No franking credits on dividends funded by capital raisings

Treasury recently released exposure draft legislation regarding the franking credits on dividends funded by capital raising on 14 September 2022. This comes long after the measures were first announced in the previous Government’s 2016-17 Mid-Year Economic and Fiscal Outlook (MYEFO 2016-17). The proposed changes include integrity measures designed to prevent companies from attaching franking credits to dividend distributions funded by capital raising activities, which would result in the issue of new equity interests.

This MYEFO 2016-17 announcement indicated that when the proposed measures become law, they will apply retrospectively to dividend distributions made on or after the announcement on 19 December 2016. However, many companies have since undertaken capital raisings and made franked distributions that may be subject to these measures. This may result in additional tax for Australian resident shareholders, as well as additional withholding tax for companies on the dividends paid to non-residents.

The Assistant Treasurer has on 5 October 2022 indicated that the Government will consider delaying the start date of 19 December 2016 for the proposed measures, but that it will not back-down on implementing these integrity measures.

We provide a summary of the retrospective changes that the Government is proposing to introduce, including the tax implications for companies making distributions funded by capital raisings and shareholders receiving these dividends. In addition, we comment on the three main issues with the proposed measures in the exposure draft legislation.

Dividends and frankable distributions

Under the imputation system, Australian resident shareholders who receive assessable dividends from an Australian company are generally entitled to a tax offset (i.e. franking credits), which is equal to the amount of income tax paid by the company on its income. However, there are rules for determining whether a distribution is frankable or unfrankable.

A company is entitled to frank a distribution to its shareholders, provided it is a ‘frankable distribution’. Certain distributions are listed as ‘unfrankable distributions’. For example, distributions sourced from a company’s ‘share capital account’ are unfrankable. However, the current law has no restrictions on using the funds from share capital raisings to fund a franked distribution, provided the company’s ‘share capital account’ is not reduced as a result.

New unfrankable distributions

The exposure draft legislation indicates that the aim of the new integrity measures is to prevent entities from manipulating the imputation system to obtain inappropriate access to franking credits. This is achieved by adding ‘distributions funded by capital raising’ to the list of ‘unfrankable distributions’. Specifically, the proposed amendments will prevent the use of ‘artificial arrangements’ for raising capital to fund the payment of franked distributions to shareholders and enable the distribution of franking credits.

Distribution funded by capital raisings

In broad terms, a distribution by an entity is funded by capital raising if:

  • The distribution is not consistent with an established practice of the entity to make distributions of that kind on a regular basis
  • There is an issue of equity interests in the entity, or another entity
  • It is reasonable to conclude in the circumstances that either:
    • The principal effect of the issue of any of the equity interests was to directly, or indirectly, fund some or all of the distribution, or
    • Any entity that issued, or facilitated the issue of, any of the equity interests did so for a purpose (other than an incidental purpose) of funding all or part of the distribution.

Taxpayer Alert 2015/2

The proposed amendments also address the issues raised in the Australian Taxation Office’s (ATO) Taxpayer Alert 2015/2 (TA 2015/2). In this alert, the ATO warned taxpayers against entering into arrangements that involved funding distributions by raising capital to release credits to shareholders.

The ATO’s concern is that companies are using these arrangements to release franking credits, or streaming dividends to shareholders. The features of these arrangements include:

  • A company with a significant franking credit balance raises new capital from existing or new shareholders
  • A company makes franked distributions to its shareholders at a similar time and in a similar amount to the capital raising
  • The franked distributions are unusually large, compared to ordinary dividends previously declared and paid.

Mid-Year Economic and Fiscal Outlook 2016-17

In TA 2015/2, the ATO indicated that these arrangements may attract s177EA of the Income Tax Assessment Act 1936. However, there are some doubts that the dividend washing and anti-avoidance rule in s177EA would apply. This may have been the rationale for the previous Government’s announcement in the MYEFO 2016-17 that it would introduce specific measures. These measures would prevent a company from distributing franking credits, where a distribution to shareholders is funded by particular capital raising activities.

The announcement stated that the measures would apply to distributions declared by a company to its shareholders outside, or additional to, the company’s normal dividend cycle (i.e. a special dividend). This is to the extent that it is funded directly or indirectly by capital raising activities, which result in the issue of new equity interests. Examples of capital raising activities include an underwritten dividend reinvestment plan, a placement, or an underwritten rights issue. However, these measures were not introduced into Parliament for many years, until the exposure draft legislation was issued recently by the new Government.

Date of effect

The proposed amendments in the exposure draft legislation would apply retrospectively to distributions made on or after 19 December 2016, which is consistent with the announcement in the MYEFO 2016-17. The Explanatory Memorandum (EM) to the exposure draft legislation states that it is necessary for the proposed amendments to apply retrospectively. This is because the measures prevent artificial and contrived arrangements to inappropriately access franking credits, which were not intended under the imputation system. In addition, the EM states that allowing such activities to continue between the announcement and passage of legislation without consequences under the law would encourage their use during this period.

Extended period for amended assessments

The exposure draft legislation provides that the Commissioner may amend assessments to give effect to these changes, where amended assessments are made within 12 months after the Bill receives Royal Assent. This effectively extended the normal two and four-year periods for amended assessments, allowing the ATO to amend assessments back to the 2016-17 income year. This would mean that many shareholders would need to pay back to the ATO the franking tax offsets they received on affected dividends since 19 December 2016.

Administrative treatment of retrospective legislation

The announcement of proposed retrospective legislation can cause a dilemma for affected taxpayers, as to whether they should follow the existing law or anticipate the proposed change. To assist with this, the ATO provides practical guidance on their administrative approach for taxpayers facing retrospective law changes.

If a proposed law change would increase a taxpayer’s liability, the ATO says it has no authority to collect the new, or higher, liabilities until the relevant law is enacted. Accordingly, taxpayer’s can self-assess their liability under the existing law. If the law is ultimately changed retrospectively, the taxpayer will need to seek an amendment and pay the increased lability, including any interest and penalties that may apply. The exposure draft legislation does not mention any concessions for interest or penalties.

BDO Comment

We address the three main issues with the proposed measures in the exposure draft legislation below.

1.  Explanation of why practice is inappropriate

There is not an adequate explanation of why Treasury considers the practice of funding franked dividends out of capital raising to be “arrangements set up to inappropriately access franking credits that were not intended under the imputation system”. The only indication of the object of the imputation provisions to identify frankable and unfrankable distributions is in s202-35 of the Income Tax Assessment Act (ITAA) 1997. This states that the object “is to ensure that only distributions equivalent to realised taxed profits can be franked”. This merely requires the company to show that the franked dividends are equivalent to realised taxed profits, which is ensured by appropriately recording the company tax paid via the franking account. There is no indication that the provisions require the funds used to pay the dividends to be directly traced back to the funds that contributed to the profits.

2.  Breadth of capital contributions affected

The types of capital contributions affected by the proposed new measures in the exposure draft legislation is much more detailed than was provided in the previous Government’s announcement on 19 December 2016.As this announcement contained very little detail of the capital contributions that would be affected, it was difficult for companies to determine whether a particular type of capital raising would be affected. As capital raising by companies is a common occurrence, and given the extended time it has taken to release the exposure draft legislation, it is inappropriate to expect companies to know the details before this was released.

3.  Impact on shareholders and ATO processing

The shareholders in the affected companies will need to repay the amount of the franking tax offsets they received on the affected distributions. This is despite the fact that most of them had no involvement in the capital raising, or the decision to pay a special dividend. Many of these shareholders will be retirees, their superannuation funds, and other low-income individuals who may find it difficult to make these repayments to the ATO. In addition, the volume of amendments that would need to be processed would present a challenge for the ATO. This would need to be completed within 12 months of the date of royal assent of the amending legislation.

The closing date for submissions to Treasury was Wednesday, 5 October 2022. BDO in Australia has lodged a submission to Treasury on the exposure draft legislation, which addresses the above three points and other relevant issues.

If you have any questions about this technical update, or would like more information on Corporate & International Tax, please contact your local BDO adviser.