Tax risk on equity funded dividends – including pre-completion dividends

Recent changes to the tax law prevent the franking of dividends which are directly or indirectly funded from the issue of equity interests where it is ‘reasonable to conclude’ that both the purpose and effect of the equity issuance was to fund a substantial part of the dividend. The rules were triggered by Treasury concerns related to special dividends funded by fully-underwritten rights issues, which occurred in a couple of instances in 2015. However, an ATO alert and Government announcement promptly stopped the practice. The enacted rules apply to a far broader range of circumstances and need to be considered in M&A transactions.

In an M&A context (whether public or private), care needs to be taken with the payment of special dividends prior to completion. Special dividends are often paid prior to completion to distribute franking credits to vendors as a ‘sweetener’ since resident shareholders will generally benefit more from the franking credit than receiving the same cash payment as capital proceeds forming part of the capital gain, even where the CGT discount applies. Pre-completion special dividends are especially common where the buyer is a non-resident since non-residents derive less benefit from franking credits.

Where a special dividend is being considered going forward, it will be necessary to ensure that:

1. the dividend is not directly funded by an equity issuance – which can include the reinvestment of the dividend; and
    
2. where the dividend is debt-funded – either directly or by drawing down available cash which results in a working capital deficit necessitating further funding – the debt is not repaid using equity raised by the target or using the proceeds of an equity raise by the buyer.

These issues are likely to be managed by representations and undertaking in the sale documents. Example drafting can be seen in the Scheme Implementation Deeds for the Newmont / Newcrest, Brookfield / Origin and CSR / Saint-Gobain schemes – we expect similar drafting will become common in share purchase agreements for private M&A where special dividends are used.

The ATO has announced that it will be releasing guidance on these rules, including covering what is “a substantial part” of the dividend and what measures parties could put in place to address concerns. In the interim, an ATO ruling is likely to be required for the payment of special dividends funded by sources other than existing excess cash reserves.

Of course, it remains the case that the existing well known issues with franking of dividends in an M&A context still need to be managed – including timelines for record and payment dates, any direct buyer funding of the dividend and the ‘qualified person’ rules.

If you have any questions on these issues, please reach out to the HSF Tax team.