Entitlements to franking credits in an employee remuneration arrangement: Commissioner's discretion

Is the conclusion that a beneficiary of a unit trust cannot satisfy the qualification period in the former section 160APHO of the Income Tax Assessment Act 1936 (ITAA 1936) a relevant matter for the Commissioner to consider in exercising the discretion to treat the unit holder's interest as vested and indefeasible under former paragraph 160APHL(14)(c) of the ITAA 1936?

No. The conclusion that a beneficiary of a unit trust cannot satisfy the qualification period in former section 160APHO of the ITAA 1936 is not a relevant matter for the Commissioner to consider in exercising the discretion to treat the unit holder's interest as vested and indefeasible under former paragraph 160APHL(14)(c) of the ITAA 1936.

Contributions are made by an employer to an employee remuneration arrangement that operates through a unit trust.

The trustee of the unit trust provides a non-recourse interest free loan to the employee. The employee uses the loan to acquire units in the trust. No repayment of the loan is required until cancellation of the units.

The trustee uses the funds that have been contributed by the employee to acquire shares in the employer and these shares are held on trust for the unit holder. The issue price of each unit is the market value of the share allocated to that unit.

The unit holder is entitled to receive, in proportion to their unit holding, income distributions, including franked dividends received by the trustee on allocated shares.

The unit holder has a cancellation entitlement when the units are cancelled. The cancellation entitlement includes a choice of receiving an in specie distribution of shares or a payment of cash equal to the market value of the shares. However, any cancellation entitlement will be first offset against any amount outstanding on the interest free non-recourse loan.

Where the cancellation entitlement is insufficient to cover the amount that is outstanding on the loan, the trustee will accept the cancellation entitlement in full and final satisfaction of the amount outstanding on the loan.

The unit holder has received more than $5000 in imputation credits and the arrangement is not an employee share scheme under Division 83A of the Income Tax Assessment Act 1997 (ITAA 1997).

The employee does not hold any further interest with respect to the shares other than the interest held as beneficiary of the unit trust and does not have a vested and indefeasible interest in the corpus of the trust. As such, the unit holder will not be a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936 unless the discretion in former subsection 160APHL(14) of the ITAA 1936 is exercised in the unit holder's favour.

A beneficiary of a trust is only entitled to the tax offset under section 207-45 of the Income Tax Assessment Act 1997 (ITAA 1997) if that beneficiary is a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936 (the Division) in relation to the distribution - paragraph 207-150(1)(a) of the ITAA 1997.

The intent of the Division is to ensure that the benefit of a franked distribution is only available to the true economic owner of a share, that is, the entity which is sufficiently exposed to the risks of loss and the opportunities for gain associated with share ownership. The Division seeks to prevent taxpayers who have limited exposure to those risks and opportunities from obtaining access to franking credits. In this regard paragraph 4.6 of the Explanatory Memorandum to the Tax Laws Amendment Bill (No. 2) 1999 ( the EM ) states: One of the underlying principles of the 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: a degree of wastage of franking credits is an intended feature of the imputation system.

Where there is a trust that is not widely held, and a beneficiary does not have a vested and indefeasible interest in the corpus of the trust, the Commissioner of Taxation may exercise the discretion in former subsection 160APHL(14) of the ITAA 1936 to treat the interest as being vested and indefeasible. In exercising this discretion, former paragraph 160APHL(14)(c) of the ITAA 1936 sets out the matters to which the Commissioner of Taxation should have regard: (i) the circumstances in which the interest is capable of not vesting or the defeasance can happen; and (ii) the likelihood of the interest not vesting or the defeasance happening; and (iii) the nature of the trust; and (iv) any other matter the Commissioner thinks relevant.

When the Commissioner is exercising the discretion in former subsection 160APHL(14) of the ITAA 1936, the fact that a taxpayer will not otherwise be able to satisfy the qualification period in former section 160APHO of the ITAA 1936 is not a relevant matter under former paragraph 160APHL(14)(c) of the ITAA 1936. The Commissioner's discretion becomes relevant because the requirements of former section 160APHO of the ITAA 1936 have not been met but whether the discretion should be exercised depends on separate considerations.

Whether the discretion will be exercised in a taxpayer's favour is dependent on an examination of the circumstances so as to understand where the true economic ownership of the shares is held.

In considering the factors set out in former paragraph 160APHL(14)(c) of the ITAA 1936, the unit holder may not be sufficiently exposed to the risk of loss or opportunity for gain in respect of their shares due to: • The limited recourse nature of the loan (so that the unit holder is wholly protected from a fall in the market value of the shares); • The loan not being interest bearing; • The requirement for the unit holder to repay the loan from their own funds before being eligible to an in specie distribution; • The arrangement being generally promoted or operated on the basis that a unit holder will, upon cancellation of the units, receive cash rather than an in specie distribution; and • The various discretions of the trustee affecting the vesting of the shares.

Consistent with the intent of the imputation system, the Commissioner will not exercise the discretion in former subsection 160APHL(14) of the ITAA 1936 to treat the interest as being vested and indefeasible where the employee is not sufficiently exposed to the risk of loss or opportunity for gain. The employee will consequently not have a vested and indefeasible interest, will not be a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936 (the Division) in relation to the distribution, and will not be entitled to a tax offset under section 207-45 ITAA 1997.