Private ruling: Income Tax
Published: April 2014
Ruling period: Year ended 30 June 2014

Ruling: Q1: Will the issuing of a new class of shares in the Taxpayer, which allows the holder to a dividend, at the discretion of the directors (but with no other rights), be a payment within the definition of subsection 109C(3) for the purposes of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) and if so, will the value of any payment be nominal? | A1: No | Q2: Will the issuing of the New Shares create a debt interest under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A2: No | Q3: Will the issuing of a New Shares, the declaration of a dividend or a payment of a dividend will not trigger capital gains tax (CGT) event K8 by virtue of the direct value shifting rules contained in Division 725 of the ITAA 1997. | A3: No | Q4: Will the issuing of the New Shares and subsequent payment of dividends to the holder of those New Shares be a scheme or arrangement to which the general anti-avoidance provisions contained in Part IVA of the ITAA 1936 applies? | A4: No | Q5: Will the issuing of the New Shares and subsequent payment of dividends to the holder of those New Shares be a scheme or arrangement to which section 177E of the ITAA 1936 apply? | A5: No | Q6: Will the issuing of the New Shares and subsequent payment of dividends to the holder of those New Shares be a scheme or arrangement to which section 177EA of the ITAA 1936 apply? Answer: No

Relevant facts and circumstances: 1. The Taxpayer is a company. 2. There are certain uninsurable risks associated with the business. 3. The Constitution of the Taxpayer permits dividends to be paid to shareholders of one class of share to the exclusion of the other classes. 4. For the purposes of asset protection, the directors of the Taxpayer are proposing to: • register a new company ( New Co ) in which the shareholding and directors will be identical to the shareholding and directors in the Taxpayer; • create a new class of share (D class) that will have no voting rights, no rights to capital in a winding up but a right to dividends at the discretion of the directors ( New Shares ); and • issue New Shares to New Co (and to no-one else). 5. The New Shares will enable dividends to be paid to New Co. The shareholding in New Co will be identical to the shareholding in the Taxpayer. 6. The New Shares will be redeemed within 48 months of issue. 7. The only method by which the shareholders of New Co will receive money in respect of the dividends paid to New Co on the new class of redeemable shares issued is by way of fully franked assessable dividend. 8. There will be no corporate value released by New Co to its shareholders or their associates in a tax free form.

Relevant legislative provisions: Income Tax Assessment Act 1936 Part IVA | Income Tax Assessment Act 1936 Division 7A | Income Tax Assessment Act 1936 Subsection 109C(3) | Income Tax Assessment Act 1936 Section 109K | Income Tax Assessment Act 1936 Section 177A | Income Tax Assessment Act 1936 Subsection 177A(1) | Income Tax Assessment Act 1936 Section 177C | Income Tax Assessment Act 1936 Subsection 177C(1) | Income Tax Assessment Act 1936 Section 177D | Income Tax Assessment Act 1936 Section 177E | Income Tax Assessment Act 1936 Section 177EA | Income Tax Assessment Act 1936 Subsection 177EA (17) | Income Tax Assessment Act 1936 Paragraph 177EA (3) (e) | Income Tax Assessment Act 1936 Subparagraph 177E (1) (a) (i) | Income Tax Assessment Act 1936 Section 177F | Income Tax Assessment Act 1997 Section 104-250 | Income Tax Assessment Act 1997 Section 722-55 | Income Tax Assessment Act 1997 Division 725 | Income Tax Assessment Act 1997 Section 725-50 | Income Tax Assessment Act 1997 Paragraph 725-50(a) | Income Tax Assessment Act 1997 Section 725-55 | Income Tax Assessment Act 1997 Section 725-65 | Income Tax Assessment Act 1997 Section 725-80 | Income Tax Assessment Act 1997 Section 725-85 | Income Tax Assessment Act 1997 Section 725-90 | Income Tax Assessment Act 1997 Subsection 725-90(1) | Income Tax Assessment Act 1997 Paragraph 725-90(1)(a) | Income Tax Assessment Act 1997 Paragraph 725-90(1) (b) | Income Tax Assessment Act 1997 Subsection 725-90(2) | Income Tax Assessment Act 1997 Paragraph 725-90(2)(b) | Income Tax Assessment Act 1997 Section 725-95 | Income Tax Assessment Act 1997 Section 725-145 | Income Tax Assessment Act 1997 Subsection 725-145(1) | Income Tax Assessment Act 1997 Paragraphs 725-145(1)(a) | Income Tax Assessment Act 1997 Paragraph 725-145(1)(b) | Income Tax Assessment Act 1997 Paragraph 725-145(1)(c) | Income Tax Assessment Act 1997 Subsection 725-145(2) | Income Tax Assessment Act 1997 Subsection 725-145(3) | Income Tax Assessment Act 1997 Section 725-155 | Income Tax Assessment Act 1997 Subsection 725-155(1) | Income Tax Assessment Act 1997 Subsection 725-155(2) | Income Tax Assessment Act 1997 Section 725-245 | Income Tax Assessment Act 1997 Section 727-355 | Income Tax Assessment Act 1997 Section 727-375 | Income Tax Assessment Act 1997 Section 960-100 | Income Tax Assessment Act 1997 paragraph 960-100(1) (a) | Income Tax Assessment Act 1997 Division 974 | Income Tax Assessment Act 1997 Subsection 974-5(4) | Income Tax Assessment Act 1997 Section 974-15 | Income Tax Assessment Act 1997 Subsection 974-20(1) | Income Tax Assessment Act 1997 Paragraph 974-20(1)(a) | Income Tax Assessment Act 1997 Paragraph 974-20(1)(d) | Income Tax Assessment Act 1997 Subsection 974-20(2) | Income Tax Assessment Act 1997 Subsection 974-20(3) | Income Tax Assessment Act 1997 Subsection 974-20(4) | Income Tax Assessment Act 1997 Paragraph 974-70(1)(a) | Income Tax Assessment Act 1997 Paragraph 974-70(1)(b) | Income Tax Assessment Act 1997 subsection 974-75(1) | Income Tax Assessment Act 1997 Subsection 974-135(1) | Income Tax Assessment Act 1997 Subsection 974-135(3) | Income Tax Assessment Act 1997 Section 974-160 | Income Tax Assessment Act 1997 Subsection 975-150(1) | Income Tax Assessment Act 1997 Section 995-1 New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002 | Taxation Laws Amendment Bill (No.3) 1998 | ATO view documents | IT 2627 Income tax: application of part iva to dividend stripping arrangements | Other references | Gathercole v Smith (1881) 17 Ch D | Norman v FCT (1963) 109 CLR 9; 9 AITR 85; 13 ATD 13 | Shepherd v FCT (1965) 113 CLR 385; 9 AITR 739 | Commissioner of Taxation v. Consolidated Press Holdings Ltd and Others (No 1) [1999] FCA 1199; (1999) 91 FCR 524; (1999) 42 ATR 575; 99 ATC 4945

Reasons for decision: Summary: The proposed issue of New Shares will not be a payment as described in subsection 109C(3) of the ITAA 1936. Detailed reasoning 1. Generally, Division 7A of Part III of the ITAA 1936 (Division 7A) applies where a private company has made a payment or loan to, or forgiven the debt of, an entity in an income year and in that income year either: • The entity was a shareholder or shareholder's associate of the private company at the time the payment, loan or debt forgiveness was made, or • A reasonable person would conclude that the loan, payment or debt forgiveness was made because the entity has been a shareholder or shareholder's associate at some time. 2. Section 109C of the ITAA 1936 describes when payments are to be treated as dividends. A payment is defined in subsection 109C(3) of the ITAA 1936 and includes a transfer of property (paragraph 109C(3)(c)). 3. The term 'transfer' is not defined for Division 7A purposes and therefore takes its ordinary meaning. According to case law, transfer has a broad import and includes every legal means by which existing property may be passed from one entity to another: Gathercole v Smith (1881) 17 Ch D 1; Norman v FCT (1963) 109 CLR 9; 9 AITR 85; 13 ATD 13; Shepherd v FCT (1965) 113 CLR 385; 9 AITR 739. 4. In the present case the issuing of New Shares to New Co will not be a transfer of property to New Co as the issuing of New Shares does not pass existing property to another entity but rather creates new property in another entity. Were it considered that the transfer of New Shares to New Co was a payment, section 109K of the ITAA 1936 would operate to exclude the transaction for purposes of Division 7A as payment made from one company to another is disregarded. | Summary: Issuing New Shares will create an equity interest under Division 974 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: 5. The object of Division 974 of the ITAA 1997 is to prescribe rules for determining whether a scheme or the combined operation of a number of schemes, give rise to a debt interest or an equity interest, for tax purposes. This characterisation determines whether a return paid by the entity on an interest it has issued will be frankable (that is, treated as a dividend) or deductible (that is, treated as interest on debt). 6. Subsection 975-150(1) of the ITAA1997 defines the term "scheme" to have the meaning given in section 995-1 of the ITAA 1997 which in turn prescribes a scheme to mean any arrangement or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. 7. Accordingly, the Taxpayer's proposal to issue New Shares to New Co will constitute a scheme under this definition. 8. Where a scheme satisfies both the debt and equity tests, it is treated as a debt interest and not an equity interest (subsection 974-5(4) of the ITAA 1997). | Detailed Reasoning - The test for an equity interest: 9. Paragraphs 974-70(1)(a) and (b) of the ITAA 1997 provides that a scheme gives rise to an equity interest in a company if the scheme satisfies the test within subsection 974-75(1) of the ITAA 1997 and the interest is also not characterised as a debt interest or forms part of a larger interest that is a debt interest in the company, or connected entity of the company. 10. The equity test in subsection 974-75(1) of the ITAA 1997 specifies (in part): | Detailed Reasoning - 974-75(1): 11. A *scheme satisfies the equity test in this subsection in relation to a company if it gives rise to an interest set out in the following table: | Detailed Reasoning - Interest: 1 An interest in the company as a member or stockholder of the company. .......... 24. The issuing of the New Shares creates an interest in the Taxpayer as a member or stockholder of the company and therefore satisfies the description in item 1 in the table in subsection 947-75(1) of the ITAA 1997. 12. As the proposed scheme satisfies the equity test, consideration must also be given to whether the scheme also meets the debt interest test. | Detailed Reasoning - The test for a debt interest: 13. The meaning of a debt interest is given in section 974-15 of the ITAA 1997 and provides that a scheme gives rise to a debt interest for tax purposes if, when it comes into existence, it satisfies the debt test in relation to the entity. 14. The debt interest test is contained in subsection 974-20(1) of the ITAA 1997 and requires: | Detailed Reasoning - 974-20(1): 15. A *scheme satisfies the debt test in this subsection in relation to an entity if: (a) the scheme is a *financing arrangement for the entity; and (b) the entity, or a *connected entity of the entity, receives, or will receive, a *financial benefit or benefits under the scheme; and (c) the entity has, or the entity and a connected entity of the entity each has, an *effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when: (i) the financial benefit referred to in paragraph (b) is received if there is only one; or (ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and (d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and (e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil. The scheme does not need to satisfy paragraph (a) if the entity is a company and the interest arising from the scheme is an interest covered by item 1 of the table in subsection 974-75(1) (interest as a member or stockholder of the company). | Detailed Reasoning - Is the scheme undertaken as a financing arrangement?: 16. Subsection 974-20(1) provides that the requirement stated in paragraph 974-20(1)(a) of the ITAA 1997 , that the scheme must be a 'financing arrangement' for the entity, need not be satisfied if the entity is a company and the interest arising from the scheme is an interest covered by Item 1 of the table in subsection 974-75(1) of the ITAA 1997 (an interest as a member or stockholder of the company). 17. The Taxpayer is a company and as discussed above, meets the requirements of item 1 of the table of subsection 974-75(1) of the ITAA 1997. As a consequence the financing arrangement requirement need not be satisfied. | Detailed Reasoning - The entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme.: 18. The term financial benefit is defined in section 995-1 of the ITAA 1997 to have the meaning given in section 974-160 of the ITAA 1997. A financial benefit is defined to include anything of economic value. The Taxpayer will issue the New Shares for a nominal value being $1 per share. Therefore the Taxpayer will receive a financial benefit and meets this requirement. The entity has, or the entity or the connected entity of the entity each has, an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities. 19. Subsection 974-135(1) provides that there is an ENCO to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action. Subsection 974-135(3) provides that an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the ability or willingness of that entity to meet the obligation. 20. In the present case, while the New Shares create a right to receive a dividend, there is not a non-contingent obligation to pay the dividends as they are at the discretion of the directors. Accordingly, this requirement is not met. | Detailed Reasoning - It is substantially more likely than not that the benefit provided will at least equal the benefit received.: 21. Subsection 974-20(2) and subsection 974-20(3) of the ITAA 1997 provide the method for which to establish what the value provided and received are for the purposes of paragraph 974-20(1)(d). However any amounts to be considered are only taken in to account if there is an ENCO. Subsection 974-20(4) provides: | Detailed Reasoning - 974-20(4): 22. For the purposes of paragraph (1)(b) and subsections (2) and (3): (a) a *financial benefit to be provided under the *scheme by the entity or a *connected entity is taken into account only if it is one that the entity or connected entity has an *effectively non-contingent obligation to provide; and (b) a financial benefit to be received under the scheme by the entity or a connected entity is taken into account only if it is one that another entity has an effectively non-contingent obligation to provide. 22. As discussed above there is no ENCO present in the scheme and therefore any amounts either provided or received are not taken into consideration pursuant to subsection 974-20(4) of the ITAA 1997. Accordingly the value received and the value provided are both nil and this requirement is not satisfied. 23. It is noted however that notwithstanding the absence of an ENCO, while there it could be considered that a benefit is received by the Taxpayer, being the nominal price paid for the New Shares, it is not considered that it is substantially more likely than not that the benefit being provided on the New Shares is equal to the benefit being received as any benefit provided on the New Shares is at the directors discretion. | Detailed Reasoning - Both the value provided and the value received are not both nil.: 24. As discussed above the value provided and the value received, as worked out under are subsection 974-20(2) and subsection 974-20(3) of the ITAA 1997, are both nil and therefore this requirement is not satisfied. | Detailed Reasoning - Conclusion of the debt and equity test: 25. The New Shares meet the equity interest test and not the debt interest test therefore the New Shares do not create a debt interest under Division 974 of the ITAA 1997. | Summary: The issuing of a New Shares, the declaration of a dividend nor a payment of a dividend will not trigger capital gains tax (CGT) event K8 by virtue of the direct value shifting rules contained in Division 725 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: 26. CGT event K8 is described in section 104-250 of the ITAA 1997 and occurs when there is a taxing event generating a gain for a down interest under section 725-245 of the ITAA 1997. 27. To establish whether issuing the New Shares will trigger CGT event K8, it is necessary to determine if Division 725 of the ITAA 1997 applies to the scheme. Division 725 deals with direct value shifting affecting interest in companies and trusts and applies where, if under a scheme, value is shifted from equity or loan interests in a company or trust to other equity or loan interests in the same company or trust. 28. Direct value shift is defined in section 995-1 of the ITAA 1997 and has the meaning given by section 725-155 of the ITAA 1997. Section 725-155 of the ITAA 1997 provides the meaning of the terms down interests, decrease time, up interests and increase times and states: | Detailed Reasoning - 725-155(1): 29. An * equity or loan interest in the target entity is a down interest if a decrease in its *market value is reasonably attributable to the one or more things referred to in paragraph 725-145(1)(b) , and occurs at or after the time referred to in that paragraph. The time when the decrease happens is called the decrease time for that interest. | Detailed Reasoning - 725-155(2): 30. An * equity or loan interest in the target entity is an up interest if subsection 725-145(2) or (3) is satisfied for the interest. The time when the interest is issued at a * discount, or the increase in *market value happens, is called the increase time for that interest. 31. Under subsection 725-145(1) of the ITAA 1997, a direct value shift will arise under a scheme involving loan or equity interests in an entity (being the target entity) if: a) there is a decrease in the market value of one or more equity or loan interests in the target entity and b) that decrease is reasonably attributable to one or more things done under the scheme and occurs at or after the time when that thing or the first of those things is done and c) either or both subsections (2) and (3) must be satisfied. 32. Subsection 725-145(2) of the ITAA 1997 provides that one or more of the equity or loan interests in the target entity must be issued at a discount and must be attributable to things referred to in paragraph 725-145(1)(b) of the ITAA 1997. 33. But if subsection 725-145(2) of the ITAA 1997 does not apply, subsection 725-145(3) of the ITAA 1997 may be applicable in the alternative. This provision refers to situations where there has been an increase in the market values of one or more equity or loan interests in the target entity. The increase must be reasonably attributable to the thing or things referred to in paragraph 725-145(1)(b) ITAA 1997. 34. The mere issuing of New Shares in the Taxpayer will not bring about a decrease in market value of the ordinary shares in The Taxpayer as required by paragraphs 725-145(1)(a) and 725-145(1)(b) of the ITAA 1997. As the New Shares carry no certainty regarding any future dividends, which are at the discretion of the directors, it cannot be said that on issuance, the New Shares will hold any value. 35. However, while issuing the New Shares will not bring about a shift in value in the ordinary shares in the Taxpayer, the declaration of a dividend upon the New Shares would bring about a decrease in value of the ordinary shares as per paragraphs 725-145(1)(a) of the ITAA 1997, at least to the extent of the declared dividend. 36. Paragraph 725-145(1)(b) of the ITAA 1997 requires that the decrease in market value be reasonably attributable to one or more things done under the scheme that occurs at or after the time that thing is done. That is to say the value shift must take place on or after one of the "…things done under the scheme…" The dividend declaration is considered to be one of the "…things done under the scheme…" and the timing requirement of paragraph 725-145(1)(b) of the ITAA 1997 would be met as the share value shift would follow after the declaration of the dividend. 37. As paragraphs 725-145(1)(a) and 725-145(1)(b) of the ITAA 1997 have been satisfied, paragraph 725-145(1)(c) of the ITAA 19997 requires that either or both of subsections 725-145(2) or 725-145 (3) of the ITAA 1997 be met in order for it to be concluded that there is a direct value shift. 38. Subsection 725-145(2) of the ITAA 1997 requires that: One or more equity or loan interests in the target entity must be issued at a discount. The issue must be attributable to the thing or one of the things referred to in paragraph (1)(b). It must occur at or after the time referred to in that paragraph. 39. In the present case, the issuing of the equity interests at a discount described in subsection 725-145(2) of the ITAA 1997, must occur at or after the declaration of the dividend on those equity interests, the declaration of a dividend being the "thing" referred to in paragraph 725-145(1)(b) of the ITAA 1997 that brought about the supposed share value shift. While the issue of the New Shares for nominal value would likely be an issue of a share at a discount, it is not considered that the decrease in value is attributable to the issue of the New Shares alone. 40. As noted above, the "decrease is reasonably attributable to the declaration of the dividend" which is "one of the things done under the scheme". Therefore in order for subsection 725-145(2) of the ITAA 1997 to apply, the declaration of a dividend must occur prior to the issuing of the New Shares. This order of events is not possible and this requirement is not met. 41. Subsection 725-145(3) of the ITAA 1997 provides an alternative and requires: Or, there must be an increase in the market value of one or more equity or loan interests in the target entity. The increase must be reasonably attributable to the thing or one or more of the things referred to in paragraph (1)(b). It must also occur at or after the time referred to in that paragraph. 42. This provision refers to an increase in the market value of one or more interests in the target entity and is not just confined to equity interests on issue prior to the commencement of the scheme. The New Shares will increase in value if and when a dividend is declared in their favour. As the declaration of the dividend is the "thing done under the scheme" that brings about the share value shift, the timing rule is met as the share value shift takes place at or after the declaration of a dividend. | Detailed Reasoning - Direct value shift conclusion: 43. The issuing of New Shares will not, on its own, create a direct vale shift. The New Shares, being preference shares with no voting rights, no rights to capital on winding up but the right to dividends at the discretion of the Taxpayer's directors, will initially not hold any value. The declaration of a dividend however, will provide a value to the New Shares, that being equal to the declared dividend and will create an up interest as defined in subsection 725-155(2) of the ITAA 1997. On declaration of a dividend upon the New Shares, the value of the Taxpayer's ordinary shares will decrease and create a down interest as defined in subsection 725-155(1) of the ITAA 1997. Therefore the requirements of section 725-145 of the ITAA 1997 are met and a direct value shift will occur under the scheme. | Detailed Reasoning - Are there consequences of the direct value shift?: 44. Having established that the scheme will give rise to a direct value shift in terms of section 725-145 of the ITAA 1997, it is also necessary to establish whether that direct value shift will have consequences for the existing shareholders of the Taxpayer under section 725-50 of the ITAA 1997. 45. Under section 725-50 of the ITAA 1997 a direct value shift involving equity or loan interests in an entity will have consequences if and only if: (a) the target entity is a company or trust at some time during the * scheme period; and (b) section 725-55 (Controlling entity test) is satisfied; and (c) section 725-65 (Cause of the value shift) is satisfied; and (d) you are an * affected owner of a * down interest, or an * affected owner of an * up interest, or both; and (e) neither of sections 725-90 and 725-95 (about direct value shifts that are reversed) applies. Analyses of these five conditions are set out below. 46. The first condition set out in paragraph 725-50(a) of the ITAA 1997 is met as the Taxpayer is a company. 47. The second condition is the controlling entity test in section 725-55 of the ITAA 1997. Under that test, an entity (the controller) must control (for value shifting purposes) the target entity at some time during the period starting when the scheme is entered into and ending when it has been carried out. What is meant by "control (for value shifting purposes)" is set out in section 727-355 to 727-375 of the ITAA 1997. 48. In section 727-355 of the ITAA 1997, one of the tests for control is a 50% stake test. This test states that an entity controls, for value shifting purposes, a company if the entity or it and its associates between them can exercise or control the exercise of at least 50% of: • Voting power • The right to receive dividends • The right to receive a distribution of capital from the company. 49. This requirement is met as the directors of the Taxpayer, are both entities as defined by section 960-100 of the ITAA 1997, between them they hold more than 50% of the shares in the Taxpayer and therefore exercise the control of at least 50% of the voting power. As such section 722-55 of the ITAA 1997 is met and therefore the second condition of section 725-50 of the ITA 1997 is also satisfied. 50. The third condition is the cause of the value shift described in section 725-65 of the ITAA 1997. Under this requirement, it must be the case that one or more of: • The target entity • The controller • An entity that was an associate of the controller at some time during or after the scheme period • An active participant in the scheme, either alone or together with one or more entities did under the scheme one or more things: • to which the decrease in the market value of the down interests is reasonably attributable and • to which the increase in the market value of the up interests or the issue of up interests is reasonably attributable, or that is or includes the issue of up interests at a discount. 51. To carry out the proposed scheme (issue New Shares), the Taxpayer, as the target entity, and its controllers,, will do things under the scheme to which the decrease in the market value of the down interests (the ordinary shares) is reasonably attributable to it and the increase in the market value of the up interest (New Shares on declaration of dividend) is also reasonably attributable to. This requirement is satisfied. 52. The fourth condition is for the existing shareholders of the Taxpayer to meet the test of being an affected owner of a down interest or an affected owner of an up interest, or both. Up interests and down interests are defined in section 725-155 of the ITAA 1997. As discussed at paragraph 18, the issuing of New Shares will create both an up and down interest. 53. An affected owner of a down interest is defined in section 725-80 of the ITAA 1997. An entity is an affected owner if and only if the entity owns the down interest at the decrease time and a least one of the following is also satisfied: • The entity is the controller • The entity is an associate of the controller • The entity is an active participant in the scheme. 54. The directors satisfy the controller test as both are considered controllers as previously discussed. As at least one of the conditions of section 725-80 of the ITAA 1997 has been satisfied, the directors would be regarded as affected owners of a down interest in the Taxpayer as specified in section 725-80 of the ITAA 1997. The directors are also affected owners of an up interest as section 725-85 of the ITAA 1997 is also satisfied. 55. As all of the tests in section 725-50 of the ITAA 1997 have been satisfied it is necessary to consider if either of the tests described in paragraph 725-50(e) of the ITAA 1997, which relate to sections 725-90 and 725-95 of the ITAA 1997, apply. 56. Subsection 725-90(1) of the ITAA 1997 provides that a direct value shift will not have consequences where: (a) the one or more things referred to in paragraph 725-145(1)(b) brought about a state of affairs, but for which the direct value shift would not have happened; and (b) as at the time referred to in that paragraph, it is more likely than not that, because of the * scheme, that state of affairs will cease to exist within 4 years after that time. 57. It has been established that the declaration of a dividend amounts to "one or more things referred to in paragraph 725-145(1) (b)". The term "state of affairs" is used to describe the circumstances which cause the value shift and includes the effects and consequences of the things done, as well as the circumstances brought about by those things. Paragraph 8.46 of Explanatory memorandum to the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill explains further: 8.46 The concept of reversal is based on the state of affairs that arises because of the thing, or things, done under the scheme to which the decrease in value of equity or loan interests is reasonably attributable. It must be the case that without the state of affairs the direct value shift would not have happened. A reversal happens where the state of affairs ceases to exist. 58. When the dividend is declared under the scheme, it will bring about a "state of affairs" being that the New Shareholders will became entitled to the profits of the Taxpayer to the exclusion of its ordinary shareholders causing a direct value shift. Therefore paragraph 725-90(1)(a) of the ITAA 1997 is met. In addition, as the New Shares are redeemable within 48 months, they will cease to exist and paragraph 725-90(1) (b) of the ITAA 1997 is also satisfied. 59. Under subsection 725-90(2) of the ITAA 1997 however, a direct value shift will have consequences where the "state of affairs" still exist: (a) at the end of those 4 years; or (b) when a * realisation event happens to * down interests or * up interests of which you are, or any other entity is, an * affected owner; 60. As outlined above, the New Shares will cease to exist within 4 year as the shares will be redeemed within a 4 year period. In addition the requirements of paragraph 725-90(2)(b) are also not met as the first realisation event will occur at the time the New Shares are redeemed as per CGT event C2 in section 102-25 of the ITAA 1997. Accordingly the requirements of subsection 725-90(2) of the ITAA 1997 are not satisfied and the direct value shift will have no consequences. Conclusion - Does capital gains tax event K8 apply? 61. The scheme to be undertaken by the Taxpayer will constitute a direct value shift as described in section 995-1 of the ITAA 1997 and given the meaning in section 725-155 of the ITAA 1997. The direct value shift however, will have no consequences for the Taxpayer by virtue of section 725-90 of the ITAA 1997 as the shares will be redeemed within 48 months. Therefore CGT event K8 in section 104-250 of the ITAA 1997 will not apply to the scheme. | Summary: The issuing of New Shares and subsequent payment of dividends to the holder of those New Shares will not be a scheme or arrangement to which the general anti-avoidance provisions contained in Part IVA of the ITAA 1936 applies. | Detailed Reasoning - Detailed reasoning: Part IVA of the ITAA 1936 gives the Commissioner the discretion to cancel a 'tax benefit' that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained by a taxpayer in connection with a scheme to which Part IVA applies. This discretion is found in subsection 177F(1) of the ITAA 1936. 47. Before the Commissioner can exercise the discretion in subsection 177F(1) of the ITAA 1936, the requirements of Part IVA of the ITAA 1936 must be satisfied. These requirements are that: | Detailed Reasoning - (i): a 'tax benefit', as identified in section 177C of the ITAA 1936, was or would, but for subsection 177F(1) of the ITAA 1936, have been obtained; | Detailed Reasoning - (ii): the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A of the ITAA 1936; and | Detailed Reasoning - (iii): having regard to section 177D of the ITAA 1936, the scheme is one to which Part IVA of the ITAA 1936 applies. | Detailed Reasoning - Scheme: 62. For Part IVA to apply, the identified scheme must fall within the following wide definition of 'scheme'. 63. Subsection 177A(1) of the ITAA 1936 defines scheme as 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 any scheme, plan, proposal, action, course of action or course of conduct. 64. It is considered that the proposed arrangement to issue New Shares falls within this definition. It is therefore a scheme in accordance with the definition in subsection 177A(1) of the ITAA 1936. | Detailed Reasoning - Tax benefit: 65. Part IVA cannot apply unless a taxpayer has obtained, or would but for section 177F of the ITAA 1936 obtain, a tax benefit in connection with a scheme. 66. Subsection 177C(1) of the ITAA 1936 defines four kinds of tax benefit, relating broadly to: • an amount not being included in the assessable income of the taxpayer of a year of income; • a deduction being allowable to the taxpayer in relation to a year of income; • a capital loss being incurred by the taxpayer during a year of income; • a foreign tax credit being allowable to the taxpayer. 67. The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA of the ITAA 1936, of an 'alternative hypothesis' or an 'alternative postulate'. This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out. 68. This alternative arrangement also forms the background against which the objective ascertainment of the dominant purpose of a person occurs in accordance with section 177D of the ITAA 1936. 69. The Taxpayer has accumulated significant retained earnings which it feels are at risk due to certain uninsurable litigation risks. Accordingly the directors of the Taxpayer proposes to register a new company (with identical directors and shareholdings) and issue redeemable shares to the New Co which will allow the retained earnings to be distributed to the New Co as fully franked dividends. 70. The income tax consequences of entering into the scheme are that the retained earnings held in the Taxpayer will be reduced by paying out fully franked dividends to New Co and therefore mitigating the litigation risk it faces. The directors of the Taxpayer have advised that the only purpose for which the scheme will be undertaken is asset protection. 71. It is accepted that this is a valid practical or commercial outcome of the scheme. To establish whether there is a tax benefit, it is therefore necessary to consider how this outcome would otherwise be met if the scheme is not entered into. It is consider that the most likely alternative would be that the Taxpayer pays the retained earnings directly to the shareholders themselves as fully franked dividends. 72. We consider that this scenario would have the same income tax consequences as would occur under the scheme because any distribution from the New Co to the shareholders of New Co will be by fully franked dividends, thereby achieving the same result as had the shareholders received fully franked dividends from the Taxpayer. Consequently, no tax benefit is obtained under section 177C of the ITAA 1936, so Part IVA of the ITAA 1936 does not apply. | Detailed Reasoning - Objective purpose test: 73. As there is no tax benefit in connection with the scheme, it is unnecessary to make an objective determination because there is no tax benefit to which Part IVA of the ITAA 1936 could apply. | Summary: The issuing of New Shares and subsequent payment of dividends to the holder of those New Shares will not be a scheme or arrangement to which section 177E of the ITAA 1936 applies. Detailed reasoning 74. Section 177E of the ITAA 1936 is an anti-avoidance provision that is designed to prevent in a nutshell a scheme by way of, or in the nature of, dividend stripping, or one that has substantially the effect of a scheme by way of, or in the nature of, dividend stripping, which in the Commissioner's opinion has the effect of delivering property representing a shareholder's entitlement to a dividend in a tax advantaged manner. 75. The term 'dividend stripping' is not defined and has no precise legal meaning. Income Tax Ruling IT 2627 Income tax: Application of Part IVA to Dividend Stripping Arrangements provides that in its traditional form, a dividend stripping operation occurs when shares in a company with retained profits are acquired, usually by a share trader who pays the existing shareholders a capital sum reflecting the value of the retained profits. The new shareholders then liberate those profits through the payment of a dividend post acquisition. Generally, the new shareholders who derive dividend income from the company would not be liable to tax upon those dividends. 76. It was held in the Commissioner of Taxation v. Consolidated Press Holdings Ltd and Others (No 1) [1999] FCA 1199; (1999) 91 FCR 524; (1999) 42 ATR 575; 99 ATC 4945 (the CPH Case) that the placement of section 177E of the ITAA 1936 within Part IVA of the ITAA 1936 is important when interpreting the meaning of dividend stripping. The legislature had used the language of tax avoidance in section 177E of the ITAA 1936 to supplement the general anti-avoidance provisions. Therefore the dominant purpose of the scheme is determinative of whether there is a scheme by way of or in the nature of dividend stripping. 77. Based on a consideration of all relevant facts it is not considered that this arrangement has the characteristics of a dividend stripping scheme as the dominant purpose in entering the arrangement is to mitigate the risk posed to the retained earnings held by the Taxpayer, rather than to obtain property representing a shareholder's entitlement to a dividend in a tax advantaged manner. 78. Consequently, the arrangement is not a scheme by way of or in the nature of a dividend stripping scheme or a scheme with substantially the same effect as a dividend stripping scheme. It is therefore not considered that section 177E of the ITAA 1936 has any application in relation to the purposed arrangement. | Summary: The issuing of the New Shares and subsequent payment of dividends to the holder of those New Shares will not be a scheme or arrangement to which section 177EA of the ITAA 1936 applies. | Detailed Reasoning - Detailed reasoning: 79. The circumstances which are relevant in determining whether a person has the requisite purpose as referred to in paragraph 177EA (3) (e) of the ITAA 1936 include, but are not limited to, the factors listed in subsection 177EA (17) of the ITAA 1936. 80. These relevant circumstances encompass a range of matters which taken individually or collectively will reveal whether or not the requisite purpose exists. Due to the diverse nature of these circumstances, some may not be present at any one time in any one scheme. In all cases however, the terms of the disposition and the relevant circumstances must be considered to determine whether they tend towards or against, or are neutral, as to the conclusion of a purpose of enabling the relevant tax payer to obtain an imputation benefit. 81. The requisite purpose is further clarified when read in conjunction with the objective of section 177EA of the ITAA 1936 which is set out in paragraph 8.124 of the Explanatory Memorandum (EM) to the Bill which led to the enactment of section 177EA. ( Taxation Laws Amendment Bill (No.3) 1998 ) stated that: One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them undermines this principle. Similarly, dividend streaming (i.e. the streaming of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings. 82. Therefore, in determining whether or not the requisite purpose is present, the relevant circumstances will reveal whether the scheme seeks to undermine the principles of the dividend imputation system by streaming franking credits to select shareholders as envisaged in the preceding extract of the EM. | Detailed Reasoning - Conclusion: 83. Having regard to the terms and circumstances of the scheme, the requirements of section 177EA of the ITAA 1936 have not been satisfied and it is not considered that section 177EA of the ITAA 1936 has any application in relation to the purposed arrangement.