1. COVER
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 scenario
A 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 refresher
Contained 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 purpose
In 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 177EA
As 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;
„„ 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
„„ modify the definition of what constitutes a class
of shares in Part IIIAA of the Act by:
„„ providing that a class of shares includes all
shares having substantially the same rights;
and
„„ 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 streaming
Paragraph 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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3. COVER
„„ 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;
„„ typically, these shares would be
redeemable as well; and
„„ 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 trading
As 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
circumstances
To 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:
„„ franking credit trading;
„„ dividend streaming; or
„„ 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, CTA
Partner – 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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