House of Representatives

New Business Tax System (Imputation) Bill 2002

New Business Tax System (Over-franking Tax) Bill 2002

New Business Tax System (Over-franking Tax) Act 2002

New Business Tax System (Franking Deficit Tax) Bill 2002

New Business Tax System (Franking Deficit Tax) Act 2002

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 2 - Franking a distribution

Outline of chapter

2.1 Franking a distribution is the means by which an entity imputes to a member tax it has paid. Therefore, to impute tax paid to its members, the entity must be capable of franking a distribution. This chapter explains how an entity may frank a distribution. In summary, an entity franks a distribution if:

the entity is a franking entity that is a resident when the distribution is made;
the distribution is a frankable distribution; and
the entity allocates a franking credit to the distribution.

2.2 This chapter also explains what rules the entity should have regard to when franking a distribution including the amount of franking credits that should be attached to the distribution, and the obligations the entity has in respect of providing information statements to members when making a distribution to them.

Detailed explanation of new law

Who can frank a distribution?

2.3 To impute tax paid to its members, an entity must be capable of franking a distribution.

2.4 An entity franks a distribution if:

it is a franking entity that is a resident of Australia when the distribution is made;
the distribution is a frankable distribution; and
it allocates a franking credit to the distribution.

[Schedule 1, item 1, section 202-5]

2.5 For these purposes a distribution made by an entity is a:

dividend, or something taken to be a dividend, made by a company;
distribution made by a corporate limited partnership, other than a distribution from profits or gains arising during a year of income in which the partnership was not a corporate limited partnership;
something taken to be a dividend, made by a corporate limited partnership; or
unit trust dividend made by a corporate unit trust or public trading trust.

2.6 A member of a corporate tax entity includes:

a member (including a shareholder) of a company;
a partner of a corporate limited partnership; or
a unit holder in a corporate unit trust or public trading trust.

What is a franking entity?

2.7 A franking entity is a corporate tax entity that is not a mutual life insurance company. Where the entity is a company that is a trustee of a trust it will be a franking entity at a particular time if it is not acting in its capacity as trustee of the trust at that time. [Schedule 1, item 1, section 202-15]

What is a corporate tax entity?

2.8 A corporate tax entity is:

a company (a body corporate or any other unincorporated association or body of persons other than a partnership);
a corporate limited partnership (see Division 5A of Part III of the ITAA 1936);
a corporate unit trust (see Division 6B of Part III of the ITAA 1936); or
a public trading trust (see Division 6C of Part III of the ITAA 1936).

2.9 The following entities are not corporate tax entities:

a non-fixed trust;
a fixed trust (other than a corporate unit trust or a public trading trust);
a complying superannuation fund;
a complying approved deposit fund; and
a pooled superannuation trust.

How does an entity satisfy the residency requirement when making a distribution?

2.10 An entity that is a company or a corporate limited partnership satisfies the residency requirements when making a distribution if, at that time, it is an Australian resident. [Schedule 1, item 1, paragraphs 202-20(a) and (b)]

2.11 A company is an Australian resident if, either:

it is incorporated in Australia; or
if it is not incorporated in Australia - it carries on a business in Australia and either has its central management and control in Australia, or its voting power is controlled by shareholders who are themselves residents of Australia.

2.12 A corporate limited partnership is an Australian resident if and only if:

it was formed in Australia; or
either it carries on a business in Australia, or its central management and control is in Australia.

2.13 A corporate unit trust or a public trading trust will satisfy the residency requirement when making a distribution if, at that time, they were a resident unit trust for the income year in which distribution occurs. [Schedule 1, item 1, paragraphs 202-20(c) and (d)]

2.14 A corporate unit trust or a public trading trust is a resident unit trust if at any time during the income year:

either of the following was satisfied:

-
the unit trust has property situated in Australia; or
-
the trustee of the trust carried on a business in Australia; and

either of the following was satisfied:

-
the central management and control of the unit trust was situated in Australia; or
-
Australian residents hold more than 50% of the beneficial interests in the income or property of the trust.

Which corporate tax entities are excluded from franking distributions?

2.15 Consistent with the imputation provisions contained in Part IIIAA of the ITAA 1936, non-resident corporate tax entities and mutual life insurance companies are excluded from franking distributions.

Which distributions can be franked?

2.16 Not all distributions made by a corporate tax entity can be franked. Generally, only distributions attributable to a corporate tax entitys realised taxed profits can be franked.

2.17 A distribution is frankable unless it is specifically made unfrankable [Schedule 1, item 1, subsection 202-40(1)] . Unfrankable distributions are explained in paragraphs 2.24 and 2.25. These rules, although expressed differently, are intended to replicate the same outcome as the provisions contained in section 160APA of the ITAA 1936.

2.18 The imputation rules specifically provide that a non-share dividend is frankable [Schedule 1, item 1, subsection 202-40(2)] . A non-share dividend has the meaning given by section 974-120 of the ITAA 1997.

What are non-share dividends?

2.19 In essence, a payment to a non-share equity interest holder that corresponds to a dividend paid to a shareholder is treated in the same way as a dividend. This is effected by the definitions of non-share distribution and non-share dividend, which are based on the definition of a dividend in the ITAA 1936.

2.20 The starting point is the definition of a non-share distribution. This is the distribution of money or property, or the crediting thereof, by the company to a non-share equity holder. In this context distribution has a very broad meaning that would encompass, for example, the repayment of a profit-participating loan.

2.21 A non-share distribution will usually constitute a non-share dividend (which corresponds to a dividend on a share). However, this is qualified by a capital distribution exception, which corresponds to the exception (subject to certain anti-avoidance rules) for distributions to a shareholder that are debited to the share capital account. In the case of the holder of a non-share equity interest, the exception relates to distributions debited to the non-share capital account of the company, or, where company law permits it, to the (untainted) share capital account. As a general rule, a share capital account is tainted if an amount other than share capital is credited to it.

2.22 These capital distributions are called non-share capital returns and are taxed as returns of capital rather than as dividends.

2.23 Non-share dividends are generally frankable in the same circumstances that dividends on shares (share dividends) are frankable.

What are unfrankable distributions?

2.24 Unfrankable distributions are distributions that are:

made by a cooperative company for which a deduction is allowable under section 120 of the ITAA 1936; [F1]
paid by a company resident in the Norfolk Islands and out of profits sourced there;
in respect of non-equity shares;
debited against certain disqualifying accounts;
non-share dividends paid by an Australian ADI and non-share dividends that exceed available frankable profits;
taken to be dividends under Division 7A (private company distributions) of the ITAA 1936;
taken to be dividends under section 47A of the ITAA 1936;
taken to be dividends under section 108 (loans to shareholders and associates) or section 109 (excessive remuneration) of the ITAA 1936; and
taken to be dividends under sections 45 and 45C of the ITAA 1936 (capital streaming and dividend substitution arrangements).

[Schedule 1, item 1, section 202-45]

2.25 In certain cases the amount, or part of the amount, taken to be a dividend in an off-market share buy-back will also be unfrankable. This will be the case where the purchase price exceeds the market value of the share. Where this occurs, the amount of the dividend reduced by any excess of the purchase price over the market value (as normally understood) of the share is taken to be unfrankable. The remainder of the dividend, however, is taken to be frankable. These rules that describe which distributions are unfrankable, although expressed differently, are intended to replicate the same outcome as the provisions contained in section 160APA of the ITAA 1936. [Schedule 1, item 1, paragraph 202-45(c)]

What is the amount of franking credit on a distribution?

2.26 To impute tax it has paid to its members, a corporate tax entity must frank a distribution. A corporate tax entity franks a distribution by allocating a franking credit to the distribution. Franking credits can only be allocated to frankable distributions.

2.27 The franking credit allocated to a frankable distribution is taken to be the amount stipulated on the distribution statement unless that amount exceeds the maximum franking credit for that distribution. This is unlike the existing law which requires a separate declaration by the company of the extent to which the dividend is franked. [Schedule 1, item 1, subsection 202-60(1)]

2.28 The maximum franking credit for a distribution is equivalent to the maximum amount of income tax that could have been paid, by the corporate tax entity, on profits underlying the distribution. It is calculated using the following formula:

amount of the frankable distribution * [corporate tax rate / (100% - corporate tax rate)]

The corporate tax rate is currently 30%. [Schedule 1, item 1, subsection 202-60(2)]

Example 2.1: Maximum franking percentage Bertone Pty Ltd has after-tax profits of $7,000 available for distribution. On 1 September 2002 Bertone Pty Ltd decides to pay $3,500 of this after-tax profit (i.e. a frankable distribution) to its shareholders. The maximum franking credit that Bertone Pty Ltd can attach to this distribution is calculated as follows:

$3,500 * (30% / 70%) = $1,500

2.29 Should the franking credit stated in the distribution statement exceed the maximum franking credit for the distribution, the franking credit on the distribution is taken to be the maximum franking credit.

What information must a corporate tax entity give to its members when it makes a franked distribution?

2.30 An entity that makes a frankable distribution must provide the recipient with a distribution statement that contains certain information about the entity and the distribution. [Schedule 1, item 1, section 202-75]

2.31 The time at which a distribution statement must be given will depend upon whether, for the income year in which the distribution is made, the entity is a private company or not.

2.32 A private company is one that is not a public company, as defined in section 103A of the ITAA 1936, for the income year. Broadly, this means that a company will be a private company if:

it does not have its shares listed on an official stock exchange; or
20 or fewer persons control 75% or more of:

-
the paid up capital of the company;
-
the voting rights in the company; or
-
the rights to the income of the company.

For the purposes of this control test an individual, their nominees, their relatives and their relatives nominees are taken to be one person.

When is a private company required to provide a distribution statement?

2.33 An entity that is a private company for the income year in which a distribution was made is required to give a distribution statement to the recipient before the end of 4 months after the end of the income year in which the distribution was made [Schedule 1, item 1, subparagraph 202-75(2)(b)(i)] . The Commissioner also has the power to extend this time if it is appropriate to do so [Schedule 1, item 1, subparagraph 202-75(2)(b)(ii)] . As the distribution statement is evidence of the franking credit attached to a distribution, these rules mean that a private company can retrospectively frank its distributions [Schedule 1, item 1, paragraph 202-75(2)(b)] .

When is a company that is not a private company required to provide a distribution statement?

2.34 An entity that is not a private company (i.e. a public company) for the income year in which a distribution is made is required to give a distribution statement to the recipient on or before the day on which the distribution is made. [Schedule 1, item 1, paragraph 202-75(2)(a)]

Form of the distribution statement

2.35 The distribution statement must be in the approved form and must contain the following information:

the identity of the entity making the distribution;
the date on which the distribution is made;
the total amount of the distribution;
the amount of franking credit allocated to the distribution;
the franking percentage of the distribution;
the amount of any dividend withholding tax that has been deducted from the distribution; and
any other information required by the approved form.

[Schedule 1, item 1, subsections 202-80(2) and (3)]

Amending the distribution statement

2.36 The legislation provides that the amount of franking credit on a distribution is the amount stated on the distribution statement. In the event that the franking credit stated on the distribution statement was not intended, steps may be taken by the entity to amend the distribution statement.

2.37 An entity may, with the Commissioners written approval, amend its distribution statement to reflect a change made to the franking credit on either:

a specified distribution; or
a specified class of distributions.

[Schedule 1, item 1, section 202-85]

2.38 An entity seeking the Commissioners approval to change the amount of franking credit on a distribution must:

apply to the Commissioner in writing; and
include in its application all information relevant to the matters that must be considered by the Commissioner.

[Schedule 1, item 1, subsection 202-85(1)]

2.39 In considering whether to allow an entity to change the franking credit on a specified distribution the Commissioner must have regard to whether:

the last day for lodging the recipients tax return for the year of income in which the distribution was made has passed;
there would be any change in the recipients withholding tax liability as a result of changing the franking credit on the distribution;
amending the distribution statement will result in the entity breaching the benchmark rule or the anti-streaming rules;
amending the distribution statement will result in a new benchmark being set for the franking period in which the distribution was made; and
any other factors are considered relevant by the Commissioner.

[Schedule 1, item 1, subsections 202-85(2) and (4)]

2.40 An entity, or a member of the entity, that is dissatisfied with the Commissioners determination in respect of an amended distribution statement may object in the manner prescribed by Part IVC of the TAA 1953. [Schedule 1, item 1, subsection 202-85(6)]

The benchmark rule

2.41 Subject to the rules explained in the remainder of this chapter, a corporate tax entity is free to frank (i.e. allocate franking credits to) a frankable distribution to whatever extent it considers appropriate. It will be able to select the level of franking having regard to the existing and expected franking account surplus and the rate at which earlier distributions were franked.

What is the benchmark rule?

2.42 In broad terms, the benchmark rule provides that all frankable distributions made by a corporate tax entity during the franking period must be franked to the same extent - the benchmark franking percentage [Schedule 1, item 1, section 203-10] . This ensures that franking credits representing tax paid on behalf of all members of an entity are not allocated (i.e. streamed) to only some of them.

2.43 This differs from the current required franking rules, which require a company to frank a dividend to the maximum extent possible having regard to the surplus in its franking account at the time of its payment.

Franking percentage cannot exceed 100%

2.44 Consistent with the current law, however, a corporate tax entity cannot frank a distribution by more than 100% [Schedule 1, item 1, subsection 202-60(2)] . In other words, an entity cannot allocate a greater franking credit to a distribution than tax paid by the corporate tax entity on its underlying profits.

2.45 The percentage to which a distribution is franked is called the franking percentage. It is expressed as a percentage of the frankable part of a distribution, rather than of the whole of the distribution. Thus, the franking percentage of a distribution may be 100% even if it is partly unfrankable. The franking percentage of a distribution is calculated as follows:

[franking credit allocated to the frankable distibution / maximum franking credit for the distribution] / 100

[Schedule 1, item 1, subsection 203-35(1)]

2.46 See paragraph 2.44 on how to calculate the maximum franking credit for the distribution.

Example 2.2: Calculating the franking percentage A corporate tax entity derives $100 taxable profits on which it pays tax (at 30%) of $30. The maximum franking credit that can be allocated to a distribution of the $70 after-tax profit is:

$70 * [(30% / (100% - 30%)] = $30

The entity distributes the $70 as part of a $200 distribution, $130 of which is unfrankable and $70 from available profits (i.e. the frankable distribution). It allocates $30 franking credits to the distribution. The distribution is franked to 100% (i.e. it is fully-franked).

To whom does the benchmark rule apply?

2.47 Broadly, the benchmark rule applies to all corporate tax entities unless they are specifically excluded from the application of the rule.

2.48 It is a fundamental principle of the imputation system that corporate tax entities should not be able to direct franked and unfranked distributions to members in a way that maximises the benefits to members. Otherwise, the cost to revenue would be higher than originally intended. Instead the benchmark rule ensures that, over time, the benefit of franking credits is spread more or less evenly across members in proportion to their ownership interest in the entity.

2.49 Arrangements undermining this fundamental principle constitute dividend streaming. They include situations where unfranked distributions are streamed to members who have no need for franking credits so as to preserve the credits for those who benefit most from the credits. Dividend streaming is discussed in greater detail in Chapter 4.

2.50 Due to the limited opportunities for streaming the benchmark rule does not apply to a company in a franking period if at all times during that period either:

it is a listed public company that:

-
under its constituent documents, must frank all distributions made to its members under a single resolution at the same franking percentage; and
-
any distributions made during the period are made to all members of the company; or

it is a listed public company with a single class of membership interest.

[Schedule 1, item 1, subsections 203-20(1) and (2)]

What is the purpose of the benchmark rule?

2.51 The benchmark rule effectively prevents a corporate tax entity making distributions to its members within a particular franking period that are franked to different extents, unless the Commissioner is satisfied that there is a legitimate (non-tax driven) reason for doing so.

2.52 The key elements of this rule are the ascertainment of the franking period and the benchmark franking percentage for that period. Once the benchmark franking percentage is established, the entity must frank all frankable distributions made within the franking period using this percentage, or face penalties. [Schedule 1, item 1, section 203-50]

Ascertaining the franking period

2.53 The franking period rules will result in an entitys franking year being aligned with its income year. This will correct an anomaly in the current law whereby some late balancing companies have a franking year that differs from their income year. The alignment of the income year and franking year will remove the complexities that arise under the current law for these companies.

2.54 A corporate tax entity that is a private company for an income year will have a franking period that is the same as its income year.

2.55 On the other hand, a corporate tax entity that is not a private company for an income year will have its franking periods determined by reference to the length of its income year. However, that period will usually be a 6 month period.

What is the franking period for a company that is not a private company?

Income year is 12 months

2.56 Each of the following is its franking period:

first 6 months beginning at the start of the entitys income year; and
the remainder of the income year.

[Schedule 1, item 1, subsection 203-40(2)]

Income year of 6 months or less

2.57 The franking period will be its income year.

[Schedule 1, item 1, subsection 203-40(3)]

Income year more than 6 months but less than 12 months

2.58 Each of the following is the franking period:

first 6 months beginning at the start of the entitys income year; and
the remainder of the income year.

[Schedule 1, item 1, subsection 203-40(4)]

Income year is more than 12 months

2.59 Each of the following is the franking period:

first 6 months beginning at the start of the entitys income year (first franking period);
next 6 months beginning immediately after the first franking period; and
the remainder of the income year.

[Schedule 1, item 1, subsection 203-40(5)]

What is the benchmark franking percentage for a franking period?

2.60 The benchmark franking percentage for a franking period will be the franking percentage allocated to the first frankable distribution made by the entity within that period. If no frankable distributions are made in the franking period, the entity does not have a benchmark franking percentage for the franking period. [Schedule 1, item 1, section 203-30]

Example 2.3: Establishing the benchmark On 31 August 2002 Wong Enterprises made a frankable distribution of $7,000 (i.e. after-tax profits) to its shareholders. The distribution statement that issued in relation to this showed that no franking credits were allocated to the distribution. As this was the first frankable distribution made in the franking period Wong Enterprises has a benchmark franking percentage of 0%.On 21 September 2002 Wong Enterprises paid its first quarterly PAYG instalment liability. This resulted in a franking credit of $3,000 in its franking account.On 31 October 2002 Wong Enterprises made another frankable distribution of $7,000. As the benchmark franking percentage for the franking period is 0%, Wong Enterprises cannot frank this second distribution made in the franking period.If on the other hand, the distribution made on 31 August 2002 was an unfrankable distribution (e.g. a distribution on a non-equity share) then the frankable distribution made on 31 October 2002 will be the first frankable distribution made in the franking period. Consequently, Wong Enterprises could potentially frank this distribution to a maximum of 100%. The franking percentage of this distribution would then set the benchmark franking percentage for the franking period.

Penalty for franking distributions differently within a franking period

2.61 A breach of the benchmark rule will not invalidate the allocation made to the distribution, but it will result in a penalty to the corporate tax entity.

2.62 The penalty is calculated by reference to the difference between the franking credits actually allocated and the benchmark percentage. The penalty is either:

over-franking tax, if the franking percentage for the distribution exceeds the benchmark franking percentage; or
a franking debit (penalty debit), if the franking percentage for the distribution is less than the benchmark franking percentage.

[Schedule 1, item 1, subsection 203-50(1)]

2.63 The amount of over-franking tax is imposed by a separate bill, the proposed New Business Tax System (Over-franking Tax) Bill 2002.

2.64 The penalty debit for under-franking a distribution arises on the day on which the frankable distribution is made and is in addition to the franking debit that arises from the payment of a franked distribution [Schedule 1, item 1, paragraph 203-50(2)(b)] . It is equivalent to the extra franking credit that should have been allocated according to the benchmark rate. The additional debit effectively cancels out the unused credit. Therefore the penalty for under-franking by the entity is that the extra franking credit that ought to have been allocated to the distribution is wasted.

2.65 The amount of overfranking tax or the penalty debit is worked out using the following formula:

franking % differential * amount of the frankable distribution * [corporate tax rate / (100% - corporate tax rate)]

2.66 For the purposes of the formula, the franking % differentialis the difference between:

the franking percentage for the distribution; and
either:

-
the entitysbenchmark franking percentage for the franking period in which the distribution is made; or
-
the franking percentage permitted by the Commissioner in a determination made under section 160-85 of this Part (see paragraphs 2.70 to 2.76).

Example 2.4: Over-franking a distribution Jeneris Ltd, a corporate tax entity, has a benchmark franking percentage for the current franking period of 80%. Using this benchmark would mean that a frankable distribution of $700 would have $240 of franking credits attached.However, Jeneris Ltd makes a fully franked distribution of $700 within that franking period. In other words, it allocates a $300 franking credit (resulting in a franking percentage of 100%). The entity has over-franked this distribution and over-franking tax will be imposed.The amount of the over-franking tax will be equivalent to the franking credit allocated in excess of the benchmark. It is calculated on the same basis as a penalty debit would have been if the distribution were under-franked, that is:

(100% - 80%) * $700 * (30% / 70%) = $60

Commissioners power to permit departure from benchmark rules

2.67 A corporate tax entity may apply to the Commissioner in writing, either before or after a distribution is made, for permission to depart from the benchmark rule. [Schedule 1, item 1, subsection 203-50(1)]

2.68 An entity seeking permission to depart from the benchmark rule should include all relevant information in support of the application. In particular, the application should address the following factors, which must be considered by the Commissioner in making a decision:

the entitys reasons for wanting to depart or proposing to depart from the benchmark rule;
the extent of the departure or proposed departure (the greater the departure, the greater the onus on the corporate tax entity to justify it);
whether the entity has previously sought the exercise of the Commissioners powers to permit the departure in the past (assuming the previous applications resulted from circumstances within the entitys control - if so, the onus on the entity to justify a departure will increase if the entity applies for a variation relatively frequently);
whether a member of the entity will be disadvantaged by the departure or proposed departure (e.g. because the member will receive a distribution with a lower franking percentage than the distribution received by another member);
whether a member of the entity will receive franking benefits in preference to other members of the entity as a result of the departure (in such a case the departure may be motivated by a desire to stream franking credits inappropriately); and
any other matters that the Commissioner considers relevant.

[Schedule 1, item 1, subsection 203-55(3)]

Power to be exercised in extraordinary circumstances only

2.69 The power to permit a departure from the benchmark rule will be exercised by the Commissioner only in extraordinary circumstances. Thus, the circumstances justifying a departure would generally need to be unforeseeable and beyond the control of the entity, its members and controllers. [Schedule 1, item 1, subsection 203-55(2)]

2.70 A change in ownership of an entity would rarely amount to extraordinary circumstances sufficient to warrant a departure from a benchmark rule.

Example 2.5: Permitted departure from the benchmark rule McDonald Ltd, a corporate tax entity, conducts a farming business. In the current franking period, its benchmark franking percentage is 80%. It declares a distribution, expecting a credit to arise in its franking account from a tax instalment to be paid later in the franking period.The distribution will be made from profits arising from the sale of its crops. However, shortly before harvest heavy flooding devastates the crops. Therefore, McDonald Ltd pays less tax than it had expected and receives only a small credit to its franking account.McDonald Ltd applies to the Commissioner for permission to depart from its benchmark franking percentage.These would be extraordinary circumstances since they are unforeseeable and beyond the control of McDonald Ltd. The Commissioner would consider all the relevant circumstances in deciding whether to permit a departure from the benchmark rules.Note: If McDonald Ltd were to apply for permission to deviate from its benchmark in a later franking period, the later application would not be weakened because McDonald Ltd had made this application.

What is the consequence of allowing a departure from the benchmark rule?

2.71 A distribution that is franked in accordance with the Commissioners permission to depart from the relevant benchmark rules is taken to comply with the benchmark rule to which the permission relates. [Schedule 1, item 1, subsection 203-55(5)]

2.72 Where the Commissioner permits a deviation from a benchmark rule the entity is taken to comply with the rule so long as it does not deviate from the rule by more than was permitted.

Example 2.6: Commissioners permission to depart from the benchmark rule Trimble Ltd is a corporate tax entity that has a benchmark franking percentage of 0% for a particular franking period. The company wishes to set a benchmark franking percentage of 50%. The entity applies to the Commissioner for permission to do so.The Commissioner determines, having regard to the relevant factors, that a benchmark franking percentage of 50% is appropriate. Notwithstanding this determination, Trimble Ltd makes a distribution allocating franking credits using a franking percentage of 100%.Over-franking tax will be imposed on the entity for franking inconsistently with the benchmark franking percentage, as set by the Commissioners determination. That is, the over-franking tax will be based on the excess of the franking percentage applied (100%) over the benchmark franking percentage the Commissioner has permitted (50%).


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