Taxpayer Alert

TA 2012/3

Structured financial products that exploit franking credits and other tax benefits

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FOI status: may be released

Overview

This Taxpayer Alert describes certain complex highly structured investment products that seek, amongst other things, to transfer franking credits. These products claim to offer investors (the taxpayers) exposure to a portfolio of listed securities and the benefit of franking credits whilst using a derivative instrument to effectively transfer the risk of investing in those securities from investors to the derivative counterparty.

Context for the arrangement

Imputation benefits (including franking credits) may attach to distributions paid by a company. An important principle underlying the imputation system is that imputation benefits should only be available to the true economic owners of the company.

The income tax legislation contains specific measures, as well as a general anti-avoidance provision in section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936), to prevent abuse of the imputation system through schemes which circumvent the basic rules for the franking of distributions. Under section 177EA of the ITAA 1936, the Commissioner may make a determination to deny imputation benefits where it may be concluded that a party to a scheme participated in the scheme or some part of the scheme for a purpose, other than an incidental purpose, of enabling a taxpayer to obtain an imputation benefit.

Description

The alert applies to arrangements with features substantially equivalent to the following:

1.

A financial institution or other entity markets an arrangement to taxpayers who are retail or wholesale investors.

2.

A taxpayer enters into the arrangement.

3.

Once the taxpayer pays the issue price, a parcel of ASX listed securities (the Parcel) is acquired and the legal title to that parcel is held by a custodian or security trustee, or under a similar trust arrangement, on behalf of the taxpayer.

4.

The taxpayer also enters into a derivative instrument with the following features:

i.

The amount of the distributions or other income generated by the Parcel is either diverted by the taxpayer, or the trustee of the trust, to the entity with which the taxpayer, or some other entity acting on their behalf, has entered into the derivative instrument;

ii.

Under the derivative, the taxpayer may be entitled to a periodic coupon which is calculated by reference to the increase in value of a notional investment in certain reference assets. If the value of those reference assets does not increase during the calculation period, then no coupon will be payable for that period. These reference assets are unrelated to the Parcel.

iii.

Instead of or in addition to the payment of a periodic coupon, the taxpayer may be entitled to an amount that is payable at the maturity of the investment. This amount may be calculated by reference to the difference between the market value of the Parcel at maturity and the value of a notional investment in a separate portfolio of reference assets. This feature changes the taxpayer's exposure from an exposure to movements in the market price of the securities comprising the Parcel to an exposure to the reference assets.

5.

The arrangement may also involve entry into put and call options over the securities comprising the Parcel or other securities that provide the same return as the notional investment. Such options may provide the mechanism to allow the taxpayer or the issuer to exit the arrangement prior to, or at maturity or to protect the invested capital of the taxpayer if they hold their investment to maturity.

6.

The taxpayer may be able to exit the investment prior to maturity. However, if this occurs the taxpayer may not receive the benefit of the capital protection mechanism described above in paragraph 5.

7.

The taxpayer may also be provided with a loan to fund the investment and, as a result, may incur interest and/or borrowing expenses.

8.

In some cases, the entity who marketed the arrangement or an associate who implements the arrangement indicates in marketing documents that certain favourable tax outcomes are available or potentially available to investors, such as:

i.

franking credits;

ii.

deductions for payments made by the taxpayer under the derivative; and/or

iii.

deductions for interest expenses or borrowing costs.

9.

The issuer, a custodian or some other entity acting on their behalf issues distribution statements or other documents that reflect favourable tax outcomes for the taxpayer, such as:

i.

tax offsets in respect of distributions constructively received, but paid to the counterparty under the derivative;

ii.

revenue deductions for payments made by the taxpayer under the derivative; and

iii.

deductions for interest or borrowing costs.

10.

The taxpayer subsequently claims some or all of the favourable tax outcomes discussed at paragraph 9 in their income tax return.

11.

In some cases, there may be differences in implementation of key steps in the arrangement that may affect the potential availability of these favourable tax outcomes, such as failures to transfer the interest in the Parcel or to execute key transactions within the derivative.

Example of an arrangement form

Features which concern us

The ATO considers that arrangements of this type give rise to a number of issues relevant to taxation laws, including whether:

a.

the substance of the arrangement provides the investor with exposure to reference assets, even though the form of the arrangement is an investment in the Parcel through a trust;

b.

the deductibility under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) of the amount of any payment made under the derivative reflecting the distributions and other income on the Parcel;

c.

the deductibility under sections 8-1 or 25-25 of the ITAA 1997 of interest or other borrowing expenses incurred by taxpayers under any loan to finance their investment;

d.

for the purposes of former Division 1A Part IIIAA of the ITAA 1936 and Subdivision 207-F of the ITAA 1997, the taxpayer is a qualified person in relation to any distribution paid on the Parcel such that the taxpayer is entitled to tax offsets attaching to those distributions;

e.

paragraph 177EA(5)(b) of ITAA 1936 applies to deny the whole, or any part, of the imputation benefits claimed by the taxpayers in respect of distributions on the Parcel of shares;

f.

other parts of Part IVA of the ITAA 1936 apply;

g.

the assessability of any fee, commission or other amount received by the promoter;

h.

any entity who marketed or otherwise encouraged the growth of the arrangement is a promoter of a tax exploitation scheme for the purposes of Division 290 of Schedule 1 to the Taxation Administration Act 1953; and

i.

any taxation statement made by taxpayers in relation to the arrangement may be false or misleading.

The ATO is currently reviewing these arrangements.

The ATO view on the operation of the imputation system and section 177EA is discussed in Taxation Ruling TR 2009/3.

Date of Issue: 14 June 2012

Date of Effect: 14 June 2012

Related Rulings/Determinations:
IT 2050
IT 2682
TR 95/33
TR 2009/3

Related Practice Statements:
PS LA 2005/24
PS LA 2008/15

Subject References:
capital protected borrowing
financial products
interest expense
interest income
prepaid expenses
product rulings
public rulings
taxation administration

Legislative References:
Income Tax Assessment Act 1936
Section 51AAA
Section 51(1)
Division 6 Part III
Former Division 1A Part IIIA
Part IVA
Section 177EA
Income Tax Assessment Act 1997
Section 8-1
Section 25-25
Division 110
Division 207
Subdivision 207-B
Subdivision 207-F
Division 247
Taxation Administration Act 1953
Division 290 of Schedule 1

Case References:

Mills v Commissioner of Taxation
[2011] FCAFC 158
2011 ATC 20-295

Authorised by:
Tim Dyce
Deputy Commissioner
Aggressive Tax Planning (ATP)