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The High Court has unanimously allowed an appeal from the decision of the Full Court of the Federal Court of Australia in Mills v FCT [2011] FCAFC 158. In so doing, the High Court set aside a determination of the Commissioner that no franking credit should arise in respect of distributions made on certain securities issued by the Commonwealth Bank of Australia.

In 2009 the bank issued ten million “Perpetual Exchangeable Resaleable Listed Securities V” (“PERLS V”), each comprising a preference share stapled to an unsecured promissory note issued out of the Bank’s New Zealand branch, and with an aggregate issue price of $2 billion. The bank issued PERLS V to meet projected capital requirements cost-effectively and consistently with applicable prudential standards requiring a certain proportion of “Tier 1” capital. Holders of PERLS V were entitled to quarterly distributions, which were expected to be fully franked and paid by the bank’s New Zealand branch out of funds earned by the New Zealand branch.

The Commissioner and the bank agreed to test in court the application of s 177EA of the ITAA 1936 to the arrangements for the franking of distributions on PERLS V and for the bank, if unsuccessful, to make a cash payment to the Commissioner settling the obligations of PERLS V holders. The Commissioner duly made a determination under s 177EA(5)(b) in relation to Mr Andrew Mills, a holder of PERLS V and an Australian resident, that no imputation benefit was to arise in respect of the first franked distribution that the bank was to make on PERLS V. The Commissioner disallowed an objection to that determination and Mr Mills appealed to the Federal Court. The primary judge, and a majority of the Full Court of the Federal Court, found for the Commissioner, holding that having regard to the “relevant circumstances” of the arrangements for the issue of PERLS V, it would, within the meaning of s 177EA(3)(e) of the ITAA 1936, be concluded from the perspective of a reasonable person that the bank entered into and carried out those arrangements “for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling” a holder of PERLS V to obtain an imputation benefit.

On appeal, the High Court held unanimously (Gageler J – French CJ, Hayne, Kiefel and Bell JJ agreeing) that the relevant circumstances to be taken into account included that distributions on the securities were to be paid by the New Zealand branch of the bank without payment of Australian income tax by the bank on the source of funding and that without the issue of PERLS V the bank would have raised Tier 1 capital by other means at higher cost. The High Court held that although it would be concluded that the bank had a purpose of enabling PERLS V holders to obtain an imputation benefit, that purpose was incidental to its purpose of raising Tier 1 capital. As the purpose was an incidental purpose, a necessary precondition to the Commissioner’s power to make the determination was not satisfied.

On the question of “incidental” purpose, Gageler J observed:

“First, 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. Indeed, the centrality of a purpose to the design of a scheme directed to the achievement of another purpose may be the very thing that gives it a quality of subsidiarity and therefore incidentality. That is not impermissibly to confine the scope of s 177EA(3)(e) to a dominant purpose: the categories of 'dominant' and 'incidental' are not exhaustive. The parenthesised words in s 177EA(3)(e) make clear that a dominant purpose of enabling a holder to obtain a franking credit is sufficient but not necessary for the requisite jurisdictional fact to exist, but it does not follow that a purpose which does no more than further or follow from some dominant purpose is incidental. Second, counterfactual analysis is not antithetical to the statutory inquiry mandated by s 177EA(3)(e). Purpose is a matter for inference and incidentality is a matter of degree. Consideration of possible alternatives may well assist the drawing of a conclusion in a particular case that a purpose of enabling a holder to obtain a franking credit does or does not exist and, if such a purpose exists, that the purpose is or is not incidental to some other purpose.

On that construction of s 177EA(3)(e), there is in the case of a capital raising where the issuer intends to frank distributions on the equity interests disposed of a 'purpose ... of enabling' the holders of those equity interests to obtain franking credits. Any such capital raising is therefore potentially within the scope of s 177EA(3)(e). 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 where it is the issue of equity interests that is incidental to the provision of the franking credits.”

Mills v FCT [2012] HCA 51 (High Court; French CJ, Hayne, Kiefel, Bell and Gageler JJ, 14 November 2012).

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