The ATO releases draft guidance on funding franked dividends with capital raising

This was followed by the enactment of specific legislation to counter these arrangements. However, many practical aspects regarding the application of the new law were still unclear post enactment of the legislation.

On 4 December 2024 the ATO issued a draft PCG 2024/D4, which aims to provide further clarity and the ATO’s practical compliance approach when dealing with such arrangements.   

If you are considering a dividend linked to a capital raise, the new law and the Commissioners views are outlined below.

1. Operation of the new law 

The new law operates by adding dividends funded by capital raising to the list of dividends that are unfrankable.

Broadly speaking, a dividend by an entity is funded by capital raising if:

• the dividend is not consistent with an established dividend payment practice;
• there has been an issue of equity interests in the entity or another entity; and
• it is reasonable to conclude that the principal effect of the issue of any of the equity interests was to directly or indirectly fund all or part of the distribution; and
• the issue of the equity interests was for a purpose (other than an incidental purpose) of funding the distribution or part of the distribution.

The equity raise could have happened before or after the dividend. The equity raise could be in the entity itself or a different entity.  Put simply, a special dividend could be unfrankable where funded by an equity raise.  

In deciding whether the rules apply, the law requires an examination of both the purpose and principal effect of the equity raise.

If the rules apply, Australian recipients of such dividends would not be entitled to the tax offset from the franking credits. For non-residents of Australia, the dividend would not be exempt from withholding tax. 

2. Concern from the Commissioner

Based on the commentary in the Explanatory Memorandum (EM) accompanying the new law, the ATO is attempting to prevent entities from manipulating the imputation system to facilitate the inappropriate release of franking credits. The concern is on the use of artificial arrangements under which capital is raised to fund the payment of franked distributions.  

The EM introducing the law has been paraphrased below:

‘The arrangements may show a flow of franking credits to shareholders that does not align with the ordinary commercial and normal profit distribution policies of entities. The arrangements may involve entities with significant franking credit balances relative to their recent or accumulated earnings or share capital that utilise capital raisings to fund unusually large, franked distributions compared to their usual practice.’

This is the most basic form of mischief that the rules are aimed at.

The law has been drafted quite broadly. There are many situations which are not artificial or contrived but which fall within the ambit of the new rules. Given these difficulties, the ATO’s views in the PCG need to be closely considered to understand what will be regarded arrangements of concern.

3. The Commissioner’s views in PCG 2024/D4

The draft PCG sets out the now typical ATO approach of green and red zones. Where a dividend is in the green/low risk zone, the ATO will generally not apply compliance resources to review the arrangement. For red/high risk zone arrangements, the ATO will likely apply compliance resources and commence a review or audit.

Some of the characteristics of green and red zone arrangements described in the PCG are as follows:

The ATO accepts the view that the arrangement is properly regarded as an arrangement where the principal effect and purpose of the capital raising is to facilitate the departure of a shareholder – not to fund a dividend. Therefore, the dividend is frankable. Notwithstanding it was funded by a capital raise, it does not meet the purpose and principal effect requirements to be unfrankable.

This provides some much needed clarity to what is a fairly typical M&A structure. While the example in the PCG is concerned with a private company sale, public company transactions will require the same consideration: what was the purpose of the capital raise and what was the principal effect of the raise?

4. Purpose and principal effect

A key requirement is that for a dividend to be unfrankable it must be reasonable to conclude having regard to all relevant circumstances that:

1. The principal effect of the issue of any of the equity interests was the direct or indirect funding of a substantial part of the relevant distribution or the relevant part; and
2. any entity that issued, or facilitated the issue of, any of the equity interests did so for a purpose (other than an incidental purpose) of funding a substantial part of the relevant distribution or the relevant part.

There are two tests to consider. Firstly a ‘purpose’ (other than an incidental purpose) and secondly ‘principal effect’. Further the legislation requires an assessment of whether it is ‘reasonable to conclude’.

These concepts make practical application difficult and require a case-by-case assessment.  Put simply, the ‘principal effect’ test looks at the outcome, while the ‘purpose’ test looks at the intention.  

Even if all of the funds raised by an issue of equity interests are earmarked and used for other business purposes, this may serve to free other funds to be distributed that would otherwise have been required to be used for that purpose. In such cases, both the effect and purpose tests may be satisfied. 

The legislation anticipates that reasons for the issue of equity interests will often be significant. Where there are clear commercial reasons for issuing equity (other than access to franking credits) that explain the features and manner of the issue, then it is not likely that the purpose of the issue is to fund a franked distribution.

Overall, the examples in the PCG and supporting documents are helpful but simplistic. There will still be many grey zones where judgement is needed.

5. Key takeaways and action points

The PCG is in draft format and further updates could be made.  If you are paying a special dividend and there is a concurrent equity raise (of any kind and whether or not by the entity paying the dividend), the key takeaways are:

1. Consider what documentation exists to support the purpose of the equity raise. The PCG confirms that documentation on the reasons for undertaking the capital raising will be crucial when assessing the Purpose and ‘principal effect’ of the capital raise.  
   
   This requires accurate record keeping of minutes of board and other meetings at which the capital raising was considered. The entity's annual reports, announcements to the ASX, scheme implementation agreement or deed, scheme booklets and prospectus are also relevant.
   
   
2. If franking credits are denied, the shareholders will lose out on a significant tax saving. Accordingly, special dividends even loosely related to an equity transaction must be approached carefully.  While the clarity in the PCG is welcome, much uncertainly still remains. The rules are still relatively unknown by shareholders. You may need to provide shareholders with information on the tax outcomes.  A ruling from the Commissioner may be needed.

We’re here to help

Please reach out to our team of tax experts should you wish to further discuss any of the above.

Learn more about how our Tax law services can help you

Visit our Tax law page