Critics damn ‘uncertainty’ in franking credit changes

Changes to franking credit rules that will exclude some distributions funded by capital raising could result in double taxation and snare normal business transactions, say a range of critics.

Deloitte said the proposals injected uncertainty into the system, the SMSF Association was concerned the changes would catch out legitimate commercial situations while Wilson Asset Management labelled the proposals a “two-pronged attack” on the franking system.

The amendments were introduced in February in Treasury Laws Amendment (2023 Measures No.1) Bill 2023 and referred to the Senate Economics Legislation Committee.

Wilson Asset Management chair Geoff Wilson said the amendments would limit the ability of companies to distribute franked dividends to shareholders.

“The changes being proposed restrict a company’s ability to undertake an off-market share buy-back with a fully-franked dividend component and pay franked dividends to their shareholders, where in Treasury’s view, are directly or indirectly funded by capital raisings,” he said.

“We believe this will significantly impact Australian companies and investors.”

The proposed amendments may stop small growth companies from raising capital and paying fully franked dividends and encourage large companies with excess franking credits to focus on minimising tax paid in Australia.

Small- to medium-sized businesses will be the hardest hit by the amendments in Schedule 5 of the bill, according to Mr Wilson.

“Small companies need capital to grow and under the proposed changes in Schedule 5, small companies that earn profit, pay tax in Australia and raise capital will have fully franked dividends taken away from them and therefore, significantly increasing the cost of capital,” he said.

“Large companies with significant franking credit balances can take on debt to pay fully franked dividends providing a significant competitive advantage over small to medium sized entities.”

SMSF Association chief executive Peter Burgess said the association’s concerns were based on two factors.

“The legislative amendments include several items that must be ‘tested’ to determine whether a distribution is funded by a capital raising and therefore ineligible for franking,” said Mr Burgess.

 “Significantly, the first test stipulates that the distribution must not be consistent with an entity’s established practice of regularly making distributions of that kind.”

There may be legitimate situations that would not satisfy the established practice requirement, including new companies with no established record of paying dividends, those operating in highly volatile and uncertain industries where dividends may only be paid irregularly, or those paying special dividends due to abnormal profits.

“In our opinion, what’s required to avoid the amendments applying to legitimate and normal business operations is a broader list of matters to determine whether a distribution satisfies the requirements of being funded by a capital raising,” said Mr Burgess.

Another test that must be met for a distribution to be funded by a capital raising is the equity issue must have the principal effect of funding the distribution or part of a distribution.

 Mr Burgess said companies often reinvest their profits instead of holding them as cash to be distributed to shareholders.

"The association contends that for these companies reinvesting profits and the raising of capital to pay dividends is merely prudent cash flow management and nothing to do with tax avoidance or the manipulation of the franking system,” he said.

“Disallowing franking in these situations would expose the shareholders to double taxation. Company profits would still be subject to tax, but the shareholder would receive an unfranked dividend with no franking credit to offset the tax paid by the company.

To avoid these untented consequences, the association is calling for the proposed amendments to be modified to make it clear they will not apply to distributions in situations where a company has made a taxable profit, those profits have been applied in funding the operations of the company, and the company now intends to distribute those profits as a dividend.

Deloitte said the measure is a difficult combination of extremely broad language in the bill, juxtaposed against some narrow examples and a forecasted small revenue impact.

“Both the broad language and the limited examples do not provide a great deal of certainty,” the big four firm said in a recent article.

“Many distributions will be at risk of the measure applying; making the relevant distribution unfrankable. This will not directly impact the tax position of the dividend paying company but will affect the tax position of shareholders via the loss of the franking credit.”

It is not clear how affected or potentially affected shareholders are expected to anticipate these rules applying to their dividends given the principal tax effects are at the shareholder level but the relevant knowledge will be in the hands of the dividend payer.

“Class rulings may become a way of managing the risks and in that way, shareholders can be advised of cases where the rules do not apply,” said Deloitte.

Given that the measure is proposed to be effective as from September 2022, many companies will have already made distributions that may be in the scope of these measures.

Companies will need to carefully manage their affairs to minimise the risk of the measure applying.

“This will involve determining and documenting the company’s practice of making distributions on a regular basis and considering whether any prior distributions are to be disregarded for the purposes of ascertaining the regular distribution practice,” Deloitte said in the article.

Companies will also need to plan and manage future dividend distributions so that nothing is done which may inadvertently affect what would otherwise be a regular dividend practice.

They will also need to determine and document that a particular distribution is or is not regarded as being in accordance with regular practice.

“Companies [will also need to] maintain clear documentation as to the use of funding that is obtained via a capital raising. This may include a more careful consideration of press releases and public messaging,” Deloitte stated.

“They will also need to consider whether any capital raisings by other entities may create risks for the dividend paying company and maintain clear documentation as to the source of funding used to pay the dividend.”

It will also be important to consider the consequences of these measure on various DRP arrangements.

The big four firm also added that the measure will add complexes, risks and uncertainties to various M&A transactions, and to companies that have transitioned into public ownership.