The Treasury Laws Amendment (2023 Measures No 1) Bill 2023 (Bill) was introduced into Parliament on 16 February 2023.The Bill contains previously announced measures by the Federal Government which seek to:
- align the tax treatment of off-market share buy-backs undertaken by listed public companies with the tax treatment of on-market share buy-backs, including treating the distribution received as part of a share capital reduction as unfrankable – see our previous article; and
- treating certain distributions (principally, special dividends) funded wholly or partly by capital raisings as unfrankable. We discuss this measure below.
On 9 March 2023, the Bill (and specifically these two measures) was referred to the Senate Economic Legislation Committee (Senate Committee). Although this is a little bit of political posturing by the Opposition and the independents, it would seem difficult for the Opposition to continue objecting against the measure dealing with the franked distributions funded by capital raisings given it was the first to announce the measure when it was in Government.
The Commissioner of Taxation (Commissioner) had long raised concerns in relation to franked distributions funded by capital raisings (see Taxpayer Alert TA 2015/2: Franked distributions funded by raising capital to release credits to shareholders). The Commissioner’s concern was that this strategy released franking credits to shareholders (where, otherwise, the franking credits were in effect trapped within the company and could never have been paid out to shareholders in the ordinary course) and resulted in no economic change for the company making the distribution.
In response, in December 2016, the former Liberal Government (currently in Opposition) announced an integrity measure which sought to prevent the distribution of franking credits where a distribution to shareholders is funded by particular capital raisings.
Application of the measure
The measure was to apply from the date of announcement in December 2016. However, typical of Australia’s tradition of legislating tax law by press release, no further details were provided until the current Government released an exposure draft late last year for consultation, which maintained the original commencement date.
Not surprisingly, the retrospective nature of the measure raised significant concerns as it could impact shareholders who had received franked distributions up to six years ago. Sensibly, the Bill has addressed this concern and the measure will now apply only to distributions made on or after 15 September 2022, one day after the consultation process for the exposure draft commenced.
Self-assessment (in theory)
The measure is not predicated on the Commissioner making a determination. Instead, it applies automatically and requires taxpayers to self-assess their compliance with the measure.
This is an absurdly difficult position for shareholders who will not have all relevant information to form a view and could result in groups of shareholders taking very different positions. Practically, listed public companies will seek to provide shareholders with information, and will try to obtain rulings from the Commissioner.
However, as we show below, and through no fault of his, the Commissioner will probably find it incredibly difficult, if not impossible, to rule on this measure, giving rise to other concerns for entities seeking to pay special distributions, including in relation to directors’ duties. He may need to manage the formulation of the questions to enable him to rule appropriately, which may still leave some uncertainties – we will have to see how this develops over time.
The Bill simply does not give due weight to the proper administration of the measure by shareholders, entities making special distributions or the Commissioner, all of whom seek certainty. Perhaps the Senate Committee review will bring some much-needed sense to this aspect of the Bill.
What does it apply to and what are the consequences?
The measure applies to any “distribution” by an entity to its members that satisfies the following conditions:
- the distribution is not consistent with an established practice of the entity of making distributions of that kind on a regular basis (as people commonly refer to them, “special” dividends or distributions); or
- the entity does not have a practice of making distributions of that kind on a regular basis; and
- there is an issue of equity interests in the entity or any other entity, whether before, at or after the distribution is made; and
- it is reasonable to conclude, having regard to all the relevant circumstances, that:
- the principal effect of the issue of any of the equity interests is to directly or indirectly fund all or part of the distribution (the Principal Effect Test); and
- any entity that issued or facilitated the issue of any of the equity interests did so for a purpose (other than an incidental purpose) of funding the distribution or part of the distribution (the Purpose Test).
These conditions are discussed in more detail below.
A distribution to which the new measure applies would be unfrankable. Since special dividends are generally paid to distribute franking credits to shareholders (particularly in the context of mergers and acquisitions), this measure carries a potentially severe impact on the value proposition of such transactions.
Entities and distributions
The measure applies to entities, a term that includes companies, partnerships and trusts, among others.
However, only entities that are taxed as companies can frank distributions (including dividends). Practically, this means the measure applies only to distributions by:
- certain types of trusts (public trading trusts); and
- limited liability partnerships (other than venture capital limited partnerships and early stage venture capital limited partnerships).
We refer to only companies and dividends below for convenience.
Distribution is special
This threshold condition ensures that the integrity rule does not affect ordinary distributions that have been made on a regular basis. Their regularity points to them not being made as part of artificial arrangements designed to accelerate the distribution of franking credits to shareholders.
The following non-exhaustive list of factors should be taken into account when determining whether an established practice of making distributions exists:
- the nature, timing and amount of past distributions; and
- the franking credits attached to past distributions and the extent to which past distributions were franked.
A company sells an asset, has excess cash from the sale and makes an out-of-cycle distribution of that excess cash. This will prima facie be a special dividend, although it is unlikely the other conditions will be satisfied.
A privately held company has never previously made a distribution or has made irregular distributions. It makes its first distribution or a new distribution in a while. Such a distribution will be considered special. However, depending on the circumstances, the other conditions may not be satisfied – they should be considered carefully.
A company (Target) receives a takeover offer from another company. Target decides it wants to take the opportunity to distribute a large amount of cash to shareholders before completion of the takeover as it has held back distributions for reinvestment in the business. This reinvestment has resulted in low available cash but high franking credit balances. This large dividend will be a special dividend. The other conditions will need to be considered carefully as the application of this measure could significantly make shareholders worse off than if the dividend was not paid at all.
Issue of equity interests
An equity interest has a specific meaning for tax purposes. It is more than just equity for accounting or legal purposes.
A debt instrument, such as a convertible loan note, can be an equity interest for tax purposes, depending on its terms. Even a straightforward loan can be an equity interest in certain circumstances.
Accordingly, legal teams should be careful not to dismiss the application of this measure simply because “debt” is used to fund the payment of the dividend.
In the entity or another entity
To capture indirect funding of a dividend by having another entity issue equity interests and then funnel the proceeds to the entity paying the dividend, the measure captures equity interests issued by any entity.
Obviously, there has to be some connection between the entity paying the dividend and the entity issuing the equity interests before the measure applies. However, no such connection is mandated by the provisions. Instead, it is a relevant factor for the third condition and the explanatory memorandum (EM) to the Bill states that, typically in arrangements to which this measure applies, there will be a significant level of connection between the two entities involved.
A company has a dividend reinvestment plan. It pays a dividend knowing that the dividend reinvestment plan will mean much of the dividend is returned to the company by the issue of new shares under the plan. Should the measure apply? We understand there are some advisers who are expressing the view that the measure could apply. We disagree. We are of the view that the dividend funds the capital raising, but the capital raising does not fund the dividend.
A company (Target) receives a takeover offer from another company (Buyer). Target decides to pay a special dividend at about the time the takeover is completed. It draws down on existing debt facilities to pay the dividend.
- On the basic facts, there is no issue of equity interests, so the measure should not apply.
- However, let us add the fact that, within a year of the transaction, Buyer issues shares to its shareholders and uses those proceeds to fund Target to enable Target to repay the external facility. Could the measure apply? Does it matter whether Buyer raises more or less capital than the amount of the loan? Does it matter how long after the dividend is paid before all of these steps happen? Regrettably, there is no clear answer, but it is conceivable that the measure does in fact apply. And the clincher – shareholders in Target (who may well not be shareholders in Buyer) must track what Buyer does for an indefinite period of time to reverse their use of the franking credits attached to the special dividend.
- Let us add a tax consolidated group into the mix. Buyer is a subsidiary member of a tax consolidated group. Buyer’s parent has lots of cash within its group to repay Target’s debt facilities. Buyer provides the cash to Target in exchange for shares. Within the Buyer/Target tax consolidated group, the issue of shares is disregarded. However, it is not disregarded for purposes outside the tax consolidated group. Could the measure apply? It would seem yes, although it feels more uncertain that the third condition would be satisfied in this circumstance.
Principal Effect Test
To deter taxpayers from entering into artificial arrangements (such as combining a distribution funded by capital raising with an ordinary dividend), the measure provides that, if the test is satisfied only in relation to some of the capital raised from an issue of equity interests or part of a franked distribution, the entire distribution ceases to be able to be franked.
Principal or other derivatives generally mean more than 50%. However, we do not think the provisions are requiring a quantitative analysis of the effect. We are of the view that it must be ready together with the Purpose Test and judged qualitatively. This would sit properly with the deterrence factor described above.
This can result in potentially adverse effects where a company routinely raises equity. If, for example, there is both a debt raising and an equity raising at around the time of the distribution, there is a risk that the fungible nature of money will mean that the Principal Effect Test is satisfied. The Purpose Test will need detailed consideration in such circumstances. It may also require careful management of bank accounts – for example, debt raisings go into a separate bank account to equity raisings, from which the cash raised can be traced to their end use.
It is not necessary that the relevant purpose be the sole or dominant purpose of the entity. It is sufficient that it was more than incidental to some other purpose.
Further, it is not necessary that the purpose is a purpose of the entity that issued the equity interest. The purpose of anyone who facilitates the equity issue can be sufficient.
The Bill provides a list of non-exhaustive factors to be taken into account when determining whether the Principal Effect Test and the Purpose Test are satisfied. These include:
- the extent to which, following the issue of equity interests and making of the distributions, there has been a net change in the financial position of the entity making the distribution and any related parties. Where there is no substantial net change in the financial position of the entity following the distribution, this strongly supports the conclusion that the effect and purpose of the issue of equity interests was to fund the distribution;
A company issues new shares to pay a special dividend. The company’s financial position remains unchanged. The Purpose Test will be satisfied. This is the classic formulation of the mischief that the measure is aimed at.
A company borrows money to pay a special dividend. Six months later, the company raises equity to refinance that debt. The Purpose Test would seem to be satisfied, as would all the other conditions.
- use of the funds raised by the issue of equity interests and the reasons for the issue of equity interests. The EM indicates that, in cases where the funds raised are used to make a distribution, it is likely that the effect and purpose of the issue would be to fund the distribution unless there is a clear commercial purpose such as raising capital to fund an acquisition that is ultimately unsuccessful;
A company issues new shares to fund an acquisition. The acquisition does not proceed. The company pays a special dividend using the funds. One would expect that the Purpose Test is not satisfied. However, it is not clear why a rational company would pay a dividend instead of undertaking some form of capital return and persuading the Commissioner that the anti-avoidance provision, section 45B, should not apply.
- how the history of the amount of franking credits in the franking account maintained by the entity making the distribution compares to the history of profits and share capital of the entity;
- extent to which there is commonality between the parties that were entitled to participate in the issue of equity interests mentioned and the parties that were entitled to receive the relevant distribution;
In the examples under the heading “In the entity or another entity”, it could be argued that the equity issues within the tax consolidated group do not satisfy the Purpose Test because there is no commonality between the shareholder(s) to whom the shares were issued (ie. another entity within the tax consolidated group) and the shareholders who received the dividend (the shareholders in the Target).
- the extent to which the capital raising is underwritten;
- the time or times at which the equity interests were issued relative to the time of the franked distribution. Clearly, the longer the interval, the less likely that the Purpose Test will be satisfied. But how long is enough and will the Commissioner ever specify a period as long enough?
- the amount of the equity interest compared to the distribution. Again, the bigger the difference, the less likely that the Purpose Test will be satisfied. But how big is big enough? and
- any other distributions made before or after the franked distribution by the same entity.
As the examples show, there is a great deal of uncertainty about the measure and how it will apply in practice, and the Senate Committee review may or may not aid this uncertainty. We know the Commissioner is considering the application of the measure in actual transactions and it will be interesting to see the approach he takes in his public rulings. It is fair to say companies must approach special dividends with extreme caution – if the franking credits are denied under this measure, the consequences for shareholders are dire. In a takeover context, for example, shareholders would generally be better off receiving a higher purchase price for their shares instead of receiving a dividend that cannot be franked. Watch this space!