On 27 June 2012, the Australian Taxation Office (ATO) released its final tax ruling, setting out the circumstances in which the ATO considers that a franked distribution may be made by a company. The position adopted is broadly consistent with its previous draft ruling, with additional clarification on the areas of uncertainty raised during the consultation process.
In summary, although new section 254T of the Corporations Act, 2001 was intended to expand the circumstances in which a dividend can be paid by removing the profits test, the 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).
The ruling explores some important intersections between tax law and company law, including:
- the different franking outcomes for tax purposes for each of the following components of earnings:
- revenue profits
- unrealised 'capital profits', and
- other comprehensive income.
- when profits are otherwise appropriated and accordingly unavailable for distribution as a dividend, and
- the tax treatment of distributions made contrary to section 254T of the Corporations Act, 2001.
These issues are necessarily complex but have important implications for company boards in signing off the year end and interim financial accounts. Understanding these issues is fundamental to prepare for the reporting and distribution season.
The ruling applies with retrospective effect from 28 June 2010.
Summary of ATO views
The ATO indicates that a company may frank a dividend paid to its shareholders (assuming compliance with section 254T and Part 2J.1 of the Corporations Act and the company's constitution) provided the dividend is:
(a) paid out of 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), or
(b) 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.
A company may not frank a distribution that is sourced directly or indirectly from share capital, including an authorised reduction or return of share capital and an unauthorised reduction or return of share capital that does not comply with section 254T and Part 2J.1 of the Corporations Act, even if it is labelled a dividend. 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.
The ruling does not address the proper construction of the tax definition of 'share capital account' which was raised in Consolidated Media Holdings Ltd v Commissioner of Taxation  FCAFC 36 and which is the subject of a special leave application to appeal to the High Court.
Although no ruling is made on:
- whether profits are available for distribution as a dividend, and
- have been distributed as a dividend in compliance with the law,
some practical observations are provided in the explanatory section on these threshold issues.
Are profits available for distribution?
According to the ATO:
- Profits must be recognised in a company's accounts and be available for distribution by way of dividend in order for a dividend to be franked.
- ‘Profits’ means profits recognised in a company’s accounts which are available for distribution by way of dividend. Profits include:
(a) revenue profits from ordinary business and trading activities, dividends received from other companies, and realised 'capital profits' recognised in the statement of financial performance in a company’s accounts, and
(b) unrealised 'capital profits' of a permanent character recognised in a company’s accounts.
Dividends sourced from revenue profits are contrasted to dividends sourced from unrealised 'capital profits' of a permanent character and are treated differently in terms of a company’s ability to frank a dividend, having regard to the company’s net asset position compared to its share capital.
Profits do not include amounts of income or loss included in the other comprehensive income (for example, temporary fluctuations in asset values) irrespective of the fact that those amounts contribute to the retained earnings/accumulated loss account in the statement of financial position in a company’s accounts.
Profits can be recognised in the company's annual financial statements for the preceding year, or in properly prepared half yearly or interim financial statements for the current financial year.
The source of the profits from which a dividend will be paid would usually be expected to be recorded in the directors' minutes of the resolution determining to pay or declaring a dividend, or in the documentation that accompanies or supports the resolution, or in notes to the accounts.
Profits are generally considered to be available for distribution as a dividend if they have not been appropriated or earmarked for other purposes.
If profits are applied against prior year losses or losses of share capital or otherwise applied or appropriated they will cease to be available for distribution by way of a dividend.
Where profits are offset or netted against accumulated losses in the accounts and there is no other evidence that is inconsistent with the application of profits against losses in the accounts, it will generally be concluded that profits are no longer available for dividend distribution. Any dividends subsequently purportedly paid out of them would be taxed either as an unfrankable dividend, or a return of share capital subject to the capital gains tax provisions, depending on the particular facts and circumstances.
There are various ways in which profits may be identified as not earmarked or appropriated for purposes other than payment of a dividend, including (according to the ruling):
a legally effective resolution determining or declaring to pay a dividend out of the profits of that year or half year at the same directors' meeting as that at which the accounts are approved by the directors,
carrying the profits for a particular year to a separate profit reserve in the statement of financial position and the statement of changes in equity in a company's accounts, rather than to reduce the balance of accumulated losses carried forward by offsetting or netting the profits against the accumulated losses account in those statements.
To the extent that profits are offset or netted against accumulated losses in the statement of financial position and the statement of changes in equity in a company's accounts are not appropriated for dividend distribution (by declaration of, or determination to pay, a dividend by a meeting of the directors) at the time the final year accounts are approved by the directors, the ruling states it will generally be concluded that they have been appropriated to the reduction of prior year losses in the company's subsequent accounts, and are thereafter no longer available for distribution as a dividend in subsequent periods.
What does this mean for Corporations Law reforms
The Corporations Amendment (Corporate Reporting Reform) Act 2010 (Reform Act), replaced the restriction that dividends must only be declared out of profits with a balance sheet test. Section 254T of the Corporations Act, 2001 now provides that a company must not pay a dividend unless:
(a) the company's assets 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
(b) the payment of the dividend is fair and reasonable to the company's shareholders as a whole, and
(c) the payment of the dividend does not materially prejudice the company's ability to pay its creditors.
The new section 254T prohibits the payment of a dividend in certain circumstances. The section does not authorise a reduction of capital by the company. However, the effect of new section 254T was intended to expand the circumstances in which a dividend can be paid, by removing the profits test. Where the tax rules do not permit or align the circumstances in which a franked dividend can be declared, then this objective is somewhat undermined.
Subsection 44(1A) was inserted into the Income Tax Assessment Act, 1936 (ITAA 1936) at the time of the Reform Act to ensure that any company distributions that were not paid out of profits but were paid as dividends in reliance on the new section 254T of the Corporations Act, would continue to be taxed as assessable dividends under section 44 of the ITAA 1936 - by deeming such dividends to be paid 'out of profits' for taxation purposes. This excludes amounts debited against an amount standing to the credit of the share capital account - which are not dividends for taxation purposes under the definition of dividend in subsection 6(1) of the ITAA 1936. However, although dividends paid or credited in compliance with new section 254T of the Corporations Act will be an assessable dividend for taxation law purposes, they will not thereby be eligible to be franked under the Tax Act. Importantly, the tax rules do not permit a distribution that is sourced directly or indirectly from a company's share capital account to be franked.
Implications for Company Boards
The ruling requires the Board to comply with the requirements of new section 254T and to determine that there are available 'booked' profits before a 'franked' distribution may be declared – thereby practically re-instating the profits test for tax purposes.
Company boards will therefore need to carefully consider both tax and corporations law requirements before declaring 'franked' distributions to shareholders, since they may not always produce aligned results. This includes:
The timing of any dividend declarations and distributions and the recognition of company profits given the ATO view that the profits must be 'booked' before a frankable dividend distribution can be made.
A consideration of the financial position of the company that is paying the dividend (rather than the economic group) to determine whether there are sufficient booked profits to declare a franked dividend from profits rather than share capital. This fact may be easily overlooked where the consolidated group position is important for both reporting and tax filing purposes.
Confirmation that profits have not been applied against prior year losses, losses of share capital or otherwise applied or appropriated since they will cease to be available for distribution by way of dividend. This will be a question of fact, requiring evidence of an appropriation – such as a positive and deliberate act by the directors, a consideration of all the surrounding circumstances including accounting entries, financial reports and company announcements.
Accounts will need to be examined to confirm their substance as either share capital or profits. Accounting or general ledger labels (such as 'Reserve Account') will not be conclusive and indeed may be potentially misleading.
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 (unlike the ATO) 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.
Hopefully some clarity on the corporate law requirements will be achieved if the Corporations Act is sensibly amended after Treasury's review. It would be valuable if 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.
 This depends on the operation of the Corporations Act, on the constitution of the distributing company, and on the conduct of its directors and members.
 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.
 Paragraph 33 of the ruling states that: 33. The better view appears to be that like the previous section 254T of the Corporations Act, the new section 254T does not authorise any act by a company; the section merely prohibits the payment of dividends in the specified circumstances. In particular, the new section 254T does not 'otherwise authorise by law' a reduction of share capital for the purposes of section 256B and Part 2J.1 of the Corporations Act. It appears that the procedures to approve a share capital reduction in Part 2J.1 of the Corporations Act would also have to be met for a company to pay a dividend not prohibited by section 254T of the Corporations Act that was sourced from share capital.
 Section 202-45(e) of the Tax Act