The ATO has taken another step in firming up its position on dividend access share arrangements. Back in July 2012 it issued a Taxpayer Alert which first flagged its concerns with these arrangements. Earlier this month the ATO issued a draft determination further explaining its position and concerns in relation to dividend stripping provisions in section 177E.
Those considering dividend payments through special classes of shares must give careful thought to the draft determination.
What arrangements are affected?
The authors of the draft determination appear to be John Mellencamp fans. They give an example of Jack and Dianne (NB: true Mellencamp fans would know it’s ‘Diane’) who are the sole shareholders and directors of Aust Co, an Australian private company which has accumulated profits of $5m. They wish to liberate the accumulated profits of Aust Co for reasons that are said to include 'asset protection', because they believe Aust Co operates in an industry which exposes it to legal risks. If Aust Co were to pay a dividend of $5m to Jack and Dianne, it would create a potential tax liability in Jack and Dianne's hands at the highest marginal tax rate net of the benefit of franking credits.
Instead, Jack and Dianne resolve to issue new 'Z' class shares, which carry no voting rights, but do carry the right to receive a dividend. The new shares must be redeemed by Aust Co within 4 years.
The new 'Z' class shares are issued and acquired for nominal consideration of $1 per share by the Jack and Dianne Trust, a discretionary trust to which Jack, Dianne and their immediate family members are beneficiaries.
Jack and Dianne resolve to declare a fully franked dividend totalling $5m to the 'Z' class shareholder - the Jack and Dianne Trust. The Trustee of that trust makes a trust distribution of $5m to Jack and Dianne's son Tommy, a non-resident. Tommy is not subject to further Australian tax on the $5m. Tommy immediately lends the amount of $5m back to Aust Co.
Dividend stripping under section 177E?
The ATO concludes that Jack and Dianne have little objective evidence to support their claims of asset protection. In any case, they are unable to explain why the asset protection in question could not have been achieved more simply by having Aust Co declare a dividend to them as ordinary shareholders. The ATO view is that Jack and Dianne have entered into a scheme 'by way of or in the nature of dividend stripping' within the meaning of section 177E of Part IVA.
The example is just one instance where the ATO believe there to be a dividend stripping scheme. Unfortunately, the determination is not precise (perhaps deliberately so) on where the boundary lies between arrangements which are caught, and those which are not. The closest they get to define that boundary is to say:
Although there is significant variety in the timing, nature and scope of the final transactions chosen, the arrangements described in TA 2012/4 generally exhibit many features common to marketed tax planning schemes. For example, the arrangements are likely to include a private company with significant accumulated profits, the issue of a new class of dividend only shares, fully franked dividend distributions on those shares and transactions with other controlled entities (that is, companies and/or trusts) as part of a complex legal arrangement with numerous preordained steps and payments made by way of promissory notes, loan agreements and accounting entries.
The substance in all these arrangements however is that in the name of asset protection, or some other alleged non-tax objective, there is a reduction or elimination of the ordinary shareholder's tax liability. That is, the final transactions chosen generally result in a reduction or elimination of the taxation liabilities that would normally arise with the payment of dividends if those dividends had been paid to the company's original ordinary shareholders.
Little choice but to tread very carefully
The upshot is that extra care needs to be taken when paying dividends through different classes of shares. And because the draft determination uses phrases such as “a scheme … having substantially the effect” and “a form of the arrangement … which displays all or most of the following features” (emphasis added) finding the point at which arrangements are not caught will be very difficult. We recommend that any structuring arrangements involving dividend access shares need to be reviewed least of which might be a consideration of the dividend stripping rules.
Despite this, there will be some circumstances where asset protection will be the sole driver of the arrangement, and where there is no reduction of the tax liabilities that would otherwise arise, so it remains appropriate not to discount dividend access shares completely.