Edited version of private advice

Authorisation Number: 1051795900058

Date of advice: 12 March 2021

Ruling

Subject: Frankable distribution

Question

For the years ending 30 June 20XX to 30 June 20XY, will a final dividend declared and paid out of the Profit Reserve account recognised in the full year audited accounts be unfrankable pursuant to paragraph 202-45(e) of the ITAA 1997 where the dividend amount does not exceed the balance of the Profit Reserve account?

Answer

No.

This ruling applies for the following periods:

The income years ending 30 June 20XX to 30 June 20XY.

Relevant facts and circumstances

Company X is a company listed on the Australian Stock Exchange (ASX).

Company X primarily derives dividend income, including franked dividends, and gains from disposal of investments.

Company X has a financial year ending 30 June.

Company X prepares half year (31 December) and full year (30 June) financial statements which are audited and lodged with the ASX.

Company X has accumulated losses of $X.

Under Company X's profit reserve policy:

•         At the meeting of Directors before each half year period end, the Directors will approve the transfer of net profits for that half year period to a profit reserve account (Profit Reserve account).

•         Prior financial years' accumulated losses are not required to be recouped before the current financial year profits can be transferred to the Profit Reserve account.

Company X's constitution does not preclude the creation of a profit reserve account or the segregation of profits.

Company X will transfer any net profits for the half year ending 31 December 20XX and 31 December 20XY to the Profit Reserve account. Company X may pay an interim dividend for the 20XX or 20XY financial year out of the balance of the Profit Reserve account as at 31 December 20XX or 31 December 20XY (as relevant).

The payment of the final dividend for the 20XX and 20XY financial years will be undertaken as follows:

•         At the end of the full year period, the Directors of Company X will pass a legally effective resolution approving the:

-        allocation (crediting) of the net profit for the second half of the financial year to the Profit Reserve account, which will be entirely separate from the 'Accumulated losses / retained earnings account' currently shown in the accounts

-        audited financial accounts for the full year period, which include the balance of the Profit Reserve account at year end.

-        Notes to the audited financial accounts for the full year period will record that a meeting of the Directors resolved that the net profit for the second half of the financial year was appropriated to the Profit Reserve account.

-        The balance of the Profit Reserve account will not be offset against the balance of the Accumulated losses / retained earnings account.

-        Dividend payments will be sourced from the Profit Reserve account for distribution to the shareholders of Company X.

When allocating (crediting) net profit for the second half of the financial year to the Profit Reserve account, the Profit Reserve account will not be credited for any amount of profit previously recognised in the half year financial statements.

Further, the balance of the Profit Reserve account at 30 June 20XX and 30 June 20XY will reflect any reduction as a result of paying out an interim dividend.

For the years ending 30 June 20XX and 30 June 20XY, Company X will be in a position to pay a final dividend under the Corporations Act 2001 (Corporations Act). The dividends will satisfy the requirements of section 254T of the Corporations Act and the payment of such dividend will not require shareholder approval under Part 2J.1 of the Corporations Act.

Company X will make a net profit for the relevant half year periods ending 30 June 20XX and 30 June 20XY and will credit that profit to the Profit Reserve account, in accordance with a legally effective Directors' resolution.

The Profit Reserve account will not be used to offset accumulated prior year losses.

The balance of the Profit Reserve account will not be appropriated for any purpose other than for distribution as a dividend.

The Directors of Company X will pass a legally effective resolution to pay the final dividend, specifying that the payment of the dividend will be entirely paid out of the Profit Reserve account.

The Profit Reserve account will not be credited with any amount other than net profits for the half year periods in the 20XX and 20XY income years recognised in the audited financial accounts.

The Profit Reserve account will be established in accordance with Company X's constitution and the Corporations Act.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

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

Reasons for decision

All legislative references are to the ITAA 1997 unless specified otherwise.

In accordance with subsection 202-40(1), a 'distribution' is a 'frankable distribution' to the extent that it is not unfrankable under section 202-45.

Section 202-45 states the following are unfrankable:

(a) (Repealed by No 101 of 2003)

(b) (Repealed by No 53 of 2015)

(c) where the purchase price on the buy-back of a * share by a * company from one of its * members is taken to be a dividend under section 159GZZZP of that Act--so much of that purchase price as exceeds what would be the market value (as normally understood) of the share at the time of the buy-back if the buy-back did not take place and were never proposed to take place;

(d) a distribution in respect of a * non-equity share;

(e) a distribution that is sourced, directly or indirectly, from a company's * share capital account;

(f) an amount that is taken to be an unfrankable distribution under section 215-10 or 215-15;

(g) an amount that is taken to be a dividend for any purpose under any of the following provisions:

(i) unless subsection 109RB(6) or 109RC(2) applies in relation to the amount--Division 7A of Part III of that Act (distributions to entities connected with a * private company);

(ii) (Repealed by No 79 of 2007)

(iii) section 109 of that Act (excessive payments to shareholders, directors and associates);

(iv) section 47A of that Act (distribution benefits--CFCs);

(h) an amount that is taken to be an unfranked dividend for any purpose:

(i) under section 45 of that Act (streaming bonus shares and unfranked dividends);

(ii) because of a determination of the Commissioner under section 45C of that Act (streaming dividends and capital benefits);

(i) a * demerger dividend;

(j) a distribution that section 152- 125 or 220- 105 says is unfrankable.

What constitutes a 'distribution' made by a company is set out in item 1 of the table in subsection 960-120(1). A dividend, or something that is taken to be a dividend, under the ITAA 1997 is a 'distribution' by a company.

A 'dividend' is defined in subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) as follows:

dividend includes:

(a)  any distribution made by a company to any of its shareholders, whether in money or other property; and

(b)  any amount credited by a company to any of its shareholders;

but does not include [emphasis added]:

(d)  moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders ... where the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company; or ...

The 'share capital account' of a company is defined by section 975-300 as follows:

(1)    A company's share capital account is:

(a)    an account that the company keeps of its share capital; or

(b)    any other account (whether or not called a share capital account) that satisfies the following conditions:

(i)the account was created on or after 1 July 1998;

(ii)the first amount credited to the account was an amount of

(iii)share capital.

(2)    If a company has more than one account covered by subsection (1), the accounts are taken, for the purposes of this Act, to be a single account.

Is there a distribution?

In addition to the definition of 'share capital account' set out in section 975-300, consideration must be had to the tests developed by the court in Commissioner of Taxation v Consolidated Media Holdings Ltd [2012] HCA 55, which provide that an account is a share capital account if:

•         it records transactions into which a company has entered in relation to its share capital; or

•         it records the financial position of a company in relation to its share capital.

Further, the case of Cable & Wireless Australia & Pacific Holdings BV (in liquidatie) v Commissioner of Taxation [2017] FCAFC 71 shows that if a review of a particular account is required in order to understand the share capital of the company, then that account is likely to be a share capital account.

However, where review of a reserve account is not required in order to understand the share capital of a company, then the reserve account is unlikely to be considered a share capital account.

On the basis that the Profit Reserve account is only credited with net profit for each half year period in the 2021 and 2022 financial years and which has been recognised in audited financial accounts, the Profit Reserve account should not be considered a share capital account because it is not an account that keeps record of share capital or transactions entered into in relation to share capital and it will not have a credit entry for an amount of share capital.

A final dividend declared and paid out of the Profit Reserve account recognised in the full year audited financial accounts (where the dividend amount does not exceed the balance of the Profit Reserve account) will therefore be a 'dividend' to shareholders as defined in subsection 6(1) of the ITAA 1936 as it will not be debited against an amount standing to the credit of the share capital account.

Such a dividend will be a 'distribution' for the purposes of considering the application of section 202-45.

Is the dividend sourced directly, or indirectly, from a share capital account?

Taxation Ruling TR 2012/5 Income tax: section 254T of the Corporations Act 2001 and the assessment and franking of dividends paid from 28 June 2010 (TR 2012/5), at paragraph 25, advances the proposition that '...a dividend paid by a company..., as defined for taxation purposes, will not be directly or indirectly sourced in a company's share capital account when it is a lawful division of profit for company law purposes, and hence not a return of capital for company law purposes...'.

Paragraph 3 of TR 2012/5 provides that a company is not prevented from paying a franked dividend out of profits recognised in the company's accounts and available for distribution and paid in accordance with the company's constitution and the Corporations Act merely because the company has accumulated losses in prior years.

Paragraph 45 of TR 2012/5 provides that if profits are applied against prior year losses or losses of share capital or otherwise applied or appropriated, they will cease to be available for distribution by way of a dividend.

Therefore, profits will be available for distribution if they have not been appropriated for other purposes.

The siloing of profits in a dedicated profit reserve is one way of ensuring that profits remain available for dividend distribution (see TR 2012/5 paragraph 47 and Example 2 at paragraphs 15 and 16) to the extent that the profit reserve is not appropriated for another purpose.

To the extent that profit is not available for distribution and a distribution is made, that distribution would be taxed as an unfranked dividend or a return of share capital (see TR 2012/5 paragraph 49).

Further, the fact that profits which have not been recognised in the audited financial accounts cannot be distributed as a frankable dividend is demonstrated by Example 3 at paragraph 73 of TR 2012/5.

Accordingly, where Company X has credited profits to the Profit Reserve account and does not apply the Profit Reserve account for any purpose other than the payment of dividends, the profits should be available for distribution and a future dividend will not be sourced directly, or indirectly, from a share capital account.

Therefore, a final dividend declared and paid by Company X out of the Profit Reserve account recognised in the full year audited financial accounts is not unfrankable pursuant to paragraph 202-45(e) where the dividend amount does not exceed the balance of the Profit Reserve account.

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