In summary

The ATO’s focus on entitlement to franking credits where a taxpayer has partly hedged their interest in the underlying securities continues, with the release of the second Taxpayer Alert in three years. Superannuation funds (and other taxpayers with a tax rate of less than 30%) should consider whether their use of derivatives is likely to draw unwanted ATO attention.

In detail

In recent times, the ATO has been focusing on the use of derivative arrangements in connection with the receipt of franked distributions, especially by superannuation funds and the managed funds in which they invest. The targeting is explained by the value of franked dividends to superannuation funds, or tax exempt entities who receive cash refunds from receipt of a fully franked dividend on the basis that the tax rate for the superannuation fund (15% or nil) is less than the corporate tax rate of 30%.

Continuing this trend, the Commissioner has released Taxpayer Alert TA 2020/5 concerning arrangements to obtain imputation benefits where the taxpayer’s economic exposure to shares is eliminated or substantially reduced by derivative instruments, including total return swaps (TRS). The Commissioner had previously targeted similar arrangements implemented over a short period spanning dividend entitlement dates (often known as dividend run-up strategies) in TA 2018/1; it seems that the  Commissioner’s concern now exists in connection with longer term holdings.

The arrangements outlined in TA 2020/5 involve an Australian taxpayer, who already holds a long position in a portfolio of Australian shares, acquiring an additional parcel of shares (or interests in shares) and, at about the same time, entering into a derivative transaction (the ruling refers to TRS and short positions as examples) to obtain an offsetting short position in those same shares. The additional long position and short position entirely or substantially cancel each other out but the taxpayer still has an overall net delta of more than 0.3 on its entire portfolio. The taxpayer claims the franking credits attached to dividends on the additional parcel of shares, but is never exposed to the risks and rewards of their ownership.

The Commissioner suggests that franking credits might be denied because the “qualified person” requirements in former s 160APHO(1) of the Income Tax Assessment Act 1936 may not be satisfied. Although the Taxpayer Alert does not elaborate on the Commissioner’s reasons, the inference is that the Commissioner considers that delta should be calculated on a share-by-share-basis or parcel-by-parcel basis, rather than a portfolio basis. This is contrary to the position generally taken in the market that delta is necessarily a concept which must be worked out on a portfolio basis.

The Commissioner also suggests that section 177EA (Part IVA for imputation benefits) can apply to the arrangement and that he may pursue promoters under the promoter penalty rules, even where the derivative pricing results in a commercial benefit to the taxpayer regardless of the imputation outcomes. Although s.177EA only requires a ‘non-incidental’ purpose, it is somewhat surprising that the Commissioner is seeking to apply a general integrity rule in circumstances where a complicated set of specific integrity rules directed to exactly the matter at hand (the degree of economic exposure to shares to enable a taxpayer to “qualify” for imputation benefits) may be satisfied.

While the Commissioner does not appear to be concerned about the use of derivatives generally, there is insufficient clarity in the Taxpayer Alert for taxpayers to know when the use of derivatives over Australian equities is likely to be of concern to the Commissioner. The lack of clarity is disappointing since the use of derivatives is common and there are good commercial reasons why institutional investors and fund managers employ derivatives. For example, derivatives trading is often quicker and cheaper than trading in physical assets – especially for larger transactions where there is a risk of moving markets.

The Taxpayer Alert is likely to be particularly relevant for Australian superannuation funds who (as noted above) are entitled to a cash refund of excess franking credits on fully franked dividends they receive.

The Taxpayer Alert also stands as a timely reminder to all fund managers and traders that the commercial advantages of employing derivatives must always be documented, and balanced against any beneficial tax effects. Practically, the use of derivatives on a short term basis to manage liquidity or portfolio weighting “around the edges” is less likely to be of concern to the ATO. However, taxpayers who are routinely overweight on physical stocks and manage the position through derivative short positions could expect interest from the ATO.