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The Federal Court (Emmett J) has held that s 177EA of Part IVA of ITAA 1936 applied to securities issued by the New Zealand branch of the Commonwealth Bank (the Bank), such that the Commissioner was entitled to make a determination  under s 177EA(5)(b) that no imputation benefits arose in respect of a distribution that was made to the taxpayer.

The relevant securities consisted of unsecured subordinated notes which were regared as equity interests for Australian tax purposes, and the distributions made in respect of them were regarded as non-deductible non-share dividends that were potentially frankable for Australian tax purposes. However, the distributions were deductible against New Zealand income for New Zealand tax purposes.

The prospectus under which the securities were issued stated that the Bank expected that distributions would be fully franked. If distributions were fully franked, holders of the securities would receive a combination of cash and franking credits. The amount of the distribution (or distribution rate) was calculated by taking into account the value of the franking credits. However, if a distribution was unfranked or not fully franked, the cash component would generally be increased to compensate holders for the unfranked portion of the distribution.

The question before the Court was whether, having regard to the relevant circumstances of the scheme, it would be concluded that 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) ("the relevant purpose") of enabling the taxpayer to obtain an imputation benefit, as required by s 177EA(3)(e). If so, s 177EA applied.

The Bank argued that its only non-incidental purpose in issuing the securities was to increase its Tier 1 capital as required by the Australian Prudential Regulation Authority (APRA). The Commissioner accepted that the raising of Tier 1 capital was a significant purpose of the Bank in issuing the securities However, as the Court noted at para 92-93:

"...the Commissioner says, that purpose of the Bank must be put in the right perspective. The cost of achieving that purpose was significantly reduced by the fact that the Notes would be franked, notwithstanding that they were a deductible interest expense for the New Zealand branch of the Bank. The imputation system seeks to avoid double taxation by providing a mechanism for the tax paid by companies to be credited to their resident members...However, the Commissioner says, no such alignment is to be found in the present circumstances, because the Bank has covered part of its cost of raising capital by providing imputation benefits in respect of deductible interest payments. The Commissioner says that the Bank’s purpose in providing the imputation benefits in the present circumstances was more than an incidental purpose."

The Court proceeded to examine the relevant circumstances or matters of the scheme listed in s 177EA(17) to determine the relevant purpose, noting that the Bank's actual purpose (to raise Tier 1 capital) was irrelevant to this exercise. The Court held that the matters described in paras (b), (f), (ga),  and (h) of s 177EA(17) and the matters referred to in s 177D(b)(ii) and (iv) pointed towards the relevant purpose, whilst the others either did not point towards the relevant purpose or neither pointed towards nor away from the relevant purpose. On balance, the Court held that overall, the relevant circumstances pointed towards the purpose of enabling holders of the securities, such as the taxpayer, to obtain an imputation benefit, such that s 177EA applied.

The taxpayer's argument that, in the light of such a finding, the Commissioner should have applied s 177EA(5)(a) and debited the Bank's franking account, rather than denying the taxpayer the benefit of the imputation credit under s 177EA(5)(b), was also rejected. The Court said, at para 143:

"I do not consider that there is any substance in the Taxpayer’s complaint. Once the preconditions to the making of a determination under s 177EA(5) are found to exist, the Commissioner may make a determination either under s 177EA(5)(a) or under s 177EA(5)(b) as he sees fit. A taxpayer’s remedy, if dissatisfied with that determination, is to show that the preconditions did not exist, namely, in the present case, that the purpose referred to in s 177EA(3)(e) was not present. However, once such a purpose is found, a taxpayer cannot escape the consequences by showing that the Bank had some other purpose that the Commissioner failed to take into account or that the Commissioner failed to take some other consideration, such as the policy of the 1997 Act or the 1936 Act, into account when making a determination."

Notwithstanding the Court's findings in respect of the taxpayer in this case (Mr Mills), all other taxpayers holding the securities will not be adversely affected, as the Court noted that the Bank and the Commissioner have entered into an agreement under which the Bank agreed, in the event of an adverse finding against it (after conclusion of all objection and appeal proceedings), to pay to the Commissioner an amount calculated to compensate the Commissioner for the amount of the tax liability that would otherwise flow in respect of the franking credits on all of the securities other than those held by Mr Mills. The Commissioner, in turn, agreed not to make a determination under s 177EA(5)(b) of the 1936 Act in respect of frankable distributions on the securities that were paid, payable or expected to be payable, to persons other than Mr Mills.

Mills v FCT [2011] FCA 205 (Federal Court, Emmett J, 11 March 2011).


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