Last year in the run up to Christmas, the ATO released a draft ruling on the tax implications of the new corporate law test for dividends enacted in 2010. Not to be outdone Treasury this year has released an Exposure Draft (ED) of legislation for a replacement of the 2010 corporate law dividend test. The more things change ....
The new version keeps the 2010 test for assets exceeding liabilities in place but overcomes the problem that even companies which are not otherwise required to keep accounts in accordance with accounting standards were required to do so for the payment of dividends by the 2010 law. For this kind of company under the ED the dividend test is applied on the basis of the financial records of the company rather than accounting standards.
The ED replaces the other two tests in the 2010 law (fair and reasonable between shareholders and no material prejudice to the company's capacity to pay creditors) with a test that directors must reasonably believe that the company will be solvent immediately after payment of the dividend. This is similar to the solvency test that applies in other places, eg, on insolvent trading, but the reduction of capital rules in corporate law still have the same version of the second and third tests in the 2010 dividend rule.
The EM purports to clarify the issue of the relationship between the dividend and share capital reduction tests. It says that the new dividend test does "not displace" the share capital test which "continues to apply." It's not immediately clear what this means. Does a dividend which creates or increases negative retained earnings have to comply with the reduction of share capital rules? The major corporate law difference is that a shareholder resolution is required for reductions of capital but not (depending on the constitution of the company) for dividends. Submissions to government in the past have highlighted the lack of clarity in this area and it is disappointing that the issue has not been clarified. Presumably the EM means, at the least, that a dividend cannot be debited against share capital account, even if assets exceed liabilities and solvency will not be affected.
This question also has to be considered in the light of the recent High Court tax decision in the Consolidated Media case that a negative account (created on a share buyback) had to be considered along with other accounts of the same class (share capital in that case). Is a negative retained earnings account a share capital account even though positive retained earnings clearly is not?
The ED also clarifies the time when the corporate law dividend tests are applied – just before declaration for dividends that are declared and just before payment for dividends that are paid without being declared. It does not directly address the fact that directors would normally be relying on accounts prepared to some previous date (interim or final financial accounts for the previous period) and the ATO seems to treat this requirement strictly in its ruling on the tax implications of the 2010 changes.
In relation to tax, the ED proposes no change to the law and the EM states:
1.19 A central feature of the income tax law is that, to the extent that a company makes a distribution out of profits, that distribution is generally taxed as a dividend and may have franking credits attached to it. Otherwise, it is generally treated as a tax-deferred return of capital, and cannot have franking credits attached to it. A number of integrity provisions in the income tax law reinforce this principle.
1.20 The new dividends test is not designed to change taxation arrangements for dividends.
So the 2010 change to tax law that anything which is a dividend for tax purposes as defined in the tax law is deemed to be out of profits is left in place. The ATO based on counsel's opinion takes the view that the word dividend in corporate law implicitly requires that the payment be out of profits and so the 2010 corporate law dividend test simply adds additional requirements to the former out of profits test and does not displace it. Nothing is done in the ED to change the basis of counsel's opinion. Presumably the EM is intended to signal that Treasury is not proposing to disturb what the ATO has stated in its ruling, though it was reasonably clear in the discussion paper leading to the ED that there were differences of opinion between Treasury and the ATO on corporate law issues.
This still leaves us with working out where we are in tax law after the 2010 change which will not be affected by the ED. Counsel say the 2010 tax law change is otiose but the ATO does not directly seem to adopt this view.
The tax legislation also retains the out of profits concept in a number of other contexts where neither the 2010 changes to tax and corporate law nor the ED have any impact, eg the definition of distributable surplus for private company deemed dividends, the reduction of reduced cost base for distributions of preacquisition profits, and the franking of non-share dividends.
In our past several tax briefs on the important issues of what is a dividend and when is it frankable for tax purposes we have commented on the on-going confusion in the law. Plus ça change ...
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