The Corporations Amendment (Corporate Reporting Reform) Bill 2010 (Cth) (the Act) was passed on 24 June 2010 with significant changes to the “profits” rule that has historically applied to the payment of dividends.
The Act amended section 254T of the Corporations Act 2001 by removing the requirement that dividends be paid out of “profits”. Under the new section 254T (which applies to the year ended 30 June 2010 and subsequent financial years), a company will be able to pay dividends provided that:
- Its assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the dividend payment
- The payment of the dividend is fair and reasonable to the company’s shareholders as a whole, and
- The payment of the dividend does not materially prejudice the company’s ability to pay its creditors.
- The new section 254T will allow companies to pay a dividend from share capital.
The Act made consequential amendments to section 44 of the Income Tax Assessment Act 1936 (the Tax Act) which treats dividends as assessable provided that they are “paid out of profits”. The result of the amendment to section 44 is that distributions paid out of amounts other than profits are now deemed to be dividends paid out of profits.
The change to section 254T gives rise to a number of inconsistencies between the Tax Act and the intended effect of the changes. The following is a discussion of just a few of these inconsistencies.
Classification of distributions
The distribution by a company out of profits was a prima facie dividend and was assessable income to a shareholder. Such a dividend could be franked by the company and was subject to withholding tax in the event that it was paid to a non-resident and was not fully franked.
Conversely, there was a clear distinction between amounts paid out of profits and amounts paid from share capital. The latter did not give rise an assessable dividend and could not be franked but, instead, gave rise to a ‘capital payment in respect of shares’ that triggered capital gains tax (CGT) Event G1 for the shareholder. The result of CGT Event G1 was that the amount of share capital received by a shareholder reduced the cost base of their shares and any excess gave rise to a capital gain.
As the CGT provisions (and thereby CGT Event G1) apply in a residual manner, an amount that is already treated as assessable income (such as a dividend under section 44) will not be subject to CGT.
The consequential change to section 44 (without any corresponding changes to the CGT provisions) could mean that all amounts paid out of share capital, whether intended to be a dividend or a return of capital, could be assessed as a dividend and CGT Event G1 becomes obsolete.
Imputation integrity measures
The Tax Act contains a number of different integrity measures designed to prevent the streaming of franking credits and capital benefits. The integrity provisions that are potentially affected by the changes to the Corporations Act are contained in section 177EA and section 45B of the Tax Act.
Section 177EA applies where there is a scheme for the sale of shares in consequence of which a franked distribution is paid. Section 45B applies where a shareholder receives an amount of share capital.
These integrity measures provide the Commissioner of Taxation (Commissioner) with wide powers to cancel any tax benefit arising for the shareholder. Both provisions contain a list of factors that the Commissioner is required to consider in exercising his discretion. One of these factors (relevant to both section 45B and section 177EA) is the extent to which the payment is attributable to/sourced from the profits of the company.
It is questionable what continued relevance the so-called “profits” factor in these provisions will continue to have. Will this still be a relevant consideration given that a company can now pay (and frank) dividends out of share capital and thereby circumvent the very reason for why section 45B and section 177EA exist?
It is also questionable whether section 45B will have any continued application, as there is no provision that determines whether the payment of a dividend out of share capital is a “dividend” (and assessed under section 44) or a capital benefit. Prima facie, it will always be a dividend given the consequential changes made to section 44.
The issues discussed above are but a few of the tax interaction problems that have been identified as a consequence of the change to section 254T. The issues identified in this article are of particular concern given the discretionary nature of the integrity measures and the fact that taxpayers incur significant time and cost to comply with these measures.
The ATO has not yet released any guidance on how it intends to interpret section 44 or how the interaction issues will be addressed. In light of this, clients considering paying dividends out of amounts other than profits or considering transactions involving the return of share capital should be aware that there are uncertainties about the tax treatment of the receipts to their shareholders.