Edited version of your written advice

Authorisation Number: 1012696626167

Ruling

Subject: Dividend access share arrangement

Question 1

Will section 725-90 of the Income Tax Assessment Act 1997 (ITAA 1997) (about direct shifts that are reversed) apply to prevent any consequences under Division 725 of the ITAA 1997 for any direct value shift that happens upon the issue of the redeemable preference shares in the company that are, consistent with their terms of issue, cancelled within four years in circumstances where no realisation event has happened to any other equity or loan interest in the company before that cancellation?

Answer

Yes.

Question 2

Will section 725-90 of the ITAA 1997 (about direct shifts that are reversed) apply to prevent any consequences under Division 725 of the ITAA 1997 for any direct value shift that happens upon the declaration and payment of a dividend to the holders of the redeemable preference shares?

Answer

Yes.

Question 3

Will section 177E of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the dividend access share arrangement?

Answer

Yes.

Question 4

Will section 177D of the ITAA 1936 apply to the dividend access share arrangement?

Answer

As the more specific integrity provision of section 177E of the ITAA 1936 dealing with dividend stripping is considered to apply in this case, the Commissioner has not considered the application of section 177D of the ITAA 1936.

This ruling applies for the following periods

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commenced on

1 July 2011

Relevant facts and circumstances

The arrangement that is the subject of the private ruling involves redeemable preference shares (RPSs).

The arrangement is set out in the following documents:

• the application for private ruling

• further documentation, including emails, received in relation to the application; and

• records of conversation with respect to the application.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 725-90.

Income Tax Assessment Act 1997 Section 207-145.

Income Tax Assessment Act 1936 Section 177A.

Income Tax Assessment Act 1936 Section 177D.

Income Tax Assessment Act 1936 Section 177E.

Income Tax Assessment Act 1936 Section 177F.

Reasons for decision

All subsequent legislative references are to the ITAA 1936 unless otherwise stated.

Direct value shifts

There can be consequences under Division 725 of the ITAA 1997 where there is a direct value shift involving the equity or loan interests in an entity.

However, a reversal exception is provided by section 725-90 of the ITAA 1997. It applies where the state of affairs that is brought about by the things done under the scheme:

• will more likely than not cease to exist within four years after the time that the first of those things is done; and

• does not still exist at the earlier of the end of those four years or when a realisation event happens to an affected interest for the direct value shift.

The legislative context shows that the term 'state of affairs' is used to refer to the factual circumstance that is the trigger or cause for the value shift. The state of affairs is one but for which the direct value shift would not have happened: paragraph 725-90(1)(a) of the ITAA 1997. The example that follows subsection 725-90(1) of the ITAA 1997 reads:

Under a scheme, the voting rights attached to a class of shares in a company are changed. As a result, the market value of shares in that class decreases, and the market value of other classes of shares in the company increases. The company's constitution provides that the change is to last for only 3 years.

Issue of the RPSs

With respect to any direct value shift that may happen upon the issue of the RPSs, the relevant state of affairs is that the Company has accumulated profits, and there is a further class of shares on issue with discretionary dividend rights.

It is more likely than not that this state of affairs will cease to exist within four years, as the terms of issue of the new class of shares require that they be cancelled within that time period.

Consequently, the reversal exception will apply to any direct value shift on the issue of the RPSs as long as:

• these shares are in fact cancelled within four years; and

• a realisation event doesn't happen to an affected interest for the direct value shift while the RPSs are still on issue (for example, no shares in the Company are sold while the RPSs are still on issue).

Declaration and payment of a dividend to the holders of the RPSs

With respect to any direct value shift that may happen upon the declaration of a dividend to the holders of the RPSs, the relevant state of affairs is that a dividend is payable to these holders. This state of affairs will cease to exist when the dividend is paid, an event that will happen within the four year period.

Consequently, the reversal exception will apply to any direct value shift upon the declaration of a dividend with respect to the RPSs.

Part IVA

Part IVA contains a number of anti-avoidance provisions. It gives the Commissioner the discretion to cancel a 'tax benefit' that, but for the operation of the Part, has been, or would be, obtained by a taxpayer in connection with a scheme to which Part IVA applies (subsection 177F(1)).

The Commissioner considers that two anti-avoidance provisions have potential application to the particular facts of this case:

• Section 177D - Schemes to which Part IVA applies

• Section 177E - Dividend stripping schemes to which Part IVA applies

As section 177E is the more specific provision, it will be considered first.

Section 177E - Dividend stripping schemes to which Part IVA applies

The relevant law

Section 177E(1) states:

Where:

(a) as a result of a scheme that is, in relation to a company:

(i) a scheme by way of or in the nature of dividend stripping; or

(ii) a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping;

any property of the company is disposed of;

(b) in the opinion of the Commissioner, the disposal of that property represents, in whole or in part, a distribution (whether to a shareholder or another person) of profits of the company (whether of the accounting period in which the disposal occurred or of any earlier or later accounting period);

(c) if, immediately before the scheme was entered into, the company had paid a dividend out of profits of an amount equal to the amount determined by the Commissioner to be the amount of profits the distribution of which is, in his or her opinion, represented by the disposal of the property referred to in paragraph (a), an amount (in this subsection referred to as the notional amount) would have been included, or might reasonably be expected to have been included, by reason of the payment of that dividend, in the assessable income of a taxpayer of a year of income; and

(d) the scheme has been or is entered into after 27 May 1981, whether in Australia or outside Australia;

the following provisions have effect:

(e) the scheme shall be taken to be a scheme to which this Part applies;

(f) for the purposes of section 177F, the taxpayer shall be taken to have obtained a tax benefit in connection with the scheme that is referable to the notional amount not being included in the assessable income of the taxpayer of the year of income; and

(g) the amount of that tax benefit shall be taken to be the notional amount.

177E(1)(a:) as a result of a scheme that is, in relation to a company: (i) a scheme by way of or in the nature of dividend stripping; or (ii)a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping, any property of the company is disposed of

Is there a scheme that satisfies subparagraphs 177E(1)(a)(i) or (ii)?

Scheme is defined in subsection 177A(1) to mean:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan proposal, action, course of action or course of conduct.

Here, the DAS Arrangement clearly constitutes a scheme as defined in subsection 177A(1).

In order for the arrangements to be one by way of dividend stripping, the following elements must be established:

(1) a target company with substantial undistributed profits creating a potential tax liability, either for the company or its shareholders;

(2) the sale or allotment of shares in the target company to another party;

(3) the payment of a dividend to the purchaser or allottee of the shares out of the target company's profits;

(4) the purchaser or allottee escaping Australian income tax on the dividend so declared;

(5) the vendor shareholders receiving a capital sum for the shares in an amount the same as or very close to the dividends paid to the purchasers (there being no capital gains tax at the relevant times); and

(6) the scheme being carefully planned, with all the parties acting in concert, for the predominant if not the sole purpose of the vendor shareholders, in particular, avoiding tax on a distribution of dividends by the target company.

The first four elements of a dividend stripping are present here because:

(1) The Company carries substantial undistributed profits which, if distributed, would expose the Original Shareholders to a potential tax liability;

(2) There is an allotment of RPSs to the New Shareholders;

(3) The Company will declare and pay almost fully franked dividends to the New Shareholders out of its accumulated profits;

(4) The Corporate Beneficiaries of the Trusts to which the dividends will be appointed by those trusts will not incur any tax liability to the extent to which the dividends are franked. As the dividends will be almost fully franked, the Corporate Beneficiaries will incur little additional tax.

The issue is the fifth element that is whether the vendor shareholders (that is, the Original Shareholders) will receive a capital sum in an amount close to the dividend paid to the New Shareholders.

The issue of whether the vendor shareholders receive anything was discussed by Jessup J in the first instance of Lawrence. Jessup J stated:

In the present case an accretion of capital, the same in effect as such a receipt, arose from the increase in the value of the assets held by the Clearmink No. 1 and No. 2 Trusts, to which the applicant and his family were beneficially entitled.¹ 

Here, as the assets of the Corporate Beneficiaries increase, the shares in the Corporate Beneficiaries will become more valuable. As the Trusts own the shares to which the Original Shareholders and their family are beneficially entitled, this accretion to the capital of the Trusts would constitute a capital sum being received by the Original Shareholders to compensate them for the Company's profits paid to the New Shareholders. As such, applying the above reasoning of Jessup J, the fifth element is present.

This leaves the last element, namely whether the DAS Arrangement has, as its dominant purpose, the avoidance of tax on the distribution of dividends by the Company. In considering this element, it is necessary to examine all of the evidence of the arrangement and to consider the relevant objective features of the arrangement to determine whether the arrangement has been carried out with the sole or dominant purpose of avoiding tax on distributions of profits from the Company. Importantly, an arrangement that has a non-tax purpose may be undertaken for the dominant purpose of avoiding tax.

One objective matter relates to the complexity of the arrangement. The most straightforward manner by which the Original Shareholders can achieve their stated objective is having the Company pay an in-specie dividend to themselves and transferring the in-specie dividend to their own separate trusts. Given the magnitude of the Company's retained profits, the in-specie dividend would be subject to a rate of tax above the company tax rate, though the Original Shareholders would have the benefit of any available franking credits.

However, after the proposed arrangement is carried out, the accumulated profits of the Company will have been distributed in a complex and contrived manner to entities associated with the Original Shareholders whilst avoiding any additional tax to the Original Shareholders.

In short, the stated objective could arguably be achieved more 'conveniently, commercially and frugally' without the creation of the RPSs. Similarly in Federal Commissioner of Taxation v. Hart [2004] HCA 26 2004 at paragraph 94, Callinan J, in the context of 177D(b)(ii), noted that it was relevant to consider whether the substance of the transaction in question (tax implications apart) could more conveniently, or commercially, or frugally have been achieved by a different transaction or form of transaction.

There is also a particular feature of the arrangement which appears to have been included to avoid specific provisions within the income tax legislation. The DAS Arrangement contains a requirement that the RPSs must be redeemed within four years, which is a feature inexplicable but for the avoidance of the direct value shifting provisions.

There are other aspects of the arrangement that point towards a tax avoidance purpose.

it is considered that the arrangement is one that is entered into for a dominant purpose of avoiding the imposition of any additional tax that the Original Shareholders would be subject to if the accumulated profits were distributed to them. As such, the DAS Arrangement constitutes a scheme 'by way of or in the nature of dividend stripping' within the meaning of section 177E.

As a result of the scheme, is property of the Company disposed of?

The second element of paragraph 177E(1)(a) is whether as a result of the arrangement (which is a scheme by way of or in the nature of dividend stripping) any property of the company is disposed of.

Paragraph 177E(2)(a) states that a reference in subsection 177E(1) to the disposal of property of a company shall be read as including a payment of a dividend by the company.

As the Company will pay a dividend to the New Shareholders, this second element of paragraph 177E(1)(a) is satisfied.

It follows that subsection 177E(1) is satisfied.

177E(1)(b) - in the opinion of the Commissioner, the disposal of the property referred to in paragraph 177E(1)(a) of the ITAA 1936 represents, in whole or in part, a distribution (whether to a shareholder or another person) of profits of the company (whether of the accounting period in which the disposal occurred or of any earlier or later accounting period)

The relevant disposal of property under the arrangement is the payment of a dividend by the Company to the New Shareholders. This shows that the disposal represents a distribution of profits of the Company. As such, this condition is met.

177E(1)(c): if, immediately before the scheme was entered into, the company had paid a dividend out of profits of an amount equal to the amount determined by the Commissioner to be the amount of profits the distribution of which is, in his or her opinion, represented by the disposal of the property referred to in paragraph (a), an amount (in this subsection referred to as the notional amount) would have been included, or might reasonably be expected to have been included, by reason of the payment of that dividend, in the assessable income of a taxpayer of a year of income

Here, if, immediately prior to the execution of the DAS Arrangement, the Company paid a dividend out of profits equal to the amount of dividend to be paid to the New Shareholders, that dividend would have been paid to the Original Shareholders, and would have been included in their assessable income by virtue of subparagraph 44(1)(a)(i). As such, the notional amount for the purpose of subsection 177E(1) is the amount of the dividend to be paid to the RPS holder.

Therefore, paragraph 177E(1)(c) is satisfied.

177E(1)(d): The scheme has been or is entered into after 27 May 1981, whether in Australia or outside Australia

The final requirement that the scheme be carried out after 27 May 1981 is clearly satisfied.

Conclusion on section 177E

Because all the criteria in paragraphs 177E(1)(a) to (d) are satisfied, in accordance with paragraphs 177E(1)(e), (f) and (g):

• the arrangement is a scheme to which Part IVA applies;

• for the purposes of section 177F, the taxpayer (that is, the Original Shareholders) is taken to have obtained a tax benefit in connection with the arrangement; and

• the amount of that tax benefit is taken to be the notional amount referred to in paragraph 177E(1)(c).

In this case, where a dividend is paid out of the accumulated profits of the Company to the New Shareholders, the Commissioner would exercise his discretion to make a determination under paragraph 177F(1)(a) to include in each of the Original Shareholders' assessable income the 'tax benefit' being their share of the dividend.

This conclusion is consistent with Taxation Determination TD 2014/1 which provides the Commissioner's view as to the application of section 177E to 'dividend access share' arrangements.

As the more specific integrity provision of section 177E dealing with dividend stripping is considered to apply in this case, the Commissioner has not considered the application of section 177D.

Further issues for you to consider

It should be noted that section 207-145 of the ITAA 1997 modifies the normal gross up and tax offset entitlement treatment afforded by sections 207-20, 207-35 and 207-45 of the ITAA 1997 in respect of the receipt of a franked distribution in certain circumstances. One of these circumstances, as provided in paragraph 207-145(1)(d) of the ITAA 1997, is when a franked distribution is made as part of a 'dividend stripping operation'. This term is defined in 207-155 of the ITAA 1997 in similar terms to section 177E. Given the conclusion reached in respect of the application of 177E, it is considered that the above arrangement would constitute a dividend stripping operation for the purposes of paragraph 207-145(1)(d) of the ITAA 1997. This would have the effect of the non-inclusion of any franking credit amount attached to the franked distribution made as part of the arrangement in the assessable income of the corporate beneficiaries of the New Shareholders, as well as the denial of any tax offset entitlement to those corporate beneficiaries in respect to the distribution which flows indirectly through the New Shareholders to them, per the operation of paragraph 207-145(1)(g) of the ITAA 1997.

¹ Lawrence v FC of T [2008] FCA 1497 at paragraph 84

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