Private ruling: Income tax: Tax integrity measures: dividend stripping, debt and equity interests, and value shifting.
Date of advice: 19 November 2015
Published: January 2016
Ruling period: 1 July 2015 to 30 June 2016
Date scheme commenced: 1 July 2015

Ruling: Q1: Will the issue of the redeemable preference share (RPS) under the scheme and subsequent payment of a dividend on that RPS constitute a dividend stripping scheme for the purposes of subsection 177E(1) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: No | Q2: Is the issue of the RPS and subsequent payment of a dividend on that RPS a scheme to which section 177EA of the ITAA 1936 will apply? | A2: No | Q3: Will the direct value shifting rules under Division 725 of the ITAA 1997 be triggered on the proposed transaction involving the issue of a RPS and result in CGT event K8 happening under section 104-250 of the ITAA 1997? | A3: No | Q4: If the answer to question 2 is Yes, will the 4-year reversal exception rule apply? | A4: As the answer to question 2 is No, this question is not necessary. | Q5: Will the redeemable preference share be treated as an equity interest under Division 974 of the ITAA 1997? | A5: Yes

Relevant facts and circumstances: This PBR application is based on the following facts, as provided by the Taxpayers: • The shareholder of Company Y is Taxpayer Z. • Taxpayer Z intends to undertake a restructure of their financial affairs for estate planning purposes. The following restructure transaction is proposed - a new trust will be established (NewTrust). • The trust deed will restrict distributions to Taxpayer Z during their life time. • The trust deed will prevent amendments to the above distribution clause during Taxpayer Z's life time. • Following Taxpayer Z's death, the beneficiaries will be in accordance with the trust deed. • A new company (NewCo) will be established with the trustee of NewTrust as sole shareholder. • Company Y will issue one redeemable preference share to the NewCo. • Company Y's amended constitution provides that the redeemable preference share will be redeemed within 4 years for less than the issue price. • Company Y will pay a fully franked dividend to NewCo within 12 months of the issue of the RPS. This dividend will then be used to facilitate the payment of a cash dividend sufficient to clear the funds held by Company Y. • The redeemable preference share will be redeemed and Company Y will then be wound up. • As a result of the above transactions, NewCo will hold the cash and term deposits that were previously held by Company Y.

Relevant legislative provisions: Income Tax Assessment Act 1997, section 104-250 | Income Tax Assessment Act 1997, Division 725 | Income Tax Assessment Act 1997, section 725-70 | Income Tax Assessment Act 1997, section 725-145 | Income Tax Assessment Act 1997, Division 974 | Income Tax Assessment Act 1997, section 974-20 | Income Tax Assessment Act 1997, section 974-70 | Income Tax Assessment Act 1997, section 974-75 | Income Tax Assessment Act 1997, subsection 995-1(1) | Income Tax Assessment Act 1936 , section 177D | Income Tax Assessment Act 1936, section 177E | Income Tax Assessment Act 1936, section 177EA

Reasons for decision: Summary: The issue of the RPS under the scheme and subsequent payment of a dividend on that RPS will not constitute a dividend stripping scheme for the purposes of subsection 177E(1) of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: 1. Section 177E of the ITAA 1936 is an anti-avoidance provision that is designed to prevent tax benefits being obtained as part of a dividend stripping scheme or a scheme with substantially the same effect as a dividend stripping scheme. 2. Dividend stripping is not a defined term, and it does not have a precise legal meaning. The meaning of dividend stripping is considered in paragraphs 8 to10 of Taxation Ruling IT 2627 Income Tax: Application of Part IVA to Dividend Stripping Arrangements, which state: 8. The term 'dividend stripping' has no precise legal meaning. Therefore, it is not possible in this Ruling to provide exhaustive definitions of what does and what does not satisfy that expression. 9. However, it can be said that in its traditional sense a dividend stripping scheme would include one where a vehicle entity (the stripper) purchases shares in a target company that has accumulated or current years' profits that are represented by cash or other readily-realisable assets. The stripper pays the vendor shareholders a capital sum that reflects those profits and then draws off the profits by having paid to it a dividend (or a liquidation distribution) from the target company. 10. No exhaustive list of other examples can be given of what might constitute a dividend stripping scheme for the purposes of section 177E. Having regard to the overall scope and purpose of the section, an important element to be looked at will be any release of profits of a company to its shareholders in a non-taxable form, regardless of the different methods that might be used to achieve this result. 3. Dividend stripping is further considered in Taxation Determination TD 2014/1 Income tax: is the 'dividend access share' arrangement of the type described in this Taxation Determination a scheme 'by way of or in the nature of dividend stripping' within the meaning of section 177E of Part IVA of the Income Tax Assessment Act 1936? The characteristics of a dividend stripping scheme are listed in paragraph 17 of TD 2014/1, of relevance: • the vendor shareholders [receive] a capital sum for the shares in an amount the same as or very close to the dividends paid to the purchasers …. , and • the scheme [is] 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 from the company. 4. For the arrangement to be a scheme to which Part IVA of the ITAA 1936 applies, it must be shown that, having regard to all the matters listed in subsection 177D (2) of the ITAA 1936, your sole or dominant purpose or the sole or dominant purpose of some other party, in entering the arrangement was to obtain a tax benefit. As discussed by the High Court in Federal Commissioner of Taxation v. Spotless Services (1996) 186 CLR 404; 96 ATC 5201; (1996) 34 ATR 183 at CLR 416; ATC 5206; ATR 188; ATR 183 ( Spotless Services ), the sole or dominant purpose of a taxpayer in entering into a scheme is 'their most influential and prevailing or ruling purpose'. 5. Spotless Services established that where a scheme makes no commercial sense without the tax benefits, there is a greater likelihood of concluding that it is entered into for the sole or dominant purpose of obtaining a tax benefit. Factors which suggest the scheme has been entered into for commercial reasons will generally lead to the opposite conclusion even if the arrangement is to some extent tax driven. 6. The relevant question in applying Part IVA of the ITAA 1936 is not whether you or another person would not have entered the scheme 'but for' the tax benefit, but what was your dominant purpose in entering the scheme. 7. As stated above, you intend to undertake a restructure of your financial affairs for estate planning purposes. An alternative strategy could be for Company Y to pay a fully franked dividend to you out of its retained profits. However, if this strategy was undertaken, a new trust and company structure would still be required to achieve your estate planning goals. 8. Based on this information, a reasonable person would not conclude that your sole or dominant purpose in entering the scheme was to obtain a tax benefit. Rather, your dominant purpose in entering the arrangement is to carry out an estate planning exercise. Consequently, Part IVA of the ITAA does not apply to the scheme. 9. Therefore, it is considered that the issue of the RPS under the scheme and subsequent payment of a dividend on that RPS will not constitute a dividend stripping scheme for the purposes of subsection 177E(1) of the ITAA 1936. | Detailed Reasoning - Question 2: Is the issue of the RPS and subsequent payment of a dividend on that RPS a scheme to which section 177EA of the ITAA 1936 will apply? | Summary: The issue of the RPS and subsequent payment of a dividend on that RPS is not a scheme to which section 177EA of the ITAA 1936 will apply. | Detailed Reasoning - Detailed reasoning: 10. The relevant circumstances 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. 11. 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 taxpayer to obtain an imputation benefit. 12. 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. 13. 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. 14. In this case, as stated above, you are undertaking a restructure of your financial affairs for estate planning purposes. Therefore, the new trust and company structure is being established for the purpose of achieving these estate planning goals, rather than to deliver a tax benefit by way of franking credit and dividend streaming. 15. As a result, having regard to the relevant circumstances of the scheme, the requirements of section 177EA of the ITAA 1936 have not been satisfied. Therefore, it is not considered that section 177EA of the ITAA 1936 has any application in relation to the scheme. | Detailed Reasoning - Question 3: Will the direct value shifting rules under Division 725 of the ITAA 1997 be triggered on the proposed transaction involving the issue of a RPS and result in CGT event K8 happening under section 104-250 of the ITAA 1997? | Summary: The total decrease in the market value (if any) of the Ordinary Shares that is attributable to any direct value shift arising from the issue of the RPS will be less than $150,000. Consequently subsection 725-70 (1) of the ITAA 1997 will preclude the arrangement from any consequences under the direct value shifting rules in Division 725 of the ITAA 1997 and therefore CGT event K8 will not happen as a result of the issue of the RPS. | Detailed Reasoning - Detailed reasoning: 16. There is a direct value shift under section 725-145 of the ITAA 1997 if, as a result of things done under a scheme, there is a decrease in the market value of one of more equity or loan interests in a company (the down interests) and either: • equity or loan interests in the company are issued at a discount (the up interests); or • there is an increase in the market value of one or more equity or loan interests in the company (the up interests). 17. A direct value shift may result in consequences under Division 725 of the ITAA 1997 which would include a realignment of the value of the equity or loan interests for tax purposes to reflect changes in market value attributable to the direct value shift and, in some cases, a capital gain being generated on the down interests (see CGT event K8 in section 104-250 of the ITAA 1997). 18. A direct value shift will not have consequences under Division 725 of the ITAA 1997 if the sum of the decreases in market value of all the down interests under the same scheme does not exceed $150,000: subsection 725-70(1) of the ITAA 1997. 19. In this regard, subsection 725-70(1) of the ITAA 1997 specifically states: For a down interest of which you are an affected owner, the direct value shift has consequences under this Division only if the sum of the decreases in the market value of all down interests because of direct value shifts under the same scheme as the direct value shift is at least $150,000. 20. In the current circumstances, Company Y intends to issue an RPS, and the applicant has contended that the issue price reflects the market value of this interest taking into consideration the entitlements attaching to the RPS. Based on the information provided, the sum of the decrease in the market value of all the Ordinary Shares in Company Y as a result of the issue of the RPS will be less than $150,000. 21. As the total decrease (if any) in the market value of the Ordinary Shares that is attributable to the direct value shift is less than $150,000, subsection 725-70(1) of the ITAA 1997 will preclude the arrangement from any consequences under the direct value shifting rules in Division 725 of the ITAA 1997. | Detailed Reasoning - Question 4: If the answer to question 2 is Yes, will the 4-year reversal exception rule apply? | Summary: As the answer to question 2 is No, this question is not necessary. | Detailed Reasoning - Question 5: Will the redeemable preference share be treated as an equity interest under Division 974 of the ITAA 1997? | Summary: The RPS is considered to be an equity interest under Subdivision 974-C of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Equity test 22. Section 974-75 of the ITAA 1997 sets out the requirements for a scheme to satisfy the equity test in relation to a company. 23. The term 'scheme' is defined broadly in subsection 995-1(1) of the ITAA 1997 to mean any arrangement, scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. The issue of the RPS would fall within the definition of a scheme. 24. A scheme gives rise to an equity interest in the company under section 974-70 of the ITAA 1997 if the scheme satisfies the equity test in section 974-75 of the ITAA 1997 and the interest is not a debt interest under section 974-20 of the ITAA 1997. 25. A scheme satisfies the equity test in relation to a company if it gives rise to an interest of the kind listed in subsection 974-75(1) of the ITAA 1997 which are: 1 An interest in the company as a member or stockholder. 2 An interest that carries a right to a variable or fixed return from the company where the right or the amount of the return is in substance or effect contingent on the economic performance (whether past, current or future) of the company or a 'connected entity'. 3 An interest that carries a right to a variable or fixed return from the company where the right or the amount of the return is at the discretion of the company or a connected entity. 4 An interest issued by the company that: (a) gives its holder (or a connected entity of the holder) a right to be issued with an equity interest in the company or a connected entity of the company; or (b) is an interest that will or may convert into an equity interest in the company or a connected entity of the company. 26. The RPS will satisfy the equity test in subsection 974-75(1) of the ITAA 1997 as the interest arising from its issue is an interest covered by item 1 of the table listed in subsection 974-75(1) of the ITAA 1997. 27. As item 1 of the table listed in subsection 974-75(1) of the ITAA 1997 is satisfied it is unnecessary, in the present context, to further consider whether any other items in the table are also satisfied for the purposes of passing the equity test. 28. Therefore, the RPS will be an equity interest unless it is characterised as a debt interest under section 974-20 of the ITAA 1997. Debt test 29. Subsection 974-15(1) of the ITAA 1997 defines the meaning of a 'debt interest' as follows: A scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1). 30. Subsection 974-20(1) of the ITAA 1997 states that a scheme satisfies the debt test 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: • the financial benefit referred to in paragraph (b) is receives if there is only one; or • 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. 31. In order to satisfy the debt test, the scheme must satisfy all 5 limbs in subsection 974-20(1) of the ITAA 1997. 32. In this case the RPS is not a debt interest pursuant to subsection 974-20(1) of the ITAA 1997, on the basis that not all of the cumulative requirements under that provision are satisfied: • Paragraph 974-20(1)(a) of the ITAA 1997 is satisfied on the basis that the issue of the RPS constitutes a financing arrangement • Paragraph 974-20(1)(b) of the ITAA 1997 is satisfied on the basis that NewCo receives a financial benefit in the form of the Issue Price of the RPS. • With respect to paragraphs 974-20(1)(c) and 974-20(1)(d) of the ITAA 1997, there are no periodic amounts payable by NewCo on the RPS. Also, the redemption price for the RPS will be less than the amount originally received by NewCo on issue of the RPS. Therefore, paragraphs 974-20(1)(c) and 974-20(1)(d) of the ITAA 1997 are not satisfied because it is not substantially more likely than not that the value of the financial benefits which NewCo has an effectively non-contingent obligation to provide will be at least equal to the value of the Issue Price that it receives. • The condition in paragraph 974-20(1)(e) of the ITAA 1997 is satisfied; however, this is immaterial given that the condition in paragraph 974-20(1)(d) of the ITAA 1997 is not satisfied. 33. Based on the above, the RPS fails the debt test under section 974-20(1) of the ITAA 1997. Therefore, the RPS is an equity interest under Division 974 of the ITAA 1997.

Question 1: Will the issue of the RPS under the scheme and subsequent payment of a dividend on that RPS constitute a dividend stripping scheme for the purposes of subsection 177E(1) of the ITAA 1936?