New guidance released by the ATO on funding franked dividends

The Tax Office (ATO) has issued a Practical Compliance Guideline PCG 2025/3 Capital raised for the purpose of funding franked distributions – ATO compliance approach (‘The PCG’) in response to the Federal Government’s amendment to the imputation legislation, which introduced Section 207-159 of the Income Tax Assessment Act 1997. 

The new legislation impacting funding of franked distributions

Section 207-159 was introduced to take effect on or after 28 November 2023, to treat as an unfrankable distribution, all or part of a distribution paid by a company that was funded by capital raising activities. There are four criteria that must all be satisfied for the provision to apply to a distribution:

• The distribution is not consistent with an established practice of the company making distributions of that kind on a regular basis, or the entity is not making the distribution in accordance with a regular practice
• There has been an issue of equity interests by the company making the distribution or any other entity, either before, at or after the payment of the distribution
• It is reasonable to conclude, given the circumstances, that the principal effect of the equity issue was to facilitate the payment of the distribution, and this was done for a purpose (not incidental) of funding a substantial part of the distribution
• The issue of the equity interests was not a direct response in order to meet a requirement, direction or recommendation from the Australian Prudential Regulation Authority (APRA) or the Australian Securities and Investments Commission (ASIC).

The criteria for application explained

While the second and fourth criteria speak for themselves, the first and third criteria have statutory factors that must be considered.

First criterion: Established practice

The first criterion requires an analysis of any established practice of paying distributions, and adherence to that practice. In the PCG, the ATO identify the following factors:

• The nature of distributions made by the entity before the time at which the relevant distribution was made (including the extent to which such distributions were a return on capital)
• The timing of such distributions
• The amount of such distributions
• Any explanations given by the entity for making such distributions
• The amount of the franking credits on, and the franking percentages for, such distributions
• Any other relevant consideration.

Third Criterion: Principal effect and purpose

The third criterion requires an analysis of the effect of the capital raising:

• The timing and amount of the equity interests issued compared to the timing and amount of the distribution
• The extent to which the company’s financial position (or another entity) changed as a result of the equity issue and making the distribution
• How the funds from the equity issue were used
• The reasons for the equity issue other than funding the distribution
• The extent to which the equity issue was underwritten
• How the history of the company’s franking account balance compares to their history of profits and share capital
• The relationship between the entities where one entity made the equity issue and another paid the distribution
• The relationship between the parties who participated in the equity issue and those who received the distribution
• Any other distributions made before or after the relevant distribution by the same entity
• Any other relevant consideration.

Colour coding arrangements

The ATO has designated arrangements according to risk in the PCG:

White - self assessment of risk unnecessary	No need to consider risk rating.
Green - low risk	The ATO will not have cause to apply compliance resources to consider the application of Section 207-159 to the arrangement, except to confirm the arrangement meets the requirements to be in the green zone.
Red - high risk	The ATO likely to apply compliance resources and commence review or audit.

White zone

The ATO states that an arrangement will be in the white zone where:

1. Either, a current private or class ruling confirms the distribution is frankable, or the ATO has assessed an arrangement as low risk or provided a high assurance rating for the distribution as part of a review, and
2. There have not been material changes to the arrangement since the date on which the ruling or rating was provided that are relevant to the application of Section 207-159.

Green zone

The ATO states that an arrangement will be in the green zone where:

1. The distribution is consistent with past practice over the preceding three years of distributions paid in relation to the relevant class of shares, where all of the following are fundamentally consistent:

• timing (e.g. biannual)
• amount (e.g. consistent pay-out ratio), and
• franking percentage.

2. The distribution is made under an arrangement involving a dividend reinvestment plan (underwritten or not) undertaken for normal commercial purposes, not an artificial or contrived arrangement
3. The issue of equity interests funded (directly or indirectly) less than 20 per cent of the entire franked distributions paid to all eligible shareholders
4. The issue of equity interests by entities regulated by APRA is to meet minimum regulatory requirements, or to maintain a reasonable buffer beyond the minimum regulatory requirements. Includes additional Tier 1 capital issued in connection with the redemption of another instrument
5. In relation to a private company, distribution made under an arrangement where capital raising and distribution initiated to facilitate departure of from the company (e.g. succession planning and shareholder exits).

The PCG contains a number of examples that assist companies to self-assess their distribution in the context of the green zone.

Example
2 & 3	Use of dividend reinvestment plans - over extended period, used for commercial purposes, not artificial or contrived, DPR participants less than 20 per cent of total distribution.
6 & 7	Use of equity raising to satisfy APRA requirements.
8	Use of equity raising in private company to finance departure of shareholder.

 

Red zone

The ATO states that an arrangement will be in the red zone where:

1. Close alignment in timing (e.g. less than 12 months) between issue of equity interests and declaration or payment of distribution
2. Distribution is a special dividend, or unusually large (significantly higher amount) compared to distributions previously declared and paid by company over prior three years. This does not apply if there has been a comparable increase in the company's profit that aligns with the special dividend or unusually large distribution
3. One or more of the following relevant to the third criterion - principal effect and purpose of funding a substantial part of the distribution applies:

• Absence of evidence for a clear and genuine commercial purpose (other than releasing franking credits) for the features of the arrangement
• No change, or minimal change, in financial position of the entity as a result of the arrangement
• Most of the funds raised by equity issue used to directly or indirectly fund distribution
• Distribution forms part of an artificial or contrived arrangement designed to facilitate release of franking credits.

The PCG contains a number of examples that assist companies to self-assess their distribution in the context of the red zone.

Example
4	Renounceable share offer taken up by all shareholders, funds invested in interest bearing account and used for special dividend 12 months later.
10	Capital raising for business expansion, small amount used in business, balance used to pay franked dividend to 100 per cent shareholder (trust with carried forward tax losses).

 

Documentation

The PCG also considers situations where an arrangement falls outside both the green zone examples and red zone examples, such that the company cannot self-assess the position of the distribution. In these situations, the ATO suggests companies maintain documentation to establish the commercial nature of the arrangement.

The ATO suggests board minutes, annual reports, business plans, ASX and market announcements, budgets, and any deeds and documentation relevant to the transaction or arrangement.

How BDO can help

The PCG provides some guidance on the application of these integrity provisions. BDO cautions companies on the breadth of these provisions and the potential adverse impacts these provisions may have on shareholders. Companies need to be aware of these provisions where they are planning equity issues, whilst the payment of special dividends or dividends outside the normal cycle of distributions also need to be carefully considered.

Your BDO contact can assist your company navigate these issues.