House of Representatives

Tax and Superannuation Laws Amendment (2014 Measures No. 2) Bill 2014

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon J. B. Hockey MP)

Chapter 3 - Preventing dividend washing

Outline of chapter

3.1 Schedule 3 to this Bill will amend the Income Tax Assessment Act 1997 (ITAA 1997) to introduce an integrity rule to limit the ability of taxpayers to obtain a tax benefit from 'dividend washing'.

3.2 Broadly, dividend washing (or 'distribution washing') is a type of scheme by which a taxpayer can obtain multiple franking credits in respect of a single economic interest by selling an interest after an entitlement to a franked distribution has accrued and then immediately purchasing an equivalent interest with a further entitlement to a corresponding franked distribution.

Context of amendments

The imputation system

3.3 Under Australian income tax law, corporate tax entities (companies, corporate limited partnerships and certain trusts - see section 960-115 of the ITAA 1997) are subject to income tax on their taxable income. Members of the corporate tax entity (that is, shareholders) are also generally subject to income tax on the economic income of the corporation when it is distributed to them.

3.4 The imputation system set out in Part 3-6 of the ITAA 1997 provides members with relief from tax where they receive distributions that have been subject to tax at the corporate level. Under this system, corporate tax entities can pass on a credit for the tax they pay (a franking credit), when they provide a frankable distribution to their members (see Division 202 of the ITAA 1997).

The consequences of franking

3.5 Members that receive franked distributions are generally entitled to a refundable tax offset equal to the amount of the franking credit allocated to the distribution. They must also include an equivalent amount in their assessable income for the same income year (section 207-20 of the ITAA 1997). This puts the members of the corporation in the same position as if they had earned the corporate income themselves, and that distributed income was subject to withholding prior to being paid to the member. This means that the corporate income distributed to a member is effectively taxed only at the member's marginal tax rate.

3.6 As the tax offset provided is generally refundable, where the tax paid by the corporate tax entity exceeds that payable by the taxpayer this can result in a refund (subject to the other tax liabilities of the taxpayer).

3.7 Special rules apply to particular types of members.

3.8 Where a member is a trust or partnership (and so does not generally pay tax that can be offset), the member must still include the amount of the credit in their income, but does not receive an offset. Instead, the tax offset goes instead to the underlying interest holders, that is the partners or beneficiaries who pay the tax on the income of these flow-through vehicles (Subdivision 207-B of the ITAA 1997).

3.9 Where a member is not an Australia resident, the member is not entitled to a tax offset or required to include the amount of the distribution in their assessable income. Instead, a franked distribution is exempt from dividend withholding tax (Subdivision 207-D of the ITAA 1997). That is, the foreign resident pays no further tax with the corporate tax being the only tax paid on that income.

Imputation and franking credit trading

3.10 Due to the differing treatment of franking credits received by different entities and differing tax rates applied to entities, not all members benefit equally from a distribution being franked. Generally, members who have either a low tax rate or little income and can access a refundable tax offset, benefit most from imputation. These entities, including for example, individuals on low marginal tax rates, charities and complying superannuation funds, may be able to fully offset the tax payable on their income and obtain a payment from the Commissioner of Taxation (Commissioner). The benefits to other types of entities are often focussed on directly preventing double taxation and are therefore more limited or situational.

3.11 As not all shareholders benefit equally from franking credits, there is an incentive to transfer, provide or sell franking credits to those shareholders who will receive a greater benefit.

3.12 Franking credit trading is contrary to the underlying policy of the imputation system, and a number of integrity rules exist to prevent practices that give this result (see Subdivision 207-F of the ITAA 1997).

3.13 These rules include:

the holding period rule, which broadly requires that an interest must be held at risk for a period (generally, 45 days) before the interest holder may benefit from franking credits;
the last-in first-out rule, which provides that the disposal of an interest will be deemed to be the disposal of the most recently acquired interest (preventing taxpayers from using staggered acquisitions and disposals to avoid the consequences of the holding period rule); and
prohibitions on dividend streaming, dividend stripping (under Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936)) and franking credit trading.

3.14 In general, where these rules apply, taxpayers will not receive a tax offset (or be required to include an amount of the associated franking credit in their assessable income) despite receiving a franked distribution.

Distribution washing

3.15 Generally, the entitlement of all interest holders to receive a distribution is fixed at the same point in time. While interests can be traded after this point (referred to as trading ex-dividend), the new interest holder will not be entitled to receive the distribution.

3.16 However, for some shares, a special market for trading in shares with the attached right to the dividend (referred to as trading cum-dividend) will operate for a period between the date on which the entitlement to the dividend is fixed for most interest holders (the ex-dividend date) and the final date of record for dividend entitlements.

3.17 It is also possible to trade shares off market on a cum-dividend basis during this period.

3.18 Such special markets were established to address problems that could otherwise arise for entities that issue call options. As there is a delay between when the option is exercised and when the issuer becomes aware of their obligation to provide a share, cases could arise where entities are obliged to provide shares cum-dividend but cannot obtain such a share on market as the ex-dividend date has passed.

3.19 However, these special markets also provide an opportunity for entities that place a higher value on franking credits to obtain multiple franking credit entitlements in respect of one economic interest.

3.20 Such entities can sell a membership interest on the normal market after becoming entitled to the distribution, and then purchase a substantially identical membership interest on the cum-dividend market. This entitles the entity to a second amount of franking credits in place of someone who places a lesser value on those credits. The acquisition and disposal prices paid and received can be adjusted to share the benefits of the arrangements - that is, a taxpayer who does not benefit as much from franking credits can sell their interest at a price that allows them to obtain some of the benefits of the credit passed on to the other taxpayer.

3.21 An entity engaging in distribution washing is able to satisfy the holding period rule in respect of both interests without breaching the last-in first-out rule. They hold the original interest for at least 45 days prior to the ex-dividend date and the new interest for at least 45 days after its acquisition, without ever holding the two interests at the same time.

Distribution washing and the general anti-avoidance rule

3.22 In some cases, distribution washing arrangements will constitute a scheme subject to the general anti-avoidance rules under Part IVA of the ITAA 1936. In these cases the Commissioner may make a determination to deny the benefit of the scheme to the relevant taxpayer and potentially apply further penalties.

3.23 In October 2013, the Australian Taxation Office identified that it had significant concerns about activities in this area in prior years and would be undertaking compliance activity. This compliance activity is unrelated to the amendments to the law set out in Schedule 3, being based solely on the application of the general anti-avoidance rule.

Summary of new law

3.24 Part 1 of Schedule 3 amends the ITAA 1997 to provide that franked distributions which a taxpayer receives due to distribution washing will not entitle the taxpayer to a tax offset or require a taxpayer to include the amount of the franking credit in their assessable income.

3.25 A distribution will be considered to be one received as a result of distribution washing, where the taxpayer has also received a corresponding distribution in respect of a substantially identical interest that the taxpayer sold before acquiring the current interest.

3.26 These amendments apply from 1 July 2013.

3.27 Part 2 of Schedule 3 amends the ITAA 1997 to make technical corrections to the imputation rules to clarify a number of cross references, with effect from 1 July 2002 (the date when the cross references were first introduced). The technical corrections merely ensure the law operates as intended and are consistent with the current administration of the law.

Comparison of key features of new law and current law

New law Current law
Taxpayers that obtain additional franking credits as a result of distribution washing will be denied any benefit from these additional credits.

An exception applies for individuals whose annual franking credit entitlement is $5,000 or less.

There is no general rule eliminating the benefits of further franking credits a taxpayer obtains as a result of distribution washing.

In some cases, Part IVA of the ITAA 1936 may apply to allow the Commissioner of Taxation to make a determination to deny benefits.

Detailed explanation of new law

3.28 Part 1 of Schedule 3 amends the ITAA 1997 to provide that distributions to which the distribution washing rules apply:

do not receive a tax offset; and
are not required to include an amount equal to the franking credit in their assessable income.

[Schedule 3, items 1 and 2, paragraphs 207-145(1)(da) and 207-150(1)(ea)]

3.29 The distribution washing rules will apply to a franked distribution in respect of a membership interest (the washed interest) where two requirements have been met.

3.30 First, the washed interest must have been acquired after the member or a connected entity of the member, disposed of a substantially identical membership interest. [Schedule 3, item 3, paragraph 207-157 (1)(a)]

3.31 Secondly, a corresponding distribution must have been made to the member or a connected entity in respect of the substantially identical interest. [Schedule 3, item 3, paragraph 207-157 (1)(b)]

3.32 However, where a connected entity has disposed of the substantially identical interest, the dividend washing rules will only apply if it would be concluded that either the disposal or the acquisition took place only because at least one of the entities expected or believed that the other transaction had or would occur. [Schedule 3, item 3, subsection 207-157(2)]

3.33 Many of these concepts are drawn from the existing holding period rules, in particular the last-in, first-out requirement. Further details of the operations of these rules and the concepts used here can be found in Chapter 4 of the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 2) 1999.

3.34 Part IVA of the ITAA 1936 continues to allow the Commissioner to make a determination to deny tax and franking benefits in cases where there is activity contrary to the general anti-avoidance rule and these amendments do apply to not negate the benefit.

Substantially identical interest

3.35 Central to both of these requirements is the existence of a substantially identical interest.

3.36 The concept of substantially identical is drawn from the existing law for the holding period rules. The concept is intentionally flexible to accommodate the wide variety of financial instruments that currently exist and as well as new instruments that may be created in future. Without constraining the concept, the amendments identify a number of circumstances in which interests are substantially identical for the purpose of the provisions (drawn from similar provisions relating to the last-in, first-out method under the holding period rules; see the former section 160APHF of the ITAA 1936). [Schedule 3, item 3, subsection 207-157(3)]

3.37 The most important of these is that an interest will be substantially identical where it is fungible with, or economically equivalent to, the washed interest. In this context, it makes clear that the identity that is being examined is the economic substance of the interest not the property rights. The item ensures that interests will be substantially identical where it is reasonable to expect that the interests will provide equivalent economic benefits.

3.38 It does not necessarily matter that the nature of the interest may vary and it is not pertinent if one interest is legal and the other equitable, or if one interest is an interest in another entity that nonetheless provides equivalent benefits indirectly, because, for example, all it holds is interests in a particular corporate tax entity.

3.39 What can matter in determining if an interest is substantially identical is the number or extent of the interests held at each time. Where an entity sells interests ex-dividend and purchases a different number of interests cum-dividend, it is possible that only some of an entity's interests may be substantially identical to the washed interest, as economic equivalency must be considered in the full context of the former and current interests.

3.40 For example, a taxpayer may sell one ordinary share in an entity ex-dividend then later purchases 100 ordinary shares in the same entity cum-dividend. The prior interest here is substantially identical to the washed interest represented by one of the shares purchased cum-dividend. It is not substantially identical to the whole 100 shares. In this case, the taxpayer would not be entitled to the benefits of franking credits in respect of the portion of the distribution relating to one share that is the substantial identical interest, but may still be entitled to franking credits in respect of the 99 additional shares acquired.

Example 3.1

Elizabeth & Co Custodians holds 10,000 ordinary shares in OT Ltd on behalf of GAV Super (an Australian resident taxpayer). On 14 April 2015, OT Ltd declares it will pay a fully franked dividend of 10 cents to all holders of its ordinary shares.
Following a direction from GAV Super, Elizabeth & Co disposes of all 10,000 shares shortly after the shares commence trading ex-dividend. GAV Super retains the right to receive a fully franked dividend in respect of the 10,000 shares that have been sold.
Immediately after disposing of the shares, in response to a further part of the instructions from GAV Super, Elizabeth & Co purchases 20,000 ordinary shares in OT Ltd in a special cum-dividend market. This purchase now means that GAV Super is now also entitled to a fully franked dividend in respect of the 20,000 newly acquired shares.
As Elizabeth & Co has disposed of the original shares then acquired new shares, to the extent that the new shares are substantially identical interests, and the distribution in respect of the original shares is a corresponding distribution, GAV Super will not be entitled to the benefits of the franking credits it has received in respect of the new shares.
Ten thousand of the new shares are economically equivalent to the interests represented by the 10,000 original shares and the dividends paid in respect of these two groups of interests clearly correspond.
However, the remaining 10,000 of the new shares Elizabeth & Co has acquired are not substantially identical, given they are interests going beyond the total number of the prior interests held on behalf of GAV Super.
As a result, GAV Super is entitled to the benefit of the franking credits it receives in respect of the 10,000 shares Elizabeth & Co disposed of on its behalf and 10,000 of the new shares purchased on its behalf (assuming no other integrity rules have been engaged). GAV Super is not entitled to any of the benefits of the franking credits attached to the dividends it receives for the remaining 10,000 new shares.

3.41 However, what matters in these cases is the economic equivalency of the interests, rather than the numbers. In cases where there are different classes of shares in an entity or where interests are held indirectly, interests may well be economically equivalent despite taking different forms or involving different numbers of interests.

Example 3.2

Sophie (an Australian resident taxpayer) holds 10 Class A shares in NAFR Ltd. Sophie is already entitled to more than $5,000 in franking credits in the income year as a result of other shares she holds.
On 20 March 2015, NAFR Ltd declares a $5 fully franked dividend on all of its Class A shares and a $1 fully franked dividend on all of its Class B shares (with the ratio between the dividends being a matter of established practice).
Shortly after her shares commence trading ex-dividend, Sophie sells all 10 shares, retaining the $50 fully franked dividend entitlement. Sophie then purchases 65 Class B shares in NAFR Ltd in a special cum-dividend market. She becomes entitled to fully franked dividends in respect of those shares totalling $65.
Sophie has disposed of shares she held and acquired new shares and she is entitled to corresponding dividends in respect of each set of interests. To the extent the shares are substantially identical, Sophie is not entitled to the benefits of franking credits attached to the dividend in respect of the Class B shares.
The Class B shares are not interchangeable with the Class A shares. However, in the circumstances they are in part economically equivalent - 10 Class B shares will provide the same immediate returns and similar expected returns as one Class A share.
As a result, 50 of the Class B shares are substantially identical to the 10 Class A shares Sophie sold. Sophie is entitled to the benefit of the franking credits she receives in respect of her original 10 Class A shares and 15 of her new Class B shares (assuming no other integrity rules have been engaged). She is not entitled to receive the benefit of the franking credits she receives in respect of the remaining 50 of the Class B shares she has acquired.

3.42 The amendments also specify that a number of other types of interest are substantially identical, without limiting the ordinary meaning of the term. These other items deal with a number of more specific interests, including interests in the same or similar classes of interest and those in other classes that are exchangeable at a fixed rate. The more specific provisions are intended to provide clarity in most of the common cases where the rule against distribution washing may apply.

3.43 In some cases, unrelated entities may have share prices that are closely correlated, for example as both entities are competitors in the supply of a class of products and are affected in the same way by broader economic factors. This mere correlation does not make the interests economically equivalent in this context. Interests are not substantially identical securities without something more than broad similarity in prior economic performance.

Example 3.3

Three Pigs Super is a medium sized superannuation fund with an investment focus in infrastructure. Its investments include 10,000 ordinary shares in Straw Constructions Ltd, an infrastructure development firm. Following the declaration of a dividend by Straw Constructions Ltd, and shortly after all of the shares commence trading ex-dividend, Three Pigs sell all 10,000 of their shares.
Immediately following this sale, Three Pigs Super purchases 2,500 shares in STiCs Infrastructure Ltd, another infrastructure development firm that has no relationship with Straw Constructions Ltd.
These interests are not substantially identical and so the distribution washing rules do not apply. Even if the shares have a similar price and have historically provided similar returns the interests are not economically equivalent.

3.44 In considering if interests are substantially identical, the time at which the new interest is acquired is generally not relevant, as this does not affect the nature of the interest. However, that said, it is only in unusual cases where the rules to prevent dividend washing would apply to interests that are not purchased close together. The rules also require that a corresponding dividend is obtained in respect of the substantially identical interest. In most cases this requires obtaining the substantially identical interest on the special cum-dividend trading market which only operates for a short period of time after most shares commence trading ex-dividend.

Disposal and acquisitions

3.45 The rules also require that the entity must dispose of the substantially identical interest before acquiring the washed interest.

3.46 The application of this requirement will generally be a matter of fact. An entity disposes of an interest when the entity ceases to be the legal owner of the interest. Similarly, an entity acquires an interest when it becomes the legal owner of the interest. Acquisitions and disposals will generally occur as a result of the purchase or sale of shares on market. For such on-market transactions, the change in legal ownership generally occurs when the sale or purchase agreement is entered into, rather than at the time of settlement.

3.47 The purpose of the requirement for the acquisition to follow the disposal of the earlier shares is to avoid overlap between this integrity rule and the existing 'last-in, first-out' rule contained within the holding period rules. Where the two interests are held concurrently, the combined effect of the holding period rules and the last-in first-out rule already prevents the entity from benefiting from multiple franking credit entitlements.

Connected entity and intention

3.48 This integrity rule is intended to address any case in which taxpayers may obtain multiple franking credits in respect of a single economic interest.

3.49 To give effect to this, none of the requirements for distribution washing relate to the intention of the taxpayer.

3.50 While deliberate distribution washing is particularly problematic, even inadvertent distribution washing results in taxpayers receiving inappropriate benefits. Additionally, requiring proof of intention would also increase the compliance burden on taxpayers and the Australian Taxation Office and was raised as a concern in consultation.

3.51 As another mechanism to prevent this double benefit, the distribution washing rules look at the actions of connected entities as well as the member, where it would be concluded that either the acquisition or disposal took place because there was an expectation the other transaction had likely taken place or was likely to take place.

3.52 Connected entity is an existing defined term in the ITAA 1997. An entity will be a connected entity where it is either an associate or (if the taxpayer is part of a wholly-owned group) a member of the same wholly-owned group.

3.53 Where entities are connected, they may have common economic interests and be acting as a single economic group. It would therefore be inappropriate should they be permitted to knowingly act to obtain multiple benefits from the imputation system as a result of a single distribution event.

3.54 Given this, where a connected entity disposes of a substantial identical interest, the distribution washing rules can apply to deny the benefit of franking credits on the distribution from the washed interest.

3.55 Taking into account the actions of connected entities prevents related taxpayers from colluding with one-another to obtain the tax benefit indirectly and avoid the restriction.

3.56 This is particularly important where the member receiving the distribution is a trust or partnership. In this case, it is the ultimate beneficiary of the distribution, the beneficiary or partner, rather than the trust or partnership that receives the franking credit. Application of the connected entity rules means that entity to which a franked distribution flows indirectly are treated in the same way as the entity to which a franked distribution is made.

Example 3.4

Giraffe Ltd is a wholly-owned subsidiary of Zoo Ltd.
Zoo Ltd disposes of 1,000 ordinary shares in Hay Co immediately after they go ex-dividend, retaining the fully franked dividend entitlement. Shortly after this disposal, Zoo Ltd arranges for Giraffe Ltd to purchase 1,000 ordinary shares in Hay Co in a special cum-dividend market, obtaining an equivalent entitlement to fully franked dividends.
As Giraffe Ltd is an associate of Zoo Ltd and was acting at the behest of Zoo Ltd, the distribution washing rules will apply to this transaction and deny Giraffe Ltd the benefit of the franking credits it receives in respect of the 1,000 shares it has acquired.

Example 3.5

Walker Custodians provides custodial services, holding shares on behalf of a number of fund management companies, including Dot Investments and Joy Financial Holdings. Dot Investments and Joy Holdings are unrelated entities.
Acting on behalf of Dot Investments, Walker Custodians disposes of an interest in HA (International) shortly after the interest goes ex-dividend. Walker Custodians remains entitled to the full franked dividend in respect of the interest, which will flow indirectly to Dot Investments.
If Walker Custodians were to purchase a substantially identical interest on behalf of Joy Financial Holdings, given Dot Investments and Joy Holdings are unrelated entities the distribution washing rules would not apply.
Walker Custodians would have disposed and acquired the interests in as the trustee of two distinct trusts. The trusts are unrelated and the associate rules do not provide that Walker Custodians acting for one trust is an associate or connected entity of Walker Custodians acting for a different trust.

3.57 However, many entities may be connected entities without having either fully unified economic interests (such two natural persons who are related) or knowledge of one another's activities (such as two companies that are ultimately owned by the same entity but which have no other connection or relationship). In these cases it would be problematic to deny franking credits to one entity based on the actions of a connected entity of which they are completely unaware. It would also impose considerable compliance costs on taxpayers to track the actions of all of their connected entity.

3.58 To address these concerns, the distribution washing rules will only apply in cases involving connected entities where it can be concluded that the acquisition (or disposal) took part at least in part because of an expectation that it was likely that the disposal (or acquisition) had taken place (or would take place).

3.59 This test involves an objective assessment of what would be concluded about the actions of an entity given the particular circumstances. This assessment will need to take into account matters such as the nature of the relationship between the connected entities and the information that could be expected to be available to each entity.

3.60 For example, only in very unusual circumstances could it be concluded that a person acting as a trustee of a publicly traded unit trust would be acting to any extent on the basis of an expectation or belief about the actions of a relative of an individual who benefits under the trust. On the other hand, it may often be reasonable to conclude that a person may be acting on the basis of a belief or expectation about the actions of their spouse or of a company or trust in which they have a significant stake.

3.61 One important factor in this assessment of what can objectively be concluded is the very unusual nature of special cum-dividend markets. These markets are intended to fulfil a very specific purpose around the settlement of options. If an entity makes purchases on such a market outside of this context and there has been a prior disposal by a connected entity, it will often be appropriate to conclude that the acquisition was undertaken at least in part on the basis of a belief about the disposal unless other factors exist demonstrating another reason why the entity would need to enter the special market.

Example 3.6

Rose and Tom are a married couple. Rose, but not Tom, is a beneficiary of Flower Trust. The trustee of Flower Trust is Bloom Ltd.
Bloom Ltd, acting in its capacity as trustee of Flower trust, disposes of 3,000 shares in Sunshine Co shortly after the shares go ex-dividend. It remains entitled to the fully franked dividend on the shares.
Both Rose and Tom are associates of Bloom Ltd in its capacity as trustee, Rose as a beneficiary of the trust, and Tom as an associate of Rose.
If either Rose or Tom purchase a substantially identical interest (which could an interest of the same type in Sunshine Co, but could also be some other type of economically equivalent interest) and receive a corresponding dividend, they may be subject to the distribution washing rules if, on an objective assessment, it could be concluded that their action was undertaken in part on the basis of a belief that Bloom Ltd had or would dispose of the shares.
Neither Rose nor Tom are engaged in the writing of options. Given this, there are only very limited reasons why they would make purchases on the cum-dividend market outside of an intention to engage in distribution washing. Absent evidence of such special reasons, if there was any reasonable basis to give rise to a belief about Bloom Ltd disposal it is likely that it would be concluded that the acquisition was undertaken at least in part because of the belief about the disposal.
A franked dividend received by Rose or Tom in respect of an interest acquired cum-dividend may also be subject to the rules if they make such a purchase and it would be concluded on an objective assessment that Bloom Ltd acted in part based on the expectation that Rose or Tom had or would acquire such an interest.

Example 3.7

RC Ltd and SC Ltd are two separate wholly-owned subsidiaries of KAS Investments Ltd. While they share an owner and are both involved in investment activities, the two companies are otherwise completely unconnected. No employee or officer of either company has any knowledge of the investment activities of the other company nor any means to reasonably obtain such information.
RC Ltd disposes of an interest in WLC Co shortly after the interest goes ex-dividend. It remains entitled to the fully franked dividend on the shares.
RC Ltd and SC Ltd are associates and hence connected entities as they are both wholly-owned by KAS Investments Ltd. Hence, if SC Ltd purchases a substantially identical interest and receives a corresponding distribution, it would not be entitled to the benefit of the franking credit in respect of that distribution if it would be concluded, on an objective assessment of the circumstance that either the acquisition by SC Ltd or the disposal by RC Ltd was undertaken with an expectation or belief about the actions of the other entity.
However, there was no basis for either party to learn of the other transactions and the relationship between the entities was not one where co-operation in this matter would be objectively expected. Given this it would not be concluded that either party acted based in any part on an expectation or belief about the other's actions.

3.62 In some cases, for example when investing through a trust structure there may be several degrees of separation between the ultimate beneficiary and the entity that has engaged in distribution washing. The loss of the benefit of the franking credit would need to be reflected in the information provided by the trustee at each stage, in the same way as presently applies for interests where the benefit of franking credit is denied due to the application of the holding period rule.

Corresponding distribution

3.63 Like substantially identical interest, the concept of corresponding distribution is also a flexible concept that is drawn from the holding period rules.

3.64 For distributions to correspond, it is not enough that they are of the same amount or from the same entity.

3.65 Correspondence requires the distributions to have ultimately arisen from the same ultimate source, or closely connected sources.

3.66 This will most obviously be satisfied in cases where a company declares a dividend to classes of membership interest including both the washed interest and the substantially identical interest.

3.67 It will also be satisfied where both dividends arise from the company declaring various dividends in respect of different types of membership interest on a common basis, in connected processes or in respect of profits that have arisen over the same period.

3.68 In some cases a dividend may be a corresponding dividend even where it is not paid by the same entity, provided the dividends ultimately arise from the same act. For example, a dividend from one company that was paid for the purposes of passing on a dividend from another company would be a corresponding distribution in respect of other dividends paid out by the other company in the same distribution process.

Example 3.8

Tuba Ltd has two classes of shares, ordinary shares and preference shares.
Its preference shareholders are entitled to receive an annual dividend of a fixed amount, subject to Tuba Ltd having profits available to distribute. Its ordinary shareholders have no fixed entitlement to dividends.
On 10 August 2015, Tuba Ltd declares a dividend in respect of its preference shares. On 11 August 2015, it further declares a dividend in respect of its ordinary shares.
Dividends paid in respect of ordinary shares will be corresponding dividends in relation to the dividends paid on preference shares and vice versa.
While the dividends are not necessarily of the same amounts and the obligations around payment differ, they both come from the same entity and are tied to the profitability of the company over the same period.

Example 3.9

Holding Ltd is a collective investment vehicle which has no assets other than shares in Big Ltd.
On 30 September 2015, Big Ltd declares a fully franked dividend to all shareholders, including Holding Ltd.
On 18 November 2015, Holding Ltd declares a fully franked dividend to its shareholders.
The dividend paid by Big Ltd is a corresponding dividend in relation to the dividend paid by Holding Ltd. The dividend is not paid by the same company or declared at the same time. However, both originate from the same ultimate source.

3.69 As corresponding distributions must generally arise from substantially the same ultimate source, in almost all cases they will be paid at or around the same time. Outside of rare cases involving distributions received through conduit entities or other complex arrangements, the passage of time will generally indicate that distributions do not correspond.

Example 3.10

Bentwood Ltd pays its annual fully franked dividend to its ordinary shareholders on 7 May 2016.
On 17 June 2016, Bentwood Ltd becomes entitled to significant amounts of money as a result of its success in contractual litigation.
It decides to return these amounts to its shareholders by declaring a special dividend.
The annual dividend is not a corresponding dividend in relation to the special dividend. While both are paid by the same entity in close succession, they arise from different sources and as part of separate processes.

Small holdings exception

3.70 Similar to the holding period rules, the amendments provide for an exception to the restrictions on distribution washing for individuals who do not receive more than $5,000 in franking credits in a year. [Schedule 3, item 3, subsections 207-157(4) and (5)]

3.71 Such individuals will generally not be in a position to deliberately engage in distribution washing in respect of those interests they hold directly. They will generally lack the knowledge and expertise to access the special market for cum-dividend trading. In the event that they do become involved in distribution washing, the amounts involved are, by definition, small.

3.72 This exception protects small shareholders from needing to consider the application of the rule to their individual investments.

3.73 However, this exception only applies to distributions made directly to an individual. It does not apply to distributions that may flow indirectly to individuals in respect of an interest held through a trust or partnership.

3.74 As a collective investment vehicle, trusts and partnerships can be in a position to engage in distribution washing on a significant scale even where the investments held on behalf of each individual beneficiary or partner are small. As a result, the considerations supporting an exception for individuals do not apply in this case.

3.75 Despite the small holding exemption, individuals who do not receive more than $5,000 in franking credits in an income year are still potentially subject to the general anti-avoidance rule under section 177EA of Part IVA of the ITAA 1936 if they engage in a distribution washing scheme with the dominant purpose of obtaining an imputation benefit.

Interaction with the general anti-avoidance rule

3.76 As noted earlier, most of the activities that are affected by the rules set out in Schedule 3 would also potentially be subject to the general anti-avoidance rules set out in Part IVA of the ITAA 1936.

3.77 Despite this overlap, it was considered necessary to introduce a specific rule to provide clarity and certainty for taxpayers and the ATO, given the scale of distribution washing activity.

3.78 Data about trading on the special market for cum-dividend interests suggests that as much as 85 per cent, by value, of all trading on this market (around $3 billion of transactions) may have been driven by entities engaging in distribution washing. As many of these transactions were carried out by entities acting for other entities, the number of entities who have benefitted is even more significant than the volume of trading would suggest.

3.79 The application of the general anti-avoidance rules requires a specific determination for each entity and amendments to a taxpayer's liabilities resulting from such a determination are generally not subject to the standard limitation periods. As a result, while the general anti-avoidance rule is a suitable mechanism to address issues with specific conduct, using it to address widespread activities places an inappropriate burden on both taxpayers and the Commissioner.

3.80 In contrast, the specific rule created by Schedule 3 applies automatically and as part of the normal process of assessment. Further, where the specific rule applies, the general anti-avoidance rule is excluded, as it only applies where an entity would otherwise receive a tax or imputation benefit. As a result, taxpayers (other than those who engage in schemes to obtain a benefit despite the specific rule) need not be concerned about both rules applying.

3.81 As noted earlier, nothing in these provisions affects the application of the general anti-avoidance rules prior to the application of these amendments or their application to schemes that are not the subject of the rules introduced by this Schedule.

Technical amendments

3.82 Part 2 of Schedule 3 also makes a number of technical amendments to update a number of references to offsets throughout Division 207 of the ITAA 1997. [Schedule 3, items 5 to 8, paragraphs 207-95(6)(b), 207-145(1)(f), 207-150(1)(g) and 207-150(6)(b)]

3.83 Presently there are a number of provisions in Subdivisions 207-D and 207-F of the ITAA 1997 that refer to taxpayers being 'not entitled to a tax offset under this Subdivision'. While offsets are dealt with throughout Division 207, in substance all entitlements to tax offsets arise under Subdivision 207-A and 207-B. What these sections are clearly intended to convey is that the Subdivision removes the taxpayer's entitlement to an offset, but the wording may leave some ambiguity.

3.84 The law has been applied by the Commissioner and taxpayers in line with intended policy. However, to eliminate any doubt and to provide certainty, this measure amends the existing law so that the references now specify 'not entitled to an offset under this Division'.

Application and transitional provisions

Distribution washing

3.85 The amendments to prevent distribution washing apply from 1 July 2013, the date set out in the original policy announcement of 14 May 2013. [Schedule 3, item 4]

3.86 This may result in the amendments having retrospective application. This retrospectivity is necessary to prevent taxpayers from seeking to benefit from distribution washing after its existence was made publicly available by the Government's announcement. Such activity would likely be subject to the general anti-avoidance rule in section 177EA of Part IVA of the ITAA 1936.

3.87 Further, distribution washing requires highly specific activities (generally selling ex-dividend and buying cum-dividend) that will generally not have a commercial rationale without the availability of the associated tax benefits. Given this, there is relatively little uncertainty arising from taxpayers from this retrospectivity, as it is unlikely taxpayers would be inadvertently affected by the measure or affected in a way that they would not expect from the announcement.

Technical amendments

3.88 The technical amendments to the references to offsets generally apply from 1 July 2002, the date when the current misdescribed cross-references were introduced. [Schedule 3, item 9]

3.89 Backdating the clarification ensures that addressing the ambiguity does not give rise to doubt about the previously settled application of the law.

3.90 As such, it is not in substance retrospective as it merely confirms the existing interpretation and operation of the law.

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 Tax Laws Amendment (2014 Measures No. 2) Bill 2014 - Preventing dividend washing

3.91 Schedule 3 to this Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

3.92 Broadly, Part 1 of this Schedule amends the Income Tax Assessment Act 1997 (ITAA 1997) to provide that franked distributions which a taxpayer receives due to engaging in distribution washing will not entitle the taxpayer to tax benefits associated with receiving franking credits.

3.93 Generally, under Australia's imputation system, companies who have paid income tax may provide their members with franking credits when making distributions of profits. Australian residents must include the amount of this credit in their assessable income, but also receive an equivalent tax offset, in effect reducing the tax they pay by the amount of tax the company has paid.

3.94 Not all taxpayers benefit equally from franking credits. A key policy underlying Australia's imputation system is that arrangements to direct franking credits to particular taxpayers are not permitted. A number of existing restrictions are included in the law to prevent various forms of franking credit trading.

3.95 Distribution washing is a new form of franking credit trading that avoids most existing specific restrictions. It takes advantage of special trading arrangements that allow for the creation of a special market on which shares can be purchased with dividend entitlements attached (cum-dividend) after shares traded in the general market have begun to trade with a dividend entitlement (ex-dividend).

3.96 To distribution wash, a taxpayer sells an interest once it has gone ex-dividend, then purchases an equivalent cum-dividend interest on the special market.

3.97 The amendments in Part 1 provide that where an entity obtains multiple franking credits in this way, they only receive a single tax offset (and need only include the amount of one of the credits in their assessable income).

3.98 Part 2 of this Schedule also makes a minor technical amendment to clarify that reference tax offsets in Division 207 of the ITAA 1997 are references to tax offsets provided under that Division. This amendment confirms the existing operation of law with retrospective effect.

Human rights implications

3.99 This Schedule does not engage any of the applicable rights or freedoms.

3.100 Part 1 of this Schedule limits the tax benefits that are available in respect of certain complex financial transactions without any wider impact.

3.101 While the amendments to Part 2 of this Schedule generally apply to events that occur on or after 1 July 2002, this retrospectivity does not engage with any applicable rights or freedoms as it merely clarifies the law to confirm existing practice.

Conclusion

3.102 This Schedule is compatible with human rights as it does not raise any human rights issues.


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