Edited version of private advice

Authorisation Number: 1051790688260

Date of advice: 23 December 2020

Ruling

Subject: Frankable distribution

Question

For the income year ending 30 June 20XX, will a future dividend declared and paid by Company X out of the profit reserve recognised in the half year accounts be unfrankable pursuant to paragraph 202-45(e) of the Income Tax Assessment Act 1997 (ITAA 1997) where the dividend amount does not exceed the net profit that is recognised in the half year audited accounts and credited to the profit reserve?

Answer

No.

This ruling applies for the following periods:

The income year ending 30 June 20XX.

Relevant facts and circumstances

Company X is an Australian resident company that has accumulated losses of $xxx from prior financial years.

Company X has a financial year ending 30 June.

Company X wants to pay a dividend after making a net profit for the half year ended 31 December 20WW.

The net profit will be recognised in Company X's audited half year financial accounts.

To facilitate the dividend, Company X has created a Profit Reserve account that will be recognised in its audited half year financial accounts.

The creation of the Profit Reserve is allowed under Company X's constitution, the Corporations Act 2001 and the Australian accounting standards.

The Directors of Company X will make legally effective resolutions to:

•       allocate the net profit for the half year period to the Profit Reserve account

•       approve the audited accounts for the half year period, which include the balance of the Profit Reserve account for the half year.

The Profit Reserve will not be credited with any amount other than profits recognised in the audited financial accounts for the half year period ending 31 December 20WW.

Company X will not offset the balance of the Profit Reserve account against the balance of its accumulated losses / retained earnings account.

The balance of the Profit Reserve will not otherwise be made unavailable for distribution as a dividend.

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

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.

1.         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.

2.         Paragraph 202-45(e) states that a distribution is unfrankable where it is '...sourced, directly or indirectly, from a company's "share capital account"'.

3.         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.

4.         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 ...

5.         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?

6.         On the basis that the Profit Reserve is only credited with profits that have been recognised in the audited half year financial accounts, the Profit Reserve 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.

7.         A future dividend declared and paid out of the Profit Reserve recognised in the half year audited accounts (where the dividend amount does not exceed the net profit recognised in the half year audited accounts and credited to the Profit Reserve) will therefore be a 'dividend' made by Company X to its 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 of Company X.

8.         Such a dividend will be a 'distribution' for the purposes of considering the application of paragraph 202-45(e).

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

9.         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...'.

10.      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.

11.      Further, TR 2012/5 specifies at paragraph 45 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.

12.      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.

13.      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).

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

15.      Company X has created a Profit Reserve account that is separate from its accumulated losses / retained earnings account.

16.      The Profit Reserve will not be credited with any amount other than profits recognised in the audited financial accounts for the half year period ending 31 December 20WW.

17.      The Profit Reserve will not be used to offset accumulated prior year losses, and the balance of the Profit Reserve will not otherwise be made unavailable for distribution as a dividend.

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

19.      On the basis that the profits credited to the Profit Reserve are recognised in the audited financial accounts of Company X for the half year period and the Profit Reserve is not appropriated for any other purpose, a future dividend declared and paid by Company X out of the Profit Reserve recognised in the half year accounts is not unfrankable pursuant to paragraph 202-45(e) where the dividend amount does not exceed the net profit recognised in the half year audited accounts and credited to the Profit Reserve.