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The Commissioner is showing a desire to see franking credits locked within companies rather than accessed by shareholders. Recent ATO announcements relying on a provision within Pt IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA36) may have far reaching consequences.

Although s 177EA of Pt IVA was included in the ITAA36 in 1998, its operation has recently received much attention from the Commissioner who is turning to this provision to attack various aspects of the dividend imputation system. Specifically, in the last 18 months, we have seen TD 2014/10 (released on 30 April 2014), TA 2015/1 (released on 30 April 2015) and TA 2015/2 (released on 7 May 2015).

A common theme in these three ATO publications is that they seek to make use of s 177EA.

In this article, the intended operation of s 177EA, and the historical context in which it was introduced, are analysed.

This article seeks to provoke thought in this area by asking the reader to consider a basic scenario and whether, in the absence of any additional circumstances, the reader would consider that this scenario would be regarded as a “scheme” entered into for a purpose of enabling a taxpayer to obtain an imputation benefit (using the ordinary meaning of these terms).

The authors conclude by asking the reader to revisit the basic scenario described below to consider whether they consider

that s 177EA could, or indeed should (as a matter of policy), be applied to the “scheme” to deny the franking credits attached to the dividend.

The basic scenarioA taxpayer notes that an ASX-listed company has declared a fully franked dividend and will soon trade ex-dividend.1 Therefore, the taxpayer acquires shares in that company on a cum-dividend basis so as to receive the additional benefit of the upcoming dividend as well as the franking credits. The taxpayer intends to hold the shares for at least 12 months. As the taxpayer is a self-managed superannuation fund in pension phase, the taxpayer places great importance on the franking credits attached to the dividend, as these will most likely be refunded to the taxpayer.

Section 177EA: a refresherContained within Pt IVA, s 177EA enables the Commissioner to make a determination denying imputation benefits to taxpayers resulting from franked distributions. Although it is noted in s 177EA(5) that a determination to deny imputation benefits does not form an assessment to the taxpayer, commonly, such a determination would trigger an amended assessment to be issued in respect of the denied franking credits.

Section 177EA centres around the existence of a “scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity”. Consistent with the interpretation

of a “scheme” in other sections of Pt IVA, the term “scheme” in Pt IVA can apply to unilateral actions made by one taxpayer.

The basic requirements of s 177EA provide that there needs to be a frankable distribution either paid, payable or expected to be payable to a person in respect of membership interests or is expected to flow to a particular member and that member would receive, or could reasonably be expected to receive, imputation benefits as a result of the distribution.

Is there a “scheme for a disposition”?When determining whether there is a “scheme for a disposition of membership interests”, a number of factors are listed in s 177EA(14). This is an inclusive list and given the breadth of the factors listed, one could possibly argue that every franked distribution made at any point would come within “a scheme for a disposition of membership interests”. For example, s 177EA(14)(b) provides that a scheme for the purposes of s 177EA includes:

“… entering into any contract, arrangement, transaction or dealing that changes or otherwise effects the legal or equitable ownership of the membership interests or interest in membership interests.”

Needless to say, this is a very broad definition of a “scheme for a disposition”, particularly when considering that unilateral action by one party can constitute such a scheme. Consistent with the basic

Abstract: Section 177EA, which is within Pt IVA (the general anti-avoidance provision) of the Income Tax Assessment Act 1936, enables the Commissioner of Taxation to make a determination denying imputation benefits to taxpayers resulting from franked distributions. The section centres around the existence of a “scheme for a disposition of membership interests, or an interest in membership interests, in a corporate tax entity”. Recently, the Commissioner has shown, through various ATO announcements, a tendency to use the section to attack various aspects of the dividend imputation system. This article argues that the Commissioner’s interpretation of s 177EA is too broad, and might catch arrangements and transactions which the section was not designed to cover. The article analyses the intended operation of section 177EA and its historical context. The authors then pose a basic scenario, and ask the reader to consider whether it would be regarded as falling within s 177EA.

by Andrew Sinclair, CTA, Partner – Tax and Revenue Group, and Phil White, Lawyer, Cowell Clarke

Is it a “scheme”?

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scenario described earlier in the article, simple trading of shares on ASX might be regarded by some as a “scheme for a disposition” despite both the buyer and the seller of the shares clearly acting at arm’s length on a regulated market and being completely unknown to each other.

Imputation benefit purposeIn order to fall foul of s 177EA, in addition to the existence of a “scheme for a disposition”, it must be established that the person, or one of the persons, who entered into or carried out 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”. This is an objective analysis test which takes into account a number of characteristics of the scheme which are listed in s 177EA(17).

If we follow the definition of “imputation benefit” in the most basic scenario where the distribution is made directly to the taxpayer (as opposed to circumstances where the benefit may flow indirectly to the taxpayer), s 204-30(6) of the Income Tax Assessment Act 1997 (Cth) (ITAA97) provides an exhaustive list of six alternatives that will constitute an “imputation benefit”. As you would expect, s 204-30(6)(a) provides:

“A member of an entity receives an imputation benefit as a result of a distribution if the member is entitled to a tax offset under Division 207 as a result of the distribution.”

In other words, if a franked dividend is received by a shareholder entitled to a tax offset, then that constitutes an “imputation benefit” for the purposes of s 177EA.

The next question to consider under s 177EA is whether one of the purposes, whether or not the dominant purpose but not including an incidental purpose, of the franked dividend was to enable the shareholder to receive a franking credit in their franking account (the imputation benefit).

This is where, in the authors’ view, the Commissioner has taken a very wide view of the purposes behind a franked distribution. If interpreted this broadly, s 177EA can be used to deny franking credits on a distribution if it is considered that the recipient had a non-incidental purpose of obtaining imputation benefits. This in turn depends on how one interprets a “not incidental purpose”. On this broad view, a taxpayer deciding to buy shares in Company X because, among other reasons

(eg potential capital growth), the company is about to pay a fully franked dividend could constitute a scheme within the meaning of s 177EA.

Intended operation of s 177EAAs with any provision of the ITAA36 or the ITAA97 and especially those provisions that are contained within Pt IVA, when interpreting the provision, one must consider the purpose behind the introduction of s 177EA and the “mischief” which it seeks to address. The authors submit that the historical context of the section should be used to assist with the interpretation of the way it operates — and there is no better tool when determining its intended operation than the explanatory memorandum of the Act which introduced the section.

The Taxation Laws Amendment Act (No. 3) 1998 inserted s 177EA into the ITAA36 (explanatory memorandum). This explanatory memorandum amended Pt IVA as well as Pt IIIAA ITAA36 “to prevent franking credit trading and dividend streaming”.2

Paragraph 8.1 of the explanatory memorandum states that the purpose of the amendments introduced by this Act was to:

“n introduce a general anti-avoidance provision which targets franking credit trading and dividend streaming schemes where one of the purposes (other than an incidental purpose) of the scheme is to obtain a franking credit benefit;

n introduce a specific anti-streaming rule which will apply where a company streams dividends so as to provide franking credit benefits to shareholders who benefit most in preference to others; and

n modify the definition of what constitutes a class of shares in Part IIIAA of the Act by:

n providing that a class of shares includes all shares having substantially the same rights; and

n deeming interests held in a corporate limited partnership to constitute the same class of shares for the purposes of the dividend imputation provisions.”

In the above paragraph, s 177EA is the “general anti-avoidance provision” referred to in the first line which is designed to combat franking credit trading and dividend streaming schemes.

The explanatory memorandum provides two examples of schemes or arrangements which would enliven s 177EA. One example relates to a scheme which involves franking credit trading and the other involves dividend streaming. The dividend streaming example is discussed first.

Dividend streamingParagraph 8.61 of the explanatory memorandum provides an example of a “scheme for a disposition of shares”:

“An example of a scheme for the disposition of shares or an interest in shares which would attract the rule would be the issue of a dividend access share or an interest in a discretionary trust for the purpose of streaming franking credits to a particular shareholder or beneficiary.”

As this example refers to the issue of a dividend access share, it is helpful to understand the characteristics of a dividend access share and why Treasury and the ATO might be concerned with using these shares to stream franking credits to particular shareholders.

In general terms, a dividend access share arrangement, as described in para 4 of TD 2014/1, has features including the following:

The authors’ concern is that the current ATO interpretation of a ‘scheme for a disposition’ is too broad, therefore it may apply to their initial ‘basic scenario’.

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n the amendment of a company’s constitution to include a new class of shares with this new class of shares generally having limited rights to dividends as well as no voting rights or rights to participate in the surplus assets of the company on its winding-up;

n typically, these shares would be redeemable as well; and

n after the issuing of these shares, a series of transactions is carried out that has the effect of ensuring that the original shareholders receive the economic benefit of the distribution of the company’s profits by using the newly created share class in one way or another.

The above features might correctly be described as a “scheme for a disposition of shares”, in the absence of any mitigating factors, as a new class of shares has been issued (which would constitute a “disposition”) and it appears that the purpose behind introducing this class of shares was to gain an imputation benefit by streaming franking credits to tax-preferred entities. Further, the economic benefits of the dividend to which the franking credits attach are ultimately passed on by the recipient to the original shareholders of the company.

Franking credit tradingAs stated above, another aspect that s 177EA was apparently designed to combat is franking credit trading. Franking credit trading refers to a transaction where franking credits are traded as between two parties.

Paragraph 8.6 of the explanatory memorandum states that franking credit trading schemes are those which:

“… allow franking credits to be inappropriately transferred by, for example, allowing the full value of franking credits to be accessed without bearing the economic risk of holding the shares.”

This is consistent with para 8.5 of the explanatory memorandum which states that:

“… the benefits of imputation should only be available to the true economic owners of the shares and only to the extent that those taxpayers are able to use the franking credits themselves.”

Paragraph 8.62 of the explanatory memorandum deals with another form of franking credit trading, that being securities lending. A typical securities lending

arrangement involves a non-resident lending Australian shares to a resident taxpayer over a dividend period. That means that the Australian resident share borrower receives the dividend and the benefit of the attached franking credits, whereas the non-resident share lender would not have received the benefit of the franking credits.

Arguably, a securities lending arrangement might enliven s 177EA as this is an example where the true economic owner of the share is not the taxpayer that receives the benefit of the franking credit and a clear separation of ownership and risk is evident. Further, there is a clear imputation benefit as the non-resident could not have used the franking credits but the scheme has allowed someone (that person being a resident) to obtain the benefit of the credits.

Shares held at risk in ordinary circumstancesTo protect shareholders who wish to use franking credits and have held shares at risk in ordinary circumstances, s 177EA(4) was included. That subsection provides that:

“It is not to be concluded for the purposes of paragraph (3)(e) that a person entered into or carried out a scheme for a purpose mentioned in that paragraph merely because the person acquired membership interests or an interest in membership interests in the entity.”

Paragraph 8.64 of the explanatory memorandum confirms that this was to ensure that the mere acquisition of shares or units in a unit trust where the shares or units are to be held at risk in the ordinary way will not, in the absence of further features, attract the rule, even though the shares or units are expected to pay franked dividends or distributions.

This section appears to be the “saving grace” that would operate to ensure that s 177EA applies only to genuine schemes where some mischief is at play, namely:

n franking credit trading;

n dividend streaming; or

n arrangements which are very similar to the above.

These are examples of schemes where the ownership of the membership interest is detached from the risk of holding the interest. This section shows a clear intention by the legislature that s 177EA should not apply in circumstances where shares are held at risk in the ordinary way.

Both franking credit trading and dividend streaming are “schemes” in the ordinary sense where two parties have intended to apply the benefit of franking credits to an entity in order to create a tax benefit. Neither of these schemes involves conduct solely by a shareholder buying and selling shares on the stock market.

The authors’ view is that s 177EA was introduced to target schemes of the type referred to in the explanatory memorandum where imputation credits are diverted to specific taxpayers inappropriately. Therefore, the authors find it difficult to reconcile the ATO’s position on why and how s 177EA should be used to target transactions that do not have the same “flavour” or characteristics as those discussed in the explanatory memorandum.

Application of s 177EA too broad?The authors’ concern is that the current ATO interpretation of a “scheme for a disposition” is too broad, therefore it may apply to their initial “basic scenario”. They express this concern as a number of ATO releases in the past 12 months take surprisingly broad interpretations of s 177EA.

TA 2015/2 suggests that a company raising capital to then pay a franked dividend may attract the operation of s 177EA. The ATO specifically states in its taxpayer alert that it is “concerned that the arrangement is being used by companies for the purpose of or for purposes which include releasing franking credits or streaming dividends to shareholders”. This taxpayer alert sheds no light on the legal basis for the ATO’s view that s 177EA may apply to this arrangement.

Another example is in relation to so-called dividend washing which prompted the ATO to release TD 2014/10. In this determination, the Commissioner expresses the view that what had perhaps been a reasonably common practice of selling Company X shares ex-dividend (on the regular ASX market) and buying Company X shares cum-dividend (on the ASX special markets), and thus receiving two dividend payments and the accompanying franking credits, constituted dividend washing within the meaning of s 177EA. Under threats of penalties, interest and audits, the Commissioner induced a very large number of taxpayers to “voluntarily” repay or forego the

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franking credits that attach to the purchased shares.

TD 2014/10 does provide an insight in the ATO’s interpretation on s 177EA but the authors contend that the ATO focuses too heavily on whether there is an intention of one of the taxpayers to obtain an imputation benefit, rather than the focus being correctly on whether a “scheme for the disposition of membership interests” actually exists.

Further, it disregards the transaction cost paid by taxpayers in “dividend washing.”

These two ATO publications target transactions that would not be described as schemes which s 177EA was designed to combat. According to the explanatory memorandum, the types of schemes at which s 177EA were aimed were, in broad terms, franking credit trading schemes including securities lending arrangements and dividend streaming schemes. The two examples of a “scheme for a disposition” provided in the explanatory memorandum involve very different arrangements or transactions than those the ATO is now targeting.

Andrew Sinclair, CTAPartner – Tax and Revenue Group Cowell Clarke

Phil White Lawyer Cowell Clarke

Acknowledgment

The authors would like to acknowledge the contributions of Brett Cowell and Peter Slegers in preparing this article.

References

1 Trading ex-dividend means that a buyer of that share will not acquire rights to any declared dividend from the date of sale. Alternatively, trading cum-dividend means that the buyer of the share also acquires the right to any dividend declared by the company at the date of the share sale.

2 Para 8.1 of the explanatory memorandum.

FP

WA State Convention

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