Private ruling: Distribution of franked dividends
Date of advice: 20 March 2017
Published: May 2017

Ruling: Q1: Does section 177EA of the Income Tax Assessment Act 1936 (ITAA 1936), apply to the distribution of franked dividends from the Australian Entity, under the proposed scheme, to Australian shareholders who also hold shares in the Group Entity’s employee share scheme? | A1: No.

Relevant facts and circumstances: Australian Entity (AE) is the Australian subsidiary of Group Entity (GE), an overseas unlisted company. GE has implemented and operated a successful employee share acquisition scheme (GE ESS). GE has run its ESS in Australia for many years but has found that its Australian resident employees do not participate and buy shares in the scheme, to the same extent as its overseas employees. As a consequence of what GE considers a poor uptake of its ESS by its Australian-based employees, AE is proposing an Australian employee share scheme (AE ESS). For the purposes of the AE ESS, AE will issue a new class of share, the AE share (hereinafter referred to as the ‘share’ or ‘shares’). In regard to the share, the following will apply: ● they will be subject to Australian Securities & Investment Commission requirements and will carry voting rights ● have an Australian value, for both issue and buyback purposes, equivalent to the overseas value, at the applicable time, and ● given AE is wholly owned by GE and unlisted, AE proposes to operate a buy-back program in order to ensure a liquid market for its shares AE employee shareholders of GE will not exchange their GE shares for shares in AE. Eligibility criteria for all future shares in AE are determined on the same basis as they would have been in GE. Dividends paid on employee share scheme shares in GE and AE are identical. Eligibility criteria to purchase shares in AE must not be increased because an employee relinquishes their shares in GE. Existing shareholders in the GE ESS will be able to participate in the AE ESS. AE ESS It is proposed that the following guidelines, applying to the GE ESS, will be applied to the AE ESS: ● only employees with at least two years’ service may be nominated ● generally employees who have held staff shares in the past and have sold them are not offered shares again ● employees who have previously declined an offering of shares are not given the opportunity again, unless there are extenuating circumstances ● offers are not automatic after two years; an employee must have a good employment record, have contributed well to the results of the company and be anticipated to remain with and contribute towards future results ● the offering should not be in lieu of remuneration ● nominations should not be unnecessarily skewed towards salaried employees and therefore nominations for worthy waged workers are expected, and ● nominated staff are expected to participate. As GE is an unlisted company and its shares are not publically traded, the process and practice of the GE ESS (which is expected to apply to the AE ESS) for determining the purchase price of GE shares offered by the GE Board (and referred to in the GE ESS as the ‘prevailing share price’) is as follows: ● the GE Board obtains an independent valuation report from a valuation expert twice a year, that sets out a value range for the GE shares, and ● in the absence of unusual circumstances, the GE Board determines, the prevailing share price to be a value within the value range set out in the most recent independent valuation report, having regard to applicable circumstances at the time and its own view of the value of the GE shares. The shares will not be issued at a discounted price, and will not satisfy the requirements of Division 83A of the Income Tax Assessment Act 1997 .

Relevant legislative provisions: Income Tax Assessment Act 1936, paragraph 177D(b) | Income Tax Assessment Act 1936, section 177EA | Income Tax Assessment Act 1936, subsection 177EA(3) | Income Tax Assessment Act 1936, paragraph 177EA(3)(a) | Income Tax Assessment Act 1936, paragraph 177EA(3)(b) | Income Tax Assessment Act 1936, subparagraph 177EA(3)(b)(i) | Income Tax Assessment Act 1936, subparagraph 177EA(3)(b)(ii) | Income Tax Assessment Act 1936, paragraph 177EA(3)(c) | Income Tax Assessment Act 1936, paragraph 177EA(3)(d) | Income Tax Assessment Act 1936, paragraph 177EA(3)(e) | Income Tax Assessment Act 1936, paragraph 177EA(5)(b) | Income Tax Assessment Act 1936, subsection 177EA(12) | Income Tax Assessment Act 1936, subsection 177EA(14) | Income Tax Assessment Act 1936, paragraph 177EA(14)(a) | Income Tax Assessment Act 1936, subsection 177EA(17) | Income Tax Assessment Act 1936, paragraph 177EA(17)(a) | Income Tax Assessment Act 1936, paragraph 177EA(17)(b) | Income Tax Assessment Act 1936, paragraph 177EA(17)(c) | Income Tax Assessment Act 1997, Division 83A | Income Tax Assessment Act 1997, section 960-130 | Income Tax Assessment Act 1997, section 960-135

Reasons for decision: Summary: All references are to the Income Tax Assessment Act 1936 (ITAA 1936) unless otherwise stated. Having regard to the relevant circumstances of the scheme, the Commissioner has come to the view that the requisite purpose is not present because the franking benefits received by the employee shareholders of AE, in this case, arise in ‘subordinate conjunction’ with the main purpose of the scheme being to attract, retain, motivate and reward key employees. | Detailed Reasoning - Detailed reasoning: Section 177EA is a general anti-avoidance rule that is intended to prevent abuse of the imputation system through schemes which circumvent the basic rules for the franking of dividends. In essence, it applies to schemes for the disposition of shares or an interest in shares, where a franked distribution is paid or payable in respect of the shares or an interest in shares. In circumstances which circumvent the basic rules for the franking of dividends, subsection 177EA(5) enables the Commissioner to make a determination with the effect of either: ● imposing franking debits or exempting debits on the issuer’s franking account, or ● denying the imputation benefit on the distributions that flowed directly or indirectly to the relevant taxpayer. Pursuant to subsection 177EA(3) the provision applies if the following conditions are satisfied: (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. In respect to the circumstances of the proposed AE ESS, the Commissioner considers that the conditions in paragraphs 177EA(3)(a) to 177EA(3)(d) are satisfied because: ● the issue of the shares constitutes a scheme for the disposition of a membership interest (paragraph 177EA(3)(a)): _ pursuant to paragraph 177EA(14)(a), a ‘scheme for a disposition of membership interests or an interest in membership interests’ includes a scheme that involves the issuing of membership interests, and _ the issue of shares on the terms set out in the application is a scheme that involves the issuing of membership interests because, once the shares are issued, the AE shareholders are members of AE and the shares are not debt interests (sections 960-130 and 960-135 of the ITAA 1997) ● AE intends to pay a frankable distribution to the AE employee shareholders (paragraph 177EA(3)(b)) ● AE intends to frank the distribution to AE employee shareholders (paragraph 177EA(3)(c)); and ● except for the application of 177EA, the AE employee shareholders will receive an imputation benefit as a result of the franked distribution (paragraph 177EA(3)(d)). As the threshold requirements of section 177EA have been met the remaining issue, pursuant to paragraph 177EA(3)(e), is whether the relevant taxpayer participated in the scheme to obtain an imputation benefit. It is necessary to consider the ‘relevant circumstances’ of the scheme in determining whether it could 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 the purpose (whether or not the dominant purpose but not including any incidental purpose) of enabling the relevant taxpayer to obtain an imputation benefit. The term ‘incidental purpose’ is not defined. Accordingly, the term takes its ordinary meaning relevant to the context. Paragraph 8.76 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 3) 1998 (the EM) states the following in this regard: A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with another purpose, or merely follows another purpose as its natural incident. For example, when a taxpayer holds shares in the ordinary way to obtain the benefit of any increase in their share price and the dividend income flowing from the shares, a franking credit benefit is generally no more than a natural incident of holding the shares, and generally the purpose of obtaining the benefit simply follows incidentally a purpose of obtaining the shares: it is therefore merely an incidental purpose. Circumstances that are relevant in determining whether any person has the requisite purpose include, but are not limited to, the factors listed in subsection 177EA(17), and these include the factors listed in paragraph 177D(b). The relevant circumstances listed encompass a range of circumstances that taken individually or collectively could indicate the requisite purpose. Due to the diverse nature of these circumstances, some may or may not be present at any one time in relation to a particular scheme. Risk of loss and opportunities for profit or gain Paragraph 177EA(17)(a) refers to the extent and duration of the risks of loss, and the opportunities for profit or gain, from holding membership interests and whether there has been any change in those risks and opportunities for the relevant taxpayer, or any other party to the scheme. The EM notes that the extent to which the person receiving a dividend is exposed to the risks and opportunities of owning shares is a relevant factor in determining purpose. Also, the EM states that generally, the greater the risk borne by the taxpayer receiving the franking credit benefit, the less likely it is that the requisite purpose is present (paragraph 8.82) and that the longer the period for which the shares were held at risk by the person obtaining the franking credit benefit, the less likely it is that the requisite purpose is present (paragraph 8.84). It is proposed that the managers’ guidelines that apply to the GE ESS, will be applied to the AE ESS, so that these restrictions and the emphasis on retention of the shares suggest that the risks and opportunities that AE shareholders will be exposed to are not materially different to that of ordinary shareholders. The analysis of this factor does not indicate the presence of the requisite purpose. Derive a greater benefit from franking credit and retain franking credits Paragraphs 177EA(17)(b) and (c) refer to whether the taxpayer would, in the year of income in which the distribution is made, derive a greater benefit from franking credits than other entities who hold membership interests, or have interests in membership interests, in the corporate tax entity (GE shareholders, for instance). The original scheme, was one in which, having regard to the relevant circumstances of the scheme, it could be concluded that the scheme was entered into for a purpose (whether or not a dominant purpose but not including an incidental purpose) of enabling an AE employee shareholder to obtain an imputation benefit. The scheme as originally proposed left open the opportunity for Australian-resident employee shareholders of GE, a company incorporated and resident overseas, to exchange their GE shares for shares in AE. The scenario where dividends paid to GE and AE shareholders were different due to the shareholder’s ability to utilise franking credits would likely be a scheme entered into for a more than incidental purpose of enabling a participant to obtain an imputation benefit for the purposes of paragraph 177EA(3)(e). However, in the revised arrangement where: ● eligibility criteria for all future shares in AE are determined on the same basis as they would have been in GE ● the dividends paid on all employee share scheme shares in GE and AE are identical ● AE employees will not be able to exchange their shares in GE for shares in AE, and ● the eligibility criteria to purchase shares in AE must not be increased because an employee relinquishes their shares in GE the Commissioner would not seek to apply section 177EA to a proposed scheme that involved Australian employees becoming eligible for future shares in AE. The principal motivation of GE, in issuing the AE employee shares is to attract, retain, motivate and reward key employees and will result in the holders of employee shares in AE receiving franked distributions. As stated above, paragraph 177EA(3)(e) does not require a conclusion of dominant purpose and a more than incidental purpose is sufficient. In Mills v Commissioner of Taxation [2012] HCA 51 Gageler J stated (at paragraph 66) that ‘a purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose’. The High Court unanimously held that section 177EA of the ITAA 1936 did not apply in respect of frankable distributions on PERLS V. Gageler J stated the following (at paragraph 67): If, however, the intended franking of distributions serves no purpose other than to facilitate the capital raising then the purpose is an incidental purpose: s 177EA(3)(e) is not engaged and s 177EA does not apply. That is to be contrasted with franking credit trading and franking credit streaming…The present case does not involve one of them. | Detailed Reasoning - Conclusion: Having regard to the relevant circumstances of the scheme, the Commissioner has come to the view that the requisite purpose is not present because the franking benefits received by the employee shareholders of AE, in this case, arise in ‘subordinate conjunction’ with the main purpose of the scheme being to attract, retain, motivate and reward key employees. Accordingly, the Commissioner will not make a determination under paragraph 177EA(5)(b) to deny the whole, or any part, of the imputation benefit to be received in relation to dividends paid to employee shareholders of AE.