ATO ID 2006/316: Income Tax: franking credits - Taxation consequences on an exempting entity ceasing to be effectively owned by prescribed persons
Date of decision: 8 November 2006
Year of income: 30 June 2004
Business line: Private Groups and High Wealth Individuals

Issue
Will subsection 208-50(2) of the Income Tax Assessment Act 1997 (ITAA 1997) apply so that an exempting entity, which has ceased to be effectively owned by prescribed persons within 12 months of it becoming an exempting entity, not be taken to become a former exempting entity, where that same entity has previously ceased to be an exempting entity (that is it was previously a former exempting entity)?

Decision
No. If a corporate tax entity becomes effectively owned by prescribed persons and, within 12 months, there is a change in ownership so that it ceases to be so owned, then that change in ownership does not result in the company becoming a former exempting entity. However, where a corporate tax entity ceases to be an exempting entity on more than one occasion, only the first cessation referred to in subsection 208-50(2) of the ITAA 1997 is ignored. If a former exempting entity becomes an exempting entity, but ceases to be an exempting entity within 12 months, it will again become a former exempting entity.

Facts
Company A was incorporated on 1 July 2002 and from this time to 30 September 2003 was effectively owned by prescribed persons for the purposes of Division 208 of the ITAA 1997. As at 30 September 2003 Company A's franking account had a franking surplus of $42,000. Following changes in the shareholding of Company A, the company ceased to be effectively owned by prescribed persons on 1 October 2003. Company A became a former exempting entity for the purposes of Division 208 of the ITAA 1997. Its exempting account was credited with an exempting credit of $42,000, being an amount equal to the surplus in its franking account and its franking account was reduced to nil with a franking debit of $42,000. As at 30 June 2005 Company A had a franking surplus of $15,000 and an exempting surplus of $33,000. Following changes in the shareholding of Company A, the company became effectively owned by prescribed persons on 1 July 2005. Company A became an exempting entity for the purposes of Division 208 of the ITAA 1997. Its franking account was credited with an amount of $33,000 from its exempting account, bringing its franking account to a total of $48,000. As at 14 March 2006, Company A had reduced its franking surplus to $41,000 as a result of a distribution to which $7,000 of franking credits were allocated. Following changes in the shareholding of Company A, the company ceased to be effectively owned by prescribed persons on 15 March 2006. The taxation consequences to this cessation are addressed in the reasons for decision.

Reasons for decision
Summary: The franking rules in Part 3-6 of the ITAA 1997 apply from 1 July 2002 onwards. These rules provide limitations in the use of franking credits by exempting entities, with subsection 208-5(1) of the ITAA 1997 providing: An exempting entity is a corporate tax entity that is effectively owned by entities that, either because they are not Australian residents .... , would not be able to fully utilise franking credits on distributions by the corporate tax entity. The primary purpose of Division 208 of the ITAA 1997 is explained in section 6.2 of the Explanatory Memorandum to the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Act 2002 , as follows: Broadly speaking, these provisions are concerned with limiting franking credits available for trading by: • prescribing that franked distributions paid by corporate tax entities, which are effectively owned by non-residents or tax exempt entities, will provide franking benefits to members in limited circumstances only; and • quarantining the franking surpluses of corporate tax entities which were formerly effectively owned by non-residents or tax exempt entities. This is reflected in section 208-15 of the ITAA 1997, specifically, paragraph (b) which seeks to: Quarantine those credits by moving them into a separate account, called the exempting account, when the entity ceases to be an exempting entity. Section 208-20 of the ITAA 1997 defines an exempting entity, stating: A corporate tax entity is an exempting entity at a particular time if, at that time, the entity is effectively owned by prescribed persons. Subsection 208-40(1) of the ITAA 1997 provides that a company is a prescribed person in relation to another corporate tax entity if the company is a foreign resident. Section 208-25 of the ITAA 1997 states in part that an entity is effectively owned by prescribed persons at a particular time if, at that time, not less than 95% of the accountable membership interests in the entity are held by, or held indirectly for the benefit of, prescribed persons. Therefore, if a foreign resident owns not less than 95% of the ordinary shares of a resident Australian company, the Australian company will be an exempting entity. While section 208-10 of the ITAA 1997 provides the following broad definition of a former exempting entity: When an entity ceases to be an exempting entity, it becomes a former exempting entity. Section 208-50 of the ITAA 1997 provides an exception to this definition of a former exempting entity: 208-50(1) Subject to subsection (2), a corporate tax entity is a former exempting entity if it has, at any time, ceased to be an exempting entity and is not again an exempting entity. 208-50(2) If an entity that, at any time, becomes effectively owned by prescribed persons ceases to be so effectively owned within 12 months after that time, the entity is not taken, by so ceasing, to become a former exempting entity. Where a corporate tax entity ceases to be an exempting entity on more than one occasion, only the cessation referred to in subsection 208-50(2) of the ITAA 1997 is disregarded. If a former exempting entity becomes an exempting entity, but ceases to be an exempting entity within 12 months, it will again become a former exempting entity. This is because there would have been an earlier cessation that did not fall within subsection 208-50(2) of the ITAA 1997 (that is, the cessation that resulted in the entity being a former exempting entity in the first instance). Section 208-110 of the ITAA 1997 provides that each former exempting entity has an exempting account. Item 1 of section 208-115 of the ITAA 1997 sets out when a credit arises in the exempting account of a former exempting entity where the entity has a franking surplus at the time it became a former exempting entity. The item states: Exempting Credits: An amount equal to: in a case not covered by paragraph (b) - the franking surplus; or if the entity has been a former exempting entity at any time within a period of 12 months before its transition - so much of the franking surplus as would have been the entity's exempting surplus had it remained a former exempting entity throughout the period Therefore, if a former exempting entity becomes an exempting entity for less than twelve months, upon its reversion to a former exempting entity, instead of converting the whole of its franking surplus or deficit to an equivalent exempting amount, the company will be able to retain the franking surplus or deficit it would have had if it remained a former exempting entity instead of becoming an exempting entity for the relevant period: the remainder is to be converted to an exempting amount. Applying these provisions to the cessation that occurred on 15 March 2006 (that is Company A ceasing to be effectively owned by prescribed persons): pursuant to subsection 208-50(1) of the ITAA 1997, as at 15 March 2006, Company A ceased to be an exempting entity and became a former exempting entity. Subsection 208-50(2) of the ITAA 1997 will not apply to this cessation as Company A has previously been a former exempting entity. That is, the cessation that occurred on 1 October 2003 and resulted in Company A being a former exempting entity in the first instance did not fall within section 208-50 of the ITAA 1997 as it was longer than 12 months. Despite the fact that subsection 208-50(2) of the ITAA 1997 does not apply, Company A will be able to apply item 1 of section 208-115 of the ITAA 1997. Company A became a former exempting entity on 1 October 2003, and then it became an exempting entity on 1 July 2005 for a period of less than twelve months. Upon its reversion to a former exempting entity on 15 March 2006, Company A will be able to retain its franking surplus as if it remained a former exempting entity for the period from 1 July 2005 to 14 March 2006. Therefore, taking into account the franking debit of $7,000 attributed to the payment of a distribution during the period from 1 July 2005 to 14 March 2006, Company A will have, at 15 March 2006, an exempting surplus of $26,000 and a franking surplus $15,000. These amounts are attributed to the position of Company A as if it had remained a former exempting entity during the period from 1 July 2005 and 14 March 2006.

Legislative references: Income Tax Assessment Act 1997 section 208-5 section 208-10 section 208-15 section 208-20 section 208-25 subsection 208-40(1) section 208-50 section 208-110 section 208-115 (Item 1)
Subject references: Franking Credits