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Government introduces new integrity measures for off-market share buy-backs and franked distributions funded by capital raisings

Taxation
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On 16 February 2023, the Government introduced the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 (the Bill). The Bill introduces measures to ‘improve the integrity of off-market buy-backs’ and deny franking credits on certain distributions funded by capital raisings, following the release of draft legislation for consultation late last year.

Off-market share buy backs

The Bill introduces measures to ‘improve the integrity of off-market share buy-backs’ to align the tax treatment of off-market share buy-backs and selective share capital reductions with on-market share buy-backs undertaken by listed public companies.

These measures are quite simple – they prevent part of the purchase price for an off-market buy-back from being taken to be a dividend where the buy-back is undertaken by a listed public company. The result is that shareholders who participate in such an off-market buy-back are only assessed on the gain or loss from the sale of the share, rather than a deemed dividend.

Though no part of the purchase price is taken to be a dividend, listed public companies that undertake an off-market buy-back must debit their franking account to the extent the buy-back price is not debited to the company’s share capital account.

To prevent companies from using selective share capital reductions in place of off-market share buy-backs, the measures also make distributions by listed public companies which are consideration for the cancellation of a membership interest in the company unfrankable. Much like off-market buy-backs, these distributions will still trigger a franking debit.

These measures will apply to buy-backs and selective share capital reductions after 7:30pm on 25 October 2022.

Companies may undertake off-market buy-backs for a discounted purchase price, relying on the availability of franking credits to deliver value to shareholders.  Should they become unfrankable, these buy-backs become less attractive for shareholders who could otherwise sell their shares on-market, particularly low-rate taxpayers such as superannuation funds, charities and certain individuals.

These measures follow calls from the Institute of Public Accountants to close this “loophole”. In their words, “while buy-backs may be a useful tool for corporate entities in terms of capital management, they come at a cost to the taxpayer”.

Franked distributions funded by capital raisings

The Bill also introduces measures to prevent certain distributions funded by capital raisings from being frankable to address artificial arrangements to release otherwise trapped franking credits, where those arrangements do not significantly change the financial position of the entity.

These measures will apply where:

  1. the distribution is inconsistent with an established practice of making distributions of that kind on a regular basis, or there is no established practice;
  2. there is an issue of equity interests in the entity or another entity; and
  3. it is reasonable to conclude:

a.   that the principal effect of issuing any of the equity interests was to fund all or part of the distribution (Principal Effect Test); and

b.   any entity that issued or facilitated the issue of any of the equity interests did so for a purpose of funding all or part of the distribution (Purpose Test).

Where these measures apply, the relevant distribution will be unfrankable. The result is that shareholders will not be entitled to imputation credits and the distribution will not be exempt from withholding tax.

To determine whether the entity has an ‘established practice’, one must have regard to a range of factors including the nature, timing, amount, and explanation of past distributions, the extent to which they are franked, and any other relevant consideration.

The ‘issue of equity interests’ can occur before, at or after the distribution, and the entity issuing the equity interests does not need to be the same entity which makes the distribution and does not even need to be a company for tax purposes.

In a major departure from the draft legislation, for these measures to apply the Principal Effect Test and Purpose Test must both be satisfied. These tests echo the existing general anti-avoidance rules for income tax and GST respectively.

To satisfy the Principal Effect Test, funding all or part of the distribution must be the principal effect of the equity issue. By contrast, all that is necessary to satisfy the Purpose Test is that ‘a’ purpose of one of the relevant entities (either the issuing entity or a facilitating entity) was to generate funds for the distribution. All this requires is a more than incidental purpose, rather than a principal or dominant purpose. It may also capture the purposes of advisers and related parties.

Importantly, this has the potential to render the entire distribution unfrankable, even where the test is satisfied in relation to some of the equity interests or part of the distribution.

Whether it is reasonable to conclude that the Principal Effect Test and Purpose Test are satisfied will turn on the relevant factors – which are not exhaustive and none of which are determinative. These factors include:

  • the timing of the equity issue and distribution;
  • the extent the funds raised differ from the amount of the distribution;
  • the change in financial position of the relevant entities;
  • the use of funds raised;
  • the reason for issuing the equity interests;
  • the extent to which the equity issue was underwritten;
  • how the history of the distributing entity’s franking balance compares to their profits and losses and share capital account balance;
  • the nature and extent of the relationship between the issuing entity and distributing entity;
  • the extent to which entities who received distributions or analogous distributions are the same as those who were issued the equity interests;
  • other distributions made by the distributing entity; and
  • any other relevant consideration.

Though the draft legislation indicated these measures would apply retrospectively from 19 December 2016, thankfully this has changed. These measures will now apply to distributions made on or after 15 September 2022.

These measures are intended to address ATO concerns, set out in TA 2015/2, about capital raisings used to fund franked distributions for the purpose of releasing franking credits or streaming distributions to shareholders. In that taxpayer alert, the ATO signalled this arrangement may attract existing anti-avoidance measures including those regarding imputation benefits.

These existing integrity measures have different requirements to the measures introduced in the Bill. These new measures may catch arrangements which were not otherwise caught, and it is not yet clear how they will interact with the existing integrity rules.  

It should also be noted that these measures do not require a determination by the Commissioner, and are instead self-executing. This potentially creates significant tax risks for special dividends, paid outside an entity’s periodic dividend policy.

As with any anti-avoidance measure, while it will be easy to identify cases which would clearly fall foul of these rules, cases at the margin will be uncertain and lead to dispute.

What is not clear is how this is an integrity issue at all. In the words of Richard Edmonds SC“If a company has franking credits which it cannot use to frank distributions to its shareholders because it has insufficient funds to make the distribution, how is the integrity of the imputation system imperilled by allowing it to raise funds to make the distribution?”

 

This article was prepared by Jonathan Ortner and Timothy Graham.

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