Franking credit trading occurs when franking credits are diverted from the true economic owners of the membership interests to others who can most benefit from the use for the credits.
Franking credit trading is addressed by:
- exempting entity rules
- qualified person test
- dividend washing rule
- anti-avoidance provisions in sections 177EA and 177EB of the Income Tax Assessment Act 1936 (ITAA).
An exempting entity is a corporate tax entity that is 95% or more effectively owned by prescribed persons (which includes foreign residents and tax exempt entities that cannot fully use franking credits). When an entity ceases to be an exempting entity and it is not again an exempting entity, it becomes a former exempting entity.
To ensure that franking credits accumulated by an exempting entity are not the target of franking credit trading the rules in Division 208 of the ITAA 1997:
- limit the circumstances in which a distribution, franked with credits from an exempting company's franking account, can give rise to benefits under the imputation system
- quarantine credits of an exempting company that becomes a former exempting entity by moving them into a separate account called an exempting account, and requiring the entity to start a new franking account
- deny a recipient of a distribution franked with an exempting credit from any benefit under the imputation system as a result of that distribution, unless the recipient was a member of the entity immediately before it became a former exempting entity.
To be entitled to a franking credit tax offset, a taxpayer is required to be a 'qualified person' in relation to a franked dividend. The qualified person test ensures only the true economic owners of shares benefit from franking credits attached to distributions made from the shares.
A shareholder generally meets the qualified person test if they satisfy either the:
An individual shareholder can also be a qualified person if the small shareholder exemption applies – that is, if they have a total of less than $5,000 franking credits in an income year (whether their shares are a single parcel or a portfolio made up of several parcels). In this case they are entitled to franking credits for all shares that satisfy the related payments rule, without having to satisfy the holding period rule.
- see eligibility details in Refunding franking credits – individuals
- tax return instructions in You and your shares 2019
The holding period rule requires shares to be held ‘at risk’ for a continuous period of at least 45 days (90 days for preference shares) during the qualification period.
The 45-day and 90-day periods don't include the day of acquisition or, if the shares have been disposed of, the day of disposal. Also excluded are days where the financial risk of owning the shares is materially diminished. For example, the financial risk may be reduced through arrangements such as hedges, options and futures.
The primary qualification period begins the day after the shares are acquired, and ends 45 days after the ex-dividend date.
Because of the way the qualification period is defined, the holding period rule only needs to be satisfied once per parcel of shares – that is, if a shareholder is a qualified person for a distribution from shares under that rule, they will also qualify for subsequent distributions from those same shares, unless the related payments rule applies.
If a shareholder purchases substantially identical shares over a period, the holding period rule applies a ‘last in first out’ method to establish which shares satisfy the holding period rule.
Testamentary trust individual beneficiaries who have a vested interest in the dividend income of the trust, but do not have current beneficial ownership of the underlying shares (such as life tenants) will have franking credits and associated tax offsets denied by the holding period rule.
For certain institutional taxpayers (such as superannuation funds and listed widely held trusts) there is an alternative test. Instead of applying the holding period rule, eligible taxpayers can elect to have a franking rebate ceiling apply. Under this test, the maximum franking rebate a fund is entitled to in an income year cannot exceed the amount (increased by 20%) of franking credits to which the taxpayer would be entitled in respect of dividends paid on a benchmark portfolio of shares with the fund's net equity exposure.
- For monthly franking credit and rebate yields on a share portfolio, refer to the list of yields in Company tax & imputation: average franking credit & rebate yields
This rule applies to a distribution on shares when there is an obligation to pass on the benefit or value of the distribution to someone else.
The related payments rule requires shares to be held ‘at risk’ for at least 45 days (or 90 days for preference shares) during the relevant qualification period (that is, the secondary qualification period). Like the holding period rule, the day of acquisition and, if relevant, disposal, is excluded, as are any days of diminished risk.
The relevant qualification period begins 45 days before the ex-dividend date and ends 45 days after.
The rule applies to each distribution on those shares where a related payment is made.
The dividend washing integrity rule prevents taxpayers from obtaining franking credits if they have engaged in dividend washing.
Dividend washing is a practice through which taxpayers seek to claim two sets of franking credits. They do this by selling shares held on the Australian Securities Exchange (ASX) on an ex-dividend basis (retaining the dividend entitlement) and then effectively repurchasing the same parcel of shares on a different ASX trading market (the special market) on a different basis (cum-dividend, meaning that you also acquire the entitlement to the dividend on this parcel of shares). The timing of when this transaction occurs can lead to an entitlement to two sets of dividends on what is economically the same parcel of shares.
The operation of the integrity rule means that if you receive a dividend as a result of dividend washing, you are:
- not entitled to a tax offset for the franking credits associated with the dividend received on the equivalent parcel of shares purchased on the special ASX trading market
- not required to include the amount of the franking credits on those shares in your assessable income.
The integrity rule applies to distributions received on or after 1 July 2013. However, for distributions made before this date, the Commissioner of Taxation may apply section 177EA of the Income Tax Assessment Act 1936 to deny franking credit benefits received through dividend washing arrangements.
See alsoRestrictions on franking credit trading are designed to prevent franking credits being diverted from the true economic owners of the membership interests to others who can most benefit from the use for the credits.