Disclaimer
This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

You cannot rely on this record in your tax affairs. It is not binding and provides you with no protection (including from any underpaid tax, penalty or interest). In addition, this record is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances. For more information on the status of edited versions of private advice and reasons we publish them, see PS LA 2008/4.

Edited version of your private ruling

Authorisation Number: 1012314581514

This edited version of your ruling will be published in the public register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Ruling

Subject: Ability to frank non-share dividend

Question 1

Will a non-share dividend paid on the mandatory convertible notes issued by the Company be regarded as an undebited non-share dividend as defined in section 215-20 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that the non-share dividend paid was recognised as an expense for accounting purposes?

Answer

No

Question 2

Should the available frankable profits of the Company, immediately before the payment of a non-share dividend on the mandatory convertible notes, determined for the purposes of section 215-15 of the ITAA 1997, include the balance of any expense accrued to pay the non-share dividend that exists at that time?

Answer

Yes.

Question 3

If the accrued expense in respect of the payment of the non-share dividend is reversed against the profits of the Company immediately before the payment of the non-share dividend, and then recognised against profits on payment of the non-share dividend, should the available frankable profits of the company immediately before the payment of the non-share dividend on the mandatory convertible notes be determined, for the purposes of section 215-15 of the ITAA 1997, after the reversal of the accrued expense?

Answer

No.

This ruling applies for the following periods:

1 July 2012 to 30 June 2013

The scheme commences on:

An earlier income year

Relevant facts and circumstances

The Company is an Australian incorporated company that is listed on the Australian Securities Exchange (ASX).

In 2XXX, the Company issued mandatory convertible notes.

The notes mandatorily convert into ordinary shares in the Company at a future date at a set conversion price, although this is subject to standard anti-dilution adjustment clauses.

Interest accrues on the mandatory convertible notes and is paid every 6 months via principal capitalisation.

The Company will recognise the payment by increasing the face value of the note, the increase is treated as a new convertible note, with a term equal to the time remaining on the original mandatory convertible notes.

The journal entry that will be made for accounting purposes to recognise the capitalisation of the amounts distributed on the notes is:

DR Interest Payable xx

CR Convertible Note Debt (liability) xx

CR Convertible Note Equity (equity) xx

An amount will then be expensed in respect of the distribution that has been made. The journal entry to reflect this will reduce the profit and is recorded as:

DR Interest Expense xx

DR Convertible Note Debt (liability) xx

CR Interest Payable xx

The distribution of interest is not debited against the non-share capital account or share capital account.

The convertible notes are equity interests for Division 974 of the ITAA 1997.

Relevant legislative provisions

Subdivision 215B of the Income Tax Assessment Act 1997

Section 215-20 of the Income Tax Assessment Act 1997

Subsection 215-20(1) of the Income Tax Assessment Act 1997

Section 974-115 of the Income Tax Assessment Act 1997

Section 974-120 of the Income Tax Assessment Act 1997

Section 995-1(1) of the Income Tax Assessment Act 1997

Section 15AA of the Acts Interpretation Act 1901

Paragraph 15AB(1) of the Acts Interpretation Act 1901

Reasons for decision

Question 1

Will a non-share dividend paid on the mandatory convertible notes issued by the Company be regarded as an undebited non-share dividend as defined in section 215-20 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that the non-share dividend paid was recognised as an expense for accounting purposes?

Answer

No

A non-share distribution

Section 995-1 of the ITAA 1997 defines a non-share distribution as having the meaning given by section 974-115 of the ITAA 1997.

Section 974-115 of the ITAA 1997 states:

The Company makes a payment of interest on the convertible notes. This distribution is recognised as an expense and is added to the face value of the convertible note (the interest is capitalised). The Company have made a non-share distribution for the purposes of section 974-115 of the ITAA 1997 as they have credited an amount to the holder of the convertible note (the non-share equity interest).

A non-share dividend

Subsection 995-1(1) of the ITAA 1997 defines a non-share dividend as having the meaning given by section 974-120 of the ITAA 1997.

Section 974-120 of the ITAA 1997 states:

The payment of interest that the Company makes is not debited against the non-share capital account or share capital account. Therefore, the payment of interest on the note is a non-share distribution, and is also a non-share dividend.

The ability to frank a non-share dividend

The ability to frank a non-share dividend is determined by the rules in Subdivision 215-B of the ITAA 1997. A non-share dividend may be franked where the company paying the non-share dividend has adequate available frankable profits.

Available frankable profits are calculated as provided in subsection 215-20(1) of the ITAA 1997 which states:

There is no guidance in the words of the provisions that explain whether the term available profit in this provision means something different to profit.

Under paragraph 15AB(1)(a) of the Acts Interpretation Act 1901 consideration may be given to extrinsic material such as the Explanatory Memorandum to the legislation introducing Subdivision 215-B of the ITAA 1997 to confirm the ordinary meaning of the phrase.

Section 15AA of the Acts Interpretation Act 1901 provides:

The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (EM) gives guidance as to the treatment of a non-share dividend, it states:

It is clear from the EM then that the available frankable profits are meant to reflect realised profits under the current law. We arrive at this conclusion because there is meant to be no difference between the application of the provisions for dividends paid for shares, and dividends paid on non-shares. Therefore, as dividends on shares must be paid out of realised profits, so too must dividends paid on non-shares if a taxpayer wishes to frank the distribution.

This interpretation therefore establishes that the concept of available profits looks to realised profits as an integrity measure to prevent frankable dividends being paid from unrealised profit.

The EM goes on to explain that the calculation method is meant to relieve the compliance burden under the self assessment system. As such paragraph 2.87 of the EM states.

There is also guidance contained in the Explanatory Memorandum to the New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 (Cth) which provides:

In considering the meaning of available profit in the calculation in subsection 215-20(1) of the ITAA 1997 we have taken an interpretation that promotes the purpose underlying the provision. We are required to do this as stated in section 15AA of the Acts Interpretation Act 1901:

With this in mind it is the preferred view that available profit is analogous to profit as defined in TR 2012/5 such that the same outcome is achieved for franking distributions on shares, and franking distributions on non-share interests.

The term undebited non-share dividends

The question is whether the expense/cost for the non-share dividend paid on the mandatory convertible notes issued by the Company would be regarded as an undebited non-share dividend as defined in section 215-20 of the ITAA 1997 to the extent that the non-share dividend paid was recognised as an expense for accounting purposes. The answer to this question is no.

The underlying rationale for this conclusion is that the amount of expense for the non-share distribution can not be undebited non-share capital because the recording of the expense itself has already reduced the available profit (realised profit) of the company.

In this context, it is considered that the term undebited non-share dividend is meant to, recognise amounts paid in respect of non-share distributions which have not otherwise reduced profits, as many non-share distributions will not have to reduce available profits due to their legal form in contrast to the treatment of a share. This construction is considered consistent with the broad purpose of the legislation as already described

In the present situation, the Company reduces the amount of profits that would otherwise be available for distribution by the accounting expense outlined previously, and thus the calculation of available profits will already be reduced. As such, the amounts expensed in this fashion will not fall within the meaning of the term 'undebited non-share dividends' for the purposes of sections 215-15 and 215-20 of the ITAA 1997.

Question 2

Should the available frankable profits of the Company, immediately before the payment of a non-share dividend on the mandatory convertible notes, determined for the purposes of section 215-15 of the ITAA 1997, include the balance of any expense accrued to pay the non-share dividend that exists at that time?

Answer

Yes

Reasons for decision

Section 215-15 of the ITAA 1997 outlines the circumstances in which non-share dividends should be regarded as unfrankable.

Subsection 215-15(1) states that -

215-15(1)

In this case, the Company pays a distribution which falls into the definition of a non-share dividend.

Section 995-1 of the ITAA 1997 defines 'available frankable profits' as having the meaning given by section 215-20 and affected by subsection 215-25(1).

215-20(1)

215-20(2)

The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (EM) relevantly states at paragraphs 2.84 to 2.86 that -

Thus, section 215-20 of the ITAA 1997 was introduced to prevent streaming opportunities that might otherwise arise due to the fact that non-share dividends need not be paid out of profits. It is also apparent from the EM that the introduction of non-share dividends was not intended to increase opportunities for the release of franking credits.

To that end, section 215-15 of the ITAA 1997 essentially provides that a non-share dividend will not be frankable to the extent that, immediately before the payment, the 'available frankable profits' of the company are less than the amount of the non-share dividend. That is to say, an entity was not to be entitled to distribute more franking credits in total after the amendments than they could have distributed before the amendments, though they were to be entitled to distribute that amount in a wider variety of ways, i.e., to frank a wider class of payments. The maximum amount of franking credits distributable before the amendments was limited to the profits available for distribution by way of dividend at any given point in time. In our understanding, for the purposes of determining the limit to the ability of an entity to frank "non-share dividends", one is to hypothesise the maximum franked actual dividend a company could lawfully distribute to its shareholders (i.e., the whole of its available profits): that amount, the maximum frankable amount, is the limit.

'Available frankable profits' therefore is linked to the definition of 'maximum frankable amount' in the calculation contained above in subsection 215-20(1) of the ITAA 1997. 'Maximum frankable amount' is defined within that subsection as 'the maximum amount of frankable distributions (other than non-share dividends) that the corporate tax entity could pay at that time having regard to its available profits at that time'.

That is, the taxpayer must have available profits out of which frankable share dividends could be paid.

Further to the EM, we considered Federal Commissioner of Taxation v Sun Alliance Investments Pty Ltd (in Liq) 2005 ATC 4955 (Sun Alliance) and Federal Commissioner of Taxation v Slater Holdings Ltd (No 2) 84 ATC 4883 (Slater Holdings) to assist us in the definition of "available profits".

In Sun Alliance, the High Court referred to an earlier decision of the court in Webb v Australian Deposit and Mortgage Bank Ltd (1910) 11 CLR 223. In that case, Higgins J at 241 said:

Commenting on this statement by Higgins J, the majority joint judgement in Sun Alliance stated at paragraph 71:

In Slater Holdings, Gibbs CJ noted at 4889:

The above cases are authority for the view that the term "profits" is a flexible concept and should be considered in the correct context in order to obtain its proper meaning.

From these cases there is no suggestion, however, that profits means something different from the amount revealed by the proper use of accounting concepts and the accounting equation, viz profit = revenue - expenses.

Therefore, taking into account the correct context of the phrase "available frankable profits" in relation to section 215-15 of the ITAA 1997 we are required to look at the accounting concept of profits.

Therefore, the relevant sections are essentially integrity provisions and the concept of 'available profits' should have regard to -

In the present circumstances, the non-share equity interest is treated as a liability for financial accounting purposes and part of the distribution is treated as an interest expense. That is, because the non-share dividend has the legal form of interest, financial accounting practices would require that the interest obligation be accrued and taken into account in determining the entity's accounting profits for the period. It is only after the profit figure has been determined in this fashion that the 'available profits' of the entity can be determined.

This view is consistent with the view expressed by the Commissioner soon after the introduction of Division 974 at the National Tax Liaison Group meeting held on 5 September 2002. The minutes of that meeting provide the following comments in a similar situation to the present:

The ATO believes that follows from a plain reading of the provisions in the light of accounting practice, having particular regard to the meaning of the defined terms discussed above.

Given the structure of the existing provisions, and the definitions adopted, the ATO does not believe that the issue can be readily dealt with by interpretation."

Conclusion

Therefore, the available frankable profits of the Company will include the balance of any expense accrued to pay the non-share dividend that exists immediately before the payment of a non-share dividend on the mandatory convertible notes for the purposes of section 215-15 of the ITAA 1997.

Question 3

If the accrued expense in respect of the payment of the non-share dividend is reversed against the profits of the company immediately before the payment of the non-share dividend, and then recognised against profits on payment of the non-share dividend, should the available frankable profits of the Company immediately before the payment of the non-share dividend on the mandatory convertible notes be determined, for the purposes of section 215-15 of the ITAA 1997, after the reversal of the accrued expense?

Answer

No

Reasons for decision

Section 215-15 of the ITAA 1997 outlines the circumstances in which non-share dividends should be regarded as unfrankable.

Subsection 215-15(1) states:

If:

The Company pays a distribution which is a non-share dividend. In this situation the concept of 'available frankable profits' determines if a company will be able to frank the distribution of the non-share dividend.

Section 995-1 of the ITAA 1997 defines 'available frankable profits' as having the meaning given by section 215-20 of the ITAA 1997 at a particular time.

The Company has advised that it is possible that the interest payable balance, being the 'interest payable' account may be reversed immediately before the payment of the distribution on the convertible notes on the certain date late 2012.

The reversing entry would have the effect of reducing the expenses recognised in the profit and loss statement of the Company on a temporary basis. The ATO understands that financial accounting practices would require that the interest obligation be accrued and taken into account in determining the entity's accounting profits for the period. Such that in preparing end of year accounts this reversal entry would need to be reversed to recognise the interest payable for the remainder of the convertible notes.

The Commissioner does not accept that the temporary change in the expenses recognised by the Company mean that the Company has increased profits just before payment of the distribution on the notes. The Commissioner is of this view as it is essential that a company maintain proper evidence of legally effective directors' resolutions and accounts that establish that profits are available for distribution as a dividend, and are properly applied to dividend distributions at the relevant time.

The adjustment that is being considered and may be made by the Company is temporary, and would not occur if the accounts were calculated in accordance with accounting standards in force at that time for an accruals taxpayer.

Conclusion

If the Company were to carry out a reversing entry immediately before the payment of the non-share dividend, the available frankable profits of the Company immediately before the payment of the non-share dividend on the mandatory notes would not change. The Commissioner would, in determining the available frankable profits for the purposes of section 215-15 of the ITAA 1997, rely on accounts that were calculated in accordance with accounting standards in force at that time for an accruals taxpayer.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).