Australia: Commissioner clarifies his views on the taxation of dividends

Clayton Utz Insights
Last Updated: 5 August 2012
Article by Mark Friezer

Key Points:

There is still considerable uncertainty on whether a purported dividend is in fact sourced out of a company's share capital.

The Commissioner has released Income Tax Ruling TR 2012/5 which deals with the taxation implications of the new section 254T of the Corporations Law.

Before it was amended, section 254T provided that a dividend could only be paid out of the profits of the company. There was a view amongst some that the so-called "profits test" was inadequate. Companies with sufficient free cash flow to pay dividends to shareholders were frustrated in doing so, as profits were eroded by expenses resulting from fair market value based accounting approaches.

The new section 254T was intended to be a more flexible requirement which allows companies to pay dividends if certain solvency criteria are met. It provides 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.

Notwithstanding the clear expression of intent behind the enactment of section 254T, the language of the section is restrictive rather than permissive.

The Commissioner's view as expressed in the Ruling is that, notwithstanding section 254T, the dividend must be paid out of either current year or accumulated profits.

However, the Corporations Law definition of dividend is not used for income tax. Under the income tax law, there is a stand-alone definition of dividend which, essentially, provides that a dividend includes any distribution made by a company to any of its shareholders (as shareholders) but not where it is debited against an amount standing to the credit of the share capital account of the company.

For most part the ruling is concerned with the application of section 202-45(e) of the Income Tax Assessment Act 1997. That section provides that a distribution is not a frankable distribution if it is sourced directly or indirectly from the company's share capital account.

Clearly, the circumstances where an amount is either directly or indirectly debited to a capital account will be relevant to the gateway issue as to whether there is a dividend at all, and then whether it is frankable. (If there is a dividend, then it will be no impediment to assessability under section 44(1) that the dividend is not paid out of the company's retained earnings account – section 44(1A)).

A frankable dividend?

The ruling clarifies that "nimble dividends" (ie. dividends paid out of current year earnings by a company with accumulated losses) are frankable in certain circumstances:

  • provided the dividend is paid by resolution by the directors at the same meeting at which they approve the accounts, the dividend will have been made prior to appropriation of current year profits against accumulated losses, so that the dividend will be regarded as being frankable;
  • the situation is clearer where a separately identifiable profits reserve is created out of current year profits – which may be carried forward in the accounts separately from the accumulated loss account and will remain available for the payment of dividends.

The company may pay a frankable dividend out of a unrealised capital profit account of a permanent character recognised in its accounts and available for distribution, provided that the company's net assets exceed its share capital by at least the amount of the dividend.

The Commissioner suggests in the Ruling that a distribution made in breach of section 254T won't be frankable. This does not seem justifiable as a blanket proposition given that a breach of section 254T does not necessarily mean that an amount has been sourced even indirectly from share capital.

What if the amount is unfrankable?

Where a distribution is sourced out of share capital, then the tax consequences may be either that:

  • in the circumstance where the distribution contravenes section 202-45(e) but is not regarded as being a debit to the share capital account in the sense contemplated in the tax law definition of dividend, the amount will be an assessable dividend for tax, but will not be frankable; or
  • if the amount is not a tax law dividend because it is regarded as having been debited against the share capital account, then the distribution will be taxed under the capital gains tax rules.

Clearly there is much uncertainty which remains to be resolved in this fundamental area of law. Much of the uncertainty results from lack of clarity around if and where a purported dividend is in fact sourced out of a company's share capital.

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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