Supplementary Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello MP)Chapter 2 - Franking of dividends and other distributions
Overview
2.1 This chapter provides further guidance on the operation of the anti-streaming measures and general anti-avoidance rule targeting franking credit trading transactions included in Schedule 8 of the Bill. In particular it provides a further explanation of the purpose test used in new section 177EA , and expands on what is divided streaming.
Background
2.2 Since the introduction of the Bill there have been requests from tax practioners for further guidance on how the measures in Schedule 8 apply. This further guidance is provided below.
Further explanation of Schedule 8
2.3 The object of the new section 177EA is to prevent abuse of the imputation system through schemes which circumvent the basic rules for the franking of dividends, including the proposed new holding period and related payment rules. New section 177EA is intended to be a 'catch-all' provision to deal with schemes not otherwise prevented by those basic rules. The policy of the Act in relation to imputation is explained in the principal explanatory memorandum at paragraph 8.5. One result of that policy is that there is an intended level of 'wastage' of franking credits resulting from their distribution to persons who cannot use them. Broadly speaking, abuse of the imputation system occurs when under a scheme franked distributions are diverted from the real owners of interests in companies, who have no use or a relatively limited use from franking benefits, to a person who has a relatively greater use for them, but who is not in substance the owner of an interest in the company: this is termed franking credit trading. Another form of abuse is the selective direction of franked dividends to only those shareholders, or holders of interests in shares, who have the greatest use for franking benefits; this is termed 'dividend streaming'. [Item 25, new section 177EA]
2.4 New section 177EA identifies these schemes by a test of purpose inferred from the relevant circumstances of the scheme. This test of purpose under new section 177EA is a test of objective purpose. That is, the test is not concerned with the motives of individuals nor with their actual, subjective, intentions; rather it looks to the relevant circumstances of the scheme itself and asks whether, having regard to those circumstances, it would be concluded that one or more of the parties to the scheme had a purpose of obtaining a franking credit advantage. In other words, a purpose is imputed to one or more of the parties to the scheme on the basis of the terms of the scheme itself, the effects it actually achieves, and the overt acts by which it is implemented. This is sometimes referred to as 'predicating' a purpose of tax avoidance. The operation of a predication test was explained by Lord Denning in Newton's case [F1] in connection with the former general anti-avoidance rule, section 260, and his explanation is generally relevant to the new section 177EA .
2.5 Thus where a person holds shares in the ordinary way, or protects himself or herself from price falls by hedging in the ordinary way, regardless of that person's actual motives in holding shares it will not be possible to infer a purpose of tax avoidance, because nothing in the relevant circumstances will point to a purpose of obtaining a franking credit advantage, except incidentally to owning shares. (Which is the intended result of imputation.) On the other hand, where the relevant circumstances are attended with artificiality or contrivance, contain uncommercial features, or appear to stultify the real purpose of share ownership (for example, by paying away the profits of share ownership) it may be possible to predicate a purpose of tax avoidance to the scheme, because in such cases the relevant circumstances may point to one of the participants having that purpose.
2.6 New section 177EA requires "a purpose (whether or not the dominant purpose, but not including an incidental purpose)" of enabling a taxpayer to obtain a franking credit benefit. The words in parentheses are inserted for more abundant caution; a reference to 'a purpose' of a scheme, is usually understood to include any main or substantial purpose of the schem, and the words in parentheses clarify that this is the intended meaning here. Thus while new section 177EA does not require the purpose of obtaining the franking benefit to be the ruling, most influential or prevailing purpose, neither does it include any purpose which is not a significant purpose of the scheme.
2.7 A purpose will be an incidental purpose when it occurs fortuitously or in subordinate conjunction with one of the main or substantial purposes of the scheme, or merely follows that purpose as its natural incident.
2.8 Dividend streaming is selectively directing the flow of franked distributions to those shareholders who can most benefit from franking. Where shareholders who benefit to different degrees from franking hold interests in the profits of a company, it is not the policy of the Act to allow credits for tax paid on behalf of all shareholders to flow to only some of them. Although the franking rules do not, in general, attempt either to track the source of distributed profits or the particular shareholders who hold an interest in the company at any given time, nevertheless the policy of the Act assumes that the benefit of franking will, over time, be spread more or less evenly across shareholders in proportion to their holdings in the company having regard to any particular rights which attach to those holdings. One consequence of generally spreading the benefit of franking evenly across shareholders is that shareholders who cannot use, or cannot fully use, franking benefits will nevertheless receive franked distributions; this will then result in the 'wastage' of those benefits. Such 'wastage' is a design feature of the imputation system. 'Wastage' of franking benefits, in this sense, also includes the failure to use franking benefits attributable to profits which are never distributed. At the time of its design, it was recognised that there might be a need to respond to the emergence of streaming and other abuse of the imputation system.
2.9 Broadly speaking, any strategy directed to defeating the policy of the law by avoiding 'wastage' of franking benefits through directing the flow of franked dividends to those shareholders who can most benefit from them to the exclusion of disadvantaged shareholders may amount to dividend streaming. While it is not possible to specify in detail every combination of circumstances which can constitute the streaming of dividends (which in some cases may involve questions of degree), in the following paragraphs some guidance is given.
2.10 In the simplest case of dividend streaming, the shareholders who can benefit from franking ('advantaged shareholders': new paragraph 160AQCBA(2)(a) ) received a franked dividend, while shareholders who cannot benefit to the same degree ('disadvantaged shareholders': new paragraph 160AQCBA(2)(b) simultaneously receive an unfranked dividend (normally adjusted in amount for the lack of franking). However, it is not necessary for there to be two distributions by the company for dividend streaming to occur. For example, in more complex cases of dividend streaming, while the advantaged shareholders will receive a franked distribution from the company, the disadvantaged shareholders may receive benefits from persons other than the company, or they (or the company) may defer the realisation of their share of the profits derived by the company. Benefits may also be directed to associates of shareholders. In some cases, described below, where the disadvantaged shareholder is a company, trust, or partnership, dividend streaming may involve by-passing the shareholder in favour of its owners. [Item 5, new paragraphs 160AQCBA(2)(a) and (2)(b)]
2.11 Where disadvantaged shareholders do not receive unfranked dividend or other benefits at the time advantaged shareholders get franked dividends, dividend streaming will occur where it is apparent that the company or the disadvantaged shareholders have deferred or avoided the distribution of their interest in profits as part of a strategy to avoid the wastage of franking benefits while realising their interest in the company's profits in some other way, either then or in the future. In these cases it is appropriate to look to the intentions of the company and the shareholders, and to the pattern of distributions among the shareholders. On the other hand, where one group of advantaged shareholders receives a franked distribution while another group of disadvantaged shareholders receives nothing at the time, it will not be dividend streaming if there is merely a deferred distribution of profits which it is reasonable to expect will be franked when it is distributed, or if it is unfranked, will not be unfranked as the result of any strategy to direct franking to advantaged shareholders.
2.12 For example, if a non-resident controlled company with resident minority shareholders adopted a strategy of distributing all its franking credits to the minority shareholders while retaining the share of profits belonging to the controlling shareholder in the company with a view to ultimately taking an unfranked dividend, or taking some other benefit from the company, or someone else, in lieu of a dividend, (which would include realising accumulated profits as a capital amount on the sale of shares), that would be dividend streaming. On the other hand, if a non-resident majority shareholder merely deferred distributions in order to provide more equity capital for its subsidiary, but ultimately takes franked distributions, that would not be dividend streaming.
2.13 Another illustration is furnished by a share buy-back. In certain circumstances a share buy-back will result in a dividend for tax purposes. Where a company has shareholders with differing ability to benefit from franking and a limited supply of franking credits, a share buy-back out of profits of only the shares owned by taxable residents would stream the limited franking benefits available to those who can most benefit from them. On the other hand, where there remain sufficient franking credits to frank distributions to the remaining shareholders, streaming would not occur, absent other special features. Where a company has 'excess' franking credits, that is, more franking credits than it is reasonably likely to use to frank its ordinary dividends, special features may be present; for in these cases avoiding 'wastage' is not a matter of concentrating scarce credits, and there may well be sufficient credits to frank distributions to disadvantaged shareholders even if dividend streaming occurs. For example, a company might buy back shares off-market predominately from advantaged shareholders (because, for example, the terms of the buy-back are not attractive to disadvantaged shareholders) using profits it would not normally distribute, thereby directing a large franked dividend predominately to those who can most use franking; this would be dividend streaming. (This type of arrangement may result in a proportionately greater interest in the company being held by disadvantaged shareholders, and a value shift in favour of the shares not bought back. In these cases the remarks above concerning deferral strategies by disadvantaged shareholders may also be applicable.)
2.14 Another illustration of more sophisticated dividend streaming is furnished by dividend access shares. Dividend access shares are, broadly speaking, shares which confer no rights, and are issued only to enable a person to get a distribution from the company; they therefore frequently feature in dividend streaming arrangements. For example, where a disadvantaged shareholder is an entity (e.g. a loss company) owned by other taxpayers who are not disadvantaged with respect to franking, dividend access shares may be used to stream dividends directly to the owners of that entity. In these cases there will rarely be any distribution flowing to the disadvantaged shareholder.
2.15 It is necessary to distinguish cases where individual shareholders have no effective interest in the profits of a company from the foregoing examples of 'single distribution' dividend streaming. In most cases the disadvantaged shareholders have a real interest in the undistributed profits of the company, although the company may not have yet allocated those profits to the shareholders. However, some companies have classes of shares where the rights of the shareholders of that class are effectively discretionary, since the directors can distribute dividends to one or more classes of shareholders to the exclusion of other classes at their sole discretion. Such companies are usually private family companies. In these companies the shareholders do not have anything, in a sense relevant for dividend streaming purposes, resembling a definite interest in the profits of the company; they have only a possibility of being considered as a possible recipient of dividends. In these cases the receipt of a franked dividend by one class of shareholders does not imply that the other classes of shareholders who have not received a franked dividend have deferred distribution of their share in the profits; more commonly it is reasonable to assume that they have simply missed out on any share in the profits. This is not dividend streaming; all those with an actual share of the profits have appropriately received franked distributions.
2.16 In general, the distribution of franked and unfranked dividends by a private family company among family members is unlikely to be dividend streaming. Because of the definition of 'greater benefit from franking credits' in new subsection 160AQCBA(17) , all resident natural person family members (other than loss taxpayers) will have the same ability to benefit from franking, even low rate taxpayers, provided they have other income the tax on which would be offset by surplus franking credits. Even where a family member receives no other income, and is thus capable of being a disadvantaged shareholder, any distribution to that person of unfranked dividends will usually be the result of a desire to achieve a low rate of tax on the unfranked dividend, rather than part of a strategy to avoid franking credit wastage, and hence not dividend streaming. [item 5, new subsection 160AQCBA(17)]
2.17 Proposed new section 160AQCBA uses an essentially objective test for dividend streaming, although purpose may be relevant where future conduct is a relevant consideration, and normally it will be apparent on the face of an arrangement that a strategy for streaming is being implemented. The distinguishing of shareholders on the bases of their ability to use franking benefits is a key element of dividend streaming. Thus, dividend streaming is unlikely to occur when a company, in making franked distributions, distinguishes between two classes of shareholders, both of which comprise advantaged and disadvantaged shareholders. However, where one class is predominantly advantaged and the other predominantly disadvantaged, it may be apparent that an arrangement is streaming dividends to advantaged shareholders notwithstanding the presence in each class of a small minority of the other type of shareholder. [Item 5, new section 160AQCBA]
2.18 Where the conditions for the making of a determination under new section 160AQCBA are satisfied a discretion is conferred on the Commissioner whether to make a determination, and if so, whether to impose a franking debit on the company or to remove the franking credit benefit from the shareholder. In considering whether and how to exercise this discretion it is relevant to consider the effect of other provisions of the Act, including the existing anti-dividend streaming rules and proposed new section 177EA , as well as the differing effects of imposing a franking debit or removing a franking credit benefit.
2.19 For example, there are certain bonus share plans where shareholders are offered a choice of bonus shares or franked dividends; usually this is because some shareholders have pre-CGT shares, and therefore a tax preference for capital. In some, but not all, cases, the shareholders with pre-CGT shares will also be disadvantaged shareholders. Under existing section 160AQCB an automatic franking debit arises to the company in these cases. New section 160AQCBA would not apply unless the bonus share plan was also part of a strategy to direct franked dividends to advantaged shareholders; but given that a franking debit is automatically imposed under section 160AQCB it would, in any event, rarely be appropriate to make a determination under new section 160AQCBA to remove the franking credit benefit from the pre-CGT shareholders receiving bonus shares. Similarly, if a dividend streaming arrangement also amounted to a scheme for the disposition of shares and the conditions for a determination under new section 177EA were otherwise satisfied, in some cases a determination would more appropriately be made under that section than under proposed new section 160AQCBA .
2.20 Where it is decided to make a determination under new section 160AQCBA , generally speaking it could be expected that a determination will be made to impose a franking debit, rather than to remove franking credit benefits, especially where there are numerous shareholders. Where, however, 'excess' franking credits are being streamed it will usually be appropriate to remove the franking credit benefit from the shareholders, because imposing a franking debit on the company may not effectively counteract the streaming arrangement if the company retains a significant surplus of franking credits. Also, these are likely to be cases where there will be no other distribution, or equivalent benefit, in respect of which a franking debit could be calculated.