Private ruling: Tax Integrity Measures - Part IVA - Application of section 177EA
Date of advice: 17 February 2016
Published: April 2016
Ruling period: Year ending 30 June 2016.
Date scheme commenced: Not yet commenced.

Ruling: Q1: Should the Company declare a fully franked dividend to Company A and Company S, will section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936) have any application to the proposed arrangement? | A1: No.

Relevant facts and circumstances: The Company was incorporated in 20XX. Since inception, Individual 1 and Individual 2 have each held one ordinary share in the Company. Individual 1 and Individual 2 are both directors of the Company. The Company has retained earnings and a franking account balance. No dividends have ever been paid by the Company. Individual 1 and Individual 2 are currently married but have separated and are looking to separate their financial affairs. As part of the matrimonial separation it is proposed that the Company will begin to declare and pay fully franked dividend distributions to its shareholders in equal proportions as they each own half the issued shares of the Company. Prior to the fully franked dividend distributions, Individual 1 and Individual 2 propose to transfer their shareholdings in the Company to respective wholly owned companies, so that the dividend distribution by the Company will be retained in the wholly owned companies for future investment activities. To achieve this objective, Individual 1 established a new company, Company A, of which they are the sole shareholder and director. It is proposed that Individual 1 will transfer their 1 ordinary share in the Company, to Company A. They will receive no consideration for the transfer other than shares in Company A. Similarly, Individual 2 established a new company, Company S, of which they are the sole shareholder and director. It is proposed that Individual 2 will transfer their 1 ordinary share in the Company to Company S. They will receive no consideration for the transfer other than shares in Company S. All entities are all Australian residents for taxation purposes.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 6(1) | Subsection 44(1) | Subsection 177D(2) | Section 177EA | Subsection 177EA(3) | Subsection 177EA(14) | Subsection 177EA(17) | Income Tax Assessment Act 1997 Subdivision 207-A | Section 975-300

Reasons for decision: Detailed Reasoning - Distribution is a dividend.: Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends, as defined by subsection 6(1) of the ITAA 1936, paid to a shareholder out of profits derived by the company from any source (if a resident of Australia for tax purposes) and from an Australian source (if non-resident). The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders. However, this broad definition is confined by later paragraphs in the definition which expressly exclude certain items from being a dividend for income tax purposes. A specific exclusion is paragraph (d) of subsection 6(1) of the ITAA 1936, which provides: ... moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company: ... 'Share capital account' is defined in section 975-300 of the Income Tax Assessment Act 1997 (ITAA 1997) as an account in which the company keeps its share capital, or any other account created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital. As the distribution is proposed to be debited against Unappropriated profits (otherwise known as 'retained earnings'), it will be viewed as a dividend and will be assessable as part of the shareholders assessable income under section 44 of the ITAA 1936. Given that it is proposed that the dividend paid by the Company will be fully franked, Company A and Company S will likely receive imputation benefits (subject to the imputation rules) and therefore, assuming there is no other income, no tax will be payable by Company S and Company A. In the future, a dividend may be paid to Individual 1 and/or Individual 2 (in their capacity as shareholders in Company A or Company S respectively) in which the imputation rules under Subdivision 207-A of the ITAA 1997 will then be applied. | Detailed Reasoning - Application of anti-avoidance provisions: section 177EA of the ITAA 1936: Subsection 177EA(3) of the ITAA 1936 sets out the circumstances in which section 177EA of the ITAA 1936 applies. They are: (a) there is a scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity; and (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; or (ii) a frankable distribution has flowed indirectly, or flows indirectly or is expected to flow indirectly, to a person in respect of the interest in 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, the 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. We agree with the applicant's assertion that there is a 'scheme' in place as per paragraph 177EA(3)(a) of the ITAA 1936 above. In particular, under paragraph 177EA(14)(b) of the ITAA 1936, an arrangement exists that will transfer each of the individual ordinary shares owned by Individual 1 and Individual 2, in the Company, to Company A and Company S respectively - otherwise referred to as the disposition of shares. Under paragraph 177EA(3)(b) of the ITAA 1936, a frankable distribution is expected to be paid in respect of the shares transferred from the Company to the two newly incorporated companies pursuant to the 'scheme' described in the facts above. Under paragraph 177EA(3)(c) of the ITAA 1936, the dividend is expected to be (fully) franked. Under paragraph 177EA(3)(d) of the ITAA 1936, the relevant taxpayer being Company S and Company A are likely to receive imputation benefits as a result of receiving the proposed fully franked dividend distribution from the Company. Furthermore, both Individual 1 and Individual 2, as the sole shareholders in Company A and Company S respectively, might have these imputation benefits passed on at a future date if these entities resolve to make a franked distribution to their shareholders. Paragraph 177EA(3)(e) of the ITAA 1936 considers whether it would be concluded that Individual 1 or Individual 2 entered into this scheme (through their newly incorporated companies) for the disposition of shares, did so for the purpose, which does not have to be the dominant purpose per se, but must be more than a mere incidental purpose, of obtaining an imputation benefit. This will be discussed below. Discussion of purpose of the scheme If the elements of paragraphs 177EA(3)(a) to (d) of the ITAA 1936 are satisfied, section 177EA of the ITAA 1936 applies if the conclusion regarding the purpose of at least one of the participants in the scheme can be drawn (paragraph 177EA(3)(e) of the ITAA 1936). It must be possible for a reasonable person to conclude, having regard to relevant circumstances that a purpose of at least one of the participants in the scheme was to obtain an imputation benefit. The person doing the considering is the Commissioner, because the Commissioner must make a determination under subsection 177EA(5) of the ITAA 1936 if section 177EA of the ITAA 1936 applies. To satisfy paragraph 177EA(3)(e) of the ITAA 1936, the relevant purpose does not have to be the dominant purpose of the scheme. However, the purpose must be more than an incidental purpose. The decision-maker must consider the relevant circumstances as specified by subsection 177EA(17) of the ITAA 1936. A "purpose" is a consequence intended by a person to result from some action. For section 177EA of the ITAA 1936 the relevant purpose is the consequence or consequences intended by a person entering into or carrying out a scheme for the disposition of relevant interests. Paragraph 177EA(3)(e) of the ITAA 1936 does not require consideration of the subjective purpose of a person involved in entering into or carrying out the scheme. It must only be concluded, after considering specified circumstances that a person entered into or carried out any part of the scheme for a purpose of "enabling" a taxpayer to obtain an imputation benefit. A similar test applies under section 177D of the ITAA 1936, except that the relevant purpose under section 177EA of the ITAA 1936 does not need to be the dominant purpose. Circumstances relevant to purpose To satisfy paragraph 177EA(3)(e) of the ITAA 1936, it must be possible for a reasonable person to conclude that a non-incidental purpose of at least one of the participants in the scheme was to enable the relevant taxpayer (e.g. the investor in shares) to obtain an imputation benefit. That conclusion must be reached having regard to the "relevant circumstances" of the scheme. The relevant circumstances as set out in subsection 177EA(17) of the ITAA 1936 are considered below: • Risks and opportunities: paragraph 177EA(17)(a) of the ITAA 1936 The relevant circumstances include the risks of loss that are borne by the various parties to the scheme, and the opportunities for profit or gain that accrue to them, as a result of holding membership interests. The ownership interests in the Company are transferred to Company A and Company S from Individual 1 and Individual 2 respectively. Individual 1 and Individual 2 will be the sole directors and shareholders of each of their respective newly incorporated corporate entities. These entities will hold cash or investments pursuant to the payment of a fully franked dividend by the Company to Company A and Company S. The risk profile of the membership interests is expected to be identical at the time the fully franked dividend is paid. Therefore, there is no requisite purpose under this criterion. • Relativities between equity holders: paragraph 177EA(17)(b) of the ITAA 1936 It is also relevant whether the taxpayer would have derived a greater benefit from imputation benefits than other entities that hold membership interests in the Company. Company A and Company S each hold equal interests in the Company and moreover no circumstances exist under subsection 177EA(19) of the ITAA 1936 that would give one shareholder any particular greater (imputation) benefit than the other shareholder. Therefore, there is no requisite purpose under this criterion. • Corporate Tax entity's distribution policy: paragraph 177EA(17)(c) of the ITAA 1936 Where the scheme involves the payment of a franked distribution, it will also be relevant whether the corporate tax entity would otherwise have retained the franking or exempting credits, or whether it would have used them to pay a franked distribution to other entities which hold membership interests. In the normal course of events, the Company does not pay dividends to its shareholders. However, due to a matrimonial separation, it is necessary to declare and distribute a fully franked dividend, so that Individual 1 and Individual 2 can separate their financial ties. Although there is a dramatic change in the Company's dividend policy, it is part of the matrimonial settlement rather than obtaining a tax benefit. Therefore, any requisite purpose would only be incidental. • Indirect distributions: paragraph 177EA(17)(d) of the ITAA 1936 This criterion considers the rationale for any proposed indirect franked distributions to the relevant taxpayer. Up until the transfer of shares to the two newly incorporated entities, it was Individual 1 and Individual 2 who had direct membership interests in the Company. Due to the matrimonial settlement, it was necessary to transfer the two the Company ordinary shares to Company A and Company S so that Individual 1 and Individual 2 can maintain their investments under a corporate structure as they have also done in the Company. It is proposed that a fully franked dividend will be paid directly to Company A and Company S, and possibly at a future time, the dividend may indirectly flow (from the Company's perspective) to Individual 1 and Individual 2. As expressed above, although there is a dramatic change in the Company's dividend policy, it is part of the matrimonial settlement rather than obtaining a tax benefit. Therefore, any requisite purpose would only be incidental. • paragraphs 177EA(17)(e) to (g) of the ITAA 1936 Not relevant. • Distribution from unrealised or untaxed profits: paragraph 177EA(17)(ga) of the ITAA 1936 As the paid up capital is expected to be returned to Individual 1 and Individual 2 under a separate arrangement, this only leaves a dividend to be paid from a taxed source of retained earnings. The applicant asserts that no dividend will be credited to an untaxed source such as Paid up capital. Therefore, there is no requisite purpose under this criterion. • Equivalence to interest: paragraph 177EA(17)(h) of the ITAA 1936 Not relevant as the dividend is not in the nature of interest. • Period for which shares are held: paragraph 177EA(17)(i) of the ITAA 1936 The period for which the relevant taxpayer held shares or an interest in shares in the company is a relevant circumstance (paragraph 177EA(17)(i) of the ITAA 1936). The longer the period for which they were held, the less likely it is that the requisite purpose is present, provided that the taxpayer has been exposed to risk. It is observed that Individual 1 and Individual 2 are the ultimate holders of the shares in the Company. Funds are expected to be transferred to Company A and Company S in the form of a fully franked dividend. Just because, Individual 1 and Individual 2 would have held shares in Company A and Company S respectively for a short period of time, it is our view that the newly incorporated companies were established pursuant to a matrimonial settlement. Therefore, no requisite purpose exists. • The matters listed in section 117D(2) of the ITAA 1936: paragraph 177EA(17)(j) of the ITAA 1936 (a) The manner in which the scheme was entered into or carried out. This is a very straightforward restructure of the Company's unappropriated profits component of its balance sheet. Ordinarily, such a scheme (described above) would lack any commercial rationale, but given the matrimonial matters involved, this is way of severing the financial ties between Individual 1 and Individual 2 in the most efficient manner. Therefore, having regard to the manner of the proposed arrangement, it could not be concluded that the scheme is being entered into or carried out to obtain a tax benefit. (b) The form and substance of the scheme. The form of the scheme is that the Company shares have been transferred to two newly incorporated entities each individually owned and directed by Individual 1 and Individual 2. But in substance, the cash and investments represented by a fully franked dividend paid to Company A and Company S, will continue to be held in a corporate environment except for the fact the financial ties (in respect of the Company) between Individual 1 and Individual 2 are now severed. The form and substance of the scheme are aligned in that it is a means of separating assets between Individual 1 and Individual 2 due to family breakdown. Therefore, having regard to the form and substance of the proposed arrangement, it could not be concluded that the scheme is being entered into or carried out to obtain a tax benefit. (c) The timing of the scheme. The timing of the scheme coincides with the settlement of the matrimonial (financial) affairs between Individual 1 and Individual 2. There is no aspect of the timing of this scheme that would indicate that the arrangement was entered into to obtain a (more than incidental) tax benefit. (d) Result achieved in relation to operation of the Act but for Part IVA. But for the operation of Part IVA, if the taxpayer enters the scheme, then it will be Company A (and Company S) that receives the fully franked dividend. Individual 1 and Individual 2 will only personally access these funds if a dividend was paid by Company A and/or Company S respectively at a future time. In this case, imputation rules will apply to Individual 1 and/or Individual 2 under their own individual circumstances. The end result is a deferral of applying the imputation rules directly to Individual 1 and Individual 2 but maintaining their investments under a corporate structure. Having said this, the status quo is effectively maintained and therefore if any tax benefit exists, then it would be only incidental. (e) Change in financial position of the taxpayer. The change in financial position relates to the unappropriated earnings being split evenly between the new entities owned by Individual 1 and Individual 2 respectively. The actual financial position and the cost base of the shares remains the same. There is no identifiable change in the financial position relating to the parties related to the scheme that would indicate that the arrangement was entered into to obtain a (more than incidental) tax benefit. (f) Change in financial position of person connected to taxpayer. See (e) above. (g) Any other consequence for taxpayer or other person connected with taxpayer. The assets will be severed pursuant to a matrimonial settlement agreement between Individual 1 and Individual 2. Therefore under this criterion, no requisite purpose exists. (h) Nature of connection between taxpayer and other person. The scheme was entered into for family reasons (separation and divorce) rather than tax planning purposes. Therefore under this criterion, no requisite purpose exists. | Detailed Reasoning - Conclusion: Individual 1 and Individual 2, through their newly incorporated entities, entered into this scheme for the purpose of separating their assets and at the same time, maintain assets in a corporate environment. In doing this, a fully franked dividend is proposed to be paid by the Company to these two new corporate entities. This scheme was undertaken purely for family reasons (separation of Individual 1 and Individual 2) rather than the more than incidental purpose of obtaining a tax benefit. Therefore, having regard to the circumstances listed above, it can be concluded that section 177EA of the ITAA 1936 has no application to this arrangement.