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Changes to tax laws on dividends:
changes in form and substance

January 2003

A revised tax system for taxing dividends has been in place since 1 July 2002, for the New Business Tax System (Imputation) Act 2002 quietly inserted a provision into the Income Tax Assessment Act 1936 to the effect that the existing (and very extensive) rules regarding franking no longer apply to events that occur on or after 1 July 2002. In its place, some of the old rules were re-written into the Income Tax Assessment Act 1997 ("the 1997 Act") and some important new principles were introduced.

To recap on the old rules

Under the now inoperative provisions, all companies maintained franking accounts from which “franked dividends” could be paid. A franked dividend is a dividend sourced from company profits in respect of which the company has paid company tax (currently a 30% tax rate applies to Australian corporate profits). Complex formulas allocated franking credits on a "taxed income" basis, and dividends had to be franked to the extent of an available franking credit surplus. At the end of each financial year, franking accounts were closed off and reopened accordingly.

All taxpayers (other than companies) receiving franked dividends were required to gross up their taxable income to reflect the franking credits attached to the dividends. In the case of a resident company being a shareholder, the inter-corporate rebate ensured that no tax would be payable where that resident company received a franked dividend from another resident company.

In addition, anti-streaming rules existed with a view to ensuring, amongst other things, that franked dividends were not paid to some shareholders who would benefit from imputation credits more than other shareholders.

So what’s changed?

As with the former rules, the new imputation system does not allow some types of distributions to be franked. These include Division 7A and section 108 dividends (loans and payments to shareholders and associates), amounts taken to be dividends under sections 45 and 45C (capital streaming) and for off-market share buy-backs, the excess of the purchase price that exceeds the market value of the share.

The major changes introduced are as follows:

• The recording of franking credits on a “ tax paid” basis

  Franking credits will now be recorded on a tax paid basis. For example a company with $100 of taxable income pays tax of $30 and receives 30 franking credits. Previously, the "taxed income" formula would have provided for 70 franking credits calculated as follows (30 x 70/30 = 70).

• The rolling franking account

  Franking accounts will no longer be closed down and reopened at year end. Instead, one franking account will operate continuously year in, year out.

• No obligation to frank a distribution

  This one is a major change. Unlike the old franking rules, companies will now have a degree of choice about the extent to which they frank distributions.

  However, the choice extends only to the first frankable distribution made by a company in each financial year. Take note: the law provides that all other frankable distributions made by a company for that year must be franked to the same extent as the benchmark franking percentage set by that first distribution for that income year. Note also that an anti-streaming rule now requires disclosure to the Taxation Commissioner of significant variations between benchmark franking percentages (see below).

• Introducing the benchmark rule

  The benchmark rule is the focal point of the new imputation system. In essence, all frankable distributions must be franked to the same extent (percentage) as the first frankable distribution made by a company in the financial year. There are pros and cons that go with this rule: if the first distribution is 100% franked, all other distributions for that year must be 100% franked.

  Penalties will be invoked if the benchmark rule is breached. These consist of either a penalty franking debit if the franking percentage is less then the benchmark franking percentage or over-franking tax if the franking percentage for the distribution exceeds the benchmark franking percentage.

  The Australian Taxation Office has indicated that the benchmark rule is viewed as an anti-streaming rule that attempts to ensure that some members do not benefit more from receiving franked distributions than others. However, another interpretation is that the benchmark rule will force a company that has suffered a loss or seasonal fluctuations in earnings to lock itself into utilizing its franking credits ahead of its tax losses. The benchmark rule can be departed from only in extraordinary circumstances and where permission has been obtained from the Taxation Commissioner.

• Franking distributions through distribution statements

  Companies that make frankable distributions are now required to issue distribution statements before the end of:

  1. four months after the end of the income year in which the distribution is made for a private company; or
  2. on or before the day on which the distribution is made, in the case of the company being a public company for Australian taxation purposes.

  It is the distribution statement that indicates the degree to which the distribution is franked (if at all). The distribution statement must state the date on which the distribution is made, the amount of the distribution, the amount of franking credits (if any) allocated to the distribution and the franking percentage of the distribution.

  One so-called concession given by the new rules is that private companies are given 4 months in which to decide to what extent if at all its initial distribution should be franked. Why this is considered “concessional” when previously there were no time limits is seriously questionable!

• Everyone who receives a franked distribution must gross up their income…

  The previous imputation regime provided for all taxpayers, except companies that received franked dividends, to gross up their income. Under the new rules, all resident taxpaying entities, including companies, will be subject to the gross up mechanism where a franked distribution is received.

  The requirement for companies to gross up their income under the new imputation system replaces the operation of the section 46 inter-corporate rebate, which no longer exists (except for unfranked dividends paid before 30 June 2003 between companies in wholly owned groups (as defined)).

• Anti-streaming rules

  In addition to the benchmark rule, the anti-streaming rules contained in the old provisions have been rewritten into the new imputation system. These rules are contained in Division 204 of the 1997 Act and do not differ significantly from their predecessors.

  Of note however is an additional anti-streaming rule which requires entities to disclose to the Commissioner significant variations (20% or more) between the benchmark franking percentage of the current period (generally, the year of income) and the previous period.

For further information, contact Joe Lederman at BALDWINS, Australian Lawyers & Consultants.

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