ATO guidance on equity funded dividends

By way of background, the Government introduced a franking credit integrity rule late last year for "equity funded dividends".  Broadly, the integrity rule will operate to treat special dividends by a company as ‘unfrankable’ where it is reasonable to conclude that the principal effect, and a more than incidental purpose, of a capital raising (either by the company or another entity) was to fund, directly or indirectly, a substantial part of the dividend . 

The ATO has now published a (long awaited) Draft Practical Compliance Guideline (PCG) on its proposed approach to the potential application of the integrity rule.   

Key takeaways

Taxpayers have been especially concerned that the ATO will enliven the integrity rule where:

• the company regularly pays franked dividends and might happen to be issuing equity around the same times – an Example in the Draft PCG says this will fall into the ‘Green Zone’ (ie should generally not invoke the rule), based on the pattern of distributions in the past 3 years. This is helpful but it is qualified by the fact that the company is actually using cash flow from operations, investments and debt to fund the dividend,
• the company operates a ‘dividend reinvestment plan’ (or DRP).  Three Examples in the Draft PCG are specifically for DRPs.  Two examples are provided of DRPs falling into the Green Zone (provided the DRP is not ‘an artificial or contrived arrangement’), but the third does not on the basis it is a temporary DRP (available for only one distribution) and the amount raised matches the distribution, and

• a target company pays a special pre-sale dividend.

The Draft PCG also contains some helpful guidance on pre-sale dividends paid by private companies but there remain questions about the basis of the ATO’s approach and the extent to which it will differ for pre-sale dividends paid by public companies.  In particular:

• the ATO say that they will not apply compliance resources to consider the application of the integrity rule for a distribution made by a private company under an arrangement where a capital raising and distribution are intended to facilitate the departure of one or more shareholders from the company (eg for succession planning and shareholder exits).  There is a related practical example where a bidder funded loan – which is partly sourced by the bidder from a capital raising – is used by a private company to pay a pre-sale dividend where the ATO conclude that the principal effect and purpose of the capital raising was to facilitate the departure of the shareholder, rather than the payment of the dividend.  This type of arrangement is considered to be in the ‘Green Zone’, but

• a separate example involving a pre-sale dividend paid by a public company – which had undertaken a fund raising 12 months earlier – in connection with a scheme of arrangement confirms that the ATO would not consider the dividend as falling in the ‘Green Zone’.     The difference in the ATO’s approach to the application of the integrity rule for private and public companies is difficult to reconcile based on the text of the legislation but finds some support in the explanatory materials.  

We expect to continue seeing undertakings and representations in transaction documents (particularly scheme implementation deeds and share purchase agreements) to help manage this risk.  We also expect to continue seeing target companies approaching the ATO to confirm the availability of franking credits for pre-sale dividends paid in connection with a scheme.

Further Detail

The integrity rule was originally proposed in 2016 to apply to an arrangement where, in essence, a company pays a non-routine, and possibly 'unusually large', fully franked dividend, and to fund the dividend payment, undertakes a capital raising at a similar time and in a similar amount.  However, the scope of the integrity rule enacted in 2023 is much broader, and has the potential to apply to franked distributions paid in connection with other arrangements.  We have previously published Tax Insight articles on this topic which is available here and here.

As a preliminary comment, a PCG has no direct operation in law but (i) it is taken to be a strong indicator of structures and transactions the ATO will likely find objectionable, and (ii) is used by the ATO as the basis for applying compliance resources by asking specific questions and imposing extra reporting obligations on taxpayers.

The Draft PCG says the hallmarks of a transaction which will likely trigger ATO inquiries are:

• is the franked distribution unusually large,
• is the franked distributions inconsistent with the pattern of past distributions of the entity,
• does the arrangement result in no substantial change in the net financial position of the entity,
• is there a lack of a ‘clear and genuine commercial purpose’ for issuing the equity ‘other than access to franking credits,’ or
• is the raising of the equity and the payment of the franked distribution proximate in time or amount?

This list is not especially helpful or informative as it largely mirrors the language of the statute.

The Draft follows the usual approach of assigning taxpayers to risk groups:

• Taxpayers will only be in the lowest risk group (the White Zone) if they have already secured a favourable ruling from the ATO or the transaction has already been identified by the ATO in a review.  
• Taxpayers will be in the Green Zone if:
  • the distribution is consistent with the past practice ‘over the preceding 3 years of distributions’ in terms of timing, amount and franking percentage;
  • the distribution is made under a DRP provided it is ‘not an artificial or contrived arrangement’
  • issue of equity interests will not represent a ‘significant’ amount of the dividend – the ATO interprets this to mean a less than 5% of the amount of the franked distribution which is a very restrictive reading of this provision;
  • the issue of equity interests is being done to meet APRA requirements, or
  • the capital raising and distribution are being done to facilitate the departure of one or more shareholders, but from private companies only.

Being in the Green Zone generally means the ATO will only look to confirm the facts rather than an extensive enquiry of the purpose of the capital raise. 

• Taxpayers will be in the Red Zone if all of the following 3 conditions are met:
  • the equity issue happens within 12 months of the declaration or payment of a distribution, and
  • the distribution is either a special dividend, or is otherwise unusually large compared to distributions paid over the prior 3 years (unless there been a noticeable increase in the profit of the company), and
  • any of the following factors applies –
    • insufficient evidence of ‘a clear and genuine commercial purpose (other than releasing franking credits)’
    • minimal change in the financial position of the entity as a result of the arrangement,
    • most of the funds raised by the equity issue are used to fund the relevant distribution, or
    • the arrangement appears to the ATO ‘artificial or contrived’ and ‘designed to facilitate the release of franking credits.’

Being in the Red Zone generally means the ATO will apply significant compliance resources to investigate the transactions and the burden will be on the company to prove why the provisions do not apply. 

There is an obvious gap for transactions that do not meet the requirements for the Green Zone but neither do they trigger the Red Zone. The Draft does not say what happens to these unclassified scenarios, other than to acknowledge that it may fall within the 2 zones.

The Draft says it will be applied in analysing any distributions made after 28 November 2023.

The Draft specifically reminds readers that nothing in the Draft limits the potential application of other anti-avoidance rules, such as the qualified person/45 day rule or s. 177EA ITAA 1936 (franking credit stripping).