When a dividend is not a dividend
On the 22nd of December last year the Commissioner of Taxation (the "Commissioner") presented the wider tax community with an early Christmas gift in the form of TR 2011/D8 (the "draft ruling"). This draft ruling builds on a discussion paper released on 21 June 2011 by the Commissioner in response to the amendments to the Corporations Act 2001 ("Corporations Act") that impact on when a company can pay a dividend (refer to section 254T of the Corporations Act).
Whilst the draft ruling does go into the interpretation of the Corporations Act amendments this analysis is a product of an opinion issued to the Commissioner by external counsel. One hopes that the finalised ruling will also rely on guidance issued by the Australian Securities and Investments Commission (ASIC) – the Regulator of Corporations Act.
The amendments to Section 254T of the Corporations Act 2001
Prior to the amendments, section 254T of the Corporations Act provided that, a dividend may only be paid out of profits of a company. These profits were generally accepted as a reference to retained or ascertained accounting profits of a permanent character. However, from 28 June 2010, the test became a three pronged test stating that a company must not pay a dividend unless:
- The company's assets exceed its liabilities immediately before the dividend declaration and the excess is sufficient for the dividend payment;
- The dividend is fair and reasonable to members as a whole; and
- Creditors are not materially prejudiced.
At the same time as the Corporations Law amendment, subsection 44(1A) was inserted into the Income Tax Assessment Act 1936 ("ITAA 1936"). This inclusion ensured that a dividend paid out of an amount other than profits (e.g. unrealised capital profit reserves) is taken to be a dividend paid out of profits and would ordinarily be assessable to the recipient.
Following these amendments, the Commissioner issued the discussion paper and raised some concerns over the ability of a company to frank a dividend that is not paid out of profits – e.g. where a company pays a dividend and does not have a positive retained profits balance at the end of the year. In such an example the question was raised as to whether the dividend could be said to be sourced directly or indirectly out of share capital and as a result not be frankable (refer to paragraph 202-45(e) of the Income Tax Assessment Act 1997 ("ITAA 1997")).
Where an interpretation was made that such a dividend was indirectly sourced out of share capital this would lead to an undesirable outcome of a shareholder being taxed on what is essentially a return of share capital without any franking credit relief.
The Draft Ruling
The draft ruling includes the Commissioner's view on what the ATO will likely consider to be a dividend and how the Corporations Act amendment impacts on this. More relevantly the draft ruling outlines the Commissioner's views regarding what distributions would be classified as a "tax dividend" and in what circumstances a tax dividend would be unfrankable (e.g. sourced directly or indirectly from share capital).
What constitutes a dividend?
The Commissioner states that the "better view" is that the amendments to Section 254T of the Corporations Act impose three additional restrictive conditions in which a dividend can be paid. The draft ruling notes that "inherently a dividend can only be paid out of profits, having regard to the ordinary and legal meaning of the word". .
Dividend paid out of current trading profits – frankable
A company that pays a dividend to its shareholders in accordance with its constitution and the Corporations Act, that is paid out of current trading profits recognised in its accounts and available for distribution, is not prevented from franking the dividend merely because the company has un-recouped prior year accounting losses, or has lost part of its share capital.
In conceding that such a dividend is eligible for franking, the Commissioner appears to have softened his view since the issue of the draft discussion paper. The draft also indicates that great care must be taken when accounting for any current year profits in a company's books as any appropriation of those current year profits (to recoup prior year accounting losses) prior to the distribution would mean that any dividend paid that is attributable to those profits would arguably be unfrankable.
Dividend paid out of an unrealised capital profit – sometimes frankable
A company that pays a dividend to its shareholders in accordance with its constitution and the Corporations Act, that is paid out of an unrealised capital profit of a permanent character recognised in its accounts and available for distribution, is not prevented from franking the dividend provided the company's net assets exceed its share capital by at least the amount of the dividend.
The Commissioner highlights that where a company's net assets figure is lower than its share capital, the ability to pay the dividend and its eligibility for franking will depend on the company's circumstances. Specifically, one must consider the nature of the unrealised profit and any other profits and losses in the company's accounts.
Distribution that is an unauthorised reduction and return of share capital - not frankable
The draft ruling highlights that a distribution (even if it is labelled as a dividend) paid by a company to its shareholders, that does not comply with the Corporations Act is in all likelihood an unauthorised reduction and return of share capital. Such a distribution would prima facie be treated as capital proceeds for a CGT event e.g. CGT event G1. However the Commissioner's does concede that such a distribution could still in some circumstances be an assessable unfrankable dividend.
Thus, whilst the Commissioner accepts that a payment to shareholders from an account other than profits (e.g. unrealised capital profits reserve) is acceptable under the Corporations Act and will often be a dividend for tax purpose , his interpretation and application of the relevant franking provisions may make it particularly unattractive to do so as it would be an unfrankable dividend.
If you wish to discuss the implication of the draft rulings on your business please contact one of the authors or your Moore Stephens Relationship Partner.
Should you require further information on the above topic please contact the authors or your Moore Stephens Relationship Partner.
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