Background
Section 207-159 was introduced by Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 (Royal Assent received on 27 November 2023) as part of the Income Tax Assessment Act (C’th) 1997 with the aim of treating as unfrankable a distribution which is funded by a capital raise.
Section 207-159 was designed to address arrangements that are entered into for a purpose (but not an incidental purpose) and with the principal effect, of accelerating the release of franking credits to members of entities in circumstances that cannot be explained by existing distribution practices, and which are typically artificial or contrived.
Section 207-159 applies to arrangements that meet all of the below conditions:
1. The distribution is not consistent with an established practice of the entity making distributions of that kind.
A non-exhaustive list of statutory factors to consider in relation to this requirement include:
- the nature of distributions;
- the timing of distributions;
- the amount of distributions;
- the explanations given by the entity for making such distributions; and
- the amount of franking credits on the distributions.
The PCG provides examples of what the ATO considers to be – and not to be – a distribution consistent with ‘established practice’. In Example 1, the relevant business paid fully franked dividends bi-annually, with a stable payout ratio, for the previous three years. In this case, the ATO said that they would not apply compliance resources to review this arrangement. Conversely, the issue of a special dividend that does not align with an increase in the business’ profits would more likely be investigated by the ATO.
2. There was an issue of equity interests by the entity making the distribution or a different entity. The issue of interests can occur before, at or after the distribution.
An obvious situation that will pique the interest of the ATO is where capital is issued close to the timing of a dividend distribution, and that capital raise has no clear links to operational needs. Reasons for a capital raise such as ‘for general corporate purposes’ is likely to rouse ATO suspicion.
3. The principal effect and purpose of funding a substantial part of the distribution.
Pleasantly, the ATO clarifies that the unfrankable amount will be the portion of the distribution that is directly or indirectly funded by the capital raise. However, the PCG is vague on what ‘indirectly’ means in this context. It will be important to maintain a robust trail of documentation of the use of funds from a capital raise. The ATO clarifies what types of documentation it will review when applying the provisions e.g. including (but not limited to) minutes of the board, the entity’s annual reports, announcements to a securities exchange, scheme implementations deeds/agreements and disclosure documents with a regulator or securities exchange.
The ATO also provide additional guidance on what constitutes a ‘substantial part’ of a distribution, being at least 20%. This is a welcome increase from the 5% threshold that was proposed in the draft PCG, and neatly resolves the issue of these provisions inadvertently capturing capital raises serving dual (or even multiple) purposes. However, just because the capital raise funded more than 20% of the distribution does not automatically make it ‘substantial’. The PCG outlines several other factors which must be considered in this respect, making this requirement ambiguous. Although tax advisers are no strangers to navigating ambiguity, it does mean that your tax adviser is more likely to recommend applying for a private ruling to obtain certainty.
4. The issue of equity interests is not a direct response to a direction, recommendation or requirement from the Australia Prudential Regulation Authority (APRA) or Australian Securities and Investment Commission (ASIC).
The reasoning behind this requirement is relatively self-explanatory – it would be unfair to penalise a company for complying with APRA or ASIC directives/recommendations.
Risk zones
The PCG outlines what the ATO considers to be a low risk (‘green zone’) and high risk (‘red zone’) arrangements.
Green zone arrangements are ones that have strong commercial purpose, where the business can show a consistent dividend history and/or capital raises that fund less than 20% of the dividend.
Red zone arrangements include those that have unusually large or one-off dividend payments, documentation that cites vague reasoning for the capital raise and/or capital raises that closely mirror dividend distributions.
The PCG goes on to provides several examples that the ATO considers to fall within the green and red zones. However – and not unexpectedly – the PCG cannot practically cover every such example, and there are some common situations that have not been addressed. While the PCG makes helpful comments about pre-sale dividends, these appear to be limited to ‘private companies’.
What next?
Overall, this will be a very difficult area of the law to apply in practice. The red zone arrangements described in the PCG appear relatively confined, targeting arrangements where there is no clear commercial purpose of the capital raise other than to fund a distribution that can utilise franking credits. However, the legislation is broadly drafted. We suspect that there will be a number of arrangements in the ‘grey zone’, where it is genuinely unclear whether they fall within the scope of these provisions.
There are some measures that can be taken to reduce the risk of an arrangement being caught under s207-159, including:
- Make sure documentation clearly and precisely expresses the commercial rationale for the capital raise.
- Avoid vague language – such as ‘strategic flexibility’ and ‘general corporate purposes’ – when discussing the rationale for a capital raise.
- If the facts are complex or unclear, consider applying for a private ruling to obtain certainty.
However, in the context of an M&A transaction, it may be challenging to seek a private ruling where there are tight timelines on completion. Therefore, if you are contemplating an M&A transaction that involves a pre-completion dividend, we recommend considering this matter well in advance of the Completion date.
For further information or assistance, please feel free to contact us.
Learn more about how our Corporate tax & advisory services can help you
*The ATO releases draft guidance on funding franked dividends with capital raising
