30 November 2022
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.
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:
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.
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.
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.
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.
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
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.