ATO Finalises Guidance On The Equity Funded Dividends Integrity Rule

Late yesterday, the ATO has finalised a Practical Compliance Guideline (PCG) outlining its approach to the application of the franking credit integrity rule for equity funded dividends.

Background

As a brief refresher, the franking credit integrity rule will operate to treat dividends paid by a company as 'unfrankable' where the dividend is not consistent with past practice and it is reasonable to conclude that the principal effect, and a more than incidental purpose, of a capital raising (either by the company or another entity) was to fund, directly or indirectly, a substantial part of the dividend.

We have previously published a Tax Insight article on the ATO's draft PCG (released in December last year) which is available here. As a reminder, a PCG does not have the operation of law but it is used by the ATO as the basis for applying compliance resources, depending on whether the arrangement is considered to be in the Green Zone (low risk) or the Red Zone (high risk).

Key changes

Overall, the changes made to the final PCG are not material but there are some notable changes which may be of interest:

• Clarification on when a dividend is 'consistent with past practice': The ATO has clarified that a dividend will only meet this requirement if the dividend, when compared to dividends paid in the last 3 years is 'fundamentally consistent' – a phrase conspicuously absent from the text of the legislation – with all of the following requirements:
  • Timing (eg bi-annual);
  • Amount (eg consistent payout ratio); and
  • Franking percentage.

• Threshold for 'non-substantial' funding increased from 5% to 20%. The ATO has sensibly raised the threshold for what it considers 'non-substantial' equity funding from 5% to 20% of the franked distribution. This means that if less than 20% of the dividend is funded directly or indirectly via an equity raising, the taxpayer falls into the Green Zone.

• If no substantial part of the dividend is funded by equity, the integrity rule will not apply at all. The law states that the amount of the distribution that is unfrankable is only limited to the portion funded by the capital raising. The final PCG provides a numerical example to support this and also confirms that if no substantial part of the distribution was funded by an issue of equity interests, the ATO considers that the integrity rule will not make any part of the distribution unfrankable. Given the 'non-substantial' threshold of 20% – if, for example, $15 million of capital raised funded a portion of a $100 million distribution – the arrangement should be within the Green Zone.

• Importance of keeping documentation relevant to purpose of capital raising. The final PCG included a new example to illustrate that even where more than 20% of a dividend is indirectly funded by the capital raised, the ATO may accept that the integrity rule does not apply – provided that the taxpayer can demonstrate a broader commercial rationale (including how historical dividend policy was disrupted by external economic conditions) through contemporaneous records. This provides another example in the PCG which illustrates that where an arrangement does not fall within either the Green Zone or the Red Zone, a taxpayer may be able to demonstrate that the integrity rule does not apply if appropriate documentation is retained.

Pre-sale special dividends

The ATO did not take the opportunity in the final PCG to clarify its approach to pre-sale dividends paid by public companies. The PCG maintains that where a bidder funded loan (sourced partly from a capital raising) is used by a 'private company' to pay a pre-sale dividend in the context of a private equity buyout – and the capital raising and distribution are intended to facilitate the shareholder's exit (rather than the payment of the dividend) – the ATO will regard this arrangement as falling within the Green Zone. The justification as to why a distinction should be drawn between private company buyouts but not a take private is not explained. The ATO did clarify, however, that the reference to 'private company' in the PCG is to the defined term in the tax legislation. For those purposes, generally speaking, a private company is any company which is not a listed entity or its subsidiaries.

Overall, for pre-sale dividends, we expect to continue seeing undertakings and representations in transaction documents (particularly scheme implementation deeds and share purchase agreements) to help manage this risk. We also expect to continue seeing target companies approaching the ATO to confirm the availability of franking credits for pre-sale dividends paid in connection with a scheme.

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.