Senate

Explanatory Memorandum

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

Chapter 4 - Franking credits, franking debits and the intercorporate dividend rebate

Overview

4.1 Schedule 4 to the Bill will amend Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936) to prevent franking credit trading and misuse of the intercorporate dividend rebate. The amendments will introduce:

•

the holding period rule which, subject to certain exceptions, requires taxpayers to hold shares at-risk for more than 45 days in order to qualify for a franking benefit or intercorporate dividend rebate from a dividend, or, in the case of certain preference shares, more than 90 days; and

•

the related payments rule which requires taxpayers who are under an obligation to make a related payment with respect to a dividend paid on shares to hold the relevant shares at-risk for more than 45 days (or 90 days for preference shares) during the relevant qualification period in order to qualify for a franking benefit or intercorporate dividend rebate from the dividend.

Summary of amendments

Purpose of amendments

4.2 The purpose of the amendments is to protect the revenue by introducing a holding period rule and related payments rule for shares to curb the unintended usage of franking credits and misuse of the intercorporate dividend rebate by persons who are not effectively owners of shares or who are only very briefly owners of shares. This will counter certain tax avoidance schemes under which franking credits or the intercorporate dividend rebate are made available to such persons.

Date of effect

4.3 The holding period rule is to apply to shares and interests in shares which were acquired on or after 1 July 1997, unless the taxpayer had become contractually obliged to acquire the shares before 7.30 pm AEST, 13 May 1997. [Subitem 25(1)]

4.4 New section 160APHL , which applies special rules for beneficiaries of certain trusts, takes effect at 3 pm AEST, 31 December 1997 and applies to:

•

shares or interests in shares which were acquired by a trust (other than a widely held public share-trading trust) after that time; and

•

widely held public share-trading trusts established after that time. [Subitem 25(6)]

4.5 The related payments rule applies to arrangements entered into on or after 7.30 pm AEST, 13 May 1997. However, shares or interests in shares acquired before that time are not exempt from the measure. Provided the arrangement is entered into after 7.30 pm AEST, 13 May 1997, the measures will apply. For example, if a financial institution issues endowment warrants after that time over shares which it acquired before then, the dividends payable on the shares will be within the measure notwithstanding that the shares were acquired before 7.30 pm AEST, 13 May 1997. [Subitem 25(9)]

Background to the legislation

4.6 One of the underlying principles of the 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: a degree of wastage of franking credits is an intended feature of the imputation system.

4.7 In substance, the owner of shares is the person who is exposed to the risks of loss and opportunities for gain in respect of the shares. However, franking credit trading schemes allow persons who are not exposed, or have only a small exposure, to the risks and opportunities of share ownership to obtain access to the full value of franking credits, which often, but for the scheme, would not have been used at all, or would not have been fully used. Some of these schemes may operate over extended periods, and typically involve a payment related to the dividend which has the effect of passing its benefit in economic terms to a counterparty. The schemes therefore undermine an underlying principle of imputation.

4.8 These or similar schemes also allow companies inappropriate access to the intercorporate dividend rebate, usually in circumstances where, because of a tax deduction against the assessable amount of the dividend, the rebate is not required to relieve the dividend from double taxation, but rather is used inappropriately to reduce tax on other income.

4.9 The Bill introduces a holding period rule and a related payments rule which provides that taxpayers must satisfy certain criteria before they qualify for the benefits of franking and the intercorporate dividend rebate. The measures restore the underlying principle of the imputation system and prevent misuse of the intercorporate dividend rebate.

Explanation of the amendments

Qualification for franking credits, franking rebates and the intercorporate dividend rebate

4.10 Schedule 4 to the Bill inserts new Division 1A in Part IIIAA of the ITAA 1936. The object of this new Division is to set out the circumstances in which a taxpayer is entitled to a franking credit, franking rebate or the intercorporate dividend rebate in respect of a particular dividend, whether received directly or indirectly though a trust or partnership. [Item 8, new section 160APHC]

4.11 To be entitled to a franking credit, franking rebate, or intercorporate dividend rebate in relation to a particular dividend, a taxpayer must be a qualified person in relation to the dividend. Broadly speaking, to be a qualified person in relation to a dividend, a taxpayer must satisfy both the holding period rule (or certain alternative rules) and the related payments rule.

4.12 The paragraphs below explain that a taxpayer is a qualified person in relation to a dividend if the taxpayer satisfies the related payments rule and:

(a)

the taxpayer satisfies the holding period rule in relation to the dividend; [Item 8, new section 160APHO]

(b)

the taxpayer is a particular kind of taxpayer that elects to have a franking credit or franking rebate ceiling applied, calculated according to a prescribed formula; [Item 8, new section 160APHR]

(c)

the taxpayer is a natural person whose franking rebate entitlement for the year is less than $2,000; or [Item 8, new section 160APHT]

(d)

the dividend is paid on certain shares issued in connection with the winding up of a company. [Item 8, new section 160APHQ]

4.13 Where a taxpayer derives dividends through a distribution from a partnership or trust consisting wholly or in part of dividends, the taxpayer needs to determine what component of the trust or partnership distribution is attributable to a particular dividend, and then determine whether, in relation to that dividend, the taxpayer is a qualified person. However, by way of exception, a taxpayer who is a beneficiary of a widely-held trust need only determine whether he or she is a qualified person in relation to the trust distribution itself, rather than the particular dividends it may be comprised of (this is explained below).

4.14 The effect for a taxpayer of not being a qualified person in relation to a dividend or distribution is explained below. Deductions that may be available to certain beneficiaries and partners who are not qualified persons in relation to a trust or partnership distribution are also explained below.

(a) Satisfaction of the holding period and related payments rules

4.15 For the purposes of the holding period rule, a taxpayer who holds shares or an interest in shares on which a dividend or distribution has been paid is a qualified person in relation to the dividend if the taxpayer has held the shares or interest in shares at-risk, not counting the day of acquisition or disposal, for at least 45 days (or 90 days for certain preference shares). [Item 8, new section 160APHO]

4.16 To be a qualified person in relation to a dividend under the related payments rule, a person must be either:

•

at-risk in respect of the relevant shares or interests in shares for the relevant period during a qualification period around the ex-dividend day; or

•

if the taxpayer is not at-risk for the relevant period during the qualification period, the taxpayer or associate must not make a related payment (explained below) in respect of the dividend.

If a taxpayer fails both these requirements, the taxpayer will not be a qualified person, and franking benefits and the intercorporate dividend rebate will be denied.

4.17 In the case of trust or partnership distributions consisting wholly or in part of dividends, the taxpayer must be either be at-risk for the relevant period (during the qualification period) in respect of the taxpayers interest in the shares from which the dividend is derived; or must not make a related payment in respect of that component of the distribution consisting of the dividend, or the distribution as a whole. An exception to this rule is that a taxpayer who is a beneficiary of a widely-held trust need only be either at-risk in respect of the interest in the trust during a qualification period around the trust distribution date; or must not make a related payment in relation to the distribution as a whole, without regard to the particular dividends of which it is comprised. (This exception is discussed in more detail under the heading Beneficiaries of a widely-held trust at paragraphs 4.136-4.138). [Item 8, new section 160APHP]

4.18 However, in these cases where a taxpayer holds shares indirectly through a trust or partnership (or through a chain of trusts or partnerships), if the trustee or partnership is not a qualified person in relation to a dividend, then the taxpayer cannot be a qualified person in relation to the dividend flowing through the trust or partnership. [Item 8, Notes to new subsections 160APHK(1) and 160APHL(1)

4.19 The holding period rule is a once-and-for-all test. It sets an initial threshold which only has to be crossed once. Therefore, once a taxpayer is a qualified person in relation to a dividend or distribution by virtue of the fact that the taxpayer has held the relevant shares or interest for more than 45 days, the taxpayer is taken to be a qualified person for the purposes of the rule in relation to future dividends or distributions paid on those shares or interest.

4.20 For example, if a taxpayer acquires a share on 1 September 1997 and, after holding it continuously at-risk, puts in place a risk diminution arrangement on 1 November 1997, the taxpayer will continue to be a qualified person in relation to the dividends paid on the shares for the purposes of the holding period rule (and therefore entitled to the franking credit and section 46 intercorporate dividend rebate on the dividends) because the taxpayer has held the shares for more than 45days prior to putting the arrangement in place.

4.21 The related payments rule, however, is not a once-and-for-all test. That is, even if a taxpayer is a qualified person in relation to a dividend or distribution by virtue of the fact that the taxpayer has held the relevant shares or interest for more than 45 (or 90) days, the taxpayer is not taken to be a qualified person in relation to future dividends or distributions paid on those shares or interest if the taxpayer or associate is under an obligation to make a related payment in relation to the future dividends or distributions and has not held the shares at risk for the requisite period during the relevant qualification period (ie. if the taxpayer triggers the related payments rule).

What is a share?

4.22 A share includes the interest of a partner in a corporate limited partnership and membership of a company which does not have share capital (eg. companies limited by guarantee). [Item 8, new section 160APHD]

When does an interest in a share arise?

4.23 New section 160APHG provides that when a partnership or trust (other than a widely held trust) holds, acquires or disposes of shares or an interest in shares:

(a)

the relevant partners or beneficiaries (including potential beneficiaries of discretionary trusts) are taken to hold, acquire or dispose of an interest in the shares; and

(b)

the relevant partners or beneficiaries are taken to hold, acquire or dispose of their interests in shares at or during the time the partnership or trust holds, acquires or disposes of its shares or interests in shares.

4.24 Furthermore, when a taxpayer becomes or ceases to be a partner of a partnership or beneficiary of a trust which holds shares or interests in shares, the taxpayer is taken to acquire or dispose of an interest in the shares at the time the taxpayer becomes or ceases to be a partner or beneficiary. [Item 8, new subsections 160APHG(1) to 160APHG(4)]

Note: While a change in beneficiaries will not necessarily result in a new trust, a change in partners is generally considered to result in a new partnership for tax purposes. However, to avoid uncertainty, partnerships as well as trusts are included.

4.25 The amount of the interest in shares held through a partnership is specified in new section 160APHK , while new section 160APHL specifies the amount of a beneficiaries interest in shares held by a trust. [Item 8, new sections 160APHK and 160APHL]

Interests in shares held by widely held trusts

4.26 A beneficiary of a widely held trust is treated as holding an interest in all the shares, or interests, held by the trust as an undissected aggregate, and is only required to satisfy the 45 day rule in relation to his or her interest in the trust as a whole, rather than in relation to each share in which he or she has an interest under the trust. The provisions do not look through the widely held trust to see whether the beneficiary has had an interest for 45 days in each of the underlying shares in the trust estate. This stands in contrast with the position of a beneficiary of an ordinary trust, where such a look through approach is required.

4.27 Where a widely held trust holds shares or interests in shares, and a taxpayer is, becomes or ceases to be a beneficiary of the trust:

(a)

the taxpayer is taken to hold, acquire or dispose of an interest in shares during or at the time the taxpayer becomes or ceases to be a beneficiary of the trust; but

(b)

the interest is not taken to be an interest in the particular shares or interests in shares held by the trust.

Where a widely-held trust which did not previously hold any shares or interests in shares acquires shares or interests in shares:

(a)

the beneficiaries of the trust are taken to acquire an interest in shares, being their interest in the trust, at that time; but

(b)

the interest is not taken to be an interest in the particular shares or interests in shares acquired by the trust.

Similarly, when a widely-held trust which held shares or interests in shares ceases to hold any shares or interests in shares, the beneficiaries of the trust are taken to have disposed of their interest in shares. [Item 8, new subsections 160APHG(5) to 160APHG(8)]

4.28 A beneficiary of a widely held trust will be treated as holding, while a beneficiary, an interest in any shares or interests in shares held from time to time by the trustee, whether or not the shares are held by the trustee during the same period as the period in which the taxpayer is a beneficiary. Thus a beneficiary of a widely held trust who receives dividends from shares previously included in the trust estate will be treated as holding an interest in those shares while he or she continues to hold his or her interest as beneficiary of the trust, even though the shares were disposed of by the trustee before or soon after the beneficiary acquired the interest in the trust. This means that a beneficiary of a widely held trust will not be precluded from franking benefits where a distribution includes dividends paid on shares or interests in shares disposed of by the trustee before or soon after they acquired their interests in the trust, provided that the beneficiary has held its interest in the trust as a whole for the required period of 45 days.

When does a person hold shares for the purposes of the holding period and related payments rules?

4.29 Generally, a taxpayer is taken to hold shares from the time the taxpayer acquires the shares until the time the taxpayer disposes of the shares. For acquisitions and disposals at a fixed price under an unconditional contract, the time of acquisition and disposal is the time of making the contract. [Item 8, new subsection 160APHH(1)]

4.30 This is because a taxpayer will assume the risks and opportunities of share ownership once he or she has an unconditional right and obligation to buy shares at a fixed price. (This would not be true if the share price could change: for example, a contract to buy shares at the market price on a future day would leave risk with the seller until then.)

4.31 For example, if a taxpayer acquires an ordinary share on 1November, the taxpayer would have to hold the share until at least 17December to be a qualified person for the purposes of new section 160APHO .

4.32 The taxpayer is not required to hold shares or an interest in shares for more than 45 days before a dividend is paid to be a qualified person in relation to that dividend: days after the dividend is paid can also be counted (although they must be within the qualifying period explained below).

Special provisions relating to acquisition and disposal

4.33 New section 160APHH outlines several circumstances where a taxpayer may be taken to acquire or dispose of shares at a time other than the actual disposal or acquisition. For example, by virtue of new subsection 160APHH(3) a person who holds an instalment receipt under a trust which converts into an ordinary share (by the cancellation of the instalment receipt and the transfer of an equivalent number of shares to the instalment receipt holder on the payment of the final instalment) will be deemed to have held the ordinary shares from the time the instalment receipt was acquired. This is because the taxpayer has the same economic interest in the shares throughout.

4.34 Similarly, new subsection 160APHH(2) provides that for the purpose of determining when shares are acquired, where shares (bonus shares) are issued in respect of existing shares (original shares):

•

if some part of the bonus shares is or is taken to be a dividend which is included in the assessable income of the taxpayer the bonus shares are acquired when they were issued;

•

if no part is, or is taken to be, a dividend which is included in the assessable income of the taxpayer, the bonus shares are taken for the purposes of this Division to have been acquired when the original shares were acquired, and they are deemed to have been held for the same number of days as the original shares are taken to have been held.

In the first case, the re-investment of the dividend in shares is analogous to a new share purchase; while in the second case, the bonus share issue is like a share split rather than a new acquisition of shares.

4.35 In addition, new subsection 160APHH(10) provides that where a company (the first company) in a wholly-owned group disposes of shares to another company in the same group the holding period of the shares is to include the days on which the first company held the shares at risk. Economically there is no real change of ownership because there is no change in the underlying ownership of the companies.

4.36 Similarly, new subsection 160APHH(8) provides that if a taxpayer disposes of shares or interests under a securities lending arrangement which satisfies subsection 26BC(4) of the ITAA 1936 (and therefore is deemed not to have disposed of the shares or interests for the purposes of the ordinary income or capital gains provisions of the ITAA 1936), then the taxpayer is also treated as not having disposed of the shares for the purposes of new section 160APHO. In such a case, the lender will still be taken to hold the shares for the purposes of determining whether the lender has satisfied the holding period rule in relation to dividends paid on the shares (during the loan period the dividends may, for imputation purposes, be passed back to the lender under section 160AQUA of the ITAA 1936). Again, this is consistent with the underlying economic ownership of the shares.

4.37 New subsection 160APHH(6) provides that if a person transfers shares or an interest in shares to a person to hold as bare trustee for the transferor, the trustee will be treated as having held the shares or interest for the period that the shares or interest were held by the transferor (in addition to the period that the trustee held the shares or interest). New subsection 160APHH(6) provides that this concession will not apply if the trust becomes a widely held trust within 45 days of the transfer if the shares are not preference shares or 90 days if the shares are preference shares.

Roll-over relief

4.38 Other cases where roll-over relief is available are:

•

on the death of a person;

•

where a person becomes subject to a legal disability (eg. on becoming mentally incapacitated); and

•

where there is a mere change of trustee or transfer of an asset between wholly-owned trusts.

[Item 8, new subsections 160APHH(4),(5) and (7)]

Disposals of shares taken to be disposals of related shares or interests

4.39 New section 160APHI ensures that the holding period operates on a last-in, first-out basis (LIFO). This is because shares are fungible assets, and the sale of any one parcel of shares is economically equivalent to any other sale of any other parcel. LIFO prevents circumvention of the holding period rule by taxpayers with portfolios of old shares buying new shares and selling old shares, as well as providing tax neutrality in a decision whether to make economically equivalent disposals of particular parcels of shares.

4.40 LIFO will apply to shares or interests in shares held by one taxpayer, but also to wholly owned company groups (which are effectively treated as one taxpayer for the purposes of the holding period rule) and to associates acting together under an arrangement. The purpose of the arrangement test is to prevent a taxpayer acting in collusion with an associate in such a way that, in essence, the taxpayer acquires shares or an interest in shares and then, under the arrangement, the associate disposes of substantially identical shares or securities which has a similar effect for the taxpayer as if the disposal had been by the taxpayer.

4.41 To achieve this, new section 160APHI provides that in determining whether a taxpayer has held particular shares or interests in shares (called the primary securities ) for the requisite period of time during a qualification period regard must be had to whether a disposal of related securities (defined below) by the taxpayer, an associate of the taxpayer or, if the taxpayer is a company, another company in the same wholly-owned group has occurred. Where such a disposal has occurred the taxpayer may be taken for the purposes of new section 160APHO to have disposed of (and immediately reacquired) the primary securities. However, a disposal of securities within a wholly-owned company group will not be treated as a disposal of identical securities held by a company within the group.

4.42 For example, if on 1 July 1997 a taxpayer acquires 100 ordinary shares in a company and on 1 August disposes of 50 ordinary shares in the same company, irrespective of whether the shares disposed of are the shares acquired in July, the taxpayer will be taken to have disposed of 50 of the July shares. Moreover, if, for example, a person acquires 100 ordinary shares in a company and, under an arrangement with the person, a company controlled by the person disposes of 100 ordinary shares in the same company, the person will be taken to have disposed of the 100 shares.

4.43 Before a related security can be treated as the disposal of a primary security, the related security must provide the taxpayer or associate with a frankable or rebatable dividend or distribution corresponding to the dividend or distribution paid on the primary security (which is the dividend or distribution against which the rule is being applied). As an example, a distribution paid by a trust holding only shares of a particular kind will correspond to a dividend paid on the shares if the distribution is attributable to that dividend. [Item 8, new section 160APHI]

What is a related security?

4.44 New subsection 160APHI(2) defines related securities as being the primary securities, securities which are substantially identical to the primary securities and substantially identical securities disposed of by a connected person (ie. the taxpayer or associate). New subsection 160APHF(1) defines a substantially identical security as being any property that is economically equivalent to (or fungible with) the relevant shares or interests in shares. [Item 8, new subsection 160APHI(2)]

4.45 Accordingly, in relation to shares (the relevant shares ), substantially identical securities include but are not limited to:

(a)

shares in the same company that are of the same class as the relevant shares;

(b)

shares in the same company that are of a different class where there is no material difference between the classes or shares that are exchangeable for shares in the same class as the relevant shares;

(c)

shares in another company that predominantly hold shares in categories (a) and (b); or

(d)

shares in another company which are exchangeable for shares in categories (a) and (b). [Item 8, new subsection 160APHF(3)]

4.46 In relation to an interest in the relevant shares, substantially identical securities include an interest in a trust or partnership that predominantly holds the shares in categories (a) and (b) in the previous paragraph. [Item 8, new subsection 160APHF(4)]

4.47 For example, in relation to an ordinary share, a converting preference share with a delta of +0.9 in relation to the ordinary share would be a substantially identical security to the ordinary share (the concept of delta is explained below).

4.48 There will be no double counting of disposals of securities. Therefore, if the disposal of a security triggers the holding period rule in relation to that security, it will not also trigger a disposal of another security, even if it is related. [Item 8, new subsection 160APHI(7)]

4.49 To avoid the need to track disposals of shares which are managed as or in a discrete fund in respect of which an election to adopt a formula-based ceiling is made under new section 160APHR , shares held in such funds are not related securities. [These elections are discussed in more detail under the heading (b) Formula-based ceiling for certain taxpayers at paragraphs 4.103-4.111.] [Item 8, new subsection 160APHI(2)]

When does a person not hold shares for the purposes of the holding period and related payments rules?

4.50 In calculating whether a taxpayer has satisfied the requisite holding period, any days during which there is a materially diminished risk in relation to the relevant shares or interest are not counted. In other words, it is as if the taxpayer did not hold the shares on those days. There would be a material diminution of risk, for example, if a taxpayer has forward sold the shares or has taken a position in derivatives which eliminates the upside and downside risk of holding the shares. [Item 8, new subsection 160APHO(3)]

4.51 To determine whether there has been a material diminution of risk, it is first necessary to understand what is a position, and how a taxpayers net position is determined by reference to long and short positions. These terms are explained below at paragraphs 4.52-4.59.

4.52 New subsection 160APHJ(2) lists some examples of positions which, because they relate to substantially similar or related property, will have a delta in relation to the shares held by the taxpayer ( substantially similar or related property refers to property sufficiently resembling the shares to exhibit a correlation in price movements). However, a position in other property could, as a matter of fact, have a delta in relation to shares if changes in its value exhibit a correlation with share price movements, notwithstanding that the property was not similar to the shares. For example, a company which derived most of its profits from the sale of one product might find that its share price was correlated with the price of that product; a derivative in that product could then be used to hedge shares in the company. Also, preference shares which behave like debt can be hedged by debt derivatives, such as bond futures; a purchase or sale of bond futures could therefore be a position in relation to those shares.

4.53 New subsection 160APHJ(2) also includes as possible positions embedded options, non-recourse loans and indemnities and guarantees. An embedded option is not an option, but an aspect of the price of something which behaves as if it were an option. For example, converting preference shares may convert into other shares on terms such as that up to a particular price (a notional strike price) the new shares received on conversion are of the same value as the money originally subscribed for the converting preference share, but above that price the new shares will be worth more than the money subscribed for the converting preference share. Such shares behave like debt with an option to purchase the new shares at the notional strike price, and are therefore said to have an embedded option, with a delta which can be calculated in the same way as for a real option. [Item 8, new section 160APHJ]

4.54 Similarly, a non-recourse loan, that is, a loan which is repayable only up to the value of certain property (eg. shares), effectively contains a put option to sell the shares to the lender, and a delta can be calculated in relation to this notional option. The value to a taxpayer of an indemnity or surety in respect of share losses would also behave like an option to sell shares.

Position in relation to shares or interests

4.55 In the absence of regulations, new subsection 160APHJ(2) provides that a position in relation to shares or an interest in shares is anything that has a delta in relation to the shares or interest. [Item 8, new subsection 160APHJ(2)]

4.56 Delta is a well-recognised financial concept that measures the relative change in the price of an option or other derivative for a given small change in the price of an underlying asset. An option with a positive delta indicates that its price is expected to rise and fall with the underlying asset, while a negative delta indicates an inverse relationship.

4.57 For example, if a taxpayer writes or buys a call option over shares in a company, the taxpayer has taken a position in relation to those shares because the obligation or right under the option provides an opportunity for profit or loss by reference to the market value of the shares (ie. the option has a delta in relation to the shares rises and falls in share price will affect the option price).

4.58 New subsection 160APHJ(1) provides that regulations may specify:

•

what is a position;

•

when a position relates to particular shares or interests; and

•

how the delta of a position is to be calculated. [Item 8, new subsection 160APHJ(1)]

Short position

4.59 A short position in relation to shares is a position which has a negative delta in relation to those shares. This would include, for example, a short sale, a futures contract to sell shares, a sold call or a bought put, and a futures contract to sell a particular share index. [Item 8, new subsection 160APHJ(3)]

Long position

4.60 A long position in relation to shares is a position which has a positive delta in relation to those shares. For example, a share purchase, a bought future, a bought call and a sold put, and a futures contract to buy a particular index are long positions. [Item 8, new subsection 160APHJ(4)]

Net position

4.61 The net position of a taxpayer in relation to shares is calculated by adding the sum of the taxpayers long positions to the sum of the taxpayers short positions. [Item 8, new subsection 160APHJ(5)]

4.62 For example, if a taxpayer holds 1,000 shares and buys one call option with a delta of 0.9 and one put option with a delta of -0.4, the taxpayers net equity position would be determined by adding the deltas of the shares with the options:

[1,000 + (1,000 x -0.4) + (1,000 x 0.9)]/1,000 = 1.5


(The delta of the options is multiplied by 1,000 because option contracts are provided over a parcel of 1,000 shares).

Delta of position taken not to have changed

4.63 If a taxpayer acquires shares or interests in shares and takes a position in relation to the shares or interests, provided the taxpayer continues to hold the shares or interests and does not enter into any other positions in relation to the shares or interests, the delta of the position remains the delta of the position on the day on which the shares were acquired or the position was entered into, whichever is the later.

4.64 For example, a taxpayer buys 1,000 ordinary shares and subsequently sells a call option which has a delta of 0.5 on the day the option was sold. Later, the shares increase in price and the delta rises to 0.8. The relevant delta for the purposes of the provision would be 0.5, the delta on the day the option was sold. [Item 8, new subsection 160APHJ(10)]

Certain short positions ignored

4.65 If a taxpayer holds shares in a company whose sole or dominant business is producing, purchasing, consuming, trading or otherwise dealing in certain commodities and a taxpayer is a controller of the company for the purposes of section 160ZZRN, then short positions held by the taxpayer in its shares in the company are disregarded under new subsection 160APHJ(6) if the positions relate to one of the listed commodities and are taken in the ordinary course of the taxpayers business. The relevant commodities are set out in new subsection 160APHJ(7). The purpose of this exception is to prevent the holding period rule applying inappropriately to deny franking benefits and the intercorporate dividend rebate on dividends paid to a company by a wholly-owned mining subsidiary where the parent company has, in the ordinary course of its business, hedged against the commodity being mined.

4.66 If a life insurance company or superannuation fund passes on the full value of any franking rebate to the policy holders or members on whose behalf the relevant shares or interest in shares are held, and no effective tax deduction arises as a result, then any short positions held by the company or fund arising from the fact that the shares or interest are held on behalf of the members or policy holders are disregarded under new subsection 160APHJ(8) . It would be inappropriate for the company or fund to be denied the franking rebate under the holding period rule and related payments rule where the policy holders or members bear all the risks and opportunities of share ownership.

Positions of associates

4.67 Where, under an arrangement, an associate of the taxpayer has entered into a short position in relation to shares held by the taxpayer, the position is deemed to be a position entered into by the taxpayer. For example, if a taxpayer holds 1,000 ordinary shares in company A and, under an arrangement, company B (which is controlled by the taxpayer) writes a call option on ordinary shares in company A, the option position taken by company B will be deemed to be an option position taken by the taxpayer. [Item 8, new subsection 160APHJ(9)]

Material diminution of risk

4.68Regulations may prescribe the circumstances in which a taxpayer is taken to have materially diminished risk with respect to shares or an interest in shares. [Item 8, new subsection 160APHM(1)]

4.69 In the absence of regulations to the contrary, new subsection 160APHM(2) provides that a taxpayer is taken to have materially diminished the risks of loss and opportunities for gain with respect to shares or interests if the net position of the taxpayer results in the taxpayer having less than 30% of the risks and opportunities associated with the shares or interests. [Item 8, new subsection 160APHM(2)]

Examples

4.70 For example, a taxpayer who holds 1,000 shares in a company and writes a call option with a delta of 0.6 in respect of those shares will not have materially diminished risk with respect to the shares because the net position of the taxpayer in relation to the shares would be in excess of 0.3. To determine the net position, the delta of the sold call option is subtracted (because it is a short position) from the delta of the shares (the delta of a share against which the delta of an option or other derivative is calculated is, by definition, +1). Accordingly, the net position of the taxpayer in relation to the shares is:

[(1,000 X 1) - (1,000 x 0.6)]/1,000 = 0.4


4.71 In contrast, a taxpayer who holds 1,000 shares and writes a call option with a delta of 0.9 will have materially diminished risk with respect to the shares because the net position of the taxpayer in relation to the shares is 0.1.

4.72 It is possible to combine several options with a holding of shares to materially diminish risk with respect to those shares. For example, a taxpayer who holds 1,000 shares in a company and writes a call option with a delta of 0.5 and buys a put option with a delta of 0.4 will have materially diminished risk with respect to the shares. To determine the net position, the deltas of the call and put option are subtracted (because they are short positions) from the delta of the shares. Accordingly the net delta of the shares and options is:

[(1,000 x 1) - (1,000 x 0.5) + (1,000 x -0.4)]/1,000 = 0.1


4.73 Derivatives with different deltas should be added on a weighted basis. For example, if, in respect of a particular shareholding, a shareholder buys one call option with a delta of 0.4, two put options with a delta of 0.3 and three put options with a delta of 0.2 then, in respect of the shares, the total delta of the options is:

[(1,000 x 0.4) + (2000 x -0.3) + (3000 x -0.2)]/1,000 = -0.8


Therefore the net position in relation to the shares is:

-0.8 + 1 = 0.2


4.74 Similarly, through the use of various hedging techniques shares and options can be combined to produce a position where the taxpayer is not exposed to risk of loss. For example, a share trader who holds 600 shares in a company and writes a call option with a delta of 0.6 will have materially diminished risk with respect to the shares. This is because the net position of the taxpayer in relation to shares is less than 0.3:

[(600 x 1) - (1,000 X 0.6)]/1,000


4.75 In addition, if a taxpayer has entered into a forward sale of shares or a futures contract to sell shares, the taxpayer will be deemed to have diminished risk with respect to the shares because the taxpayers net position in relation to the shares would be less than 0.3. This is because the delta of the future or forward in relation to the shares would be -1. As a result, the net position of the taxpayer in relation to the shares would be:

[(1,000 x 1) - (1,000 x 1)]/1,000


When do beneficiaries under a trust have a material diminution of risk?

4.76 Some interests in shares held through a trust are inherently risk-less. For example, a potential income beneficiary of a discretionary trust cannot be said to bear the risks of loss or opportunities for gain from shares held by the trust. To prevent such risk-less holdings being used to circumvent the holding period rule, special provisions apply to interests in shares held through trusts.

4.77 New section 160APHL determines how beneficiaries under a trust calculate the extent of their interests. This calculation is required to determine whether the beneficiary is holding the relevant interest at-risk.

4.78 In calculating the extent of a beneficiaries interest, it is necessary to distinguish between the interest of a beneficiary in shares held by a widely-held trust (as defined below), and the interest of a beneficiary in shares held by other trusts. This is because, for beneficiaries of a widely held trust, it is the interest in all the shares held from time to time by the trust that is relevant in determining whether a beneficiary holds an interest at-risk for the requisite period, while for beneficiaries of trusts other than widely-held trusts it is the interest of the beneficiary in particular shares that is relevant. Therefore the interest in shares of a beneficiary of a widely-held trust is taken to be that beneficiaries share of the dividend income from all shares (or interest in shares) held by the trust in respect of which the beneficiary receives a distribution, expressed as a proportion of the total dividend income received by the trust in relation to those shares. On the other hand, the interest of a beneficiary in each share (or interest in shares) held by non- widely held trusts is that beneficiaries share in the income from that share, expressed as a proportion of the total dividend income received by the trust in relation to that share. [Item 8, new subsections 160APHL(5) and (6)]

4.79 For the purposes of calculating a beneficiaries net position under new subsection 160APHJ(5) , the interest in shares calculated in this way is a long position with a delta of +1 in relation to itself (in the same way that direct ownership of a share constitutes a long position in that share). [Item 8, new subsection 160APHL(7)]

4.80 However, this deemed long position is effectively cancelled by a matching short position for beneficiaries of trusts other than family trusts, deceased estate trusts and employee share scheme trusts (all of which are discussed below). After the effective cancellation of the deemed long position, and assuming there are no other positions held by the beneficiary which relate to the trust holding (see below), a beneficiary of these other trusts has a long position in only so much of the beneficiaries interest in the shares held by the trust as is a fixed interest. As a result, if a beneficiary of such a trust does not have a fixed interest and has no other long positions which relate to the trust holding, the beneficiaries net position in his or her interest in the shares held by the trust will be zero, and the beneficiary will have materially diminished risks of loss and opportunities for gain for the purposes of new sections 160APHO and 160APHP . The consequence of having materially diminished risks and opportunities is that days on which this occurs are not counted in determining whether the beneficiaries interest in the shares has been held for the requisite period. [Item 8, new subsection 160APHL(10)]

4.81 For these purposes an interest is fixed if it is vested and indefeasible. An interest may be defeasible if it is redeemable for less than its value, or if its value can be materially reduced by the creation of other interests in the trust (which, in the case of a unit trust, includes the issue of further units). Special provisions apply in determining whether a unit-holder in a unit trust has a vested and indefeasible interest. [Item 8, new subsections 160APHL(12) and (13)]

4.82 Even if an interest is not fixed and indefeasible, the Commissioner may, in appropriate circumstances, deem it to be so. For example, it may be appropriate to exercise this discretion, if necessary, in relation to beneficiaries of certain hardship trusts (eg. trusts established under workers compensation legislation). [Item 8, new subsections 160APHL(14) and (15)]

Definitions of widely-held trusts, family trusts, deceased estate trusts and employee share scheme securities

4.83 New section 160APHD provides a definition of widely-held trust . A trust is a not a widely-held trust if it is a non-fixed trust (as defined in Schedule 2F of the ITAA 1936) or a closely-held fixed trust. A trust is a closely-held fixed trust if 20 entities (which include natural persons) or less (none of whom is an associate of any of the others) have interests in the trust that together entitle them to 75% or more of:

•

the beneficial interests in the income of the trust; or

•

the beneficial interests in the property of the trust.

4.84 In this context, beneficial interests refer to the immediate beneficial interests of beneficiaries of a trust and not the ultimate beneficial interests. For example, a trust with only two superannuation funds as beneficiaries would not be widely-held even though there may be many ultimate beneficiaries of the trust (ie. the superannuation fund members). Also included in the definition of widely held trusts are unit trusts where the trustee is eligible to make an election under subsection 160APHR(1) to apply the benchmark portfolio ceiling approach irrespective of whether the election is actually made. [Item8, new section 160APHD]

4.85 Schedule 2F to ITAA 1936 provides the definition of a family trust used for the purposes of the holding period rule. To ensure that a trust is not precluded from making a family trust election merely because the beneficiaries are unable to control the trustee, the definition in Schedule 2F has been modified by the Bill to include a category of trust where the only group able to benefit under the trust are family members. Thus a damages trust administered for the benefit of a disabled accident victim could be a family trust, even though the beneficiary is not necessarily in a position to control the trust. [Item 24, new paragraph 272-87(g)]

4.86 Deceased estate trusts are estates administered by executors or administrators: they are not trusts created by will. [Item 8, new paragraph 160APHL(10)(b)]

4.87 Employee share scheme trusts are trusts established to provide shares to employees under an employee share scheme for the purposes of Division 13A of Part III of the ITAA 1936, provided that any forfeiture condition relating to the scheme does not extend beyond 10 years. However, for the purpose of the employee share scheme concession under the holding period rule and related payments rule, employee share schemes include schemes where shares are acquired at or above market value. [Item 8, new section 160APHD definition of employee share scheme security]

Other positions

4.88 Apart from the long position mentioned in new subsection 160APHL(7) , and the long position constituted by a beneficiaries fixed and indefeasible interest in the shares held by the trust, in working out whether there has been a material diminution of risk the beneficiaries other long and short positions are also counted.

4.89 In the case of trusts other than widely-held trusts, these other positions include positions of the trustee which are imputed to the beneficiary because they relate to the beneficiaries interest in the shares. A position of the trustee relates to a beneficiaries interest if:

•

the position relates to shares in which the beneficiary has a vested and indefeasible interest; or

•

the beneficiary stands to directly gain a benefit or suffer a loss from the position.

[Item 8, new subsections 160APHL(8) and (9)]

4.90 For example, a closely-held fixed trust established in January 1998 with two beneficiaries entitled to share equally in the trust income and capital (ie. they have equal fixed interests in the corpus) holds 1,000 shares in a company which were acquired at the time of the trusts establishment. In October 1998 the trustee appoints a third beneficiary, who shares in the trust income and capital equally with the original beneficiaries. At the same time the trustee buys a deep-in-the-money put option with a delta of -0.8 as against the shares (so that the risk with regards to the shares is materially diminished).

4.91 In this example, the original beneficiaries will continue to be eligible for franking benefits and the intercorporate dividend rebate in relation to dividends paid on the shares (provided they are not under an obligation to make a related payment) because they have held their interest in the shares at risk for the requisite period. However, the position entered into by the trustee in respect of the shares will be deemed to be a position of the beneficiaries. As a result, the new beneficiary will not be entitled to franking benefits because the beneficiary will not have held an interest in the shares for the requisite period of time to qualify for franking benefits and the intercorporate dividend rebate.

Example of the operation of new section 160APHL

4.92 Assume the trustee of a trust which is not a family trust, deceased estate trust or employee share scheme trust holds 2000 shares and that a beneficiary is entitled to half the dividends from those shares. The beneficiaries interest in those shares will be 50% of the trustees holding, or 1,000 shares. However, this long position is offset by a matching short position under new subsection 160APHL(10) , leaving the beneficiary with a long position of only so much of the beneficiaries interest as is a fixed interest. If the beneficiary does have a fixed interest of 30% or greater in the 1,000 shares (ie. the equivalent of 300 shares), then there will not be a materially diminished risk in respect of the interest in the shares. On the other hand, if the beneficiary has a lesser fixed interest, or no fixed interest, in corpus (eg. because the beneficiary is only a discretionary object of the trust) there would be a material diminution of risk.

When does the 45 or 90 day holding have to take place?

4.93 The relevant holding period has to occur during the qualification period . For the holding period rule the relevant qualification period is the primary qualification period ; for the related payments rule it is the secondary qualification period . New section 160APHD defines the primary qualification period as the period commencing on the day after the day the taxpayer acquires the shares or interest, and ends on the 45th day (or 90th day for preference shares) after the day on which the shares or interests become ex-dividend . The secondary qualification period , if the shares are not preference shares,is defined as the period commencing on the 45th day before, and ending on the 45th day after, the day on which the shares or interest become ex-dividend . If the shares are preference shares, the secondary qualification period commences on the 90th day before, and ends on the 90th day after, the day on which the shares or interest become ex-dividend .

4.94 If a taxpayer is not under an obligation to make a related payment in relation to a dividend or distribution, the taxpayer will have to satisfy the holding period requirement within the primary qualification period. If a taxpayer is under an obligation to make a related payment in relation to a dividend or distribution, the taxpayer will have to satisfy the holding period requirement within the secondary qualification period.

4.95 For these purposes, a share or interest becomes ex-dividend on the day after the last day on which the shares or interest in shares can be acquired by a taxpayer so as to become entitled to the dividend or distribution on the shares or interest. For example, if a company declares a dividend on 1 June, to be paid on 30 June, and the dividend can be paid to a shareholder who held shares up until 25 June (but no later), then the ex-dividend day is 26 June. [Item 8, new section 160APHE]

4.96 Therefore, a taxpayer who acquires shares on the day before the ex-dividend day will be a qualified person (for the purposes of the holding period rule) in relation to a dividend for the purposes of new section 160APHO provided the taxpayer immediately thereafter holds the shares for the requisite period.

What is a related payment?

4.97 A taxpayer or associate is taken for the purposes of the provisions to have made a related payment if the taxpayer or associate is under an obligation to pass the benefit of a dividend or distribution to other persons. The requirement that the benefit be passed on means that if the benefit of the dividend or distribution remains with the taxpayer, there will not be a related payment. For example there will not be a related payment merely because a dividend is paid directly into the taxpayers bank account. [New section 160APHN]

4.98 Although new section 160APHN uses the expression related payment it is immaterial whether an actual payment or some other method is used to pass the benefit of the dividend to another person; any method of passing the benefit of a dividend to another person may be a related payment within the meaning of the section. New subsection 160APHN(3) provides the following examples as transactions which may constitute the making of a related payment:

•

any distribution, whether in money or other property, which is equal to, calculated by reference to or approximates the amount of the dividend or distribution;

•

any amounts which are credited or notionally credited (explained below) to a party to the arrangement which are calculated by reference to, equal to or approximates the amount of the dividend or distribution; and

•

any amounts payable to a party to the arrangement which are calculated by reference to, equal to or approximates the amount of the dividend or distribution. [Item 8, new subsection 160APHN(3)]

Notional crediting

4.99 Because a person does not need to receive an actual payment to receive the economic benefit of a dividend, a related payment includes a notional crediting of an amount which is calculated by reference to the amount of the dividend or distribution. A notional crediting of an amount usually involves having the extent of a persons obligation under an arrangement (eg. a futures contract or warrant arrangement) determined by a formula which is calculated by reference to the amount of the dividend. A notional crediting differs from an actual crediting in that the dividend amounts are not actually attributed to the relevant person, that is, the relevant person has no actual rights in relation to the dividend . [Item8, new subsection 160APHN(6)]

4.100 For example, holders of endowment warrants have their obligation under the warrants (ie. price payable on completion of the warrants) reduced by the amount of dividends received by the issuing institution; however, the warrant holders cannot demand payment of the dividends in lieu of having the dividends offset against their obligations. Similarly, the buyer in a futures contract cannot demand that the seller pass on the cash amount of the dividend. The buyer is only able to receive the benefit of the dividend indirectly when the futures contract is settled.

4.101 Accordingly, if the amount payable on maturity of a security is calculated by reference to the amount of the dividend, the specific inclusion of the dividend amounts in the calculation of the amount payable will be a related payment.

Other examples of related payments

4.102 The following will also be related payments, provided they are calculated by reference to the amount of the dividend:

•

amounts which are credited by way of discounts on debt securities;

•

a partial, total or notional offset of interest payable on a loan arrangement; or

•

an amount representing capitalised interest which is payable on the maturity of a security.

4.103 Likewise, where the price paid for a security includes an estimated dividend component, the offset of the interest component by the estimated dividend component will be a related payment. For example, the theoretical price of a share under a futures contract is usually calculated by taking the current market price, adding interest on the outstanding share price for the term of the contract, and subtracting expected dividends: the subtraction from the price of the expected dividends is a related payment.

4.104 Apart from cases where a payment or crediting relates to a particular dividend, there are cases where payments or credits are made in respect of a number of dividends, for example, under index derivatives. Where dividends are received from a number of shares and there is a matching outgoing under an index derivative, there may be a related payment. In some cases the related payment may be calculated in respect of dividends on shares which do not exactly match those held by the taxpayer. However, the match need not be exact for the payment to be a related payment, provided it is substantially the same. This is because small discrepancies in the relevant parcels of shares, particularly those shares with a low weighting in an index, will not necessarily prevent the payment under the derivative from effectively passing the benefit of the dividends to the counterparty. Generally, a correspondence between a share parcel and an index derivative which is sufficiently close to reduce risk materially in a qualification period will, if the index derivative requires a dividend equivalent benefit to pass to the holder of the derivative, also be sufficiently matched with the dividends on the parcel to constitute a related payment.

Share price index (SPI) and other futures

4.105 It is necessary for the related payments rule to apply to Share Price Index (SPI) future transactions where the seller of the future hedges by holding the physical stock (ie. a share portfolio which is closely correlated with the All Ordinaries Index (AOI)) and effectively credits the buyer with the estimated dividends on the shares through the price against which the contract is agreed to be settled. This is because otherwise such transactions could be used to generate inappropriate tax benefits. Such benefits would come about because the tax payable on the dividends is offset by the seller paying less tax on the profit on the futures transaction or generating a greater loss (by virtue of the fact that the seller receives less cash on settlement of the contract). The seller, however, remains in the same economic position because any reduction in cash received on the futures transaction is offset by the dividend income. In this case the profit made (and therefore the tax paid) by the seller on the sale price does not include the amount of the expected dividends so that, when the dividends are received, there has been an effective tax deduction against them. Any rebates attaching to the dividend are therefore used to offset the tax payable on other income. Taxpayers entering into such transactions are indifferent to rises and falls in the price of the shares, because any losses or gains made by the seller on the shares will be offset by equivalent gains or losses on the SPI contract.

4.106 In relation to equity swaps the financial institution which holds the legal title to shares is required to pay the counterparty an amount equivalent to the dividends received by it plus any capital gains under an obligation which is represented by the swap arrangement. The financial institution is under an obligation to make a related payment because under the swap arrangement the institution is obliged to pay the counterparty an amount which is calculated by reference to the amount of the dividend.

Sales of subsidiary companies

4.107 New section 160APHNA provides an exception to the related payments rule for dividends paid within 6 months of the sale of a group company out of profits which it is reasonable to regard as attributable to the period of ownership of the selling company.

4.108 If a parent company, whether resident or non-resident, sells a resident subsidiary company, the risks of ownership and opportunities for gain will generally pass to the buyer because a contract of sale is in place. If the seller is entitled under the contract to cause the subsidiary to distribute dividends to it, and to reduce the sale price accordingly, the reduction in the sale price would be a related payment under the current provisions, and consequently the inter-corporate dividend rebate would be denied. However, this would prevent holding companies from extracting the franking credits attributable to what are, in substance, their own taxed profits from their subsidiaries once a contract of sale was agreed. By deeming such reductions not to be related payments (provided the dividend is paid within six months of the contract to sell), the selling shareholder is afforded a reasonable opportunity to extract its own taxed profits from the company along with the franking credits applicable to them.

(b) Formula-based ceiling for certain taxpayers

4.109 The above paragraphs explained how the related payments rule and the general holding period rule operate. Below is an explanation of special cases where the taxpayer may be a qualified person irrespective of how long the shares or interests in shares are held.

4.110 The Bill provides that certain eligible taxpayers may elect to have franking credit or rebate ceilings applied in accordance with a particular formula on shares or interest in shares managed as or in a discrete fund. These eligible taxpayers are:

•

listed widely-held trusts; [Item 8, new paragraph 160APHR(1)(a)]

•

unlisted very widely held trusts ; [Item 8, new paragraph 160APHR(1)(b)]

•

life assurance companies; [Item 8, new paragraph 160APHR(1)(c)] ;

•

general insurance companies; [Item 8, new paragraph 160APHR(1)(d)]

•

friendly societies; [Item 8, new paragraph 160APHR(1)(e)]

•

health insurance funds; [Item 8, new paragraph 160APHR(1)(f)]

•

trustees of complying superannuation funds, other than excluded superannuation funds (which have fewer than five members and are subject to less regulation than larger funds); [Item 8, new paragraph 160APHR(1)(g)]

•

trustees of funds which are complying approved deposit funds (ADFs), other than excluded ADFs; [Item 8, new paragraph 160APHR(1)(h)]

•

trustees of unit trusts which are pooled superannuation trusts; [Item 8, new paragraph 160APHR(1)(i)]

•

any other taxpayers who are declared by regulations to be an eligible taxpayer for the purposes of the election; and [Item 8, new paragraph 160APHR(1)(j)]

•

unit trusts where at least 75% of the units are owned by any of the above entities (or entities unable to benefit from franking or the intercorporate dividend rebate, namely non-residents and tax-exempt entities). [Item 8, new paragraph 160APHR(1)(k) and new section 160APHS]

4.111 These taxpayers are treated differently because they would incur high compliance costs in meeting the requirements of the holding period rule, and because they are considered to be low revenue risk taxpayers. Moreover, their investment activities make comparison with a share index benchmark an appropriate alternative to the holding period rule.

4.112 The regulations can also provide for the inclusion of other low revenue risk taxpayers as eligible for making an election; such taxpayers generally also need to be subject to high compliance costs in applying the holding period rule. In this regard, closely-held investment vehicles and geared funds are likely to be higher revenue risk than low turn-over and fully invested funds, as well as funds owing a high level of fiduciary duties to investors; a high turn-over of shares, investments spread over a number of different funds and frequent use of derivatives are indicia of high compliance costs. [Item 8, new paragraph 160APHR(1)(j)]

4.113 An election to have a franking credit or rebate ceiling applied is irrevocable without leave of the Commissioner.

4.114 An eligible taxpayer who makes such an election is deemed to be a qualified person for the purposes of new section 160APHO in relation to every dividend paid in relation to the shares or interest in shares in respect of which the election is made during the time the election is in force. [Item 8, new subsection 160APHR(8)]

4.115 The election will not apply in relation to shares or interests which are subject to equity swaps or securities lending arrangements attracting the related payments rule. Therefore, if an eligible entity enters into such an arrangement, the entity is taken not to be a qualified person in relation to the dividend or distribution paid on the shares or interest which form the subject of the arrangement. Accordingly, if a superannuation fund enters into an equity swap where the fund is the legal holder of the shares but it is under an obligation to make a related payment with respect to the dividends paid on the shares, the election to have a franking rebate ceiling will not apply in relation to those shares. [Item 8, new subsections 160APHR(3) and 160APHR(4)]

4.116 If the Commissioner has made a determination under subsection 177EA(5) (the general anti-avoidance rule) in respect of dividends or distributions paid on shares or interests in shares, the Commissioner may also determine that the election to apply a franking credit or rebate ceiling made by the relevant taxpayer is effectively revoked. [Item 8, new subsection 160APHR(9)]

4.117 Where the following conditions are satisfied:

•

there is an election in force in relation to shares or interests;

•

the Commissioner is of the opinion that the taxpayer has entered into an arrangement with a third party (eg. the asset overlay manager) or an associate; and

•

pursuant to the arrangement, the third party or associate has taken a position which materially diminishes the risks of loss and opportunities for gain in relation to the shares or interests but is not taken into account when calculating the net equity exposure under new subsection 160AQZF(2) ;

the relevant short positions are taken into account for the purposes of calculating the net equity exposure of the fund or taxpayer, and the Commissioner may determine that the election made by the relevant taxpayer ceases to have effect. [Item 8, new subsection 160APHR(10)]

Calculation of the franking credits ceiling

4.118 The maximum franking credits a taxpayer is entitled to during a year of income from dividends or distributions paid on shares and interests in shares held directly or indirectly by the taxpayer, which are managed by the taxpayer, or on the taxpayers behalf, as or in a discrete fund, is not to exceed the ceiling amount in relation to the fund. If, for example, the taxpayer holds $100 million of shares which are divided into two $50 million funds, one managed by Fund Manager A, the other managed by Fund Manager B, the ceiling amount applies separately in relation to each fund. Where the ceiling amount has been exceeded, a franking debit will arise to reduce a companies total franking credit claim for an income year. [Item 22, new subsection 160AQZE(1)]

4.119 For a particular year of income, unless regulations prescribe otherwise, the ceiling amount in relation to a fund is the notional total credit amount increased by 20%. [Item 22, new subsection 160AQZE(3)]

4.120 The notional total credit amount in relation to a fund is, unless regulations prescribe otherwise, the total amount of franking credits to which the taxpayer would be entitled in respect of dividends on shares which become ex dividend during the year of income on a benchmark portfolio of shares (explained below). [Item 22, new subsection 160AQZE(4)]

4.121 Therefore the total amount of franking credits a taxpayer would be entitled to would depend on the franked dividend yield of the relevant benchmark portfolio. If the taxpayer is a life assurance company paid a class A franked dividend and the company is entitled to a class A franking credit then, in calculating the sum of the franking credits to which the company is entitled under new section 160AQZE , the class A franking credits are converted into equivalent class C franking credits (for other companies, no entitlement to a class A franking credit arises because such credits are converted into class C franking credits under section 160ASI of the ITAA 1936). The benchmark yield is to be the yield calculated for the taxpayers income year. [Item 22, new subsection 160AQZE(2)]

4.122 Where a fund exists for only part of a year of income, the ceiling amounts for franking credits and franking rebates and intercorporate dividend rebates will be calculated on the basis of the shares in the benchmark portfolio which become ex-dividend during that part of the year during which the fund exists. [Item 22, new subsections 160AQZE(5) and 160AQZE(6)]

Calculation of the franking rebate and intercorporate dividend rebate ceiling

4.123 New section 160AQZF provides for the calculation of the maximum franking and intercorporate dividend rebates a taxpayer is entitled to from dividends or distributions paid on shares (and interests in shares) held (directly or indirectly) by the taxpayer, which are managed by the taxpayer, or on the taxpayers behalf, as or in a discrete fund. The ceiling is calculated in an equivalent way to the calculation of the franking credit ceiling for companies (see paragraphs 4.112-4.115 above). [Item22, new section 160AQZF]

Calculation of the ceiling for dividends received through trusts and partnerships

4.124 Trusts and partnerships receiving dividends (directly or indirectly from other trusts or partnerships) are not entitled to franking benefits or the intercorporate dividend rebate, but such benefits can flow through to the ultimate beneficiaries or partners.

4.125 If a trust is of a kind mentioned in new subsection 160APHR(1) , or a partnership is prescribed in regulations as being eligible to make an election under that section, the trust or partnership may elect to have a franking credit or rebate ceiling applied against shares or interests in shares managed as or in a discrete fund. In such a case the flow through of franking benefits or the intercorporate dividend rebate to the ultimate beneficiaries or partners needs to be limited by reference to the ceiling.

4.126 To implement this, new section 160AQZG limits the potential rebate amount flowing through the trust or partnership (ie. the mechanism used in Part IIIAA of the ITAA 1936 to allow franking benefits to flow through a trust or partnership), while new section 45ZB caps the intercorporate dividend rebate available to corporate beneficiaries or partners that receive dividends indirectly through one or more interposed trusts or partnerships. [Item 8, new section 160AQZG, Item 5, new section 45ZB]

Standard benchmark portfolio

4.127 The standard benchmark portfolio applicable in respect of a fund managed by or on behalf of a taxpayer is to be a portfolio comprising the All Ordinaries Index (AOI) equal in value to the net equity exposure of the fund for the relevant year of income. [Item 22, new paragraph 160AQZH(1)(a)]

4.128 Some portfolios will legitimately have a higher franked dividend yield than an equivalent AOI holding. For example, a portfolio that matches the Banks and Finance Index will generally have a higher franked yield than one matching the AOI. To allow for this, taxpayers whose equity portfolio matches, or has a sufficient weighting towards, a recognised share index will be able to benefit from the higher yield such an index provides. In a few cases, the AOI may be inappropriately high; for example, where a fund specialises in low yielding or unfranked stocks. Accordingly, new paragraph 160AQZG(1)(b) allows for the making of regulations providing details of alternative benchmark portfolios. However, until those regulations are made taxpayers will be required to adopt the standard (AOI) benchmark portfolio. [Item 22, new paragraph 160AQZH(1)(b)]

Net equity exposure

4.129 To compare the franked yield from the taxpayers fund with the benchmark portfolio, it is necessary to determine the net equity exposure of the fund for a year. Unless regulations prescribe otherwise, this is to be determined generally by calculating an average for the year based on weekly figures. [Item 22, new subsection 160AQZH(4)]

4.130 In calculating the net equity exposure of a particular fund for the purposes of the holding period rule, any positions which the taxpayer has which are subject to equity swaps or securities lending arrangements where the taxpayer is under an obligation to make a related payment with respect to the relevant dividends are ignored for the purposes of determining the net equity exposure of the fund. Therefore, in calculating the net equity exposure of the fund, the long position comprising the shares and the short position represented by the offsetting obligation are not taken into account when calculating the net equity exposure of the fund. [Item 8, new subsection 160APHR(5)]

4.131 For example, if Fund Manager A (who manages a fund of $50 million) has derivatives which, as against the shares held in the fund, have a delta of -0.1, the net equity exposure of the fund is:

(50 million x 1) + (50 million x -0.1) = 45 million


Example of application of the ceiling

4.132 Suppose a complying superannuation fund (which is not an excluded fund) holds an equity portfolio with an average market value of $100 million and derivatives which, as against the shares, have a delta of minus 0.05 so that the net equity exposure would be $95 million. The AOI has, for example, a 4% yield (70% franked) which would provide a franking rebate on a $95 million portfolio of $1.5 million ($95million 4% 70% 36/64). Therefore the taxpayer will be able to claim a franking rebate of up to $1.5 million plus 20% (ie. $1.8 million). Any rebate above $1.8 million will be denied.

(c) Small shareholder exemption

4.133 Taxpayers who are natural persons (ie. not companies, trusts or partnerships) can also elect to have a franking rebate ceiling applied in relation to a year of income. If a natural person taxpayer makes such an election, the taxpayer is a qualified person for the purposes of the holding period rule in relation to every dividend paid during that year of income. [Item 8, new section 160APHT]

4.134 Under new section 160APHT , all natural persons will be able to elect to apply a franking rebate ceiling instead of satisfying the holding period rules. This ceiling will apply to franked income from all sources, not just from shares held directly by the taxpayer. For example, a franked distribution from a trust is included. [Item 22, new subsection 160AQZJ(1)]

4.135 However, an electing taxpayer will not be taken to be a qualified person in relation to a dividend or distribution if the related payments rule applies to the dividend or distribution.

4.136 New subsection 160AQZJ(1) provides that the sum of the franking rebates claimed by a natural person who has made an election in accordance with new section 160APHT is not to exceed the amount specified in new subsection 160AQZJ(2) . [Item 22, new section 160AQZJ]

4.137 Under new subsection 160AQZJ(2) the maximum franking rebate is calculated by adding all franking rebates to which the relevant person would have been entitled if the taxpayer was a qualified person in relation to all dividends and trust and partnership distributions received in the income year in which the taxpayer has made the election, and subtracting $4 for every $1 of franking rebate in excess of $2,000. [Item 22, new subsection 160AQZJ(2)]

4.138 For example, a taxpayer who has made an election with a franking rebate of $2,001 would not be entitled to the rebate in excess of $2000 and will also have the remaining rebate reduced by $4, leaving an entitlement to a rebate of $1,996.

4.139 Taxpayers must elect to apply the threshold in relation to a particular year. If no election is made the ordinary holding period rule applies. The election need not be in a particular form.

4.140 A deduction is allowable for the gross-up amount of a dividend included in assessable income (eg. under section 160AQT) for which the taxpayer is denied a franking rebate. The maximum deduction allowable is $2,500. [Item 22, new section 160AQZK]

(d) Shares issued in connection with winding up

4.141 New section 160APHQ provides that if shares are issued and cancelled in the course of winding up a company and a dividend is paid on those shares, the taxpayer who holds the shares or an interest in the shares is a qualified person in relation to the dividend for the purposes of the holding period rule. However, if, for example, shares are issued in the course of winding up and then within 45 days are disposed of to a third party (as opposed to the issuing company), the taxpayer will not be a qualified person in relation to any dividends paid on the shares (this exception has been created because companies sometimes issue shares in the course of winding up to capitalise debt).

4.142 However, new paragraph 160APHQ(c) excludes dividends which attract the related payments rule.

Beneficiaries of a widely held trust

4.143 A taxpayer who holds an interest in shares as a beneficiary of a widely-held trust on which a distribution has been paid will be a qualified person in relation to any dividend paid on the shares from which the distribution is derived if the taxpayer has held the interest in shares during the relevant qualification period in relation to the interest (ie. if the taxpayer or associate is under an obligation to make a related payment with respect to the distribution, the secondary qualification period, and if the taxpayer or associate is not under an obligation to make a related payment, the primary qualification period), not counting the day of acquisition or disposal, for 45 days. [Item 8, new subsection 160APHP(1)]

4.144 Unlike closely-held trusts, where a trustee of a widely-held trust enters into a position with respect to shares or an interest in shares (relevant shares) which form the property of the trust, the beneficiaries of the trust are not deemed to have entered into a proportionate position with respect to their interests in the relevant shares.

4.145 Therefore, beneficiaries of widely-held trusts do not have to be concerned with whether the trustee of the trust has taken a position with respect to the shares in the trust property. Only positions entered into personally by the beneficiary can materially diminish risk in relation to the beneficiaries interest. Provided the beneficiary personally satisfies the holding period requirements, the beneficiary will be a qualified person. [Item 8, new subsection 160APHO(2)]

What is the effect of not being a qualified person in relation to a franked dividend or distribution?

4.146 Where a taxpayer is not a qualified person in relation to a dividend or distribution, the taxpayer will be denied the franking credit (and therefore the franking rebate) and the intercorporate dividend rebate on the dividend or distribution.

4.147 As a result, the Bill will amend:

•

section 160APP so that no franking credits arise upon the receipt of franked dividends if the company in receipt of the dividends is not a qualified person in relation to those dividends; [Item 9, amended subsection 160APP(6)]

•

section 160APQ so that no franking credit arises in respect of a trust or partnership amount included in a companies assessable income if the company is not a qualified person in relation to the relevant dividend (ie. the dividend to which the trust or partnership amount is attributable); [Items 10 and 11, new paragraphs 160APQ(1)(c) and 160APQ(2)(c)]

•

section 160AQT so that no gross-up is made (and hence no entitlement to the franking rebate under section 160AQU arises) upon the receipt of a franked dividend if the taxpayer who receives the dividend is not a qualified person in relation to the dividend; [Items 12 to 16, new paragraphs 160AQT(1)(ba), 160AQT(1AB)(ba), 160AQT(1A)(ba) and 160AQT(1C)(ba)]

•

section 45Z so that, for the purposes of determining whether company beneficiaries or partners will be entitled to the intercorporate dividend rebate, the trust or partnership distribution will not carry the right to an intercorporate dividend rebate if the company is not a qualified person in relation to the relevant dividend; [Items 1 to 4 , new paragraphs 45Z(1)(ca) and 45Z(3)(ca) and new subparagraphs 45Z(2)(c)(iia) and 45Z(4)(c)(iia)]

•

sections 160AQX, 160AQY, 160AQYA, 160AQZ and 160AQZA so that no franking rebate arises in respect of a trust or partnership amount included in a taxpayers assessable income, if the taxpayer is not a qualified person in relation to the relevant dividend; [Items 17 to 21, new paragraphs 160AQX(ca), 160AQY(ba), 160AQYA(1)(ca), 160AQYA(2)(ca) and 160AQZ(ca)]

•

section 46 and 46A so that a company in receipt of a dividend will not be eligible for the intercorporate dividend rebate if the company is not a qualified person for the purposes of Division1A in relation to the dividend. [Items 6 and 7 , new subsections 46(2B) and 46A(5B)]

Adjustments in relation to section 160AQT amounts

4.148 The 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 if the relevant beneficiary or partner is not a qualified person for the purposes of Division 1A .

4.149 However, as section 160AQT requires an amount to be included in the assessable income of the trust or partnership to gross-up the dividend, a beneficiaries or partners share in the net income of the trust or partnership would be inappropriately increased.

4.150 Therefore the Bill will provide a tax deduction for a trust or partnership amount included in a taxpayers assessable income where the taxpayer is not a qualified person for the purposes of Division 1A in relation to the relevant dividend. The amount of the deduction is to be the same as the amount currently allowed under section 160AR, ie. the potential rebate amount. For the purposes of sections 111C, 116CF,116H and 116HB of the ITAA 1936, this deduction relates exclusively to the trust or partnership amount referred to in new paragraph 160ARAB(1)(a) or 160ARAB(2)(a) . [Item 23 , new section 160ARAB]

Regulation Impact Statement: Franking credit trading (Holding period and related payments rules)

Specification of policy objective

4.151 The policy objective is to prevent franking credit trading by requiring that:

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shares be held at-risk for more than 45 days before a shareholder is entitled to the franking credit and intercorporate dividend rebate (the holding period rule); and

•

shares held by taxpayers who are under an obligation to make a related payment with respect to a dividend paid on the shares be held at-risk for more than 45 days during the relevant qualification period before the shareholder is entitled to the franking credit and intercorporate dividend rebate (the related payments rule).

4.152 These measures form part of a package of measures to prevent franking credit trading which were announced in the 1997-98 Budget. The holding period rule applies from 1 July 1997 and the related payments rule applies from 13 May 1997.

Identification of implementation options

Background

4.153 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, franking credit trading transactions can also pose a threat to the revenue where the dividends paid are rebatable under section46 of the ITAA 1936 because they are paid to a company shareholder.

Implementation Option

4.154 The holding period and related payments rules deny franking credits and the intercorporate dividend rebate on dividends paid to holders of shares whose interest in the company is insufficient to justify the receipt of franking and other benefits accorded to true economic owners of shares.

4.155 The holding period rule applies to deny franking credits or the intercorporate dividend rebate where the taxpayer acquires shares or interests in shares and disposes of them (or equivalent shares or interests) within 45 days (or 90 days in the case of preference shares).

4.156 The related payments rule applies to deny franking credits or the intercorporate dividend rebate where the taxpayer is under an obligation to make a related payment in respect of a dividend and the taxpayer has not held the relevant shares at-risk for more than 45 days (or 90 days in the case of preference shares) during the relevant qualification period.

4.157 In determining whether shares or interests are held for the requisite period, days during which there is in place a risk diminution arrangement (eg. if the shareholder has eliminated the risks and opportunities of share ownership by entering into a derivative transaction) are not counted.

4.158 An alternative approach to the holding period rule is available for certain taxpayers (eg. superannuation funds and life companies) who face substantial compliance difficulties under the standard operation of the rule and which represent a relatively low risk to the revenue because of various regulatory and prudential requirements. This approach, referred to as the formula approach, reduces compliance costs by allowing eligible taxpayers to compare the actual franked return on a portfolio with a franked return on a benchmark portfolio consistent with the taxpayers net equity exposure instead of applying the holding period rule. The ratio of franking rebates or credits to equity exposure must be within a specified limit; the taxpayer will not be entitled to any rebates or credits in excess of that allowed by the ratio.

4.159 Individual shareholders (natural persons) entitled to a franking rebate of $2,000 dollars or less annually will also be exempt from the holding period rule, thereby eliminating compliance costs on small individual shareholders.

4.160 Taxpayers electing to apply the alternative approach and individual taxpayers claiming franking rebates of $2000 dollars or less will, however, still be required to comply with the related payments rule. Therefore, if an electing taxpayer is under an obligation to make a related payment in respect of a dividend, the taxpayer will be required to hold the relevant shares for more than 45 days at-risk (or 90 days in the case of preference shares) during the relevant qualification period.

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

Impact group identification

4.161 The holding period rule will affect taxpayers, who buy and sell shares within 45 days, and taxpayers who enter into risk diminution arrangements (eg. derivative transactions) within 45 days of acquiring shares. The related payments rule will affect taxpayers who have diminished risk with regards to their shares during the relevant qualification period and who are under an obligation to make a related payment with respect to a dividend. These taxpayers typically include share traders, options traders, merchant banks and investment companies. The rules will also affect members of the legal and accounting professions who advise these taxpayers.

4.162 The holding period and related payments rules will also have an impact on the ATO (in administering the rule, for example, information campaigns), the Government (in that the revenue base will be protected) and non-residents and tax-exempt shareholders (whose ability to transfer franking credits will be hampered).

4.163 Certain institutional investors such as superannuation funds will not be required to comply with the holding period rule because they will be able to adopt the formula approach. Similarly, as mentioned above, small individual shareholders will also be exempted from the holding period rule.

4.164 It is not possible to provide any numerical data on the numbers of taxpayers in particular stakeholder groups or the extent of their interests. This is because shares are often held through complicated trust, nominee or group company arrangements, or funds are invested by fund managers on behalf of clients. Accordingly, underlying ownership is difficult to trace.

Analysis of the costs and benefits associated with each implementation option

4.165 Certain institutional investors (such as superannuation funds) and natural person taxpayers with franking rebates of less than $2000 have been carved-out of the holding period rule because the policy objective of the rule is to prevent franking credit trading and not to inhibit legitimate risk management or bona-fide share investment. The absence of the carve-out would result in the legislation going beyond the Governments policy objective and attacking commercial transactions that do not have the effect of a franking credit trade.

4.166 The regulatory regime and the prudential requirements placed on entities like superannuation funds and life assurance companies (ie. restrictions on gearing and use of derivatives) make it more difficult for these entities to engage in franking credit trading. In addition, as noted above, these taxpayers have been given a different treatment because they would incur high compliance costs in meeting the requirements of the holding period rule, and because they are considered to be low revenue risk taxpayers. Moreover, their investment activities make comparison with a share index benchmark an appropriate alternative to the holding period rule.

4.167 Natural person taxpayers claiming franking rebates of $2000 or less are unlikely to be engaging in franking credit trading because the transaction costs associated with a franking credit trading scheme would result in the elimination of any tax benefit derived.

4.168 The threshold has been set so that an individual investor with a share portfolio of between $50,000 and $100,000 could be within the exemption (depending on the yield). Accordingly, any investors outside the threshold would not be within the small investor category. Data provided by the Revenue Analysis Branch of the Australian Taxation Office indicates that the number of individual taxpayers claiming franking rebates (imputation credits) of up to $2000 in the 1996 income year was 1,095,000. The numbers of taxpayers claiming rebates ranging from $2001 to $5000 was approximately 115,000. Accordingly, increasing the threshold to $5000 would not benefit a proportionately greater number of taxpayers but may create opportunities for abuse of the exemption. By contrast, the reduction of the threshold would impose unnecessary compliance costs on a large number of small shareholders.

4.169 The advantages of a provision where the Commissioner is not required to make some finding or determination such as the holding period rule are certainty and reduced administrative costs as compared to a test where some avoidance purpose has to be found. This certainty reduces the ATO's administrative costs because the provisions do not have to be applied on a case by case basis. It also reduces compliance costs for taxpayers by reducing uncertainty in the application of the law. However, taxpayers who are required to comply with the rules will have to incur additional compliance costs in tracking their share acquisitions and disposals and their derivative transactions on shares. The extent of the compliance costs which will be incurred by taxpayers will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.

4.170 Taxpayers applying the formula approach generally already have the necessary information to perform the required calculations. Consequently, although there may be some (unquantifiable) costs in applying the formula approach, the approach does not require an extensive gathering of new information. The ATO will work with the ASX to ensure that costs are minimised by, wherever possible, providing taxpayers with any additional information required (eg. yields on relevant indices). No reliable data on the extent of the administrative costs which will be incurred by the ATO is available. However, 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.

4.171 The related payments rule will only apply to taxpayers who enter into specific arrangements (ie. where taxpayers have diminished risk with respect to their shares and are under an obligation to make related payments with respect to the dividends). This minimises the potential for the measure to apply to genuine commercial transactions and taxpayers compliance costs will be kept to a minimum. Accordingly, the related payments rule should not impose high compliance costs on taxpayers.

Taxation revenue

4.172 The holding period and related payments rules will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. The rules are part of a package of measures targeting franking credit trading and dividend streaming. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. While it is not possible to provide an exact estimate of the revenue loss that already existed from franking credit trading and dividend streaming, $130 million a year has been factored into the forward estimates for 1998-99 and subsequent years to take account of the effect of the measures on existing activities.

Consultation

4.173 The ATO and Treasury held extensive consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, the ASX, merchant banks, superannuation and investment funds) shortly after the Budget announcement on matters relating to the holding period rule. The issues discussed during the consultations concerned tailoring the risk diminution aspect of the holding period rule so that risk reduction strategies not having the effect of a franking credit trade would not be affected, and other issues concerning the general anti-avoidance rule and the specific anti-streaming rule.

4.174 As a result of these consultations, the risk diminution aspect of the holding period rule was tailored to exclude risk reduction strategies that do not have the objective effect of a franking credit trade. In addition, the formula approach was devised to provide institutional investors like superannuation funds an alternative to the holding period rule.

4.175 Details of the formula approach were finalised having regard to further consultations with interested parties (in particular, the general insurance, life and superannuation industries).

Conclusion

4.176 The holding period and related payments rules are important elements of the franking credit trading measures announced in the Budget and they ensure that taxpayers do not gain an undue tax benefit from entering into arrangements involving franking credit trading and mis-use of the intercorporate dividend rebate.

4.177 They implement this policy objective in a way that, as far as possible, minimises administrative and compliance costs while providing taxpayers with certainty (eg. small shareholder exemption and eligible investor carve-out).

4.178 The ATO will monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising from the rules. 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.