Australia: ATO fact sheets continue the distribution confusion

Last Updated: 21 September 2011

The Australian Taxation Office (ATO) has released two draft fact sheets relating to the 2010 amendments to corporate law and the income tax in relation to dividends.

Some of the contentious propositions stated or implied by the fact sheets are as follows.

  • Distributions which result in negative retained earnings are taxable but not frankable.
  • Such distributions are only taxable because the ATO assumes 'for illustrative purposes' that they do not reflect a reduction of share capital, and are thus 'dividends', although they are not treated as being paid from profits either. No reasoning is given to support the assumption, in fact, the only direct authority cited by the ATO on the reduction of share capital point is actually contrary to their assumed position.
  • Such dividends are unfrankable because they are directly or indirectly sourced from share capital. This would appear to be inconsistent with the assumption adopted by the ATO in treating the dividend as taxable, although the ATO attempts to distinguish the relevant franking and taxing rules despite their being very similar in their literal terms.
  • The ATO appears to regard the source of corporate distributions as limited to either share capital or booked profits, and not also amounts that are not booked or cannot be recognised in the relevant company's accounts. This would appear to conflict with views previously expressed by the ATO, at least on unbooked profits.

In summary, not only do the fact sheets create potential traps for taxpayers in relation to corporate distributions, they are also part of a wider trend under which the ATO increasingly interprets the tax legislation to produce distributions that are taxed in full without the benefit of franking.

This tax brief relates the background to the amendments, provides an analysis of the fact sheets and the problems they will cause, and then sets them against a broader context of increasing taxpayer confusion in relation to corporate distributions.


Modern corporate law until 2010 provided that companies could only pay dividends 'out of profits'. Australian federal tax law has followed this approach from its earliest days. From a corporate law perspective there were a number of problems with the out of profits test including:

  • case law was unclear about what were, relevantly, 'profits';
  • in particular, it was unclear to what extent the test was based on the financial statements of the company;
  • the maintenance of capital rules, of which the out of profits rule was a part, had been significantly watered down over recent decades (share buybacks, abolition of par value for shares and greater freedom for returns of share capital) but the dividend rules remained in their previous form; and
  • IFRS had produced greater swings in the amount of corporate profits so that companies may have significant cash reserves or borrowing capacity and yet been unable to pay dividends because of uncertainty whether there were any profits in whatever sense was required.

The corporate law answer was to replace the out of profits requirement for the payment of dividends in section 254T of the Corporations Act with a three pronged test which followed other changes in the Corporations Act to the maintenance of capital rules by moving the emphasis to solvency, directors' duties and shareholder fairness. The resulting requirements for the payment of a dividend are as follows:

  1. the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and
  2. the payment of the dividend is fair and reasonable to the company's shareholders as a whole; and
  3. the payment of the dividend does not materially prejudice the company's ability to pay its creditors.

For the purposes of (a), assets and liabilities are determined by accounting standards at the relevant time. There was a statement in the explanatory material to the 2010 amendments that where a company was not required to prepare financial statement in accordance with accounting standards, assets and liabilities could be determined by reference to its other accounting records but this has not been legislated.

This amendment to section 254T of the Corporations Act has caused considerable confusion among corporate advisers.

As accounting liabilities do not include shareholders funds, and these in turn are made up in a broad sense of share capital and profits, a dividend can now be paid even where there are not sufficient recognised profits to support it. Indeed that is the whole purpose of the amendment. The provision does not, however, spell out the implications of such distributions: accounting, corporate law and otherwise. For example, the corporate law still has rules about distributions of share capital which usually require a shareholders' resolution, whereas typically dividends can be paid without such a resolution. Can a distribution debited to share capital be treated as a dividend by the company and thus bypass the shareholder resolution requirement? Most corporate law advisers consider that the answer to this question should be no.

From a tax perspective, distributions by a company to its shareholders were dividends at the time of the 2010 amendments, except, relevantly, where debited to a company's share capital account. Such dividends were then included in the recipient shareholder's assessable income where 'paid out of profits' (under section 44(1)). Typically such dividends could also be franked.

The drafters of the 2010 amendments evidently recognised that the corporate law change to remove the requirement for dividends to be paid from profits may result in companies making distributions which would be characterised as neither a distribution of profits nor a share capital reduction. It was also contemplated that such a distribution would be a dividend under then current tax law because it would not fall within the exclusion for amounts debited to a company's share capital account, but that it would not be taxable as it would not be paid from profits.

Rather than remove the test which is deeply embedded in tax law in many provisions, the following simple amendment was inserted as section 44(1A) of the 1936 Act:

For the purposes of this Act, a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits.

The effect is that any distribution within the definition of dividend for tax purposes is taken to be out of profits and taxable accordingly.

On franking, the explanatory material to the 2010 amendments stated that 'subject to the operation of the current imputation integrity rules, these distributions will be frankable under section 202-40'. Relevantly, section 202-45(e) is an integrity rule which prevents the franking of a distribution sourced directly or indirectly from share capital.

An unfortunate consequence of the tax amendment to introduce section 44(1A), together with the corporate law amendments, is that taxpayers must now identify distributions which, although not paid out of profits, are nonetheless taxable dividends because they are not to be debited against a company's share capital account. This is not a straightforward exercise, as the immediate reaction may be to suggest that a distribution must be paid either from profits or share capital.

The ATO's response to this identification issue in its first fact sheet is to acknowledge the difficulties and then proceed on the basis of an assumption about the operation of corporate law in a particular fact situation for which they provide no justification other than it being for 'illustrative purposes'. What they proceed to illustrate in the second fact sheet is a taxable but unfrankable distribution. The fact sheets are examined in detail below.

Fact Sheets

What the 2010 amendments mean for tax and, incidentally, corporate law purposes is the subject of the two draft ATO fact sheets, the first dealing with the consequences for assessability under section 44(1) for dividends and the second dealing with the frankability of distributions.

There are two key examples, one of which is common to both fact sheets.

In the first example, the company does not have sufficient profits in its accounts to support a dividend but has a revaluation reserve which is debited with the distribution. In the second example, there is no revaluation reserve and insufficient profits to support the dividend which is debited to profits to produce negative retained earnings.

The ATO suggests that both distributions are dividends for tax purposes and therefore assessable under section 44(1) even though not out of (positive) profits. On imputation, the ATO states that the dividend debited to the revaluation reserve is frankable on the basis that the revaluation reserve is a 'profit' account. However, the dividend debited to profits to produce negative retained earnings is unfrankable as it is 'sourced indirectly' from share capital.

It is the second example that creates the problems and hence that is what we focus on here.

On the dividend point, the reasoning is effectively that the form of the transaction governs, that is, there has actually to be a debit to an account which is (part of) the share capital account for a distribution not to be a dividend. For imputation, however, the ATO asserts that substance (not formal accounting) applies and the amount must be indirectly sourced from share capital as there are no (positive) retained earnings.

The approaches adopted by the ATO to both the dividend and franking issues are somewhat concerning.

On the dividend issue, the ATO does question at one point whether an accounting debit to accumulated losses can properly be made where the distribution reduces the net assets of the company below the value of contributed share capital (ie, causes it to go into negative retained earnings) as such a distribution on one view must represent a share capital reduction. Without concluding on that point, the ATO proceed on the completely unsupported assumption that relevant provisions of the Corporations Act would not prohibit the distribution 'because share capital is not reduced'.

Given the implications that flow from the interaction between the ATO's initial position on the dividend point and its position on imputation, it could reasonably be expected that the ATO would express a concluded view on this point, rather than relying on an unsubstantiated assumption.

Furthermore, even if that assumption is correct, the ATO's position that the distribution is not a tax dividend depends on a further conclusion that no amount has been debited against the company's share capital account for tax purposes in this situation. Any possible distinction between the Corporations Act concept of a share capital reduction and the tax concept of a debit against a company's share capital account (based on its definition under the tax legislation) is not acknowledged in the fact sheet.

Some of the issues mentioned above were recently raised in the Consolidated Media share buyback case.

In Consolidated Media, the company created a negative 'Share Buy-back Reserve Account' in its accounts to reflect the amount paid to its sole shareholder as consideration for buying back some of the shares it held. The company separately kept an account of its contributed share capital titled 'Shareholder's Equity Account', the balance of which was unaffected by the buyback. It was held that the Share Buy-back Reserve Account reflected part of the account kept by the taxpayer of its share capital (so that it was part of its share capital account for tax purposes) and its creation reflected the debiting of an amount to that share capital account. Accordingly, the buyback consideration was not a dividend for tax purposes.

The ATO refers to the Consolidated Media decision in its dividend fact sheet. The ATO implies that the Court held that where a debit is made to a new account producing a debit balance, regard may be had to the substance of the transaction in determining the source of the debit. Despite this statement, no attempt is then made to apply Consolidated Media in determining whether the accumulated losses/negative retained earnings account in the example in the fact sheet may reflect an amount debited to the company's share capital account. If so, it would not be a dividend and the related imputation issues would not arise.

It is not immediately clear why the ATO does not address Consolidated Media in this context. The ATO may simply be uncertain whether the distribution in the example reflects a return of share capital, whereas this appeared to be relatively clear in Consolidated Media, at least for tax and also under the then Corporations Act. In addition, the facts of that case occurred before the relevant tax and Corporations Act amendments and before the introduction of IFRS accounting standards. It must also be acknowledged that at the time of release of the draft fact sheets, Consolidated Media was within the statutory appeal period and no appeal notice had then been lodged.

In turn, the ATO's justification for its substance approach in relation to franking comes in three main parts and is highly debatable.

First, it is stated that the imputation system is only intended to apply to distributions of realised or taxed profits. There is no statement in the material quoted by the ATO that supports this proposition. Since its inception the basic imputation system has gone out of its way to avoid any such tracing because it would place an impossible burden on the company. If the ATO approach is taken at face value it would mean that imputation would not apply to a dividend paid out of traditional profits unless the company can show that those very profits were realised or taxed. The ATO to date has relied on anti-avoidance provisions such as section 177EA when it wished to assert this proposition, not on the basic nature of the imputation system.

Second, the ATO states that the words 'sourced indirectly' in the imputation rule for unfrankable dividends require a substance approach. For this purpose they quote selectively from cases on the geographic source of income (a very different issue) relying in particular on the judgment of Gibbs J in the Esquire Nominees case which was overruled by the Full High Court on appeal on the source issue. In this context the ATO also states that the rule was intended to continue the policy of the so called 'tainting' rules in the former inter-corporate dividend rebate. An inspection of those rules indicates clearly that they operate off the form of the accounting entries and that 'indirectly' is intended to refer to the situation where a share capital account is debited and a profit account credited followed by a distribution debited to a profit account. Further, the ATO is silent on the interaction of section 44(1A) deeming the dividend to be paid out of profits for all purposes of the Act. It could be arguable that this provision is designed to nullify section 202-45(e).

Third, the ATO relies on the recent decision in the Consolidated Media share buyback case (which, as already noted, was subject to appeal when the fact sheets were released). As noted above, in that case, the proceeds of a buyback were debited to a newly created 'Share Buy-back Reserve Account'. The company had no retained profits and the debit was the only entry in that 'reserve'. Emmett J concluded that the buyback reserve was 'part of' the account kept by the taxpayer of its share capital and that therefore the consideration for the buyback was debited to the share capital account. That is, the distribution was sourced directly from share capital.

The ATO relies on this decision to conclude that a 'dividend' debited to negative retained earnings is indirectly (though inferentially not directly) sourced from share capital. It is doubtful if this is consistent with the decision which concerned what is a debit to a share capital account – the ATO's view of the decision would suggest that the account is part of the share capital account when negative and not part of the share capital account when positive. The decision however says nothing about amounts sourced indirectly from share capital as the legislation in question had no such provision.

More broadly there is an assumption in the fact sheets that because accounts are an element of the new corporate law dividend rule, it is only the accounts that can be looked at for the purposes of the tax rules. They simply fail to acknowledge that directors, having satisfied themselves that the accounts reveal an excess of assets over liabilities, could then agree to pay a dividend under the other parts of the corporate law rules because they reasonably believe that the company has unrealised profits which are not (or depending on the situation cannot be) recognised in the accounts and which justify paying a dividend rather than distributing share capital. The ATO operates on the assumption that if the accounts do not reveal sufficient retained earnings then any dividend must be from share capital for imputation purposes whereas in the scenario just described a negative retained earnings figure is a much truer representation of what the directors have decided.

This position would appear to be slightly at odds with views previously expressed by the ATO in relation to the concept of profits where dividends are concerned. For instance, TR 2003/8 broadly indicated that where a company distributed assets to its shareholders on a demerger, the market value of the assets in excess of the amount debited to the company's share capital account would be treated as an assessable dividend paid 'out of profits' even where the assets were only recognised in the company's accounts at a value which reflected the amount debited to the share capital account. This followed an earlier public ATO ruling (IT 2637) which suggested that 'profits' for dividend purposes essentially was any accretion in value of an asset since its acquisition.

Until the issues in the ATO's approach identified above are resolved, clearly there are significant tax risks in making franked distributions which involve debiting an account to produce or increase negative retained earnings, or treating such a distribution as a return of capital which writes down the CGT cost base of the shares.

Broader issues

Increasingly the ATO is adopting positions which treat payments from companies to shareholders as taxable in full without the benefit of imputation, quite apart from the anti-avoidance imputation and capital benefit rules, for reasons which are difficult to understand.

Another recent example aside from the current fact sheets is the draft ruling on retail premiums associated with rights issues, TR 2010/D8. There is now a decade of history of related activity which has completely confused taxpayers as to how corporate distributions are taxed including TR 2003/8 with the related Condell case on distributions in a foreign demerger and CR 2001/75 together with the McNeil case on St George Bank's sellback rights.

The 2010 amendments are being interpreted to the same effect. It has become clear from a corporate law perspective that those amendments have created confusion rather than assisting companies even though they were 10 years in the making. At least the corporate law problems are being discussed. The ATO fact sheets, unsatisfactory though they are, have not begun to scratch the surface of the even more problematic nature of the tax amendments.

On the one hand, it is possible that the amendments have done away with the need for various deemed dividend provisions in the tax law, which was not stated to be the intention. Section 47 on liquidation distributions is a case in point. On the other hand, many other provisions in the tax law still require a determination that a distribution is out of profits for various purposes (private company deemed dividends, the impact of distributions of pre-acquisition profits on the reduced cost base of shares and the franking of distributions on non-share equity) so that the tax amendment has not done away with the out of profits concept for tax purposes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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