Franking credits changes back on the agenda – with effects on distributions funded by capital raisings

Since the Henry review, successive governments in Budget and Mid-Year Economic and Fiscal Outlook (MYEFO) speeches have announced tax changes that have simply been filed away in the bottom drawer of Treasury's filing cabinet. This has often caused administrative difficulties as the date of effect of such measures is when announced, rather than legislated.

While the broader tax community has been hoping for certain changes – such as the announced TOFA changes or expansion of the treaty network – there are others that it was hoped it would be long forgotten. Unfortunately, the Government has picked up the previous Government’s 2016-2017 MYEFO policy regarding franking credits, releasing for consultation the Treasury Laws Amendment (Measures for a later sitting) Bill 2022: Franked distributions funded by capital raisings.

The draft Bill seeks to amend section 202-45 of the Income Tax Assessment Act 1997 by including a new type of unfrankable distribution. The proposed section 207-159 seeks to make a distribution unfrankable where the distribution is funded by a capital raising. This would have the effect of denying an offset for the investor for the associated franking credit, and for foreign investors subjecting the distribution to withholding tax as if it were an unfranked dividend.

Distributions funded by a capital raising

A distribution will be considered to be funded by a capital raising where:

• The distribution is not consistent with an established practice of the entity making distributions of that kind on a regular basis.
• There has been an issue of equity interests in the entity or another entity, and
• It is reasonable to conclude in the circumstances that either:
• The principal effect of the issue of any of the equity interests was to directly or indirectly fund some or all of the distribution; or
• Any entity that issues or facilitated the issue of any of the equity interests did so for the purpose (other than an incidental purpose) of funding the distribution or part of the distribution.

Franking credits changes going further than expected

While there is some merit to the measures (albeit existing integrity measures probably were sufficient), they have been crafted in a manner that could have quite broad and unintended consequences, in particular:

• The measures assume that all companies have fixed and standard distribution policies. A company may potentially fall within the rules in circumstances where there has been an unintended influx of money (insurance claim, successful resolution of a dispute, or some other windfall gain) and rather than keep the cash on the balance sheet, have paid the money out to investors, or even where there has been intervening circumstances (ie. a pandemic), where dividends were paused, and a catch-up dividend is made.
• The draft explanatory memorandum states that the issue of the equity interests could occur either before or after the distribution. This broad application of the rules could render capital releases as part of transactions subject to the rules.

Retrospective application of the proposed changes to franking credits

The initial consultation paper noted that the rules would have retrospective application from 19 December 2016, however after a short consultation period, the Assistant Treasurer announced that this may be revisited, although the announcement makes no reference to transitional measures or how the retrospective application would apply. In particular:

• How would a retrospective application of the rules be administered by the ATO? In the context of the application of the measures to a listed entity, is the ATO intending to go back an amend the returns of all investors on the register at that date or will a penalty be imposed on the company?
• If it is a tax that will be imposed on the investor, will this be a shortfall tax that will not be subject to penalties, as in these circumstances the investor was not at fault for this shortfall?
• If it will be a tax on the company, would this be imposed by way of an additional debt to the franking account of the company, similar to the share buyback provisions? If this was to occur, would the additional debit be at the time the distribution was made? This could lead to flow-on franking deficit tax issues.
• For companies that are no longer in operation, will the ATO have no other means but to go against the broad class of shareholders?
• For foreign shareholders of companies impacted by the rules, how will the ATO seek to administer the application of treaty benefits? Will a pragmatic approach be adopted, or would foreign shareholders have to seek a retrospective tax reclaim?
• As a key beneficiary of franked dividends, superannuation funds face a key question:  how would the retrospective application of these measures operate from a member equity perspective? No doubt APRA would be closely monitoring the fallout of these measures.