Edited version of private advice

Authorisation Number: 1052173215775

Date of advice: 26 September 2023

Ruling

Subject: Share buy-back

Question 1

Does section 177EA of the Income Tax Assessment Act 1936 apply to the circumstances around the proposed selective off-market share buy-back to be conducted by Company Y on the shares held by Company X as trustee for Foundation X in Company Y?

Answer

No

Question 2

In relation to the proposed selective off-market share buy-back to be conducted by Company Y on the shares held by Company X as trustee for Foundation X in Company Y, are distributions or distributions and other benefits streamed to empower the Commissioner to make a determination pursuant to section 204-30 of the Income Tax Assessment Act 1997?

Answer

No

This ruling applies for the following periods:

Income Year ended 30 June 20XX

Income Year ending 30 June 20XX

The scheme commenced on:

DD MM 20XX

Relevant facts and circumstances

Background

Company X is the trustee for Foundation X, a Private Ancillary Fund (the Foundation).

The Foundation is an income tax exempt fund, endorsed to access income tax exemption under Subdivision 50-B of the Income Tax Assessment Act 1997.

The Foundation currently holds shares in Company Y, which it acquired on DD MM 20XX as a beneficiary of a deceased estate (the Estate).

All shareholders of Company Y are Australian tax residents.

The testator of the deceased estate (the Testator) passed away on DD MM 20XX. The testator had a spouse (the spouse) and children.

The spouse and the children were appointed as directors of Company X (being the trustee of the Foundation) shortly after the testator's death.

The Will of the Testator

The last will of the Testator was made on DD MM 20XX (the Will). A copy of the Will has been provided. The Will also refers to an earlier will dated DD MM 20XX (Earlier Will) and other documents which were not provided.

The Will includes a clause for the Foundation, an increase in the payments to the Foundation to a maximum of $XX.

As at the Testator's death, the Testator or entities controlled by the Testator had made payments totalling $X to the Foundation.

The Spouse's entitlements under the Will include any contents owned solely by the Testator of the properties at different addresses.

The Will also includes the following bequests:

• $XX to each of the children (along with the forgiveness of any loans owing by them); and
• Legacies totalling $X to friends and relatives.

While gifted to the Spouse in the Will, two out of three properties were held jointly by the Spouse and the Testator. These properties were passed to the Spouse as the sole surviving joint tenant pursuant to the principle of survivorship.

Probate was granted on DD MM 20XX.

The Deed of Family Arrangement

On DD MM 20XX, the Foundation, the executors of the Estate and other beneficiaries executed a Deed of Family Arrangement (DOFA).

The Foundation obtained its shares in Company Y under the DOFA, settling its entitlement from the Estate.

The Foundation advised the ATO the following in relation to the DOFA:

• the DOFA was entered into by the Foundation and the other parties on the understanding that there were considerable obstacles in determining entitlements of the beneficiaries under the Will if a negotiated agreement was not reached;
• Despite clause X of the Will, the Spouse was not adequately provided for under the Will and was eligible to apply to the Supreme Court of New South Wales for an order that further provisions be made for her out of the Estate. Such further provision, if granted, would reduce the assets of the Estate available to satisfy other legacies including that of the Foundation. The Spouse appointed their own lawyers and accountant to represent them in respect of any entitlements they may have in the Estate;
• Legal advice obtained by the Foundation indicated that the Foundation's entitlement could be any amount from $X to $XX (on the basis that the Foundation had already received $X, the Foundation was entitled to a maximum of $XX less $X);
• There were insufficient assets in the Estate to make all intended bequests in the Will. This added to the uncertainty of the Foundation's entitlements, as not only was the gift under the Will uncertain as to amount, but it would also need to be reduced due to the limited assets in the Estate;
• The form of the gift - being shares in Company Y - was dictated by the nature of the assets in the Estate and was not something that the Foundation had any choice over. The Foundation did consider the nature of the underlying investments held by Company Y and formed the view that their risk profile was not contrary to the Foundation's investment objectives; and
• A selective off-market share buy-back was not contemplated at the time the DOFA was being negotiated by the Foundation. Until the gift was actually received there was such a level of uncertainty about what, if anything, the Foundation would receive that it was not possible to plan for what would be done with the gift. The focus was on securing the gift.

Off-Market Share Buy-back

The directors of Company Y intend to offer a selective off-market share buy-back (the Buy-Back) to the Foundation. Company Y will conduct the off-market share buy-back in accordance with the Corporations Act 2001.

Under the Buy-Back, Company Y proposes to purchase and cancel 100% of the fully paid shares held by the Foundation.

The shares will be bought back for market value consideration.

Company Y intends to use the 'Average Capital Per Share' method to determine the dividend and capital components of the buy-back proceeds, as outlined in Practice Statement Law Administration PS LA 2007/9 Share buy-backs.

Commercial drivers

In MM 20XX the Foundation's financial advisors were asked to review the Foundation's investment position. The Foundation currently has direct investments in its own name and an interest in Company Y which is itself an investment vehicle.

Their advice was that the Foundation's investments should be held 'under one umbrella' for transparency, more efficient asset allocation and ease of reporting. Further, a comparison of the Foundation's investment strategy, and that of Company Y, showed a divergence of views on investment philosophy. The Foundation's financial advisors stated in respect of its shareholding in Company Y:

Given the fundamentally different purposes, it is appropriate for the investment strategy of the foundation to be given more control and flexibility rather than having an indirect interest via a shareholding Company Y. As such, separating the funds is appropriate moving forward.

The existing shareholders of Company Y were approached and asked whether they would buy the Foundation's shares in Company Y, in whole or in part. However, all existing shareholders indicated that they did not wish to acquire further shares in Company Y. The existing shareholders stated either that they had insufficient funds to purchase the shares or did not want to commit further funds to this particular investment believing that their portfolios would be overweight in one investment. Further, as a private investment company, it was not desirable to seek external buyers for the Foundation's shares.

In the absence of a ready buyer for the shares in Company Y, the Foundation approached Company Y about the potential for a buy-back of the shares.

Company Y agreed to undertake the Buy-Back in respect of the shares of the Foundation. This aligns with the Company's own role in managing its investments. The Foundation, being a tax-exempt body, has different investment priorities from Company Y 's other shareholders and different objectives being a charitable entity. Accordingly, the Buy-Back would simplify Company Y's role in managing its investments, as it would no longer be required to consider and balance the differing views of various shareholders.

Relevant legislative provisions

Section 177EA of the Income Tax Assessment Act 1936

Section 204-30 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Summary

Section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936) will not apply to the Buy-Back to be conducted by Company Y on the shares held by the Foundation in Company Y.

Detailed Reasoning

Section 177EA of the ITAA 1936 is a general anti-avoidance provision that applies to a wide range of schemes designed to obtain imputation benefits. In essence, it applies to schemes for the disposition of shares or an interest in shares, where a franked distribution is paid or payable in respect of the shares or an interest in shares. This may include an off-market share buy-back with a franked dividend component.

Subsection 177EA(3) of the ITAA 1936 provides that section 177EA applies if:

(a)  there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity;

(b)  either:

                    (i)        a frankable distribution has been paid, or is payable or expected to be payable, to a person in respect of the membership interests;

                   (ii)        a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of membership interests, as the case may be; and

(c)   the distribution was, or is expected to be, a franked distribution or a distribution franked with an exempting credit; and

(d)  except for this section, a person (the 'relevant taxpayer') would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution; and

(e)  having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose, but not including an incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit.

Where section 177EA of the ITAA 1936 applies, the Commissioner has the discretion to make a determination to deny the imputation benefit to each participating shareholder pursuant to paragraph 177EA(5)(b).

Subsection 177EA(14) of the ITAA 1936 provides the meaning of 'scheme for a disposition'. Paragraph 177EA(14)(b) states that a scheme for a disposition of membership interests includes a scheme that involves entering into any contract, arrangement, transaction of dealing that changes or otherwise affects the legal or equitable ownership of the membership interests or interest in membership interests.

Application to your circumstances

The Foundation advised that a buy-back was not contemplated at the time the DOFA was being negotiated by the Foundation. In this regard, the two transactions, being the execution of the DOFA and the proposed Buy-Back, are separate transactions and will not be considered together in the application of section 177EA of the ITAA 1936.

The Buy-Back constitutes a scheme for a disposition of membership interests, as a contract, arrangement or transaction that is proposed to be entered into, which would change the legal or equitable ownership of the membership interest. The conditions of paragraphs 177EA(3)(b) to 177EA(3)(d) of the ITAA 1936 are also satisfied in respect of the Buy-Back.

Accordingly, the issue is whether, having regard to the relevant circumstances of the scheme, it would be concluded that on the part of Company Y, its shareholders or any other relevant party, there was more than a merely incidental purpose of conferring an imputation benefit under the scheme. In respect of the Buy-Back, the relevant taxpayer is the Foundation and the scheme comprises the circumstances surrounding the Buy-Back.

In arriving at a conclusion, the Commissioner must have regard to the relevant circumstances of the scheme which include, but are not limited to, the circumstances set out in subsection 177EA(17) of the ITAA 1936. The relevant circumstances listed in subsection 177EA(17) encompass a range of circumstances which, taken individually or collectively, could indicate the requisite purpose.

The Buy-Back is being carried out to allow the Foundation to exit their investment in Company Y. Based on the information provided, including the commercial drivers of the Buy-Back, the Commissioner's consideration of all of the relevant circumstances of the scheme would not, on balance, lead to a conclusion that any purpose of enabling the Foundation to obtain imputation benefits is a more than incidental purpose.

As a result, and having regard to the relevant circumstances of the scheme, the five conditions in subsection 177EA(3) of the ITAA 1936 have not been satisfied and section 177EA will not apply to any fully franked distribution under the Buy-Back.

Where section 177EA of the ITAA 1936 does not apply, the commissioner does not have a discretion to deny the imputation benefit pursuant to paragraph 177EA(5)(b).

Conclusion

The execution of the DOFA and the decision to implement a selective off market share Buy-Back are considered separate transactions as a selective-off market share buy-back was not contemplated at the time the DOFA was executed. That is, by not being in contemplation at that time, the Buy-Back was not planned in a way to ensure the Foundation received the imputation benefit. As the five conditions in subsection 177EA(3) of the ITAA1936 are not satisfied in relation to the Buy-Back, section 177EA does not apply to the circumstances around the Buy-Back to be conducted by Company Y on the shares held by the Foundation in Company Y.

Question 2

Summary

In relation to the Buy-Back, distributions are not streamed and the Commissioner will not make a determination pursuant to section 204-30 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Subsection 204-30(1) of the ITAA 1997 empowers the Commissioner to make certain determinations if a corporate tax entity streams one or more distributions, or one or more distributions and the giving of other benefits, to its members in such a way that:

(a)  an 'imputation benefit' is, or apart from section 204-30 of the ITAA 1997 would be, received by a member of the entity as a result of the distribution or distributions (paragraph 204-30(1)(a)); and

(b)  the member would derive a 'greater benefit from franking credits' than another member of the entity (paragraph 204-30(1)(b) of the ITAA 1997); and

(c)   the other member of the entity will receive lesser imputation benefits, or will not receive any imputation benefits, whether or not the other member receives other benefits (paragraph 204-30(1)(c) of the ITAA 1997).

An imputation benefit is (relevantly) received as a result of a distribution where a member is entitled to a tax offset under Division 207 of the ITAA 1997 (paragraph 204-30(6)(a)).

For section 204-30 of the ITAA 1997 to apply, a member of an entity must derive a greater benefit from franking credits. The member that derives the greater benefit from franking credits is the favoured member. The member that receives the lesser imputation benefits is the disadvantaged member. Some of the cases in which a member of an entity 'derives a greater benefit from franking credits' are listed in subsection 204-30(8) by reference to the ability of a member to fully utilise franking credits.

The term 'streaming' is not defined in the ITAA 1997. Streaming of distributions is broadly explained in paragraph 3.28 of the Explanatory Memorandum to the New Business Tax System (Imputation) Bill 2022 as selectively directing the flow of franked distributions to those members who can most benefit from imputation benefits.

Under the Buy-Back, the Foundation will be provided with an imputation benefit as a result of franking the dividend component to be paid in relation to the buy-back of their shares. What occurred under the Buy-Back does not constitute streaming of a distribution to the favoured member. The imputation benefit provided to the Foundation will be merely incidental to the exit of the Foundation from Company Y, and in relative terms, will be in proportion to the Foundation's share of Company Y's franking credit balance.

Company Y will pay franking credits to the Foundation based on their shares held and none of Company Y's shares are held by non-resident shareholders who do not benefit from franking credits to the same extent as the Foundation. Therefore, the conditions in subsection 204-30(1) of the ITAA 1997 will not be met.

Conclusion

The Commissioner concludes that section 204-30 of the ITAA 1997 does not apply and therefore will not make a determination in relation to the imputation benefits that the Foundation will receive arising out of the Buy-Back.