Australian Tax Brief

The Australian Taxation Office (ATO) has now released (on 21 December 2011) draft taxation ruling TR 2011/D8 which sets out the circumstances in which the ATO consider that a distribution made by a company in accordance with section 254T of the Corporations Act and the company's constitution may be franked.  The date of effect for the final ruling is proposed to be from 28 June 2010 – that is, with retrospective effect.  Comments are due by 24 February 2012.  In releasing the draft ruling, the ATO have notably also provided a copy of the joint opinion received from Counsel on these issues.

The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Reform Act), replaced the profits restriction for declaring dividends with a balance sheet test.  Section 254T of the Corporations Act, 2001¹ now provides that a company must not pay a dividend unless:

1. the company's assets² exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend (the balance sheet test) and
   
   
2. the payment of the dividend is fair and reasonable to the company's shareholders as a whole and
   
   
3. the payment of the dividend does not materially prejudice the company's ability to pay its creditors.

Unclear drafting of the 2010 amendments has raised a question whether a dividend complying with these new requirements will nevertheless be unlawful if it amounts to a reduction of share capital and the shareholder approval procedure of Part 2J.1 is not followed.  In its recent discussion paper, Treasury does not accept that the present drafting is unclear but is prepared to contemplate an amendment that would have the effect that a dividend complying with section 254T is an authorised exception to the reduction of capital rules.

Nevertheless the new section 254T expands the circumstances in which a dividend can be paid by removing the profits test.  

For tax purposes, a distribution to a shareholder is taken to be a dividend unless specifically excluded.  A specific exclusion applies for a distribution which is debited to the share capital account of the company.  In 2010, the Tax Act was also amended to ensure that a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits.  These amendments did not disturb the specific exclusion for distributions resulting in a debit to the company's share capital.

A distribution can only be franked for tax purposes where it meets the franking requirements under the Income Tax Assessment Act, 1997 (the Tax Act).  Relevantly, the franking rules do not permit a distribution that is sourced directly or indirectly from a company's share capital account to be franked.³  

The draft ruling in effect concludes that company distributions may only be franked where they represent a distribution of 'booked' profits (thereby practically re-instating the profits test for tax purposes).

Summary of ATO views

In their draft ruling, the ATO indicate that a company may frank a dividend paid to its shareholders (assuming compliance with 254T and Part 2J.1 of the Corporations Act and the company's constitution) provided the dividend is:

• paid out of current trading profits recognised in its accounts and available for distribution (even where the company has unrecouped prior year accounting losses or has lost part of its share capital)
  
  
• paid out of an unrealised capital profit of a permanent character recognised in its accounts and available for distribution provided the company’s net assets exceed its share capital by at least the amount of the dividend.

The ATO also consider that a distribution (even if it is labelled as a dividend) paid by a company to its shareholders, that does not comply with section 254T or Part 2J.1 of the Corporations Act, is an unauthorised reduction and return of share capital that will be taxed as a CGT event under the capital gains tax provisions in Part 3-1 of the ITAA 1997, or will be taxed as an assessable unfranked dividend, depending on the particular facts and circumstances of the payment.  This will include a 'dividend' from 'unbooked' profits, underived profits, asset accounts such as internally generated goodwill, negative reserve accounts or a gross amount of other comprehensive income.

What remains uncertain

The draft ruling does not express any view on whether a franked dividend can be paid out of an unrealised capital profit where a company has a deficiency of net assets below its share capital on the basis that these are questions of fact and law that cannot be dealt with in this public ruling.⁴ This question would need to consider the specific circumstances of the loss of subscribed capital, the nature of the unrealised profit, whether the company’s accounts reveal other profits and losses, and the interpretation of section 254T of the Corporations Act.
The following examples (extracted from the draft ruling) suggest that unless the directors have determined to book any unrealised profits in the company's accounts, then any distribution in these circumstances is likely to be considered a return of capital (un-frankable) or sourced indirectly from the company's share capital account and so therefore be un-frankable.

Example 3: Debit to reserve

Company B has the following balance sheet:

Company B is assumed to have a positive franking account balance due to its activities in prior years. Company B determines to pay an $80 dividend. To pay the $80 dividend the company makes the following accounting entries:

In this example, the company has sourced the distribution from a species of profit account which is ascertained in its accounts, namely the asset revaluation reserve, although it does not have any current or retained earnings. The payment of the $80 dividend does not result in net assets being less than share capital either before or after the dividend payment. On this basis, the dividend will be assessable under paragraph 44(1)(a) of the ITAA 1936, and will be a frankable distribution as it will not be sourced indirectly from the share capital account.

However, a company’s accounts may contain no positive profit amounts and only be represented by positive amounts of share capital. In those circumstances where the distribution is debited to retained earnings⁵ when the 'net asset' test in s 254T of the Corporations Act is satisfied, such a distribution would be sourced indirectly from share capital for the purposes of paragraph 202-45(e) of the ITAA 1997. Accordingly any such distribution either would not be considered to be a dividend, and would be taxable under the capital gains tax provisions; or if a dividend it would be assessable under paragraph 44(1)(a) as a result of the deeming in subsection 44(1A) of the ITAA 1936, and considered an unfrankable distribution sourced indirectly from a company’s share capital account.

Example 5: dividend paid out of an amount other than retained earnings (such as a reserve account) and net assets are less than share capital

Company D has the following balance sheet:

The company purports to determine to pay a dividend of $100 pursuant to the new section 254T of the Corporations Act.
Company D does not credit accumulated losses but rather creates a dividend reserve to effect payment:

The balance sheet of Company D post dividend distribution will be as follows:

Assuming such accounting entries and such payments are possible under the Corporations Act, given that the dividend reserve is not a profit reserve and net assets do not exceed share capital, the payment would not be a dividend for taxation purposes and would be taxed as a return of capital under the capital gains tax provisions. Alternatively, if the payment was a dividend for taxation law purposes, it would be assessable under subsection 44(1A) and unfrankable on the basis that it was sourced indirectly from the share capital account of Company D under paragraph 202-45(e).⁶

In circumstances where a company has a deficiency of net assets below its share capital, whether a dividend can be paid out of an amount other than profits, and whether it would be a frankable distribution are questions of fact and law, the answers to which depend on the specific facts and circumstances of the loss of subscribed capital, the nature of the unrealised profit, whether the company’s accounts reveal other profits and losses, and the interpretation of section 254T of the Corporations Act.

In conclusion

The draft ruling in effect concludes that a company distribution may only be franked where it represents a distribution of 'booked' profits (thereby practically re-instating the profits test for tax purposes).  Plainly this is an unsatisfactory state of the law and creates much uncertainty for companies in managing their shareholder distribution policies in all other circumstances.
Hopefully some clarity on the corporate law requirements will be achieved if the Corporations Act is sensibly amended after Treasury's review (see our Alert – Dividends: untangling the web of 2 December ).  We also recommend that the tax rules are reconsidered as part of this review to ensure the dividend policy objectives for tax and corporations law are aligned.  The situation needs to be resolved with some urgency, in time for the 2012 financial reporting season.

These issues are necessarily complex, involving an intersection of legal, accounting and tax considerations but are also fundamental for our capital markets.  

¹ The Corporations Amendment (Corporate Reporting Reform) Act 2010 (the CACRRA) amended section 254T of the Corporations Act, 2001 to remove the requirement that a dividend must be declared only out of profits with effect from 28 June 2010.

² Assets and liabilities are calculated in accordance with accounting standards in force at the time. If a company is not required to prepare audited financial reports, balance sheet solvency can be determined by reference to the records required to be kept pursuant to section 286 of the Corporations Act (see paragraph 3.12 of the Explanatory Memorandum to the Reform Act).

³ section 202-45(e) of the Tax Act

⁴ For some further consideration of these issues see the legal opinion obtained by the Commissioner in connection with this ruling, ATO 254T advice final 1211.

⁵ The Commissioner is given to understand that this would be to negative retained earnings in this context. The example proceeds on the assumption that section 254T of the Corporations Act does not prohibit such a distribution.

⁶ In Consolidated Media Holdings Limited v Commissioner of Taxation [2011] FCA 367, Emmett J held that irrespective of the fact the account was not called the share capital account, it was held to be an amount of share capital.