On 14 September 2022, Treasury released exposure draft legislation Treasury Laws Amendment (Measures for a later sitting) Bill 2022: Franked distributions funded by capital raisings (Exposure Draft). If enacted, it will give effect to an integrity measure announced in the 2016-17 Mid-Year Economic and Fiscal Outlook.
The proposed measure will prevent companies from attaching franking credits to distributions to shareholders made outside of, or additional to, the company's normal dividend cycle, to the extent the distributions are funded directly or indirectly by capital raising activities that result in the issue of new equity interests. In particular, shareholders will be affected by the new measure through the receipt of unfranked distributions.
Importantly, the measure will apply to future distributions as well as those made as far back as December 2016.
KWM is planning to submit a response to the consultation on the Exposure Draft, which ends on 5 October 2022. Should you wish to discuss the Exposure Draft and how it may affect past or future distributions, please contact one of the authors or your KWM contact.
Background to the measure
The measure is designed to address a mischief first described in Taxpayer Alert 2015/2 (TA). In the TA, the Australian Taxation Office (ATO) announced its intention to scrutinise certain arrangements that involved:
- a company with significant franking credits raising new capital from existing or new shareholders (e.g. through a renounceable rights issue); and
- at a similar time to the capital raising, the company making franked distributions to its shareholders in a similar amount to the amount of capital raised (e.g. as a special dividend or through an off-market share buy-back).
Specifically, the ATO was concerned that such arrangements released franking credits (that may otherwise have been retained by the company) or streamed dividends to shareholders in a way that attracted the operation of the anti-avoidance rule in section 177EA of the Income Tax Assessment Act 1936 (Cth) or other anti-avoidance rules.
Key observations
At first glance, the Exposure Draft merely seeks to implement a measure announced in 2016 by the previous Federal Government.
However, the current drafting may have unintended consequences that could be of significant concern to companies that have engaged, and will engage, in capital raising activities and that have made, and will make, franked distributions to shareholders.
We are concerned that the current drafting may be capable of impacting a significant number of capital raising activities, including activities we would consider are market practice.
It is also likely to mean more distributions may be within the scope of the measure, which makes a retrospective application problematic and concerning for taxpayers and shareholders.
Proposed amendments
The Exposure Draft would prevent “distributions funded by capital raisings” from being franked by the operation of section 202-45 of the Income Tax Assessment Act 1997 (Cth).
The new measure would apply where:
(a) the distribution in question is distinct from an established practice of the entity making the distribution (if any);
(b) there is an issue of equity interests in the entity (before, at, or after the time the distribution in question was made);
(c) it is reasonable to conclude having regard to all relevant circumstances that:
(i) the principal effect of any of the equity interests issued was the funding (directly or indirectly) of the distribution (or any part thereof); or
(ii) any entity issuing (or facilitating the issue of) any of the equity interests had the purpose (not including an incidental purpose) of funding the distribution (or any part thereof).
Concerns with the measure
Applies to the entire distribution
The entire distribution ceases to be able to be franked even if the test is satisfied only in relation to some of the capital raised from an issue of equity interests or part of a franked distribution. It appears that it is sufficient for the measure to apply where the purpose of an equity raising was only to fund a part of the distribution. Again, this is likely to mean the measure will apply in more circumstances than was expressed by the TA and the 2016 announcement.
This does not appear to be consistent with the expressed policy of the measure.
Applies retrospectively
The measure will apply retrospectively to distributions made on or after 19 December 2016.
The Commissioner will have 12 months after the amending legislation receives Royal Assent to amend prior year assessments to give effect to the amendments. This could impact the position of shareholders. The Government is unapologetic for this – it points out that the December 2016 announcement made it clear that the measure, when introduced, would apply retrospectively. In fact, the Government says the retrospective application is necessary. At the same time, Treasurer Jim Chalmers is quoted as saying the measure is a ‘very minor change’.[1]
Unclear why measure is needed
It appears the ATO may have considered the release of the TA sufficient. At the 27 November 2015 meeting of the ATO Tax Practitioner Advisory Group, the ATO provided an update in relation to the TA. The update included that the ATO would be:
"issuing additional market guidance for payer companies, for example those entities paying franked distributions funded by linked capital raisings (as a follow-on from Taxpayer Alert 2015/2) in early 2016 to provide further certainty regarding those transactions we consider to be low compliance risk, and those we consider to be high compliance risk."
That guidance was never issued.
Previous Government did not enact the legislation
It appears the previous Government may also have moved on from the policy. At the very least, it appears it had no interest in legislating the policy, in particular during 2020 and 2021 when COVID was wreaking havoc and a large number of listed companies raised equity on the capital markets.
Around 110 of the ASX200 entered into approximately 400 capital raising transactions between 1 March 2020 and 31 December 2021. A large number of ASX200 companies also paid dividends during that time. A smaller number of companies both raised equity and paid a dividend in that period.
The ATO showed common sense and compassion during COVID and was praised for doing so. It will be interesting to see the ATO’s approach to compliance in respect of capital raisings and distributions made not just during COVID but back to December 2016.
Nonetheless, given the history of this measure, it is concerning that the Government insists on it having a retrospective application. We expect much will be made of this during consultation on the measure.
What is the ‘mischief’ that is being addressed and why do we need this measure?
The Explanatory Materials accompanying the Exposure Draft states that the proposed amendments are designed to ‘prevent entities from manipulating the imputation system to obtain inappropriate access to franking credits’.
The ‘mischief’ to be addressed is ‘the use of artificial arrangements under which capital is raised to fund the payment of franked distributions to shareholders and enable the distribution of franking credits’.
It is not obvious from the Exposure Draft what the real mischief is.
The TA and the 2016 announcement also do not specifically address this question.
The TA provides that the ATO was concerned about arrangements releasing franking credits that may otherwise have been retained by the company.
It is not clear that this is a policy underlying the imputation system in the absence of a broader strategy of dividend streaming to avoid wasting franking credits. Further, it is not apparent why raising funds by issuing equity is mischievous but doing so by way of debt is not.
In each case, the financial position of the company raising funds and paying distributions is different before and after the transactions in a real and potentially substantive way.
Whatever the ‘mischief’ is, the measure goes beyond transactions that we consider could be challenged under section 177EA – noting that section 177EA was the anti-avoidance rule specifically raised by the ATO in the TA – and that were contemplated by the TA and the 2016 announcement.
Practically, there are also several potentially significant unintended consequences — for companies, shareholders, and capital markets alike — that could flow from the proposed changes.
Start-ups
Fast-growing small and medium-sized companies, including start-ups, would be impacted by the new rules. In the absence of profits, these companies typically fund their early growth by raising capital from shareholders, to whom they aim to eventually pay dividends. Without a practice of making distributions on a regular basis, the measure could apply to early distributions by such companies.
Dividend reinvestment plans
A strict reading of the Exposure Draft may mean the measure captures distributions that are accompanied with dividend reinvestment plans.
By definition, dividend reinvestment plans involve the payment of dividends that are simultaneously reinvested by the shareholder, resulting in a capital raising by the company. As mentioned, the entire distribution ceases to be frankable even if the test is satisfied only in relation to some of the capital raised from an issue of equity interests or part of a franked distribution. Therefore, there is a risk such plans could result in distributions being unfrankable.
