Edited version of private advice

Authorisation Number: 1051754759368

Date of advice: 13 October 2020

Ruling

Subject: Frankability of distribution and return of capital

Question 1

If the taxpayer were to liquidate its portfolio and pay a dividend comprising the realised profits balance of its Dividend Distribution Reserve, would this payment constitute a frankable distribution for the purposes of section 202-40 of the Income Tax Assessment Act 1997?

Answer

Yes.

Question 2

If, following the payment of the dividend as set out in Question 1, the taxpayer returned capital to its shareholders by debiting its share capital account (whilst its Dividend Distribution Reserve was in a credit balance), would the Commissioner make a determination under subsection 45B(3) of the Income Tax Assessment Act 1936 that section 45C of the Income Tax Assessment Act 1936 applies to the whole, or a part, of the capital return?

Answer

No.

This ruling applies for the following period:

The income tax year ended 30 June 20XX.

The scheme commences on:

1 July 20XX.

Relevant facts and circumstances

The taxpayer is an Australian resident company for tax purposes and is listed on the Australian Securities Exchange (ASX). It is a corporate tax entity for the purposes of section 960-115 of the Income Tax Assessment Act 1997 (ITAA 1997). Its principal activity is investing in a portfolio of listed securities with the core object of paying a recurring dividend to its investors.

It paid regular dividends from inception until 30 June 20XX. Further dividends were declared and/ or paid throughout the reporting period ending 30 June 20XX and following that period.

As an ASX listed entity, the taxpayer's shareholders comprise a mixture of retail, institutional, foreign and Australian holders.

The taxpayer has a third-party investment manager.

The Dividend Distribution Reserve

During the year ended 30 June 20XX, the taxpayer established a Dividend Distribution Reserve (DDR) to set aside amounts from current and retained earnings to fund future dividend payments.

The taxpayer has advised that a DDR, or similar type of account, is commonly used by listed investment companies to assist with maintaining dividends though periods of poor market performance, although it is common to split such an account between a capital profits reserve and an asset revaluation reserve.

The taxpayer has moved funds in and out of its DDR since it was created. At present, the balance comprises a combination of both realised and unrealised profits.

Financial Position

The taxpayer's portfolio has experienced a significant decline and the taxpayer made a loss for the year ending 30 June 20XX.

The taxpayer has approximately $XX in accumulated losses. The taxpayer's net assets and share capital account balances are approximately $XX each. The taxpayer's DDR balance is approximately $XX. The taxpayer's franking account balance is approximately $XX.

The taxpayer's shares have historically traded at a discount to its net tangible assets.

Proposed wind up

The taxpayer is considering winding up by completion of the following steps:

1. Under a wind up, the taxpayer's entire portfolio would be liquidated.
2. The taxpayer would declare and pay a fully franked dividend comprising the realised profits component of the Dividend Distribution Reserve (Final Dividend). The full amount of the Final Dividend would be debited to the DDR leaving a credit balance in the DDR represented by unrealised profits.
3. The taxpayer would undertake a capital return and return all remaining funds to its shareholders (Capital Return). The full amount of the Capital Return would be debited to the taxpayer's share capital account.
4. The shares in the taxpayer would be cancelled for nil consideration.

Other matters:

None of the shares in the taxpayer are non-equity shares as defined in section 995-1 of the ITAA 1997.

The taxpayer had approximately XX ordinary shares on issue as at 31 December 2019.

The taxpayer's share capital account is untainted (within the meaning of section 197-50 of the ITAA 1997).

The taxpayer has obtained legal advice stating that the payment of the Final Dividend would satisfy the requirements outlined in section 254T of the Corporations Act 2001.

Assumption(s)

The taxpayer will be an Australian resident company at the time the Final Dividend is paid.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-135

Income Tax Assessment Act 1997 section 197-50

Income Tax Assessment Act 1997 section 202-5

Income Tax Assessment Act 1997 section 202-15

Income Tax Assessment Act 1997 section 202-20

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Income Tax Assessment Act 1997 section 960-120

Income Tax Assessment Act 1997 section 975-300

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 section 45B

Income Tax Assessment Act 1936 section 45C

Income Tax Assessment Act 1936 subsection 177A(1)

Corporations Act 2001 section 254T

Reasons for decision

All legislative references in these reasons for decision are to the Income Tax Assessment Act 1997 unless otherwise specified.

Question 1

If the taxpayer were to liquidate its portfolio and pay a dividend comprising the realised profits balance of its Dividend Distribution Reserve, would this payment constitute a frankable distribution for the purposes of section 202-40 of the Income Tax Assessment Act 1997?

Summary

The payment would constitute a frankable dividend for the purposes of section 202-40.

Detailed reasoning

In order for a dividend to be franked, a number of corporations law and income tax law requirements need to be satisfied.

Corporations law requirements

Section 254T of the Corporations Act 2001 provides that a company must not pay a dividend unless:

1. The company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend
2. The payment of the dividend is fair and reasonable to the company's shareholders as a whole, and
3. The payment of the dividend does not materially prejudice the company's ability to pay its creditors.

The taxpayer has obtained advice stating that the payment of the Final Dividend would satisfy the requirements outlined in section 254T of the Corporations Act 2001.

Taxation law requirements

Section 202-5 sets out the conditions that must be satisfied for an entity to frank a distribution. It states:

202-5 An entity franks a distribution if:

(a)  the entity is a *franking entity that satisfies the *residency requirement when the distribution is made,

(b)  the distribution is a *frankable distribution, and

(c)   the entity allocates a *franking credit to the distribution.

Distribution

A 'distribution' by a company is defined in subsection 960-120(1) as 'a dividend, or something taken to be a dividend, under this Act'.

A 'dividend' is relevantly defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) as including 'any distribution made by a company to any of its shareholders, whether in money or in other property' but does not include 'moneys paid or credited by a company to a shareholder...where the amount of the moneys is debited against an amount standing to the credit of the share capital account of the company'.

The term 'share capital account' referred to in paragraph (d) of the definition of 'dividend' in subsection 6(1) of the ITAA 1936, is defined in subsection 975-300(1) as 'an account that the company keeps of its share capital' or 'any other account...[where] the first amount credited to the account was an amount of share capital'.

The DDR is not an account that the taxpayer keeps of its share capital, nor was the first amount credited to it an amount of share capital. Rather, it is an account that was established for the purposes of earmarking profits to be paid out as future dividends. It does not distinguish between realised and unrealised profits and is not a record of only capital profits. As such, the DDR is not a 'share capital account' as defined in section 975-300.

The Final Dividend will constitute a distribution made by the taxpayer to its shareholders in money. The Final Dividend will be debited in full to the realised profits component of the DDR and not against any amount standing to the credit of its share capital account. Hence, the Final Dividend to be made by the taxpayer will be a dividend pursuant to subsection 6(1) of the ITAA 1936 and therefore a 'distribution' as defined in section 960-120.

Subsection 202-5(a)

A franking entity is defined in section 202-15:

202-15 An entity is a franking entity at a particular time if:

(a)  it is a corporate tax entity at that time, and

(b)  it is not a life insurance company that is a mutual insurance company at that time, and

(c)   in a case where the entity is a company that is a trustee of a trust - it is not acting in its capacity as trustee of the trust at that time.

The taxpayer meets the requirements of a franking entity because it is a corporate tax entity and is not excluded by subsections 202-15(b) or (c).

Under section 202-20 an entity satisfies the 'residency requirement' when making a distribution if, in the case of a company, the company is an Australian resident at that time. The taxpayer is an Australian resident company and it is assumed that the taxpayer will remain an Australian resident company at the time the Final Dividend is paid. It follows that the taxpayer will satisfy the 'residency requirement' when the Final Dividend is made.

For these reasons, the taxpayer will satisfy subsection 202-5(a) at the time the Final Dividend is paid.

Subsection 202-5(b)

Under section 202-40, a distribution is a frankable distribution to the extent that it is not unfrankable under section 202-45.

Types of unfrankable distributions are listed in section 202-45. Subsection 202-45(c) will not apply because the taxpayer is not performing a buy back. Subsection 202-45(d) will not apply because there are no non-equity shares in the taxpayer. Subsection 202-45(f) will not apply because sections 215-10 and 215-15 do not apply (the taxpayer is not an ADI and is not making a non-share distribution). Subsections 202-45(g), (i) and (j) do not apply because the distribution is not a deemed dividend, an excessive payment to an associate or as a result of a demerger. The remaining subsection is 202-45(e), which states that a distribution is unfrankable if it is sourced directly or indirectly from a company's share capital account.

The question of whether a distribution is sourced, directly or indirectly, from a company's share capital account directs attention to the equity fund which is depleted by payment of the distribution.

In this case, the Commissioner is satisfied that the Final Dividend represents a lawful division of the taxpayer's realised profits for company law purposes and hence not a return of capital for company law purposes. In both in form and substance, the equity fund which will be depleted by payment of the Final Dividend will be the realised profit component of the DDR which, as stated above, is not a 'share capital account' as defined in section 975-300.

It follows that subsection 202-45(e) will not apply and the taxpayer will satisfy subsection 202-5(b) in relation to the Final Dividend.

Subsection 202-5(c)

The taxpayer will allocate a franking credit to the Final Dividend and has disclosed a franking account balance containing enough credits to do so, satisfying this requirement.

Conclusion

The payment of the Final Dividend will satisfy the requirements outlined in section 202-5. If the taxpayer were to liquidate its portfolio and pay a dividend comprising the realised profits balance of its DDR, this payment (the Final Dividend) would constitute a frankable distribution for the purposes of section 202-40.

Question 2

If, following the payment of the dividend as set out in Question 1, the taxpayer was to return capital to its shareholders by debiting its share capital account (whilst its Dividend Distribution Reserve was in a credit balance), would the Commissioner make a determination under subsection 45B(3) of the Income Tax Assessment Act 1936 that section 45C of the Income Tax Assessment Act 1936 applies to the whole, or a part, of the capital return?

Summary

No, the Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole or any part of the proposed capital return.

Detailed reasoning

Section 45B of the ITAA 1936 applies where certain capital payments, including a return of capital, are paid to shareholders in substitution for dividends. The purpose of section 45B of the ITAA 1936 is to ensure that relevant amounts distributed to shareholders of a company are treated as dividends for tax purposes if certain payments, allocations and distributions are made in substitution for dividends.

The conditions that must be met for section 45B of the ITAA 1936 to apply are set out in subsection 45B(2) of the ITAA 1936, which states:

This section applies if:

(a)  there is a scheme under which a person is provided with a demerger benefit or a capital benefit by a company; and

(b)  under the scheme, a taxpayer (the relevant taxpayer), who may or may not be the person provided with the demerger benefit or the capital benefit, obtains a tax benefit; and

(c)   having regard to the relevant circumstances of the scheme, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit.

Scheme

A 'scheme' for the purposes of section 45B of the ITAA 1936 is taken to have the same meaning as provided in subsection 177A(1) of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan, or proposal. In particular, a scheme is anything that satisfies any of the terms in the statutory definition.

The taxpayer's proposed Capital Return will constitute the relevant scheme for the purposes of section 45B of the ITAA 1936.

Capital benefit

A person is provided with a capital benefit if they receive distributions of share capital or share premium (paragraph 45B(5)(b) of the ITAA 1936).

As the Capital Return will be debited to the taxpayer's share capital account, the taxpayer will provide shareholders with a capital benefit under paragraph 45B(5)(b) of the ITAA 1936.

Tax benefit

Paragraph 45B(2)(b) of the ITAA 1936 requires the provision of a tax benefit to a taxpayer under the scheme. Subsection 45B(9) of the ITAA 1936 provides that a taxpayer 'obtains a tax benefit' if the amount of tax payable by the relevant taxpayer (not necessarily the same person receiving the capital benefit (refer paragraph 45B(2)(b) of the ITAA 1936)) would, apart from the operation of section 45B of the ITAA 1936, be less than the amount that would be payable, or would be payable at a later time, if the capital benefit had been an assessable dividend instead.

To ascertain whether a tax benefit is provided, the tax outcomes following the Capital Return and the tax outcomes from a payment of a dividend must be compared.

The Capital Return will generally be subject to the CGT provisions. Where the distribution is less than the cost base of the shares, the cost base of the shares is reduced under CGT event G1 (section 104-135). If the distribution exceeds the cost base of the shares, a capital gain arises.

By contrast, an assessable dividend would generally be included in the assessable income of a resident shareholder or in the case of a non-resident, be subject to dividend withholding tax.

As a result, the Capital Return made to the shareholders of the taxpayer is a provision of a tax benefit, so paragraph 45B(2)(b) of the ITAA 1936 is satisfied.

Relevant circumstances

While the conditions of paragraphs 45B(2)(a) and (b) of the ITAA 1936 are met in respect of the proposed Capital Return, having regard to the 'relevant circumstances' (as outlined in subsection 45B(8) of the ITAA 1936), the Commissioner is of the view that the requisite purpose of enabling a person to obtain a tax benefit as a result of the capital distribution will not be present.

Accordingly, section 45B of the ITAA 1936 will not apply and the Commissioner will not make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the whole, or a part, of the proposed Capital Return.

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