Taxation Ruling

IT 2605

Income tax: rebate on dividend income

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FOI status:

May be releasedFOI number: I 1012265

PREAMBLE

The purpose of this Ruling is to set out the views of this Office on the operation of former subsection 46(7) of the Income Tax Assessment Act 1936 (the Act).

2. Under section 46 of the Act, a rebate is allowable on dividends included in the taxable income of a resident company. Subsection 46(7) prescribes the basis for calculating the amount of dividends included in the taxable income of a company. Prior to the amendment of subsection 46(7) with effect from the year of income commencing on 1 July 1987 the amount of rebate was calculated on net dividends, i.e. gross dividends included in assessable income less deductions allowable against such income. Since the introduction of the dividend imputation system of company taxation from 1 July 1987, the rebate is calculated on the full amount of dividends without offsetting any allowable deductions.

3. Prior to 1 July 1987 subsection 46(7) provided:

"46(7) For the purposes of sub-section (2) and sub-section (3)...

(a)

the part of any dividends that is included in the taxable income of a shareholder of the year of income is the amount remaining after deducting from the amount of the dividends included in the assessable income of the shareholder of the year of income the deductions allowable to the shareholder under this Act from income from dividends; and

(b)

the part of any private company dividends that is included in the taxable income of a shareholder of the year of income, being a company that is a private company in relation to the year of income, is the amount remaining after deducting from the amount of the private company dividends included in the assessable income of the shareholder of the year of income -

(i)

any deductions allowable to the shareholder under this Act from income from dividends, being deductions that relate directly to the private company dividends; and

(ii)

so much of any other deductions allowable to the shareholder under this Act from income from dividends as, in the opinion of the Commissioner, may appropriately be related to the private company dividends".

4. The effect of former subsection 46(7) was to reduce the amount of dividends the subject of the section 46 rebate by the deductions allowable from income from dividends. This Ruling considers the circumstances in which deductions may be set off against dividends for the purposes of calculating the section 46 rebate. The issue of the operation of the former subsection 46(7) has arisen in the context of share acquisitions by public companies funded through borrowings where it is sought to deduct the interest on the borrowings and at the same time to claim a full rebate on dividends undiminished by the interest deduction. The Ruling therefore concentrates on the circumstances where an interest deduction may be set off against dividend income pursuant to paragraph 46(7)(a). The related issue of interest deductibility is the subject of a separate ruling (see Taxation Ruling IT 2606).

RULING

5. In applying former subsection 46(7) it is necessary to determine which (if any) allowable deductions are to be characterised as "allowable from income from dividends". To do this reference must be made to section 50 of the Act (see The North Australian Pastoral Co Ltd v. F.C. of T. (1946) 71 CLR 623, 3 AITR 314, 8 ATD 121; Rowdell Pty Ltd v. FCT (1963) 111 CLR 106, 37 ALJR 332, 9 AITR 177, (1964) ALR 449, 13 ATD 242). Section 50 provides an order of deductions code where there are different classes of income included in a taxpayer's assessable income.

6. Section 50 is as follows:

"50. Where the assessable income is derived from more than one of the following classes of income, that is to say, income from personal exertion, income from property other than dividends, and income from dividends, the following provisions shall apply to all allowable deductions:-

(a)

where a deduction or part of a deduction relates directly to income from dividends (whether of the year of income or of a previous year of income) the deduction or part of the deduction, as the case requires, shall be made successively from income from dividends, from income from property other than dividends and from income from personal exertion;

(b)

where a deduction or part of a deduction relates directly to the income from property other than dividends (whether of the year of income or of a previous year of income) the deduction or part of the deduction, as the case requires, shall be made successively from income from property other than dividends, from income from dividends, and from income from personal exertion; and

(c)

in all other cases, the deduction or part of the deduction shall be made successively from income from personal exertion, from income from property other than dividends and from income from dividends".

7. When former subsection 46(7) and section 50 are read together it is apparent that the section 46 rebate was to be calculated by deducting from dividend income only such deductions or parts of deductions as "relate directly" to income from dividends (paragraph 50(a)), plus such other deductions as remain after being offset against other classes of income. As a practical matter, apart from paragraph 50(a), it will be only paragraph 50(b) that will potentially impact on a taxpayer's final tax liability. This will be in cases where the taxpayer has income from each of the three sources mentioned in that paragraph and the deductions which relate directly to income from property other than dividends exceeds the income from that source.

8. It should be noted that paragraph 50(a) and section 46 deal with outgoings which are otherwise deductible under the Act. Before applying paragraph 50(a) and subsection 46(7) it will always be necessary to consider, as a threshold question, whether the outgoing is deductible under the Act.

9. The application of the section 46 rebate has been considered in several cases before the courts and the former Boards of Review.

10. The High Court considered the then subsection 46(3) rebate in The North Australian Pastoral Co Ltd case (supra). The taxpayer carried on a cattle breeding business from an extensive cattle station in the Northern Territory. The taxpayer also held shares in other pastoral companies from which it received dividends. Dixon J, as he then was, found that the taxpayer's only activities with respect to those dividends was to receive cheques, endorse them and pay them into a bank account. In calculating the rebate on those dividends, the Commissioner deducted 1% of the company's operating expenses as being "estimated costs of collection etc". Dixon J noted that the amount involved had not been allowed as a specific deduction from the dividends. His Honour rejected the Commissioner's contention that there did not need to be a specific connection between the dividends and the expenses. In his Honour's view subsection 46(3) intended "to deduct from the rebate what had been deducted from the dividends in arriving at the taxable income"(at CLR 635, AITR 323, ATD 129). He found, in any event, that the amount deducted against the dividends was excessive and remitted the assessment for reassessment.

11. The Board of Review in Case 19 (1946) 12 TBRD (OS) 128 at page 177 referred to the judgment of Dixon J in The North Australian Pastoral Co Ltd case as indicating that the Commissioner could only deduct from rebatable dividends if he could point to a deduction which "relates directly to income from dividends - s.50(a)". In that case, the Commissioner had deducted that proportion of overdraft interest which he regarded as referable to the acquisition of the shares producing the dividends. A deduction had been allowed for the full amount of interest. The Board found as a fact that no part of the overdraft related to the acquisition of the shares and accordingly held that there was no relevant deduction which related directly to income from dividends.

12. The issue was again considered in Case 42 (1950) 1 TBRD 129, 1 CTBR(NS) Case 56 where moneys deposited with the taxpayer company were paid into a general banking account and were used "indiscriminately" for the purposes of the company, including the acquisition of shares from which dividends were received. The Board of Review concluded that some part of the deduction claimed for interest on those deposits did relate directly to the dividends, even though the Commissioner had not made a specific deduction from the dividends in arriving at the taxable income. A sufficiently intensive examination of the records of the company would show that a certain amount of the deposits had, in fact, been invested in shares which returned dividends. The Board rejected the taxpayer's contention that the word 'directly' in s.50(a) meant 'specifically' or 'exclusively'.

13. In Rowdell Pty Ltd v. F.C. of T. (supra) the taxpayer was a share trader which purchased shares in other companies as trading stock with a view to stripping the net assets of those companies by way of dividend distribution and then selling the shares at a loss. The question arose as to whether the purchase price of the shares or the loss on realization of the shares were deductions which related directly to dividends for determining the amount of the then subsection 46(3) rebate. The Commissioner had reduced the amount of dividends included in the taxpayer's taxable income by apportioning the purchase price of the shares over the total of the dividends and the proceeds of their disposition.

14. Dixon CJ dealt with the question (at CLR 119) by saying there was no justification for the Commissioner reducing the rebatable dividends "by apportioning the one outgoing, viz. the cost of the shares or the loss, pro rata against the dividends".

15. Menzies J dealt with the issue in more detail. He concluded (at CLR 136) that the loss on the disposal of the shares could not be offset against the dividends. He stated as a general rule that no part of the purchase price of a share purchased by a sharetrader related directly to income from dividends. His Honour noted, however, that there might be a special case where the vendor and purchaser of the shares had calculated the purchase price by adding together the amounts paid in respect of expected or intended receipts, and where accordingly it might be possible to show that the component of the purchase price relating to the intended dividends related directly to those dividends when received.

16. In F.C. of T. v. Patcorp Investments Ltd (1976) 140 CLR 247, 51 ALJR 40, 76 ATC 4225, 6 ATR 420, Gibbs J (as he then was) followed the majority of the Court in Rowdell in holding that neither the cost of shares nor the loss on sale of the shares related directly to the dividends paid on the shares.

17. In Palvestments Pty Ltd v. F.C. of T. (1965) 112 CLR 661, 13 ATD 527, the taxpayer was a trader in shares and securities. It incurred interest on an overdraft which was used in part to pay for the purchase of some shares. The Commissioner sought to offset a proportion of the interest incurred on the taxpayer's overdraft against dividend income in order to calculate the section 46 rebate. The proportion was that which the dividend income bore to the total assessable income. Menzies J held (CLR 665-6 ATD 529) that this was an arbitrary and unrealistic appropriation and that on the evidence he was not able to infer that any part of the interest paid in the relevant year related directly to any of the dividend income.

18. In Case C58 71 ATC 255, 17 CTBR(NS) Case 56 the taxpayer company acquired shares by the issue to the vendor of interest bearing convertible notes. The notes were subsequently exchanged for unsecured loans bearing interest retrospectively. The Board of Review held that the interest on the unsecured loans related directly to the dividends received on the shares acquired. The obligation under the unsecured loans was an exact substitution for the original liability for the purchase price of the shares, and so the obligation related directly to the shares. By the same reasoning, the interest payable in respect of that obligation related directly to the dividends produced by the shares.

19. In the course of representations on the application of the former subsection 46(7), it has been said that the cases effectively preclude the establishment of a direct relationship between an interest deduction and dividend income in any circumstances. This view is not accepted. It is considered that the following broad conclusions can be drawn from the cases:

.

Deductions allowable for the cost of shares or losses incurred on disposal of shares acquired as trading stock do not relate directly to income from dividends except in the limited circumstances mentioned by Menzies J in Rowdell (see paragraph 15).

.

Deductions for interest incurred by a sharetrader on funds borrowed to acquire shares as trading stock will also not relate directly to income from dividends except in the same limited circumstances.

.

The cases do not prohibit a finding that a deduction for interest may relate directly to income from dividends in the case of a company where the only ground for deductibility of the interest expense is the production of dividend income. The comments in the sharetrading decisions must be read in the context of the nature of the sharetrader being able to obtain income both from dividends on the purchased shares and also from the proceeds of disposal of the shares. This "dual-income" position contrasts with the case of a company which is only entitled to a deduction for interest because of the derivation of, or at least the expectation of, dividend income.

.

Where there is a direct relationship between part of an interest deduction and dividend income, there is nothing in the cases to preclude an appropriately based apportionment of the interest deduction between dividend and other income for the purposes of ascertaining the section 46 rebate. It is however clear that such an apportionment cannot be made on an arbitrary basis.

20. While broad conclusions and guidance can be drawn from the cases, the meaning of the words "relates directly" in paragraph 50(a) still needs to be considered in deciding whether deductions should be offset against dividend income in different factual circumstances.

21. The Oxford English Dictionary suggests that "relates" means "connected with" or "having a relationship with" or "having reference to". The word "directly" is defined by the Oxford Dictionary as meaning "without interruption", "not round about", "without delay".

22. From the dictionary definitions it would seem that for two matters to relate directly, what is required is that one matter be connected to another or have reference to the other without interruption or without delay or not in a round about way. Thus a direct relationship can be said to involve a "specific connection" (see Palvestments per Menzies J at CLR 664, ATD 529 citing North Australian Pastoral Co Ltd per Dixon J at CLR 636, ATD 129).

23. Further guidance can be found in F.C. of T. v. Dixon (1952) 86 CLR 540, 10 ATD 82, where the High Court considered the meaning of the expression "in relation directly or indirectly to, any employment" as it appears in paragraph 26(e) of the Act. Dixon CJ and Williams J (at CLR 553-4, ATD 83-4) made the following comments on the wording of paragraph 26(e):

"It is hardly necessary to say that the words 'directly or indirectly' extend the operation of the words 'in relation to'. In spite of their adverbial form they mean that a direct relation or an indirect relation to the employment or services shall suffice. A direct relation may be regarded as one where the employment is the proximate cause of the payment, an indirect relation as one where the employment is a cause less proximate, or, indeed, only one contributory cause".

24. Having regard to the dictionary definitions and the High Court's comments in Dixon (supra), it could be said that a deduction for interest on borrowed funds will "relate directly" to dividend income if the acquisition of shares on which dividends are received is the proximate cause of the borrowings giving rise to the interest expense. This might lead to a conclusion that a direct relationship will not necessarily depend on a demonstration that the borrowed funds, in respect of which the interest is incurred, were the actual funds used to acquire the shares. In other words the relationship would not depend upon the tracing of the borrowed funds into the hands of the vendors of the shares.

25. On the other hand it seems clear that a deduction will not relate directly to dividend income for the purposes of paragraph 50(a) unless the outgoing giving rise to the deduction was incurred in the production of dividend income. For example, if interest expenditure was deductible under subsection 51(1) because it was incurred in the production of trading income, the interest deduction would not relate directly to dividend or other property income.

26. The position is not as clear where a deduction can be justified on more than one ground. This might occur where a company borrows funds for the purpose of acquiring shares but in fact uses its own funds to acquire the shares and the borrowed funds replace those other funds and are used for income producing purposes of the company's business. If in such a case the deduction for interest could be justified because of the dividend income from the shares and also as being incurred in the carrying on of the business, would the interest deduction relate directly to the dividend income? On one view, so long as it can be said that interest deductibility is capable of being sustained by the connection between the interest expense and the dividend income, the deduction relates directly to the dividend income. Another view is that the deduction relates directly only if the sole ground upon which the deductibility can be properly sustained is the connection between the interest expense and the dividend income. In other words, if a deduction for interest would not have been allowable were it not for the connection with the dividend income, the direct relationship test is satisfied.

27. While the matter is not free from doubt, it is considered that the second view is the better approach. This stricter view is more in line with the meaning of the phrase "relates directly" where the word "directly" signifies something more specific than a mere connection between a deduction and dividend income. This view is also consistent with the basic policy of section 46 before 1 July 1987 in that gross dividends should only be reduced by deductions which would not have been allowable other than for the connection with dividend income.

28. Cases may arise where funds borrowed for the purpose of acquiring shares are passed into a pool or are on-lent interest free to a subsidiary which acquires the shares in the target company. Whether there is a direct relationship between the interest deduction and dividends received in such situations will very much depend on the facts in each case.

29. In the case of pooled funds, a direct relationship between the interest deduction and dividend income will not exist unless the other amounts forming part of the pool are quite minimal in comparison with the amount of the borrowed funds. If they are, the situation would not be materially different to that where borrowed funds are used directly to acquire the shares. If the sole ground of deductibility for the interest is because of the connection with dividend income the direct relationship test would be satisfied.

30. In the case of borrowed funds passing through an interposed subsidiary company, a direct relationship may still exist between the interest deduction and dividends received from the interposed subsidiary. If it could be said that the sole ground of deductibility of the interest expense is because of the derivation of dividend income from the interposed subsidiary, the deduction would be directly related to dividend income. Where, however, a deduction for interest would have been sustainable because of the connection with other income producing activities of the company, there would not be a direct relationship between the interest deduction and dividend income.

31. In summary, it is the view of this Office that a deduction, or a part of a deduction, for interest "relates directly" to dividend income where the interest expense, or part thereof, is deductible solely because of its connection with the dividend income. In such cases the interest outgoing will be a deduction "allowable ... from income from dividends" for the purposes of the former subsection 46(7) of the Act.

32. Where an interest expense is deductible solely because of the connection with the dividend income it will of course be allowable under the first limb of subsection 51(1). If in some cases it could be said that a deduction would also have been allowable under the second limb merely because the company was carrying on a business of a holding company for the purpose of gaining or producing assessable income from dividends, the direct relationship otherwise existing would not be broken. In such a case, where the interest is deductible under the second limb only because of the connection with dividend income (and other like income in the future), it could hardly have been intended that such a second limb connection would sever the direct relationship between the interest deduction and dividend income.

33. The following examples are provided in order to illustrate the application of the former subsection 46(7). It is assumed for the purposes of each example that the interest outgoing is an allowable deduction.

.

A company borrows funds and uses those funds solely to purchase shares and dividends are paid on those shares. The sole reason for deductibility of the interest on the borrowed funds is because of the connection with the dividend income. The deduction for interest and the dividends are directly related for the purposes of subsection 46(7) and paragraph 50(a).

.

As part of an arrangement to acquire shares a company borrows funds for the purpose of acquiring those shares. The shares are actually acquired from other funds of the company while the borrowed funds replace the other funds and are used for income producing purposes. In this situation there would not be a direct relationship between the interest deduction and dividends received on the acquired shares because it could not be said that the interest was deductible solely because of the dividend income.

.

A company borrows funds for use in its business and places the borrowed funds in an account which is used for general business purposes. The company subsequently decides to acquire shares using funds from its general business account. In this situation there would not be a direct relationship between the interest deduction and dividends received on the acquired shares.

34. Once it is established that for the purposes of paragraph 50(a) a deduction relates directly to a particular dividend, the deduction is offset against all dividend income and not merely the dividends from the particular shares to which the deduction relates. The following example illustrates the point.

35. A company owns shares in company A and borrows funds which are used to buy shares in company B. In year 1, the company incurs interest of $1000 on the borrowed funds and receives dividends of $2000 from the shares in company A. Because the interest deduction does not relate directly to the company A dividends, the company's section 46 rebate is calculated on the whole $2000. In year 2, the company incurs interest of $1000 and receives $500 dividends from company A and $250 dividends from company B. Because the interest deduction relates directly to the dividends from company B the $1000 deduction must be made from the total dividend income of $750. In this case, there will be no dividend income remaining which will attract a section 46 rebate. In year 3, the company incurs interest of $1000 and receives dividends of $2000 from company A. The dividend income of $2000 would be reduced by the interest deduction of $1000 for the purposes of the rebate calculation because of the direct relationship with dividend income in the previous year of income (see paragraph 50(a).

COMMISSIONER OF TAXATION
16 August 1990

References

ATO references:
NO 90/3553-2

Date of effect:
Immediate

Subject References:
DIVIDEND REBATES
DEDUCTIONS

Legislative References:
FORMER 46(7)
50

Case References:
- Case 19
(1946) 12 TBRD 128

- Case 56
1 CTBR(NS) 56
- Case C58
71 ATC 255
- FC of T v Dixon
(1952) 86 CLR 540
10 ATD 82
- FC of T v Patcorp Investments Ltd
(1976) 140 CLR 247
51 ALJR 40
76 ATC 4225
6 ATR 420
- North Australian Pastoral Co Ltd v FC of T
(1946) 71 CLR 623
3 AITR 314
8 ATD 121
- Palvestments Pty Ltd v FC of T
(1965) 112 CLR 661
13 ATD 527
- Rowdell Pty Ltd v FCT
(1963) 111 CLR 106
37 ALJR 332
9 AITR 177
[1964] ALR 449
13 ATD 242