Franking credits for distributions funded by capital at risk

Key points

• The Government has released the Treasury Laws Amendment (Measures for a later sitting) Bill 2022: Franked distributions funded by capital raisings (Exposure Draft). If enacted, franking credits will not be available for distributions made since 19 December 2016 that are funded by capital if they made outside of ordinary distribution patterns (e.g. quarterly or annual distributions paid).
• Companies need to review distributions that have been made since 19 December 2016, and future arrangements, to determine if there is any risk that shareholders cannot claim franking credits as a result of these measures. This requires identifying whether any distributions have been funded by capital (e.g. as part of a share issue, share buy-back, share redemption or share-split) and, if so, whether the distributions are consistent with ordinary distribution patterns.
• If there is a risk that a distribution made since 19 December 2016 falls within the measures, the company will need to consider how to advise affected shareholders and deal with the Australian Taxation Office. All shareholders receiving the ‘tainted’ distribution will be affected and will have to pay tax attributable to any franking credits previously claimed. Shareholders will be impacted even if they did not participate in the capital raising.
• Many start-ups and small and medium private groups will be impacted by the proposed measures because they will not be able to show a regular distribution pattern. Dividend reinvestment plans (DRPs) may also be affected because the issue of additional shares in lieu of dividends would be considered capital.
• Representations have been made to amend the commencement date. However, we do not recommend that companies wait until the legislation has passed to assess if they have an issue. They would be better to have identified tainted distributions so that they can be prepared to act quickly to assist shareholders through the amendment process. The focus needs only to be on distributions funded by capital raisings such as share buy-back, share redemption or share-splits.

What is the Government proposing?

On 14 September 2022, Treasury released for consultation the exposure draft legislation, and the accompanying explanatory materials (Explanatory Materials).

The proposed measures seek to make non-routine distributions to shareholders facilitated by capital raising ‘unfrankable’. As currently drafted they will go further than that. They will create additional complexity for companies (including start up’s and SME’s) which do not have fixed and standard distribution policies and capture unintended transactions such as DRPs and share buy-backs.

Even if the legislation is not passed, per a previously released ATO ruling, there remains risk that distributions funded by capital could be considered to fall within the anti-avoidance provisions in section 177EA of the Income Tax Assessment Act 1936. These provisions allow the Commissioner to determine that the distribution should be treated as unfranked and no franking credit would be available to the shareholder. That risk is narrower than under the announced measures as it is not likely to extend to distributions made by start-ups or to dividend reinvestment plans or share buy-backs as extensively as the announced measures as there are more checks and balances within section 177EA to ensure that it is only arrangements with an anti-avoidance purpose that are captured.

Distributions that are at risk

Under the proposed measures a distribution would be regarded as having been funded by capital and could be captured if the following criteria are met:

• distributions (including those in the form of a dividend or made as part of a share buy-back, share redemption or share-split) are made to shareholders outside of the company’s regular distribution practice
• there is an issue of equity (e.g. shares) in the same income year
• having regard to relevant circumstances, it is reasonable to conclude the  purpose of the equity issue is to (directly or indirectly) fund the distribution.

A dividend paid solely out of profits could also be at risk if there is a share buy-back, redemption or split that occurs in the same income year. Advisors and entities alike need to be aware that there will be extra scrutiny for taxpayers and companies, even where the purpose of the buy-back was for legitimate business reasons.

The Exposure Draft provides various circumstances to be considered to determine what an entity’s regular distribution practices are.

Retrospectivity and impact on prior year assessments

A major concern that has been voiced is the measures in the Exposure Draft are retrospective, and are proposed to apply to distributions made on or after 19 December 2016. If the Exposure Draft is legislated, the Commissioner will have 12 months to amend prior year assessments – which could have a significant effect on companies and shareholders who had acted within the law at the time.

Start-ups and small and medium enterprises amongst most impacted

Startups and small and medium private groups are amongst the most likely to be impacted by the proposed measures. That is because these entities are least likely to be able to establish a regular distribution pattern and therefore come within the ambit of the provisions.  This is almost certainly an unintended consequence.

Dividend reinvestment plans impacted

DRPs – that is where individuals choose to reinvest dividends into acquiring additional shares rather than getting the dividend paid to them in cash – may be captured by the proposed rules because the issue of additional shares would be considered capital - creating an unfair outcome for investors who participate in DRPs and those who don’t. This could significantly reduce the attractiveness of DRPs for investors and companies alike.

Actions that can be taken to manage the risk

You should review all distributions made since 19 December 2016.  If any have been funded by capital raisings you will need to consider if the distribution has occurred outside of an ordinary distribution pattern. It will be critical for you and your clients to review and substantiate past and current distribution practices to ensure that you are not unexpectedly ‘caught out’.

If there is a risk that a distribution falls within the proposal, a risk assessment needs to be undertaken and a strategy determined.  It could be decided that it is better to wait for the legislation to pass before disclosing anything to shareholders.  This decision needs to be made on an informed basis given the impact it will have on the cashflow of shareholders. 

Moving forward, to minimise the risk of future distributions being affected companies should look to establish distribution practices (eg quarterly/bi-annual distributions).

For advisors to start ups and small and medium entities the opportunities are more limited given the making of distributions is so dependent on cash flow considerations which are lumpy and unpredictable. Not to mention the need for flexibility as to how available funds are used especially in the start up phase. In this type of scenario where certainty is required early planning and engagement with the Revenue for guidance could help manage the risk.

If you or your clients have any concerns about dividend distribution practice or franked dividends, or would like assistance in engagements with the ATO, please get in touch with Partner Sue Williamson or Special Counsel Megan Bishop, or a member of our national tax team in the Key Contacts section below.

Authors: Megan Bishop & Nikhil Sachdev

Disclaimer
The information in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this article is accurate at the date it is received or that it will continue to be accurate in the future.

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