What the new dividend rules mean for franking credits 31 August 2011 In brief The ATO has released draft fact sheets outlining its preliminary views on the interaction of the amendments to the dividend rules and the franking rules. If a distribution is proposed to occur during the course of a takeover or scheme, a ruling should be sought from the ATO confirming whether the distribution is frankable. The ATO has recently released draft fact sheets outlining its preliminary views on the interaction of the amendments to the dividend rules in section 254T of the Corporations Act 2001 (Cth) and the franking rules in the tax legislation. These fact sheets were not widely distributed and, if finalised, would not have the status of a public ruling. It is beyond the scope of this article to discuss the merits, or otherwise, of the ATO’s analysis. For those who are interested in such a discussion, please see the tax brief1 prepared by our associated tax practice, Greenwoods & Freehills2. Prior to the amendment to section 254T, a company could only pay dividends out of its profits. Under the changes to section 254T, a company may not pay a dividend unless: the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend, it is fair and reasonable to the company’s shareholders as a whole, and it does not materially prejudice the company’s ability to pay its creditors. While it is generally accepted that the revised wording of section 254T is intended to provide companies with more flexibility to pay dividends, there is considerable uncertainty as to what sources of funds can be used to pay dividends under the revised rules. In particular, can dividend payments be paid out of share capital? There are broadly three views in relation to the sources of funds: 1. 2. 3. Broad view: the revised wording allows companies to pay dividends to shareholders out of share capital without having to comply with chapter 2J of the Corporations Act 2001 (Cth) (ie prior shareholder approval), Middle view: the revised wording allows companies to pay dividends out of retained earnings and other equity reserves, even where those accounts have a negative balance or where the amount of the dividend is greater than the existing positive balance, or Narrow view: the revised wording allows companies to pay dividends out of retained earnings and other equity reserves, even where those accounts have a negative balance or where the amount of the dividend is greater than the existing positive balance, but only if the company has other equity reserves other than share capital to offset the negative balance. In summary, the tax legislation defines a dividend to be any distribution by a company to its shareholders other than where an amount is debited to share capital. However, a dividend is only assessable to the extent it is paid out of profits. Rather than undertake wholesale amendments to reflect the changes to section 254T, the government simply deemed any dividend to be a payment out of profits. The Explanatory Memorandum to the bill amending section 254T indicated that distributions made in accordance with section 254T would be frankable, subject to the existing ‘integrity rules’. One of those ‘integrity rules’ provides that a dividend cannot be franked if it is sourced directly or indirectly from share capital. In the draft fact sheets, the ATO provides two examples of where a dividend is paid by a company without sufficient retained profits. In the first example, the dividend is debited against an asset revaluation reserve. In this case the ATO considered that the asset revaluation reserve is a ‘profit’ account and the dividend is therefore not sourced directly or indirectly from share capital. Accordingly it is frankable. However, where the dividend is debited against either accumulated losses or a dividend reserve, the ATO considers this is a distribution sourced from share capital and is therefore unfrankable. It is unclear what the position would be where the company declares a dividend out of current year profits, but has significant retained losses. In the course of a friendly takeover or scheme, the target company will often seek to distribute its franking credit balance to its existing shareholders by way of a special dividend. To the extent that this special dividend is paid other than from retained earnings, a ruling should be sought from the ATO confirming whether the distribution is frankable. This article was written by Toby Eggleston, Director, Melbourne and James Pettigrew, Director, Sydney of Greenwoods & Freehills. Endnotes 1. 2. Greenwood & Freehills tax brief: 'ATO continues the distribution confusion' Greenwood & Freehills More information For information regarding possible implications for your business, contact Toby Eggleston Director, Greenwoods & Freehills, Melbourne Direct +61 3 9288 1454 toby.eggleston@gf.com.au James Pettigrew Director, Greenwoods & Freehills, Sydney Direct +61 2 9225 5979 james.pettigrew@gf.com.au This article provides a summary only of the subject matter covered, without the assumption of a duty of care by Freehills or Freehills Patent & Trade Mark Attorneys. The summary is not intended to be nor should it be relied upon as a substitute for legal or other professional advice. Copyright in this article is owned by Freehills or Freehills Patent & Trade Mark Attorneys. For permission to reproduce articles, please contact Freehills' Public Affairs Consultant, Megan Williams at media@freehills.com on +61 3 9288 1132.