Summary

  • A proposed reduction in the corporate tax rate from 30% to 28.5% with effect from 1 July 2015 would likely result in a commensurate fall in the value of companies’ existing franking credit balances for resident shareholders.
  • An innovative strategy recently adopted by Tabcorp and Harvey Norman is to fund a franked special dividend by way of an equity raising using a shareholder rights issue.
  • The key issue from an income tax perspective is the potential application of an integrity rule s.177EA of the Income Tax Assessment Act 1936.
  • The Australian Tax Office (ATO) is yet to give any public guidance on its attitude to these arrangements.

Overview

In last year’s Federal budget, the Government announced that the corporate tax rate would be reduced from 30% to 28.5% with effect from 1 July 2015. 

It was also proposed that large companies would pay a 1.5% levy under the Paid Parental Leave scheme – so the effective tax rate for large companies would have still been 30%.  The PPL has now been dropped.  But at this stage we don’t know whether the Government will proceed to reduce the corporate tax rate.

If the tax rate does fall, the value of companies’ existing franking credit balances for Australian resident shareholders will commensurately fall. 

Example: A company had taxable profit of $1,000 and paid tax of $300 before 1 July 2015.  If the after tax profit of $700 is distributed after 1 July 2015, the maximum franking credit that can be attached to the dividend falls from $300 to $279.  Or put another way, for every $1,000 of franked dividend paid, resident superfunds are $25 worse off and individuals on the highest marginal tax rate are $15 worse off.

So what can Australian companies with large franking balances do?

Paying a special dividend before 1 July 2015 is a simple enough option.  However, whereas special dividends are typically funded from surplus cash or borrowings, an innovative strategy recently adopted by Tabcorp and Harvey Norman is to fund a special dividend by an equity raising using a shareholder rights entitlement issue.   In both cases, the issued rights were rights to subscribe for shares at a significant discount and the rights were tradeable on the ASX.  Tabcorp used a retail premium bookbuild structure, Harvey Norman didn’t.

Under such transactions, resident shareholders should generally benefit from the franking credits attached to the dividend.  Superfund investors (taxed at 15%), who benefit from a cash refund from the ATO for the excess franking rebate, are more likely to reinvest by taking up their rights entitlement.  On the other hand, individual investors on higher marginal tax rates are likely to have a top-up tax cost and may be more inclined to keep the cash dividend and sell their rights.

From the company’s perspective, the transaction is cashless as the special dividend and the equity raising are closely aligned in terms of quantum and timing.  The balance sheet effect is to move an amount from the company’s retained earnings to share capital.  However, one would expect that the company’s earnings per share would be adversely impacted as more shares are on issue after the transaction.

The key issue from an income tax perspective is the potential application of an integrity rule s.177EA of the Income Tax Assessment Act 1936 which can deny shareholders the benefit of franking credits attached to a dividend.  In broad terms, the section applies where:

  • there is a scheme for a disposition of shares (defined to include an acquisition of shares),
  • a franked dividend is paid on the shares, and
  • a more than incidental purpose of anyone involved in the scheme was to enable a taxpayer to obtain a franking credit benefit.

Where s.177EA applies, shareholders can be denied the benefit of franking credits.  The section requires that the shares which are the subject of the scheme for a disposition and the shares in respect of which the franked dividend is paid must be the same shares.  This is not the case with the kind of transaction under consideration, the special dividend is only paid on the shares which the company had on issue prior to the equity raising and not the newly issued shares.

As class rulings have not been issued by the Australian Taxation Office for shareholders of either Tabcorp or Harvey Norman, the ATO is yet to give any public guidance on its attitude to these equity funded special dividends. 

These transactions are not substantially different from the circumstances where a company pays a dividend with a fully underwritten dividend reinvestment plan.  The ATO recently issued a class ruling (CR 2015/17) in relation to a fully underwritten DRP by Vita Group.  The ATO confirmed that s.177EA did not apply in that case.  However, the reasons were essentially due to the absence of the requisite purpose of enabling a taxpayer to obtain a franking credit benefit and the ruling glosses over the technical reason noted above for the section not applying.

This article was written by Richard Hendriks, Director, Greenwoods & Herbert Smith Freehills, Sydney.