Senate

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 8 - Franking of dividends and other distributions

Overview

8.1 Schedule8 of the Bill will amend Part IVA and Part IIIAA of the Income Tax Assessment Act 1936 (the Act) to prevent franking credit trading and dividend streaming. The amendments will:

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introduce a general anti-avoidance provision which targets franking credit trading and dividend streaming schemes where one of the purposes (other than an incidental purpose) of the scheme is to obtain a franking credit benefit;

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introduce a specific anti-streaming rule which will apply where a company streams dividends so as to provide franking credit benefits to shareholders who benefit most in preference to others; and

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modify the definition of what constitutes a class of shares in PartIIIAA of the Act by:

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providing that a class of shares includes all shares having substantially the same rights; and

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deeming interests held in a corporate limited partnership to constitute the same class of shares for the purposes of the dividend imputation provisions.

Summary of the amendments

Purpose of the amendments

8.2 The purpose of the amendments is to protect the revenue by introducing a general anti-avoidance rule and anti-streaming measures to curb the unintended usage of franking credits through dividend streaming and franking credit trading schemes.

Date of effect

8.3 Subject to the transitional measure explained below and at paragraphs 8.34 and 8.102:

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the general anti-avoidance and specific anti-streaming rules will apply to dividends and other distributions paid on or after 7.30 pm AEST, 13 May 1997, including those relating to schemes and arrangements entered into before this time; and [Subitems 9(1), 26(1) and 26(2)]

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the amendment to the definition of what constitutes a class of shares will apply to franking years commencing after 7.30 pm AEST, 13 May 1997, irrespective of whether the shares or partnership interests were issued before or after that time. [Subitem 9(2)]

8.4 As a transitional measure, the amendments will not apply to dividends declared, but not paid, by publicly listed companies before 7.30 pm AEST on 13 May 1997, and to distributions made after that time that relate to such dividends. [Subitems 9(3), 9(4), 26(3) and 26(4)]

Background to the legislation

8.5 Two of the underlying principles of the imputation system are, firstly, that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves and, secondly, that tax paid at the company level is in broad terms imputed to shareholders proportionately to their shareholdings.

8.6 Franking credit trading schemes allow franking credits to be inappropriately transferred by, for example, allowing the full value of franking credits to be accessed without bearing the economic risk of holding the shares. These schemes undermine the first principle.

8.7 Companies can also engage in dividend streaming (i.e. the distribution of franking credits to select shareholders), which undermines the second principle by attributing tax paid on behalf of all shareholders to only some of them. Generally this entails the streaming of franking credits to taxable residents and away from non-residents and tax-exempts.

8.8 The Bill introduces a general anti-avoidance rule and anti-streaming measures to restore these underlying principles of the imputation system.

Explanation of the amendments relating to the anti-streaming measures

Specific anti-streaming rule

8.9 Part 1 of Schedule 8 of the Bill will amend Part IIIAA of the Act by inserting a specific anti-streaming rule. The rule will apply where a company streams the payment of dividends, or streams the payment of dividends and the giving of other benefits, to its shareholders in such a way as to give shareholders who benefit most from franking credits a greater franking credit benefit than those who would not benefit to the same degree. [Item5; new subsection 160AQCBA(2)]

8.10 The rule will apply irrespective of whether a company streams dividends within a single franking year or between different franking years.

What is a franking credit benefit?

8.11 For the purposes of determining whether the specific anti-streaming rule applies, a shareholder will be considered to receive a franking credit benefit if:

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the shareholder is a company and a franking credit of the company would arise under section 160APP of the Act; [Item 5; new subparagraph 160AQCBA(16)(a)(i)]

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the shareholder is a private company and the company would be entitled to a rebate of tax under section 46 or 46A of the Act as a result of the operation of section 46F for the reason that the dividend is franked; [Item 5; new subparagraph 160AQCBA(16)(a)(ii)]

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the shareholder is a trust or partnership and would include an amount in its assessable income under section 160AQT of the Act; [Item 5; new paragraph 160AQCBA(16)(b)]

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the shareholder is entitled to a franking rebate under section 160AQU or 160AQY of the Act; [Item 5; new paragraph 160AQCBA(16)(c)]

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the shareholder would be entitled to an exemption from withholding tax under paragraph 128B(3)(ga) of the Act but for the operation of the new specific anti-streaming rule; or [Item 5; new paragraph 160AQCBA(16)(d)]

8.12 If a shareholder is entitled to any one or more of the above benefits because of the streaming of a dividend, the rule can apply.

What other benefits can a company give to its shareholders?

8.13 The specific anti-streaming rule will apply where a company streams the payment of dividends only (e.g. where it pays franked dividends to some shareholders and unfranked dividends to others). The rule will also apply in circumstances where a company streams the payment of franked dividends to certain shareholders and provides other benefits to other shareholders. This will ensure that distributions that are not capable of being franked cannot be used as a mechanism to stream unfranked dividends to certain shareholders who cannot benefit from franking credits while preserving franking credits for shareholders who can. [Item 5; new subsection 160AQCBA(2)]

8.14 In determining whether a company has provided other benefits to shareholders, other benefits include, but are not limited to:

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the issue to the shareholder of bonus shares in the company; [Item 5; new paragraph 160AQCBA(15)(a)]

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the return to the shareholder of capital paid on shares in the company; [Item 5; new paragraph 160AQCBA(15)(b)]

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the forgiveness of a debt owed by the shareholder to the company; [Item 5; new paragraph 160AQCBA(15)(c)]

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the making of a payment of any kind, including the giving of property, to or on behalf of the shareholder, whether made by the company or another person. [Item 5; new paragraph 160AQCBA(15)(d)]

8.15 The making of a payment on behalf of the shareholder would include, for example, circumstances where a shareholder receives, in lieu of a franked dividend, a benefit in the form of the payment of superannuation contributions by the company on behalf of the shareholder.

8.16 The streaming of other benefits would also include circumstances where a benefit is paid to a shareholder by someone other than the company. For example, if a company pays a franked dividend to a particular shareholder and that shareholder passes on a related amount to another shareholder (without the franking credits).

When will a shareholder receive a greater benefit from franking credits?

8.17 In determining whether a shareholder would derive a greater benefit from franking credits than another shareholder in relation to franked dividends, among other relevant factors, regard will be had to:

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the residency of the shareholders (non-residents cannot fully use franking credits); [Item 5; new paragraph 160AQCBA(17)(a)]

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whether the amount of tax (if any) payable on the dividend or distribution would be less than the franking rebate; [Item 5; new paragraph 160AQCBA(17)(b)]

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if one of the shareholders is a company, whether it would be unable to pay a franked dividend to its shareholders because it has insufficient profits; [Item 5; new paragraph 160AQCBA(17)(c)]

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if one of the shareholders is a company, whether it would not be entitled to franking credits (e.g. if it is a mutual company or it is effectively wholly owned by non-residents or tax-exempts) or would be less able to use franking credits than other companies (e.g. co-operatives and credit unions). [Item 5; new paragraph 160AQCBA(17)(d)]

Commissioner's determination

8.18 Where the specific anti-streaming rule applies, the Commissioner may make a determination that either:

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the streaming company will incur an additional franking debit in respect of each dividend paid or other benefit received by a shareholder; or [Items 5 and 6; new paragraph 160AQCBA(3)(a) and new section 160AQCNA]

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no franking credit benefit is to arise in respect of any streamed dividends paid to a shareholder. [Item 5; new paragraph 160AQCBA(3)(b)]

8.19 The determination made by the Commissioner can be revoked or varied and can be made at any time after the streaming has occurred.

8.20 To give effect to the determination, the Commissioner will be required to serve notice of the determination in writing on the taxpayer to which it relates. The notice may be included in a notice of assessment or served separately. [Item 5; new subsection 160AQCBA(4)]

8.21 Where the Commissioner makes a determination under new paragraph 160AQCBA(3)(b) and the determination applies in respect of a dividend paid by a listed public company (as defined in subitem 9(4) ), the Commissioner will be able to satisfy the requirement of serving the notice of determination in writing on the taxpayer by publishing the notice in an Australian national newspaper. The notice is taken to have been served on the day that it is published. [Item 5; new subsection 160AQCBA(5)]

8.22 New subsection 160AQCBA(7) enables the machinery provisions of the Act concerning the review of assessments and appeals against decisions of the Commissioner to apply in relation to determinations made by the Commissioner under new subsection 160AQCBA(3) . A taxpayer dissatisfied with a determination will have the same rights of review and appeal as if the determination were an assessment. [Item 5; new subsection 160AQCBA(7)]

8.23 To ensure that a determination carries its own rights of appeal a determination will not form part of an assessment. [Item 5; new subsection 160AQCBA(3)]

8.24 New subsection 160AQCBA(6) specifies the evidentiary value of certain documents and copies of documents issued or given, or purporting to be issued or given, under the hand of the Commissioner, a Second Commissioner or a Deputy Commissioner. The production of a notice of a determination or document purporting to be a copy of such a notice is to be conclusive evidence of the due making of the determination and that the determination is correct, except in proceedings relating to an appeal against the determination. [Item 5; new subsection 160AQCBA(6)]

How is the additional franking debit calculated?

8.25 Where the Commissioner determines that the streaming company is to incur an additional franking debit, new subsection 160AQCBA(8) sets out how the additional franking debit is to be calculated. [Item 5; new subsection 160AQCBA(8)]

8.26 Where the streaming involves the payment of dividends only, the additional franking debit is equal to the difference between:

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the franked amount (if any) of the dividend paid to those shareholders who do not derive as great a franking credit benefit as others; and

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the amount that would have been the franked amount if the dividend had been franked to the same extent as the streamed dividend paid to shareholders who benefit most from franking credits. [Item 5; new subsections 160AQCBA(9) and 160AQCBA(10)]

8.27 If the streaming arrangement involves the streaming of more than one dividend to the shareholders who benefit most from franking credits, it is the extent to which the maximum franked dividend is franked that is relevant in determining the additional franking debit. For example, if a company streams two franked dividends to a shareholder, one of which is franked to the extent of fifty per cent and the other franked to the extent of eighty per cent, and one unfranked dividend to another shareholder, the additional franking debit that could arise is the amount of the franking debit that would have arisen if the unfranked dividend had been franked to eighty per cent.

8.28 Where the streaming involves the payment of dividends and the giving of another benefit in the form of bonus shares from a share premium account, the additional franking debit is equal to the franking debit that would have arisen if a dividend equal to the amount of the debit to the share premium account had been franked to the same extent as the streamed dividend. [Item 5; new subsection 160AQCBA(11)]

8.29 Where the streaming involves the payment of dividends and the giving of another benefit, the additional franking debit is equal to the franking debit that would have arisen if a dividend equal to the value of the benefit provided had been franked to the same extent as the streamed dividend. [Item 5; new subsection 160AQCBA(12)]

8.30 In determining the amount of the franking debit arising under new subsection 160AQCBA(12) the value of the benefit provided is used, not the value of any underlying property. Therefore, if a company provides a benefit by buying back a shareholder's shares for $100 but the market value of those shares is $50, the franking debit is calculated by reference to the $100.

8.31 If a franking debit arises under the existing dividend streaming provisions contained in section 160AQCB of the Act no further franking debit is to arise under the amendments introduced by Part 1 of Schedule 8 of the Bill. [Item 5; new subsection 160AQCBA(13)]

How are franking credit benefits denied?

8.32 Where the Commissioner determines that it would not be appropriate to impose an additional franking debit on a streaming company, the Commissioner can alternatively make a determination that no franking credit benefit is to arise in respect of any streamed dividends paid to shareholders. [Item 5; new paragraph 160AQCBA(3)(b)]

8.33 As a result, Part 1 of Schedule 8 of the Bill will amend:

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section 160APP of the Act so that no franking credits arise upon the receipt of franked dividends where a determination to deny franking credit benefits is made; [Item 4; new subsection 160APP(1C)]

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section 160AQT of the Act so that no gross-up is made upon the receipt of franked dividend where a determination to deny franking credit benefits is made; [Item 7; new subsection 160AQT(1D)]

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subsection 46F(2) of the Act so that, for the purposes of determining whether private companies will be entitled to the intercorporate dividend rebate, the dividend will be treated as if it were unfranked where a determination to deny franking credit benefits is made; [Item 1; amended subsection 46F(2)]

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section 160AQY of the Act so that no franking rebate arises in respect of a trust or partnership amount on which a trustee is liable to be assessed where a determination to deny franking credit benefits is made; and [Item 8; new subsection 160AQY(2)]

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paragraph 128B(3)(ga) of the Act so that a shareholder will not be entitled to an exemption from withholding tax on a dividend that has been franked where a determination to deny franking credit benefits is made. [Item 2; amended paragraph 128B(3)(ga)]

Transitional measure: dividends declared by public companies before the Budget

8.34 The specific anti-streaming rule will not apply to dividends declared, but not paid, by publicly listed companies before 7.30 pm AEST on 13 May 1997, and to distributions made after that time that relate to such dividends. [Subitems 9(3) and 9(4)]

8.35 An example of where a distribution would relate to a dividend would be where, under a stapled stock scheme, the declaration of a dividend in one company provides a shareholder in the company with the right to a distribution from another entity: both the distribution from the other entity, and any distribution to that entity necessary to support the distribution, will be related to the original declared dividend.

What constitutes a class of shares?

8.36 To prevent inconsequential differences in share rights being used to classify shares into different classes, Part 1 of Schedule 8 of the Bill will amend the definition of what constitutes a class of shares to provide that a class of shares includes all shares having substantially the same rights. [Item 3; new subsection 160APE(1)]

8.37 For example, where rights are substantially the same but there is merely a difference in par values or voting rights, those shares would now be considered to constitute the same class.

8.38 Part 1 of Schedule 8 of the Bill will also amend the definition of what constitutes a class of shares by deeming partners in a corporate limited partnership to hold a single class of shares. [Item 3; new subsection 160APE(2)]

Explanation of amendments relating to the general anti-avoidance rule

General anti-avoidance rule

8.39 The general anti-avoidance rule applies to schemes to obtain a tax advantage in relation to franking credits (franking credit schemes). Franking credit schemes involve the disposition of shares or an interest in shares where the elements described in new subsection 177EA(3) exist. [Item 25; new subsection 177EA(3)]

Commissioner's determination

8.40 Where both the company and the person receiving the dividend or distribution are parties to the scheme the Commissioner has a choice as to whether to post a debit to the company's franking account or deny the franking credit benefit to the recipient of the dividend or distribution. [Item 25; new subsection 177EA(5)]

8.41 Where there are numerous shareholders, it will generally be appropriate to debit the company's franking account. In some cases, however (for example where the company has very substantial surplus credits), posting debits to the company's franking account will not effectively counteract the scheme; in these cases, it would be more appropriate to deny the shareholders the franking credit benefit directly.

8.42 The amount of the debit to the franking account will be such amount as the Commissioner considers reasonable in the circumstances, not being an amount larger than the debit to the franking account occasioned by the payment of the dividend. [Item 25; new paragraph 177EA(10)(b)]

8.43 In some cases it may be appropriate to debit an amount which is less than the franked amount of the relevant dividend. This is because only part of the dividend may really represent a franking credit benefit under a scheme. For example, where the scheme involves the receipt of a franked dividend and an associated offsetting deduction or capital loss, the real benefit of the scheme may be limited to so much of the franked dividend which is offset by the deduction or loss; while the rest of the franking credit benefit merely serves to reduce tax payable on the dividend or distribution. In such a case, it may be appropriate for the Commissioner to debit the company's franking account only by an amount which represents the real benefit to the shareholders under the scheme.

8.44 Similarly, where the determination applies to a recipient of a dividend or distribution, the Commissioner may decide to deny the franking credit benefit to a specified extent only.

8.45 To give effect to the determination, the Commissioner will be required to serve notice of the determination in writing on the taxpayer to which it relates. The determination made by the Commissioner can be revoked or varied and can be made at any time after the scheme has been entered into. [Item 25; new subsection 177EA(6)]

8.46 Where the Commissioner makes a determination under new paragraph 177EA(5)(b) and the determination applies in respect of a dividend paid by a listed public company (as defined in subitem 26(4) ), the Commissioner will be able to satisfy the requirement of serving the notice of determination in writing on the taxpayer by publishing the notice in an Australian national newspaper. [Item 25; new subsection 177EA(7)]

8.47 New subsection 177EA(9) enables the machinery provisions of the Act concerning the review of assessments and appeals against decisions of the Commissioner to apply in relation to determinations made by the Commissioner under new subsection 177EA(5) . A taxpayer dissatisfied with a determination will have the same rights of review and appeal as if the determination were an assessment. [Item 25; new subsection 177EA(9)]

8.48 To ensure that a determination carries its own rights of appeal a determination will not form part of an assessment. [Item 25; new subsection 177EA(5)]

8.49 New subsection 177EA(8) specifies the evidentiary value of certain documents and copies of documents issued or given, or purporting to be issued or given, under the hand of the Commissioner, a Second Commissioner or a Deputy Commissioner. The production of a notice of a determination or document purporting to be a copy of such a notice is to be conclusive evidence of the due making of the determination and that the determination is correct, except in proceedings relating to an appeal against the determination. [Item 25; new subsection 177EA(8)]

If the Commissioner makes a determination to debit the franking account of a company, what is the maximum amount or extent of the debit?

8.50 If the Commissioner determines that a company (which was a party to the scheme) should incur a franking debit, the maximum amount of the debit is the same as the debit which arises under section 160AQB when the company pays the relevant franked dividend (i.e. the dividend received directly or indirectly by the relevant taxpayer). [Item 25; new subsection 177EA(10)]

8.51 The debit arises on the day on which notice in writing of the determination is served on the company. [Item 15; new section160AQCNB]

8.52 For example, if the Commissioner makes a determination that a company should incur the maximum franking debit in respect of a class C franked dividend of $1 million, the total amount of the class C franking debit would be $2 million. This is because the company would be required to post the debit which arises under section 160AQB and an additional debit of the same amount.

What is the effect of the Commissioner making a determination to deny franking credits on dividends?

8.53 Where the Commissioner determines that it would not be appropriate to impose an additional franking debit on a company, the Commissioner can alternatively make a determination that no franking credit benefit is to arise in respect of dividends paid to the relevant taxpayer.

8.54 As a result, Part 2 of Schedule 8 of the Bill will amend:

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section 160APP of the Act so that no franking credits arise upon the receipt of franked dividends to the extent that a determination to deny franking credit benefits is made; [Item 13; new subsections 160APP(1D) and (1E)]

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section 160APQ of the Act so that no franking credit arises in respect of a trust or partnership amount included in a taxpayer's assessable income to the extent that a determination to deny franking credit benefits is made; [Item 14; new subsections 160APQ(4) and (5)]

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section 160AQT of the Act so that no gross-up is made upon the receipt of a franked dividend to the extent that a determination to deny franking credit benefits is made; [Item 16; new subsections 160AQT(1E) and (1F)]

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subsection 46F(2) of the Act so that, for the purposes of determining whether private companies will be entitled to the intercorporate dividend rebate, the dividend will be treated as if it were unfranked where a determination to deny franking credit benefits is made; [Item11; amended subsection 46F(2)]

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section 45Z of the Act so that, for the purposes of determining whether private company beneficiaries or partners will be entitled to the intercorporate dividend rebate, if a determination to deny franking credit benefits is made, the trust or partnership distribution will not carry the right to an intercorporate dividend rebate if, had the dividend been paid directly to the private company and it had been unfranked, the company would not have been entitled to the rebate; [Item 10; new subsection 45Z(6)]

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sections 160AQX, 160AQY, 160AQYA, 160AQZ and 160AQZA of the Act so that no franking rebate arises in respect of a trust or partnership amount included in a taxpayer's assessable income to the extent that a determination to deny franking credit benefits is made; and [Items 17 to 21; amended sections 160AQX, 160AQY, 160AQYA, 160AQZ and 160AQZA]

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paragraph 128B(3)(ga) of the Act so that a shareholder will not be entitled to an exemption from withholding tax on a dividend that has been franked where a determination to deny franking credit benefits is made. [Item 12; amended paragraph 128B(3)(ga)]

8.55 For example, if the Commissioner makes a determination to deny the franking benefits on a dividend paid to a natural person shareholder, the shareholder will not gross-up the dividend (section 160AQT) and therefore cannot claim the franking rebate (section 160AQU). Similarly, a private company receiving a franked dividend to which the rule applies, is not entitled to credit its franking account (section 160APP) and, unless it is a dividend paid within a wholly-owned company group, cannot claim the intercorporate dividend rebate (section 46F).

Adjustments in relation to 160AQT amounts

8.56 The above amendments to sections 160AQX, 160AQY, 160AQYA, 160AQZ and 160AQZA will prevent a beneficiary or partner gaining franking credit benefits from a trust or partnership distribution in respect of which a determination to deny franking credit benefits is made.

8.57 However, as a result of the section 160AQT gross-up to the assessable income of the trust or partnership, their share in the net income of the trust or partnership would, but for a consequential amendment, be inappropriately increased.

8.58 This problem currently arises for company beneficiaries and partners because, although they are assessed by reference to the grossed-up amount of the dividend received by the trust or partnership, companies do not receive a franking rebate for the grossed-up amount. To cater for this, section 160AR of the Act currently allows company beneficiaries and partners to receive a tax deduction equal to the potential rebate amount (i.e. the amount of the franking rebate they would have received had they been an individual shareholder entitled to the rebate).

8.59 Consistent with this tax treatment, Part 2 of Schedule 8 of the Bill will provide a tax deduction for a trust or partnership amount included in a taxpayer's assessable income in respect of which a determination to deny franking credit benefits is made. The amount of the deduction is to be the same as the amount currently allowed under section 160AR, i.e. the potential rebate amount. [Items 22 to 24; amended section 160AR, and new section 160ARAA]

What is a scheme for the disposition of shares or an interest in shares?

8.60 The definition of scheme in subsection 177A(1) of the Act includes any agreement, arrangement, understanding, promise or undertaking (whether express or implied and whether legally enforceable or not), and any plan, proposal, course of action or course of conduct.

8.61 An example of a scheme for the disposition of shares or an interest in shares which would attract the rule would be the issue of a dividend access share or an interest in a discretionary trust for the purpose of streaming franking credits to a particular shareholder or beneficiary.

8.62 An example of a sale of shares which would attract the rule would be a securities lending arrangement under which a shareholder who cannot fully use franking credits (typically a non-resident) lends shares to a taxpayer over a dividend period so that the dividend, and attached franking credits, is paid to the borrower (legally, the transaction constitutes a disposal and reacquisition rather than a loan but is generally not treated as such for tax purposes). The general anti-avoidance rule would apply to this transaction because there is a scheme for the disposal of shares by the lender and a purpose (other than an incidental purpose) of the scheme was to give the borrower a franking credit benefit.

8.63 For the rule to apply there does not need to be a legal disposition of shares or an interest in shares. This is because a scheme for the disposition of shares or interest in shares includes de facto sales or dispositions as well as the other transactions listed in new subsection 177EA(14) . For example, there will be a disposition for the purposes of the rule if a taxpayer transfers the right to receive income from shares to another taxpayer and that other taxpayer assumes the risks of share price fluctuation, even if there is no change in the legal ownership of the shares. [Item 25; new subsection 177EA(14)]

8.64 The mere acquisition of shares or units in a unit trust where the shares or units are to be held at risk in the ordinary way, will not, in the absence of further features, attract the rule, even though the shares or units are expected to pay franked dividends or distributions. [Item 25; new subsection177EA(4)]

What is a share or an interest in shares for the purposes of the rule?

8.65 A share includes the interest of a partner in a corporate limited partnership and membership of a company which does not have share capital (e.g. companies limited by guarantee). If a person is a shareholder in a company, whatever asset the person holds that makes that person a shareholder will be a share for the purposes of the rule. [Item 25; new subsection 177EA(12)]

8.66 New subsection 177EA(13) provides a definition of an interest in shares so that a partner in a partnership that holds shares (directly or indirectly) or a beneficiary of a trust holding shares (directly or indirectly) has an interest in shares. Therefore, beneficiaries of discretionary trusts hold an interest in shares of the trust if they can benefit from those shares (e.g. because the trustee can distribute dividend income to them). [Item25; new subsection 177EA(13)]

Special rules for life assurance companies

8.67 Life assurance companies can be taxed as a single taxpayer but they have insurance funds which are taxed differently from the general fund of the company (for example, franked dividends paid on shares included in the insurance funds of a life assurance company give rise to franking rebates for the company, whereas franked dividends paid on shares in the general fund give rise to franking credits only). They therefore have the capacity to move shares between their insurance and general funds and thereby affect the taxation treatment of the dividends paid on shares.

8.68 To prevent exploitation of the different tax treatment depending on the fund in which the shares are held, transfers between the general fund of a life assurance company and the insurance funds will be treated as if they were transfers between different taxpayers for the purposes of the rule. Accordingly, there is a disposition for the purposes of the rule if assets cease to be included, or commence to be included, in the insurance funds of a life assurance company. [Item 25; new paragraph 177EA(14)(f)]

When is a distribution payable or expected to be payable?

8.69 A distribution on an interest in shares for the purposes of the rule is a trust or partnership amount (as defined in section 160APA of the Act) which is included in, or allowed as a deduction from, a taxpayer's assessable income. Therefore, a distribution will be payable or expected to be payable on an interest in shares if it is expected that a trust or partnership amount will be included in the taxpayer's assessable income. [Item 25; new subsection 177EA(15)]

8.70 In determining whether a trust or partnership amount is included in, or allowed as a deduction from, a taxpayer's assessable income, certain provisions are to be disregarded. [Item 25: new subsection 177EA(17)]

What is a franked dividend or distribution?

8.71 A franked dividend is defined in section 160APA as a dividend which has been franked in accordance with section 160AQF. It can be a class A, class B or class C franked dividend.

8.72 A franked distribution is a trust or partnership amount (as defined in section 160APA) in relation to which there is a class A, B or C flow-on franking amount. For example, a beneficiary of a trust who is presently entitled to franked dividend income of the trust will receive a franked distribution for the purposes of the rule because there would be a flow-on franking amount in relation to the trust amount included in the beneficiary's assessable income. [Item 25; new subsection 177EA(16)]

What is a franking credit benefit for the purposes of these rules?

8.73 A franking credit benefit is defined in new subsection 177EA(18) . If a taxpayer is entitled to any one or more of the benefits described in the subsection, the rule can apply. [Item 25; new subsection 177EA(18)]

Determining purpose

8.74 The test of purpose under new section 177EA is a test of objective purpose. The question posed by the rule is whether, objectively, it would be concluded that a person who entered into or carried out the scheme under which the disposition of shares occurs, did so for the purpose of obtaining a tax advantage relating to franking credits. In determining the purpose of the scheme, the purpose of one of the persons who entered into or carried out the scheme (whether or not that person is the person receiving the franking credit benefit) will be sufficient to attract the rule. [Item 25: new paragraph 177EA(3)(e)]

8.75 For example, if a taxpayer enters into a scheme involving a disposition of shares with another taxpayer for the purpose of enabling either of the taxpayers to obtain a franking credit benefit, the fact that the second taxpayer does not share that purpose will not prevent the rule from applying. Also, if a taxpayer enters into such a scheme with two or more purposes, neither of which is merely incidental, the fact that one purpose is not that of obtaining a tax advantage relating to franking credits will not prevent the section from applying.

Incidental purpose

8.76 A purpose is an incidental purpose when it occurs fortuitously or in subordinate conjunction with another purpose, or merely follows another purpose as its natural incident. For example, when a taxpayer holds shares in the ordinary way to obtain the benefit of any increase in their share price and the dividend income flowing from the shares, a franking credit benefit is generally no more than a natural incident of holding the shares, and generally the purpose of obtaining the benefit simply follows incidentally a purpose of obtaining the shares: it is therefore merely an incidental purpose.

8.77 On the other hand, if a taxpayer, being a company, entered into a scheme involving the disposition of shares for the immediate purpose of obtaining a tax advantage for itself (for example, one deriving from an allowable deduction and the inter-corporate dividend rebate) and another, substantial, purpose of obtaining franking credits (which will ultimately benefit its shareholders), the fact that the taxpayer may regard the immediate benefit of the first tax advantage as more important than the deferred benefit of obtaining the franking credits does not mean that the second purpose is merely incidental to the first.

Relevant circumstances

8.78 In determining whether it would be concluded that a person entered into or carried out a scheme involving the disposition of shares or an interest in shares for a purpose, not being merely an incidental purpose, of enabling a taxpayer to obtain a tax advantage in relation to franking, regard must be had to the terms of the disposition and the relevant circumstances.

8.79 Circumstances which are relevant in determining whether any person has the requisite purpose include, but are not limited to, the factors listed in new subsection 177EA(19) . These factors include the eight factors which are used to determine purpose under the existing section 177D in relation to schemes which omit assessable income or create allowable deductions. To give further guidance to the operation of the new measures, other matters more specifically relevant to schemes to trade or stream franking credits are also included. These are listed below.

Risk

8.80 The extent to which the person receiving a dividend is exposed to the risks and opportunities of owning shares or an interest in shares, or another person is so exposed, is a relevant factor. [Item 25; new paragraph 177EA(19)(a)]

8.81 For example, a taxpayer who buys a put option on shares (which provides the right but not the obligation to sell for a stipulated price on or before a specific date) will have diminished risk with respect to the shares because the taxpayer will have guaranteed the sale price of the shares and will be indifferent to falls in the market price of the shares.

8.82 The incidence of risk is a strong pointer to where real ownership of the shares lies. The risks and opportunities of share ownership may be removed or altered, among other ways, by entering into a derivative (for example, a futures contract or an option). For example, where the value of a derivative contract of a shareholder varies inversely with the value of the shareholder's shares, to the extent of the inverse variation, the effect is to pass the risks and opportunities of holding the share to the counterparty under the contract. By using derivatives the risks and opportunities of share ownership can be reduced to nothing, or to any fraction of the ordinary exposure (or even increased). Generally, the greater the risk borne by the taxpayer receiving the franking credit benefit, the less likely it is that the requisite purpose is present.

8.83 Apart from the taxpayer receiving the franking credit benefit, it is relevant to look to see whether some other person (or associated persons) held the shares or the interest in shares (or their economic equivalent) before and after the period in which the relevant taxpayer became entitled to the franking credit benefit, or had the risks and opportunities of share ownership during the period when legally the shares belonged to the relevant taxpayer, or some combination of both. Generally, the greater the risks and opportunities of a person other than the taxpayer receiving the dividends, the greater the likelihood that there is present the requisite purpose. This is especially likely to be so if the same person had those risks before, during and after the period in which the relevant taxpayer became entitled to the franking credit benefit.

The length of the period for which the shares were held

8.84 The length of time in which the shares or the interest in the shares were held, or the length of the period in which the holder was exposed to the risks and opportunities of holding the shares or the interest, is another relevant circumstance. The longer the period for which the shares were held at risk by the person obtaining the franking credit benefit, the less likely it is that the requisite purpose is present. [Item 25; new paragraphs 177EA(19)(a) and 177EA(19)(h)]

The tax profiles of the parties to the scheme

8.85 It is relevant to enquire whether the taxpayer would gain a greater benefit from franking credits than other persons who hold shares or interests in shares in the company, or the other parties to the scheme. [Item 25; new paragraph 177EA(19)(b)]

8.86 It is also relevant to enquire whether, as a result of the scheme, maximum value is derived from the franking credits and wastage is avoided (i.e. the franking credits end up in the hands of taxpayers who can make most use of them and are not wasted by being distributed to taxpayers who would not gain the same benefit, or by remaining undistributed in the company's franking account). If the relevant taxpayer derives no additional advantage over anyone else from franking credits it is less likely that the requisite purpose is present; conversely, if the taxpayer does obtain such an advantage, that may point to the existence of the requisite purpose. [Item 25; new paragraph 177EA(19)(c)]

8.87 In determining whether a person would derive a greater benefit from franking credits than another person in relation to a franked dividend or distribution, among other relevant factors, regard will be had to:

•

the residency of the persons (non-residents cannot fully use franking credits);

•

whether the amount of tax (if any) payable on the dividend or distribution would be less than the franking rebate;

•

if one of the persons is a company, whether it would be unable to pay a franked dividend to its shareholders because it had insufficient profits; and

•

if one of the persons is a company, whether it would not be entitled to franking credits (e.g. it is a mutual life company or is effectively wholly owned by non-residents or tax-exempts) or would be less able to use franking credits than other companies (e.g. cooperatives and credit unions). [Item 25; new paragraph 177EA(20)]

The consideration paid by or to the relevant taxpayer

8.88 It is relevant to note the extent to which consideration paid or provided by the relevant taxpayer represents the value of franking. Where consideration paid by or to, or provided by, the relevant taxpayer is calculated, wholly or in part, by reference to the franking credit benefit, that may indicate the presence of the requisite purpose. For example, in a securities lending arrangement compensation may be paid to the lender for the dividend foregone and for the franking credit benefit obtained by the borrower. [Item 25; new paragraph 177EA(19)(e)]

Associated deductions or losses

8.89 In some schemes the franking credit benefit is captured by matching the franked dividend or distribution with an associated allowable deduction or capital loss. The deduction or loss in effect relieves the dividend or distribution from tax, enabling the franking rebate or franking credit to be used to shelter other income from tax. Accordingly, it is relevant to note whether there is an associated allowable deduction or capital loss under the scheme. [Item 25; new paragraph 177EA(19)(f)]

Equivalence to interest

8.90 Some dispositions of shares or an interest in shares may cause the character of a dividend or distribution to be equivalent for the relevant taxpayer to interest or a like amount. In these cases, a franking credit benefit is often being provided to allow another party to obtain tax-effective finance. [Item 25; new paragraph 177EA(19)(g)]

Other factors

8.91 Other relevant factors include whether the parties to the scheme are associated; whether they are acting at arm's length; and whether fair value is paid or provided for any shares, other property, or contractual obligations involved in the scheme. It may also be relevant to note whether dealings are in the ordinary course of business, or are conducted on or off market.

Examples of application of the test

Example 1

8.92 Smith, an individual, acquires shares, which have a history of paying franked dividends, on the Stock Exchange from his broker for the prevailing market price. Shortly after acquiring them, he becomes concerned at a downturn in the market and buys a market traded put option. This entitles him to sell the shares at a fixed price. The likelihood of the option being exercised when it is bought by Smith is about 50% (technically, it has a delta of -0.5). The put option reduces most of the risks of owning the shares, but not the opportunities. During this time Smith derives a franked dividend. Later on, the market picks up, and Smith closes out the option. He continues to hold the share. Smith has a low marginal rate of tax and a small amount of interest income, and he finds the after-tax rate of return on his share investment attractive, among other reasons, because he can fully use the franking rebate.

8.93 Buying a put option over shares can be a disposition of shares for the purposes of the rule. However, consideration of the relevant circumstances shows that no person connected with the scheme has the requisite purpose so the rule will not apply:

•

the shares are held for a substantial period;

•

over time, most of the risks (and all of the opportunities) of share ownership lie with Smith;

•

the reduction in risk for a period is fully explained as insurance against a market downturn;

•

there is no association between Smith, the seller of the shares, or the seller of the share option;

•

there is no other party to the scheme who might otherwise obtain franking credits who is less able to use them than Smith;

•

more generally, all dealings are at arm's length and for market prices; the form and substance of the scheme appear to be the same; and all transactions are carried out in a commercial manner.

8.94 The mere fact that Smith finds the return from the shares attractive because he can fully use the franking rebate does not mean, objectively, that he entered into a scheme for a purpose (not being an incidental purpose) of conferring a franking credit benefit upon himself.

8.95 The same result would follow if the trustee of an imputation trust bought shares and Smith bought units in the trust.

Example 2

8.96 A trust is established with a nominal capital and units are issued to investors. One class of units, A class units, entitles the holder, at the discretion of the trustee, to receive the franked dividend income of the trust up to a specified rate: this rate is calculated by taking the prevailing rate of interest and reducing it to the cash amount of dividends which, grossed up for franking, provide the equivalent after-tax return. (There is also a collateral guarantee of payment.) The A class unitholders may redeem their units at face value after 5 years. Another class of units, B class units, is entitled to any excess over the amounts paid to the A class unitholders. The A class units are acquired by persons who can benefit from franking; B class units are acquired by a single investor associated with the trustee, who cannot benefit from franking, as it has extensive tax losses from interest deductions.

8.97 With the money provided by the A class unitholders, and some additional funds from the B class unitholder, the trustee buys shares on which franked dividends are expected to be paid; it is anticipated that those dividends will suffice to pay the A class holders the agreed rate.

8.98 This arrangement is a scheme involving the disposition of an interest in shares. The units in the trust are issued with a view to the beneficiaries obtaining an interest in shares. For the purposes of new section 177EA the discretionary beneficiaries are taken to have an interest in the shares because they will form part of the trust estate.

8.99 The A class unit holders are not entitled to receive any capital growth from the shares, nor are they exposed to any consequences of a fall in share prices. From their perspective their trust investment behaves like an interest bearing bond, where the lower rate of interest is compensated for by the benefit of franking. They do not have the risks and opportunities associated with share ownership; the B class holder has all those risks. However, it is expected that they will receive a franking credit benefit from distributions from the trust.

8.100 In this case, consideration of the relevant circumstances indicates that there is a purpose (other than an incidental purpose) of obtaining a tax advantage from franking. The incidence of the risks and opportunities of holding the shares points to the B class unitholder as the effective owner of the shares, and to a purpose of the scheme being to confer a tax advantage in relation to franking on the A class unitholders in order to obtain a cheaper cost of funds for the B class unit holder. This is because the subscription of the funds by the A class unitholders is effectively a loan to the B class unitholder, and the disposition of the shares upon the trusts described above is intended to be a means of paying the equivalent of interest in a tax advantaged way through the use of franking credits.

8.101 In this case it would be appropriate to cancel the benefit of franking by denying the A class unitholders a franking rebate or franking credit, as there is no evidence that the company paying the dividend is a party to the scheme.

Transitional measure: dividends declared by public companies before the Budget

8.102 The general anti-avoidance rule will not apply to dividends declared, but not paid, by publicly listed companies before 7.30 pm AEST on 13 May 1997, and to distributions made after that time that relate to such dividends. [Subitem 26(3)]

8.103 An example of where a distribution would relate to a dividend would be where, under a stapled stock scheme, the declaration of a dividend in one company provides a shareholder in the company with the right to a distribution from another entity: both the distribution from the other entity, and any distribution (for example, a dividend) to that entity necessary to support the distribution, will be related to the original declared dividend.

Regulation Impact Statement: anti-streaming measures

Specification of policy objective

8.104 The policy objective is to prevent the unintended use of franking credits through dividend streaming arrangements, which involve a company disproportionately directing franked dividends to select shareholders who benefit most in preference to others. This measure will involve amendments to the Income Tax Assessment Act 1936 (the Act).

Identification of implementation options

Background

8.105 One of the underlying principles of the imputation system as introduced in 1987 is that tax paid at the company level is, in broad terms, imputed to shareholders in proportion to their shareholdings. Dividend streaming (i.e. the distribution of franking credits to select shareholders) undermines this principle by attributing tax paid on behalf of all shareholders to only some of them. Generally this entails the streaming of franking credits to taxable residents and away from non-residents and tax-exempts.

8.106 The Act contains a number of provisions designed to limit dividend streaming. However, these rules have proved to be ineffective in preventing all streaming and the Government announced further measures in the 1997-98 Budget to limit streaming opportunities.

Implementation Option

8.107 To prevent companies exploiting the current definition of share class by using artificial and inconsequential differences between share classes to facilitate dividend streaming an amendment to the definition of class of share in the Act is to be made so that a class of shares includes all shares having substantially the same rights.

8.108 A general anti-streaming rule targeting dividend streaming was also announced in the recent Budget. This rule will apply to arrangements whereby a company streams dividends so as to provide franking credits to shareholders who benefit most in preference to others.

Assessment of impacts (costs and benefits) of each implementation option

Impact group identification

8.109 The proposed general anti-streaming provision will only impact on those companies entering into dividend streaming arrangements as defined. Therefore, only those companies that enter into such arrangements, and their tax advisers (e.g. members of the legal and accounting professions), need to put their mind to the operation of the general anti-streaming rule.

8.110 The proposed rule may also impact on the ATO in administering the rule.

8.111 Publicly-listed companies will generally not be affected by the amendment to the definition of share class because these companies tend to have only one class of ordinary shares. Private companies often have different classes of shares and therefore may be affected by this measure.

Analysis of the costs and benefits associated with each implementation option

Strengthening existing provisions

8.112 The advantages of strengthening the existing provisions are simplicity, certainty and a lack of added complexity. This is because, by amending the definition of share class, opportunities for streaming are limited within the framework of the current law. Therefore, companies will not incur significant costs associated with understanding the operation of the proposed amendments. Some cost may be incurred in determining whether shares have substantially the same rights. However, this cost would not be significant and would only be incurred once.

8.113 A disadvantage of this approach by itself is that it is narrowly targeted and lends itself to circumvention by carefully constructed schemes. Therefore, the strengthening of the existing provisions by itself would not be sufficient to prevent dividend streaming. Accordingly, a general anti-streaming rule targeting dividend streaming is required.

General anti-streaming rule

8.114 The most significant advantage of the general anti-streaming rule approach is that the legislation implementing it will not be complex. Furthermore, the approach will only affect companies that enter into dividend streaming arrangements. These two advantages will ensure that companies' compliance costs are kept to a minimum.

8.115 The general anti-streaming rule also has advantages in that marketing/educational costs will be low.

8.116 A disadvantage of the general anti-streaming rule is that there could be less certainty for companies because of the need to determine whether streaming is occurring, albeit on the basis of objective criteria. This may also have a further undesired outcome of increasing ATO administration costs because of the requirement to apply the provision on a case by case basis. However, this uncertainty will reduce over time as companies become more familiar with the provisions and as a result of ATO rulings.

8.117 The extent of the administrative costs which will be incurred by the ATO and the compliance costs which will be incurred by taxpayers will vary depending on the circumstances and facts of particular cases. Accordingly, the amount of these costs is unquantifiable. Any costs that do arise for the ATO are not expected to be high and would be met within the ATO's existing budget allocation.

Taxation revenue

8.118 The general anti-streaming rule will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of dividend streaming practices. In the absence of the measure, to the extent that the revenue base would not be protected, there would be a significant revenue loss compared to the forward estimates. The general anti-streaming rule will assist in preventing this loss to the revenue. The amount by which this revenue loss would be reduced is unquantifiable.

Consultation

8.119 The ATO and Treasury held consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, merchant banks, superannuation and investment funds) shortly after the Budget announcement on matters relating to franking credit trading. Dividend streaming issues were also raised at these consultations which enabled the ATO to clarify the operation of the general anti-streaming rule. These issues concerned the interpretation and operation of parts of the rule.

Conclusion

8.120 The above amendments have the objective of ensuring that companies and their shareholders gain no undue tax benefit by streaming franking credits to particular shareholders through dividend streaming.

8.121 They implement this policy objective in a way that minimises compliance costs by amending existing provisions while protecting the revenue with a general anti-streaming rule.

8.122 The ATO will closely monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising with the general anti-streaming rule. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and the business community and through other taxpayer consultation forums.

Regulation Impact Statement: general anti-avoidance rule

Specification of policy objective

8.123 The policy objective is a general anti-avoidance rule to address trading in franking credits and dividend streaming, and thereby protect the Government revenue. This measure will involve amendments to the Income Tax Assessment Act 1936 (the Act).

Identification of implementation options

Background

8.124 One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them, undermines this principle. Similarly, dividend streaming (i.e. the streaming of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings.

8.125 The Government announced in the 1997 Budget various amendments to the Act to combat franking credit trading and misuse of the intercorporate dividend rebate. These amendments include the introduction of a holding period for shares so that shares or interests in shares have to be held at risk for more than 45 days (90 days for preference shares) before franking credits and the intercorporate dividend rebate are available on dividends paid to the holders of the shares or interests in shares, and a measure denying franking credits and the inter-corporate dividend rebate on dividends where the taxpayer (or an associate) is under an obligation to make related payments with respect to positions in substantially similar or related property.

Implementation Option

8.126 Specifically targeted anti-avoidance provisions of the kind explained above are vulnerable to franking credit trading arrangements designed to fall outside their ambit. More sophisticated franking credit trading schemes would therefore circumvent the specific provisions. As a result, the Government also announced a general anti-avoidance rule targeting franking credit trading which applies to arrangements where one of the purposes (other than an incidental purpose) is to obtain a tax advantage in relation to franking credits. This rule will also limit dividend streaming opportunities.

8.127 The general anti-avoidance rule is the only option for implementing the government's policy objective.

Assessment of impacts (costs and benefits) of the implementation option

Impact group identification

8.128 The proposed general anti-avoidance provision will only impact on those taxpayers entering into arrangements for the purpose (being more than an incidental purpose) of obtaining a franking credit advantage. Therefore, only those taxpayers that enter into such arrangements, and their tax advisers (e.g. members of the legal and accounting professions), need to put their mind to the operation of the general anti-avoidance provision. The proposed provision may also impact on the ATO in administering the provision.

Analysis of the costs and benefits associated with the implementation option

8.129 The most significant advantage of the general anti-avoidance rule is that the legislation implementing it will not be complex. Furthermore, the rule will only apply to taxpayers who enter into arrangements having a purpose of franking credit trading or dividend streaming. These two advantages will ensure that there will be minimal impact on genuine commercial transactions and taxpayers' compliance costs will be kept to a minimum. Accordingly, the general anti-avoidance rule should not impose high compliance costs on taxpayers.

8.130 The general anti-avoidance rule also has advantages in that marketing/educational costs will be low.

8.131 A disadvantage of the general anti-avoidance rule is that there could be less certainty for taxpayers because of the need to determine purpose, albeit on the basis of objective criteria. This may also have a further undesired outcome of increasing ATO administration costs because of the requirement to apply the provision on a case by case basis. However, this uncertainty will reduce over time as taxpayers become more familiar with the provision and as a result of ATO rulings.

8.132 The extent of the administrative costs which will be incurred by the ATO and the compliance costs which will be incurred by taxpayers will vary depending on the circumstances and facts of particular cases. Accordingly, the amount of these costs is unquantifiable. Any costs that do arise for the ATO are not expected to be high and would be met within the ATO's existing budget allocation.

Taxation revenue

8.133 The general anti-avoidance rule will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and dividend streaming practices. In the absence of the measure, to the extent that the revenue base would not be protected, there would be a significant revenue loss compared to the forward estimates. The general anti-avoidance rule will assist in preventing this loss to the revenue. The amount by which this revenue loss would be reduced is unquantifiable.

Consultation

8.134 The ATO and Treasury held consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, merchant banks, superannuation and investment finds) shortly after the Budget announcement on matters relating to the introduction of the holding period for shares and interests in shares. Issues were also raised at these consultations concerning the general anti-avoidance rule which enabled the ATO to clarify its operation. These issues concerned the interpretation and operation of parts of the rule.

Conclusion

8.135 The general anti-avoidance rule is an important element of the measures ensuring that taxpayers gain no undue tax benefit from entering into franking credit trading and dividend streaming arrangements.

8.136 It is required to ensure that the specific provisions cannot be circumvented by carefully constructed schemes.

8.137 The ATO will closely monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising from the general anti-avoidance rule. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and the business community and through other taxpayer consultation forums.