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Ruling

Subject: Income tax: franking of dividends and section 254T of the Corporations Act 2001

Question 1

Did the past dividends paid by the company constitute frankable distributions under section 202-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the interim and final dividends that the company pays out of current period profits in respect of its financial year ending 30 June 2012 constitute frankable distributions, under section 202-40 of the ITAA 1997 even if the company's net assets are less than its share capital at the time the dividends are paid?

Answer

Yes.

This ruling applies for the following period:

1 July 2010 to 30 June 2012

The scheme commences on:

1 July 2010

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6(1)

Income Tax Assessment Act 1936 section 44(1)

Income Tax Assessment Act 1936 section 44(1A)

Income Tax Assessment Act 1997 section 202-25

Income Tax Assessment Act 1997 section 202-40

Income Tax Assessment Act 1997 section 202-45

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The company is an Australian resident company listed on the Australian Securities Exchange.

The company currently has accumulated losses and its net assets are less than its share capital.

The company has had profits every year for the last few years.

The company has paid past dividends out of a portion of its profits and has retained the residual profits within the business. The company had sufficient franking credits to fully frank each dividend.

The company will pay dividends out of current period profits in respect of its financial year ending 30 June 2012.

Reasons for decision

Issue 1

Question 1

Section 254T of the Corporations Act 2001 (Corporations Act) previously provided for a 'profits based test' in relation to the payment of dividends that stated: 'A dividend may only be paid out of profits of a company'.

Amendments to the Corporations Law pursuant to the Corporations Amendment (Corporate Reporting Reform) Act 2010, introduced a new three-tiered test (a balance sheet test) which applies to company dividends declared on or after 28 June 2010. The new section 254T of the Corporations Act provides:

1. A company must not pay a dividend unless:

(a) The company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and

(b) The payment of the dividend is fair and reasonable to the company's shareholders as a whole; and

(c) The payment of the dividend does not materially prejudice the company's ability to pay its creditors.

Note 1: As an example, the payment of a dividend would materially prejudice the company's ability to pay its creditors if the company would become insolvent as a result of the payment.

Note 2: For a director's duty to prevent insolvent trading on payment of dividends, see section 588G.

2. Assets and liabilities are to be calculated for the purposes of this section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).

Dividends

'Dividend' for tax purposes 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 -

(d) The amount of the value of the property [that] is debited against an amount standing to the credit of the share capital account of the company; or…

This definition of dividend in subsection 6(1) of the ITAA 1936 provides the basis for the application of section 44 of the ITAA 1936. In particular, subsection 44(1) of the ITAA 1936 provides that:

The assessable income of a shareholder in a company (whether the company is a resident or a non-resident) includes:

(a) If the shareholder is a resident:

(i) Dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source…

(b) If the shareholder is a non-resident:

(i) Dividends (other than non-share dividends) that are paid to the shareholder by the company out of profits derived by it from any source…

As a result of the substitution of section 254T of the Corporations Act, a consequential amendment was made to the ITAA 1936 to introduce subsection 44(1A) of the ITAA 1936, which provides:

For the purposes of this Act, a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits.

The Explanatory Memorandum to the changes set out the following explanation for this amendment:

Consequential amendments to the income tax law

3.15 For income tax purposes, a dividend is defined to mean, broadly, any distribution made by a company to its shareholders, other than an amount that is capital account (subsection 6(1) of the Income Tax Assessment Act 1936). Therefore, distributions made as a result of the amendments to section 254T of the Corporations Act will generally be dividends for income tax purposes.

3.16 Dividends paid to shareholders are included in assessable income provided that the dividends are paid by the company out of its profits (section 44 of the Income Tax Assessment Act 1936). As a result of these amendments, some corporate distributions that are dividends for Corporations Act purposes may not be paid by the company out of its profits.

3.17 Therefore, a consequential amendment to section 44 will deem these distributions to be paid by a company out of profits for the purposes of the income tax law. This will ensure that shareholders include these distributions in assessable income. [Schedule 1, Part 4, item 56]

3.18 Subject to the operation of the current imputation integrity rules, these distributions will be frankable under section 202-40 of the Income Tax Assessment Act 1997 (ITAA 1997).

Frankable Distributions

Section 202-25 of the ITAA 1997 provides that generally distributions that are made out of realised profits can be franked.

Under section 202-40 of the ITAA 1997, a distribution is a frankable distribution to the extent that it is not unfrankable under section 202-45 of the ITAA 1997.

Although the Corporations Act rules regarding the ability of a company to pay a dividend in accordance with section 254T have been changed, the concept of profits and the source of a distribution continues to be relevant to the franking of dividends under the imputation system.

Section 202-45 of the ITAA 1997 lists the distributions that are unfrankable. Paragraph 202-45(e) of the ITAA 1997 lists one of those distributions as:

a distribution that is sourced, directly or indirectly, from a company's share capital account.

Section 975-300 of the ITAA 1997 states that:

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 share capital.

Draft Taxation Ruling TR 2011/D8 is about the taxation of dividends paid in compliance with section 254T of the Corporations Act from 28 June 2010 including the franking of dividends under Part 3-6 of the ITAA 1997.

In accordance with paragraph 3 of Draft Taxation Ruling TR 2011/D8, a company subject to the Corporations Act that pays a dividend to its shareholders, in accordance with its constitution and without breaching section 254T or Part 2J.1 of that Act, that is paid out of current trading profits is not prevented by paragraph 202-45(e) of the ITAA 1997 from franking the dividend merely because the company has unrecouped prior year accounting losses or has lost part of its share capital.

The profits must be available for distribution by way of dividend, and be recognised in proper accounts of the company kept in accordance with the Corporations Act and accounting standards, and calculated pursuant to them.

Paragraph 40 of Draft Taxation Ruling TR 2011/D8 explains that the presence of accumulated losses and a deficiency of a company's net assets below its share capital does not change the character of an amount of ascertained current year booked trading profits, or a dividend paid out of such an amount. Previous case law has established that prior accumulated losses do not have to be recouped before a dividend can be paid out of current year profits.

Where the financial statements of the prior and current years evidence the fact that share capital has been lost in a previous year, and that current year profits are an available source for a dividend payment without prior year losses being recouped, current year profits do not have to be applied against the accumulated losses as a matter of law or accounting, and hence retain their character as profits available for distribution.

The changes to section 254T of the Corporations Act have not altered what is defined as a dividend for tax purposes or the process for determining what is a taxation law dividend. This position is summarised in paragraph 4 of Taxation Ruling TR 2003/8 as follows:

The amount of a dividend in respect of a distribution of property… to a shareholder in their capacity as a shareholder will be the money value of the property at the time it is distributed, reduced by the amount debited to a share capital account of the distributing company in respect of the distribution.

Therefore, in applying the definition of dividend in subsection 6(1) it is generally the form of the distribution from the company's perspective that is examined. Thus, if a company makes a distribution to a shareholder it will prima facie fall within the definition of a dividend, unless it is subject to one of the exclusions in subsection 6(1) of the ITAA 1936.

As a practical, hard matter of fact, whether a dividend paid pursuant to section 254T of the Corporations Act is sourced from a company's share capital account is a question that can only be determined by examination of the company's balance sheet and accounting records at the time the distribution is made. Where a company has derived trading profits, and accounts for that profit so as to maintain its availability for distribution as a dividend to shareholders, it will be possible to pay a franked dividend sourced from that profit, notwithstanding the presence of prior year trading losses or a deficiency of net assets below share capital.

In this case the company has indicated that it currently has accumulated losses and its net assets are less than its share capital. However, the company has had a profit every year for the last few years and has adopted a policy of paying out only a portion of profits as dividends and retaining the residual profits within the business. This has reduced their accumulated losses.

As the company did not apply all the profits against its accumulated losses or otherwise render them unavailable for distribution, they were available as a source for the payment of a franked dividend.

Question 2

Summary

In accordance with the above reasoning, the dividends that the company pays out of current period profits in respect of its financial year ending 30 June 2012 will constitute frankable distributions under section 202-40 even if the company's net assets are less than its share capital at the time the dividends are paid.