Ref: AMK:lg
27 February 2024
Australian Taxation Office
Virginia.Gogan@ato.gov.au
Dear Virginia
CONSULTATION PAPER – CAPITAL RAISED FOR THE PURPOSE OF FUNDING FRANKED DISTRIBUTIONS
1. Thank you for the opportunity to provide comments on the Australian Taxation Office (“ATO”) consultation paper on the new integrity measure addressing franked distributions funded by capital raisings (“Consultation Paper”), being the measure contained in new section 207-159 of the Income Tax Assessment Act 1997 1
2. Pitcher Partners specialises in advising taxpayers in what is commonly referred to as the middle market. Accordingly, we service many taxpayers that would be impacted by the proposed changes to the corporate imputation system
3. This submission primarily outlines what we see as being the main issues that the rules give rise to for private groups and what we see as the key areas of priority in need of future public advice and guidance from the ATO in relation to that segment of the market. However, we also provide comments of general application to corporate distributions.
4. We provide our submissions and commentary in Appendix A. These do not specifically address each of the consultation questions in turn, but nevertheless address most of those questions. We also provide some worked examples in Appendix B for common transactions that arise for private group for which we seek public advice and guidance.
If you would like to discuss any aspect of this submission, please contact either Leo Gouzenfiter on (03) 8612 9674 or me on (03) 8610 5170
Yours sincerely
A M KOKKINOS Executive Director
1 All legislative references are to the Income Tax Assessment Act 1997 (“ITAA 1997”) unless otherwise specified.
APPENDIX A – DETAILED COMMENTS
Background and context of section 207-159
5. Based on our understanding of the context in which new section 207-159 was introduced (e.g. CR 2015/17W and TA 2015/2) many arrangements of concern were entered into by large public companies from 2015 onwards. Particularly those public companies with significant ownership held by large institutional superannuation funds.
6. For such companies, the corporate tax and imputation system provides for the reinvestment of profits at the corporate rate. Reinvestment of profits at the corporate rate does not favour shareholders whose marginal tax rate is less than the corporate rate (i.e. as such taxpayers would otherwise obtain a tax refund upon receiving fullyfranked dividends)
7. We understand that the policy of the provision is to target those companies that may “release” franking credits to shareholders for reasons motivated by tax rather than for normal capital management reasons. However, shareholders of closely-held groups commonly have a tax rate at or above the corporate rate. Accordingly, where this is the case, we do not believe that it should be the case that a distribution to such taxpayers is motivated by tax reasons.
8. We note that section 207-159 is in the nature of an integrity rule and targeted at the “early release” of franking credits. However, the provision does not contain an overt tax purpose test. Nor does it contain factors which would tend to exclude arrangements which involve shareholders with higher marginal tax rates. By way of comparison, Subdivision 204-D and section 177EA 2 require one to consider whether members obtain greater imputation benefits than other members. Similarly, sections 45A and 45B of ITAA 1936 require a comparison between members who obtain greater benefit from capital benefits than other members.
9. Our understanding of the purpose of the new provision is articulated in the Explanatory Memorandum to the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 (“EM”) at paragraph 5.15.
These amendments are an integrity measure. They prevent entities from manipulating the imputation system to facilitate the inappropriate release of franking credits. They prevent the use of artificial arrangements under which capital is raised to fund the payment of fr anked distributions (including by way of non-share dividends) to shareholders to enable the accelerated release of franking credits. This addresses concerns raised in Taxpayer Alert TA2015/2 issued by the Commissioner.
10. Section 207-159 is not necessarily an anti-streaming rule designed to prevent benefits being directed towards some members and not others. Rather, we understand that it is more about ensuring companies with particular shareholder profiles (i.e. those with tax rates below the corporate rate) do not cycle payments in and out of the company in order to generate tax benefits for their shareholders. That is, removing the incentive for the company to pay dividends only to have the funds representing those same dividends retained by the company However, as the provision does not take into account whether a tax benefit is derived from the distribution, a literal application of the
2 Income Tax Assessment Act 1936 (“ITAA 1936”)
rule can result in the provision applying to cases that have do not have a tax minimisation purpose.
11. For completeness, we note that we believe that this concern is effectively the opposite one to which Division 7A is targeted at. Division 7A is about shareholders with higher tax rates informally accessing corporate profits in a disguised way (as opposed to section 207-159 which we understand is about formally accessing those profits without an obvious commercial objective for the company to release funds).
Consideration of shareholder tax rates
12. For top-rate taxpayers, a $1 “early release” of franking credits from a company actually results in a net additional tax paid of $0.5667 (or $0.88 for base rate entities). 3 By comparison, for charities or super funds in pension phase, the early release of $1 of franking credits results in the full $1 amount being refunded to the shareholder. Where this is the case, we believe that the ‘recirculation of dividends’ in a private group context is more than likely to be driven by commercial or private factors rather than be motivated by tax benefits associated with an early release of franking credits.
13. With this background, we encourage the ATO to adopt public advice and guidance that provides appropriate outcomes for taxpayers that are shareholders of closely-held private companies, recognising that the new measure was not generally designed with private groups in mind.
14. While we have provided many examples in Appendix B, we note that it will be difficult for the ATO to comment on the application of section 207-159 for a wide range of scenarios for private groups. However, as a broad statement, where a dividend is paid by a private company that results in ‘top-up’ tax being paid, we believe that the ATO should be capable of classifying the arrangement as being ‘low risk’ from a section 207159 perspective. That is, the fact that additional tax has been paid should be indicative that any ‘recirculation of dividends’ was not motivated by tax considerations This may give rise to a sensible compliance approach for taxpayers in the private group middle market sector.
15. We note that the inclusion of a comment in the Supplementary EM that certain family or commercial dealings of private companies are not intended to be affected by the operation of the measure. We suggest that the ATO’s guidance on the measure makes clear that ordinary family or commercial dealings of private companies in all circumstances should not be caught by the measure (i.e. not limited to merely those that facilitate the departure of one or more shareholders) We believe that this is consistent with our comment in the previous paragraph. That is, to the extent that there is no tax benefit obtained in connected with the payment of the dividend, we believe that the arrangement should therefore be indicative of an ordinary family or commercial dealing of a private company (due to the dichotomy between such dealings and those motivated by tax considerations).
16. We highlight this conclusion is not dissimilar to the ATO’s ruling on section 100A of ITAA 1936 in TR 2022/4 (at paragraph 28), which states:
3 A release of $1 of franking credits requires a franked dividend of $2.333. Tax on the $3.333 grossed-up amount of taxable income (at 47%) is $1.5667 with net additional tax payable of $0.5667 taking the offset into account. For base rate entities a release of $1 of franking credits requires a franked dividend of $3. Tax on the $4 grossed-up amount of taxable income (at 47%) is $1.88 with net additional tax payable of $0.88 taking the offset into account.
28. If the objective of a dealing can properly be explained as the payment of less tax to maximise group wealth, rather than some other objective which is a family or commercial objective, it is not an ordinary family or commercial dealing
17. Where there is no tax mischief, we believe that the rule should not apply to private company dividends, which would otherwise effectively resulting in double taxation (i.e. effective tax rates of 62.9%). 4
18. We would like the opportunity to discuss with the ATO whether there is a compliance approach that generally excludes private companies from the measures where it can be shown that the arrangements are not motivated by obtaining tax benefits In particular, we recommend that ATO consider the following guidance options:
18.1. Public advice and guidance that includes statements that the tax outcomes of the arrangement should be considered as part of the “purpose and effect test” 5 , in particular, as part of the considerations for the reasons for issuing equity interests (under s 207-159(4)(e)) or as an “other relevant consideration” (under s 207-159(4)(k)); and
18.2. The adoption of a compliance approach, or compliance guidelines, where arrangements involving franked distributions to shareholders who pay additional “top-up” tax in respect of the distributions should be considered ‘low risk’ of the ATO dedicating compliance resources to.
19. We believe that these two fundamental approaches will remove a lot of uncertainty with respect to the potential application of section 207-159 and may eliminate the need to deal with a long list of very specific examples.
Private companies and established practice of paying dividends
20. We note the relevant private companies may be newly established with no history of paying dividends. Somewhat unfairly, despite smaller private companies not being the main target of new section 207-159, these companies by their nature would be ones for which s 207-159(1)(a) would be more commonly satisfied.
21. In this regard, we recommend that the ATO consider the way in which private companies typically pay dividends. For example, rather than paying regular (e.g. semiannual) dividends of a relatively stable amount of cents per share, private company dividends are generally more ad-hoc and volatile.
22. The ATO should consider that a “regular basis” for private companies may not necessarily be as frequent as expected of large public companies with institutional investors.
23. Additionally, the quantum of the dividends may not be as consistent for private companies but nevertheless may still be part of a particular practice based on the dividend policy adopted by the group.
24. For example, a dividend policy may be adopted by private companies that is primarily aimed at ensuring operating companies that are “at-risk” hold as little retained earnings
4 Where 47% is paid on an unfranked distribution that is 70% of the underlying corporate profits (i.e. 32.9% tax at the shareholder level and 30% tax at the company level).
5 That is, whether s 207-159(1)(c) is satisfied.
as possible, with those profits instead retained in passive companies that are not “atrisk”. Dividends may be paid in these cases where banks and other restrictive covenants permit the payment of such dividends to be made.
25. Additionally, private companies may pay franked distributions in order to manage their Division 7A obligations. Where shareholders have obtained loans, a franked dividend (and set-off) may be the shareholder’s only means to repay that loan (or to make the minimum annual repayment in compliance with section 109E of ITAA 1936). While such a practice may lead to highly volatile dividends year-on-year, we nevertheless believe that in such circumstances, a private company should be considered as having adopted “a practice of making distribution of a kind on a regular basis” for the purposes of s 207-159(1)(a).
26. Further, we note that many private groups are not consolidated, and new standalone entities may be incorporated frequently. While such entities have no established history, we suggest that ATO consider whether the established practice of its associated companies can be included in “other relevant considerations” under s 207159(2)(f) so that such companies can more easily demonstrate and establish a practice of making distributions. For example, if a new company follows the practice of other companies within the same group, or where an ultimate holding company or main company in the group has a practice of paying regular distributions
At-call loans that may be considered equity interests
27. Private groups commonly enter into arrangements whereby shareholders borrow amounts from private companies on an at-call basis. It was recognised that such loans could give rise to equity interests in the company.
28. While certain exceptions to the ‘equity interest’ treatment are provided for in ss 97475(4)-(7), not all taxpayers will meet these criteria.
29. In the context of s 207-159, we believe that such loans (i.e. those that satisfy the criteria in s 974-75(4)(a), (b) and (c)) should generally be considered low-risk.
30. Section 207-159 is not concerned with companies borrowing money to fund the payment of franked distributions, even if the main purpose and effect of the borrowing is to fund the distribution. Evidently, a company changing its gearing levels (by replacing shareholders equity with debt) should similarly not be within scope.
31. Where the shareholder provides a legal form loan that is recognised as a liability (but may technically be classified as equity for income tax purposes), we suggest that this should similarly be at low-risk of section 207-159 applying.
32. The EM notes that the measure is designed to ensure that arrangements are not put in place to release franking credits that would otherwise remain unused where those arrangements “do not significantly change the financial position of the entity”. This is also stated in the ATO’s position paper which notes that “the absence of any meaningful change to the financial position of the entity will usually be a feature of such arrangements”.
33. Given these considerations, an at-call loan should be considered to be a meaningful or significant change to the financial position of a company, as it has replaced equity with debt (the holding of which would be preferential to being a shareholder on the liquidation of a company).
34. The ATO guidance should consider that equity interests that arise from legal form loans (recognised as liabilities for accounting purposes) should be considered low risk for the application of section 207-159, regardless of the loans giving rise to an equity interest under Division 974.
35. At the very least, this should be a factor pointing against the ‘purpose and effect test’ being satisfied under s 207-159(4)(e). In particular, where the arrangement is one whereby the shareholder lends their dividend back to the company (which may be a secured loan) for the purpose of moving higher up in the priority of those who have claims against the company’s assets, this should be a further reason that points towards a commercial purpose rather than any tax purpose such that the provision should be less likely to apply.
Direction of funding: what if the dividend funds the raising of capital?
36. As a more general consideration, we believe it is imperative that the ATO publish its considered view about the most fundamental aspect of the rule, being the direction of causation that is necessary for the requirements of section 207-159 to be satisfied.
37. In our view, the ‘purpose and effect test’ in s 207-159(1)(c) clearly requires that the ‘equity raised’ funds the making of the ‘franked distribution’, but not the other way around.
38. This is further supported by:
38.1. The heading of section 207-159 (i.e. “distributions funded by capital raising”) 6
38.2. The description of section 207-159 in s 202-45(ea)
38.3. Various comments in the EM
38.4. TA 2015/2 titled “Franked distributions by raising capital to release franking credits to shareholders”
39. Example 5.1 of the EM involves a company raising new capital from shareholders, the proceeds from which are then used to pay a special dividend a month later.
40. Example 5.2 of the EM involves half of the dividend funded by cash raised from the underwriter. Although the conclusion in the example is that section 207-159 is satisfied, the reasoning for this is not immediately obvious. It may be argued that the dividend funded the dividend reinvestment, rather than the other way around. We note also that this example was included in the EM before the final amendments to section 207- 159 that limited its application to make unfrankable only the part of the distribution that was funded by the issue of equity (rather than making the entire distribution unfrankable if any part of it was so funded). The example was not revised following those changes. Arguably, it could be considered that only half of the $40m dividend satisfies the requirements in section 207-159 under this example.
41. The ATO should provide their views as to how the provision operates in a basic example where a company has a single shareholder, and an arrangement involves the payment of a franked dividend and the reinvestment of that dividend for fresh equity in the company. Further, the shareholder has no access to funds other than those held by the company. It may be the case that the shareholder is a low-rate taxpayer (e.g. a
6 Under s 950-100, section headings from part of the Act.
superannuation fund or exempt entity) and enters into the arrangement for the main purpose of obtaining franking credit tax offset refunds.
42. In such a scenario, it is arguable that it is clearly the dividend that is funding the issue of equity interests in the company and not the other way around. The shareholder has no means to fund the payment of the dividend. Instead, the shareholder has means to fund the injection of equity, with those means being the ability to cause a dividend to be paid to it
43. We acknowledge that the provision can apply whether or not the issue of equity interests was made at or after the time of the distribution. 7 However, this would cater for an example where the overall arrangement results in the funding of the dividend (indirectly) by the issue of equity. For example, a company may obtain a loan to pay a dividend, where the dividend is reinvested as equity and used to repay the loan. Applying the refinancing principles, we understand that this would likely be a case where the ‘equity’ is taken to have a nexus to funding the ‘dividend’.
44. However, in the basic case (non-refinancing example) despite the provision not being limited by the order or sequence of events, we believe that this scenario is one where it is more appropriate to conclude that the dividend funded the issue of equity and not the other way round.
45. The ATO needs to explain whether section 207-159 can apply in such basic circumstances on a reading of the text. If so, it needs to explain why it believes it can be concluded that the issue of equity funded the dividend or whether it otherwise does not matter which transaction funded the other so long as one funds the other.
46. We highlight that this fundamental element of the provision is a key issue in each of the examples contained in Appendix B.
From who’s perspective is the franked distribution made?
47. We highlight that a potentially different result can occur in applying section 207-159 depending on whether a distribution paid by the company is regarded as a single distribution (to all shareholders) or many distributions (to each individual shareholder).
48. Section 202-5 refers to an entity franking a distribution and the requirements for it to do so. Subsection 205-30(1), item 1 provides for a franking debit when an entity franks a distribution.
49. These provisions may suggest that when a company makes a distribution, regardless of the number of shareholders to which it is made, it is a single distribution.
50. However, the general ‘gross up and credit’ rule contained in section 207-20 sets out the consequences for the shareholders “if an entity makes a franked distribution to another entity” and provides for the receiving entity including an amount in its assessable in relation to the distribution. Subsection 205-15(1), Item 3 also provides for a credit to a company’s franking account where a franked distribution is made to the entity.
51. These provisions suggest that the franked distribution made by a company is that which is made to a particular shareholder. That is, if a company with two shareholders pays a dividend to all shareholders it is making two franked distributions and if the
7 As stated in s 207-159(1)(b).
company with 1 million shareholders pays a dividend to all shareholders it is making 1 million franked distributions at that time.
52. It is not immediately obvious how to reconcile the two views. However, the ATO needs to consider what the distribution actually is for the purposes of section 207-159. This will help determine the consequences for shareholders where it is concluded that only a part of a franked distribution was substantially funded by the raising of capital.
53. For example, an arrangement could involve an $8m raising of capital and a $10m dividend. This could involve shareholders who own 80% of the shares in the company injecting equity into the company to fund 80% of the dividend with the other $2m funded from existing cash surpluses. The other shareholders (who own the other 20% of shares) simply receive the franked dividend and use the funds for other purposes (including to partly fund the payment of income tax on the dividend).
54. The ATO should provide guidance explaining its views, including whether:
(1) The company makes one distribution (of $10m) with the $8m raised by the issue of equity substantially funding the $8m of distributions and, if so, whether the result that the issue of equity funded a part of the distribution means that:
A) 80% of the entire distribution is unfrankable resulting in all shareholders being denied gross-up and tax offset treatment for 80% of their distribution 8 on a pro-rata basis; OR
B) 80% of the entire is unfrankable resulting in the part of that distribution that is made to the 80% of shareholders who participating in the issue of equity treating their dividend as unfrankable, with the 20% of shareholders who did not so participate not being affected.
(2) The company made many distributions (totalling $10m) with the $8m raised by the issue of equity entirely funding the $8m of distributions made to those shareholders who subscribed for the equity interests.
55. We believe that alternative (1)(A) or alterative (2) are the most appropriate outcomes as it results in adverse tax consequences only for those shareholders who participated in the proscribed conduct and does not otherwise penalise those who simply received a dividend and nothing more, especially where that recipient paid tax at marginal rates (e.g. at 47%) on the dividend and was otherwise powerless to prevent the dividend being paid by the company in the circumstances it did.
56. Regardless of whether the better view is that the company is making a single distribution, or a distribution to each shareholder, we believe the ATO could adopt an interpretation to result in appropriate and fair outcomes.
57. If alternative (1)(B) is adopted, this effectively results in the shareholders who did engage in the proscribed conduct benefiting from the tax paid by those who did not (i.e. it would result in those shareholders still getting to treat 20% of their distribution as franked at the expense of the other shareholder who have to treat 80% of their distribution as unfranked). This is an unfair outcome that should not arise.
8 In addition to other consequences such as 80% of the distribution becoming subject to dividend withholding tax for non-resident shareholders or only 20% of the franking credits otherwise allocated to the distribution resulting in a credit to the franking account of a corporate shareholder (with 80% remaining in the franking account of the company making the distribution).
Issue of equity funding a part of the relevant part of a relevant distribution
58. Originally, the EM stated that:
5.36 Even if the test is satisfied only in relation to some of the capital raised from an issue of equity interests or part of a franked distribution, the entire distribution ceases to be able to be franked. This is to deter entities entering into these arrangements.
59. However, amendments to section 207-159 that were made to by the Senate wound back the ‘all or nothing’ application of the rule and instead allowed for a more limited application so that it may only apply to the ‘relevant part’ of a franked distribution. This is where the effect and purpose of the issue of equity interest was the funding of a substantial part of the of this ‘relevant part’
60. We highlight that the possible application to a ‘relevant part’ of a franked distribution may render the “substantial part” element of the test meaningless. By way of a simple example, if a $100 franked distribution is funded by both an issue of equity ($1) and other sources such as retained profits ($99), even though it is clearly the case that the issue of equity did not fund a substantial amount of the $100 franked distribution, it appears to be the case that the $1 issue of equity substantially (i.e. entirely) funded a relevant part of the $100 distribution (i.e. $1 of it).
61. The ATO should consider providing guidance on how it would seek to apply the “substantial part” element of the provision in the context where the application can be limited to parts of a franked distribution.
62. We highlight that this could be considered in conjunction with the analysis in the section above relating to whether the provision can be interpreted so as to apply to some recipients of the distribution and not others.
Meaning of equity interest for the purposes of section 207-159
63. We highlight that s 207-159(1)(b) refers to the issue of equity interests in an entity (including an entity other than the one making the franked distribution).
64. The definition of equity interests is contained in section 995-1 and refers to Subdivision 974-C (in the case of a company) and section 820-930 (in the case of a trust or partnership).
65. Section 820-930 provides for a modified definition of equity interest in the case of a trust or partnership “for the purposes of this Division (i.e. Division 820) and Division 230”. Given that the definition does not apply for the purposes of the Act more broadly (e.g. for the purposes of Part 3-6), we do not believe that a partnership or trust is able to issue an equity interest in a way that satisfies the requirement in s 207-159(1)(b).
66. Further, we do not believe that section 102T of ITAA 1936 means that a public trading trust (otherwise a corporate tax entity) can be considered to issue an equity interest. The modifications in section 102T do not provide for the modification of the meaning of equity interest in Subdivision 974-C so that it applies to units in the public trading trust. Instead, the only modifications that are made are in relation to dividends, shares and shareholders but not specifically in relation to equity interests.
67. Accordingly, to the extent that a dividend is paid to assist in the funding of a partnership interest (being an associate of the company), we do not believe that the dividend is used to fund an ‘equity’ interest in an associate of the company.
68. We believe that this view is consistent with the policy of the provisions (i.e. as it is unlikely to result in an ‘early release’ of franking credits. The ATO should clarify this issue as part of its public advice and guidance on the operation of section 207-159.
Application of the single entity rule
69. There may be transactions that involve tax consolidated groups which will require consideration of the application of the single entity rule in the context of section 207159. In many cases, a distribution may be outside the scope of the single entity rule. This will occur where the head company pays a dividend or where a subsidiary member pays a distribution on a non-membership equity interest. In both cases, the distribution will be regarded as a distribution for section 207-159 purposes.
70. The payment of the distribution may be linked to equity transactions that occur in respect of other members in the tax consolidated group. For example, an arrangement may involve a distribution by a subsidiary member (e.g. in respect of a nonmembership interests), a loan by the recipient to head company and a subscription of equity by the head company in the subsidiary to fund the dividend. If the single entity rule applied to the whole of the transaction, the intra-group issue of equity would be ignored for the purpose of applying section 207-159.
71. However, the determination of section 207-159 in such a case is not a core purpose under section 701-1 as it does not affect the amount of the company’s liability for income tax. Instead, it affects the head company’s franking account and the income tax liability of the non-member recipient of the distribution Accordingly, in such a case, it would seem difficult to apply the single entity rule to the transaction.
72. While it may be considered appropriate and relevant to view the consolidated group (as a whole) making a distribution that is funded by debt so that section 207-159 does not apply, we believe that the ATO needs to consider this example and provide guidance if the single entity rule should be ignored (so that taxpayers are aware of the anomalies that could occur in such a case).
73. Section 254K of the Corporations Act 2001
74. We highlight that section 254K(b) of the Corporations Act 2001 restricts companies from redeeming redeemable preference shares unless the redemption is made out of profits or out of the proceeds of a new issue of shares.
75. A company may have preference shares on issue that are equity interests for tax purposes. To the extent that the company does not have sufficient profits for the whole of the redemption, the company may be forced to redeem those preference shares out of the proceeds of a new issue of shares. The redemption may be for a price that provides a return to the preference shareholders that would be treated as a dividend (and may be paid out of profits). Therefore, the arrangement could potentially trigger the application of section 207-159.
76. Where the issue of new shares is mainly done in order to comply with section 254K we believe that this should result in section 207- 159 being less likely to apply as the primary reason is due to the statutory restrictions imposed on companies rather than
seeking an “early release” of franking credits. Where preference shares that are redeemed at or close to maturity (rather than early), this should also result in the distributions being less likely to be subject to section 207-159.
Multiple application where only a single raising of capital
77. We highlight that section 207-159 can apply where the issue of equity funds a distribution, directly or indirectly. The entity issuing the equity interest need not be the entity making the distribution.
78. For non-consolidated structures, this could result in the ultimate shareholder of a parent company funding a series of back-to-back dividends through the subscription of equity in the entity at the bottom of the chain of companies. This could result in each dividend in the series satisfying the requirements of section 207-159. Example 5 in Appendix B demonstrates this potential multiple application.
79. We recommend that the ATO address whether they believe this is the outcome under the law or if the provision can be applied so that only one dividend is made unfrankable (e.g. either the first company-to-company dividend or the last dividend by the parent company to the ultimate shareholder).
APPENDIX B – EXAMPLES
80. This section provides a number of examples that are used for the purposes of obtaining further clarity on the operation of section 207-159. We note that the proposed compliance approach (outlined in paragraph 18) could potentially reduce the scope and need for detailed analysis of each of these examples.
81. However, nonetheless, we believe that these examples provide a useful platform for drawing out many of the issues and uncertainties articulated in Appendix A.
Example 1 – Dividend to shareholder on 1 July reinvested as at-call loan
1 July 2023
1 July 2023
ABC Pty Ltd
82. This scenario involves the profits of a private company being paid out as a franked dividend at the start of the year. However, the funds are accessed at a later time as and when the shareholder requires. To facilitate this, the amount of the dividend is loaned back on at-call terms. Marginal rates of tax are paid on the dividend.
83. This scenario sets out one way Division 7A risks may be managed for smaller private groups. Instead of borrowing amounts throughout the year and repaying these loans by way of dividend and set-off at a later time, this arrangement results in no Division 7A loan at all. Where the company has employees, it may also provide more certainty regarding loan fringe benefits if no loan is advanced by the company. Lastly, there may be asset protection where the company’s assets are at risk as the shareholder becomes a creditor.
84. There is no relevant tax purpose or mischief but on these facts the provisions of proposed section 207-159 may be satisfied because ABC Pty Ltd has no prior distribution history, the at-call loan may be considered an equity interest in ABC Pty Ltd and it may be considered that the company obtained the loan to fund the dividend
85. With regard to this last requirement, section 207-159 is framed as a unidirectional test. It is arguable in this example that the distribution funded the financing of the equity interest (but not the other way around) as the dividend was the first step and the at-call loan could not be made without the dividend first having been paid.
86. Assuming the principal effect test is satisfied it is unclear if the purpose test would also be satisfied. It may be that the purpose of the company is simply to distribute profits rather than to fund the issue of equity interests. We note the purpose of the member is not considered under s 207-159(c)(ii).
87. We highlight that it not uncommon for such arrangements to occur where no tax mischief is present. In fact, these arrangements accelerate the “top-up” tax that is paid on corporate profits. It is important useful to understand if the ATO believes that section 207-159 could apply even despite a lack of any tax purpose.
$100,000
ABC Pty Ltd
XYZ Pty Ltd
88. This is a slight variation of example 1 that involves the at-call loan being provided by a beneficiary of the shareholder rather than the shareholder itself.
89. This scenario involves the extraction of franked profits by a company to a shareholder that is a trust with that dividend flowing to a related group company. Relevantly, there is no “top-up” tax payable by XYZ Pty Ltd in this example but no tax refund either (it is assumed that either both companies are base rate entities or that XYZ Pty Ltd is not a base rate entity)
90. This scenario effectively moves corporate profits in a separate entity. This may be prudent if ABC Pty Ltd is an operating entity with its assets at greater risk. Where ABC Pty Ltd still requires the cash representing the profits to fund its operation, it may borrow these back from XYZ Pty Ltd on at-call terms. The loan provided by XYZ recharacterises the profits and provides the private group with a preferential claim on a liquidation of assets. Accordingly, this practice of paying a dividend would be common for asset protection purposes.
91. While this may result in no additional tax paid above the corporate rate, there is no relevant tax mischief associate with the “early release” of franking credits and is largely commercially driven. However, there is a risk that section 207-159 could apply if the atcall loan were considered an equity interest. This scenario raises similar issues requiring ATO guidance as example 1 above.
ABC Pty Ltd
XYZ Pty Ltd
92. This example involves, the shareholder using a dividend to fund XYZ Pty Ltd under a financing arrangement. The key difference in this example (as compared to Example 2) is that the shareholder is not a trust and uses the dividend to provide finance to XYZ Pty Ltd (either debt or equity).
93. If the shareholder simply lent the dividend proceeds back to ABC Pty Ltd (as a debt interest) the provision should not operate. Neither should it operate if the shareholder subscribed for a debt interest in XYZ Pty Ltd which in turn subscribed for a debt interest in ABC Pty Ltd.
94. In this scenario involving more than two entities (and more than one financing arrangement) we believe it is critical for taxpayers to understand how section 207-159 is intended to operate and how it may change under different variations of the facts. In particular we think it is important to understand the ATO’s view as to:
94.1. Whether the provision is most likely to apply where both financing arrangements are equity interests?
94.2. Where one of the financing arrangements being an equity interest is sufficient and whether it matters which one is the equity interest?
94.3. Where one of the financing arrangements being an equity interest is sufficient, whether the provision can apply where one leg involves “funding” that is neither a debt interest nor equity interest (e.g. a financing arrangement covered by s 974-130(4))? For example, the arrangement could involve a payment of a dividend from ABC Pty Ltd which is used to fund equity in XYZ Pty Ltd in order for XYZ Pty Ltd to acquire an asset to be held separate from the business of ABC Pty Ltd. The asset could be used in a lease of assets from XYZ Pty Ltd to ABC Pty Ltd Despite no tax purpose, the conditions of section 207-159 may be satisfied in such an arrangement.
94.4. We question whether the ATO would see this as a low risk or a high risk case? We would like to understand if the position of the ATO would be any different
depending on whether the shareholder has paid ‘top-up tax’ or has received a refund of franking credits.
95. Our initial view in this example is that the last leg is critical in such an arrangement rather than the earlier legs (i.e. whether the shareholder subscribes for debt or equity in XYZ Pty Ltd should be less of a factor). It would be important to understand the ATO’s views on this.
96. Even though from a group perspective the overall level of equity in the two companies has not changed and the level of net debt has not changed, there may be good commercial reasons to increase the mix of debt and equity in the particular company paying the dividend.
97. Finally, we note that both companies could be in a tax consolidated group or MEC group with the issue of an equity interest occurring wholly within the group. ATO guidance on the application of section 207-159 to an arrangement involving dealings within tax consolidated and MEC groups would be welcome (where the dividend is paid to a party that is not a member of the tax consolidated group).
Shareholder
(1) Issue of shares in exchange for transfer of shares in Op Co
Head Co Pty Ltd
(2) $100,000 franked dividend
Op Co Pty Ltd
98. This scenario involves the simple interposition of a holding company between a shareholder and an operating company it owns, followed by a payment of a franked dividend to the head company. This would not be an uncommon scenario where there is a Subdivision 122-A roll-over, Subdivision 124-M roll-over or Division 615 roll-over.
99. The dividend may be paid for simple asset protection reasons (i.e. reduce surplus assets of Op Co Pty Ltd). This may be viewed as a variation of example 3 in that it represents an arrangement in which profits of a company are “parked” into a related company with this example being the parking of those profits into a parent/holding company rather than a “sister” company.
100. Where a franked distribution is paid in conjunction with a roll-over or restructure arrangement, the requirements of section 207-159 may be present.
101. We do not believe the provision is likely to apply as the issue of equity by Head Co Pty Ltd is a form of non-cash consideration for the acquisition of shares in Op Co Pty Ltd and does not actually fund Op Co Pty Ltd in reality (i.e. no money comes back into Op Co Pty Ltd).
102. However, it would be useful to understanding the ATO’s view of this. In particular, how the rules operate where the issue of equity is done by way of a share exchange rather than for cash.
Shareholder
(1) $70,000 equity interest
(3) $70,000 franked dividend
Head Co Pty Ltd
(2) $70,000 franked dividend
Op Co Pty Ltd
103. This scenario demonstrates the possible multiple application of the provision in nonconsolidated groups. Assuming this is an arrangement of concern where relevant mischief exists, our understanding is that both franked dividends in this example be subject to section 207-159. That is, the equity interest funds the first dividend directly and the second dividend indirectly and there is no easy way to interpret the provision to conclude that the equity interest did not indirectly fund the second franked dividend.
104. In this case the outcome would involve HeadCo paying $21,000 of corporate tax (at 30%) in addition to the shareholder paying tax on an unfranked $70,000 dividend. If the shareholder has a 15% tax rate (i.e. consistent with a relevant mischief), the shareholder will pay $10,500 of income tax (rather than receive a $15,000 tax refund if the dividend were franked). This outcome results in total income tax of $61,500 (or 61.5%) in respect of the underlying $100,000 of Op Co’s operating profits (i.e. $30,000 + $21,000 + $10,500).
105. If there were no interposed company in this arrangement then the outcome would only be a $70,000, unfranked dividend to the shareholder such that $40,500 of income tax (or 40.5%) is paid on the underlying corporate profits. Every interposed (30% taxed) corporate entity effectively results in an additional tax rate of 21% for each for a potentially unlimited effective corporate tax rate
106. This lack of a double-counting rule could result in an unfair and harsher outcome than appropriate merely because the “early release” of franking credits involves a company at the bottom of a chain of companies instead of a standalone company.
107. Under a restructure, a company with two equal shareholders is looking to pay dividend on its ordinary shares where Shareholder B requires the funds for their own use while Shareholder A would rather invest the funds in the company. The shareholders agree that Shareholder A will reinject their dividend to subscribe for more equity in the ABC Co Pty Ltd and increase their control and shareholding percentage. Both parties agree to this as part of a commercial arrangement.
108. The requirements of section 207-159 may be satisfied despite the commercial drivers and ATO guidance would be important for shareholders looking to understand if and when they are at risk where they choose to reinvest their dividends.
109. This example also highlights that the extent of the “part of the relevant distribution” is unclear. From the company’s perspective it may be making one distribution of $200,000 (to be paid to shareholders on a pro-rata basis). Conversely, from each shareholder’s perspective, the company is making a different franked distribution.
110. It may be impractical for the ATO to apply this provision on a member-by-member basis where there are millions of shareholders. However, it may be practical to do so in a closely-held context. We note though that the provision is self-executing and does not require a determination to be made by the Commissioner
111. ATO guidance should explain whether it believes the provision applies to all shareholders in receipt of a dividend or whether, in some cases, whether it can apply to only those that who funded the payment of the dividend by an injection of capital
112. We question whether the ATO would regard this as low risk where the shareholder is required to pay ‘top-up’ tax on the dividend (or there is no tax refund in respect of the dividend).