian Accounting Standards Board (2019) AASB 137: Provisions, Contingent Liabilities and Contingent Assets, paragraph 10.

[16] Lexis Nexis Australia (2022) Encyclopaedic Australian Legal Dictionary, accessed https://advance.lexis.com/document/?pdmfid=1201008&crid=a39e9726-5c25-4244-830a-9d505c5fa7bf&pddocfullpath=%2Fshared%2Fdocument%2Fanalytical-materials-au%2Furn%3AcontentItem%3A5D0V-DK91-FCK4-G036-00000-00&pdcontentcomponentid=603560&pdteaserkey=sr3&pdicsfeatureid=1517127&pditab=allpods&ecomp=rxgpk&earg=sr3&prid=e39947de-b065-463f-b609-99211939880a&identityprofileid=FQHPHR53258&cbc=0 on 22 August 2022.

[17] Law J (ed) (2022) A Dictionary of Law, 10^th edition, Oxford University Press, accessed https://www.oxfordreference.com/view/10.1093/acref/9780192897497.001.0001/acref-9780192897497-e-2255?rskey=MoWx3f&result=1 on 22 August 2022.

[18] 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, citing Spencer v The Commonwealth (1907) 5 CLR 418.

[19] 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? See also

[20] ATO Interpretative Decision ATO ID 2005/211 (Withdrawn) Income Tax: Capital gains tax - cost base/reduced cost base - debt. While this ATO ID was withdrawn, the withdrawal notice doesn't suggest a change of view.

[21] Case S43 - No. 3 Board of Review (1985) 85 ATC 343; (1985) 28 CTBR (NS Case 49), per Dr P. Gerber (M.B. Hogan and G.W. Beck agreeing).

[22] 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?

[23] 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.

[24] 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.

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

[26] 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?

[27] 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 II of the Income Tax Assessment Act 1936?

[28] 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.

[29] Federal Commissioner of Taxation v H [2010] FCAFC 128 (income tax); Federal Commissioner of Taxation v Byrne Hotels Qld Pty Ltd [2011] FCAFC 127 (legal fees and real estate agent fees).