Tax ruling on dividends and changes to Section 254T

On 27 June 2012, the Commissioner of Taxation (Commissioner) issued Taxation Ruling TR 2012/5 (Ruling) (previously issued as Draft Taxation Ruling TR 2011/D8), dealing with section 254T of the Corporations Act and the assessment and franking of dividends. The Ruling applies with effect from 28 June 2010, when changes to section 254T came into operation. The main points in the Ruling are discussed below.

Executive Summary

• The Ruling confirms that a frankable dividend can be paid out of current year profits where the company has accumulated losses and out of certain unrealised profits.
• In both cases, the profit must be recognised in the accounts (in accordance with accounting standards) and available for distribution as a dividend. In the case of unrealised profits, net assets must also exceed share capital by at least the amount of the dividend.
• Where there are accumulated losses, the profit should preferably be carried to a separate profit reserve to ensure it remains available. If it is offset against the losses, the directors' resolutions can make it clear that the profit was available for the dividend but any remaining profit will cease to be available for distribution.
• Other purported dividends may be either assessable but unfrankable dividends or not dividends for tax purposes (and therefore subject to the CGT rules), depending on the circumstances.
• Companies need to ensure that directors' resolutions for dividends are appropriately drafted and appropriate records are kept.

Change to section 254T

Section 254T previously provided that a dividend may only be paid out of profits of the company.

New section 254T provides that the company must not pay a dividend unless:

1. The company's assets exceed its liabilities immediately before the dividend declaration and the excess is sufficient for the dividend payment;
2. The dividend is fair and reasonable to the members as a whole; and
3. Creditors are not materially prejudiced.

The change raised doubts as to whether a dividend could now be paid out of an amount other than profits without undertaking the procedures for undertaking a reduction of capital under the Corporations Actand also as to the taxation implications.

The Commissioner was concerned in particular about the implications of the payment of a purported dividend under s 254T in the following circumstances:

1. out of current year profits but prior year (PY) losses and/or net assets of a value less than share capital; or
2. out of an account such as an asset revaluation reserve, unbooked profit account, expense account, asset account or reserve account with a negative balance, if the company has net assets of a value less than share capital.

The Commissioner obtained a joint opinion from Counsel on these issues (Joint Opinion). Based on the Joint Opinion, the Commissioner considers the better view is that new s 254T does not authorise a return or reduction of capital but merely specifies 3 additional prohibitions on the payment of a dividend, with the concept of profits as the source of a dividend remaining relevant under s 254T and for taxation purposes.

Relevant tax provisions

The Income Tax Assessment Act 1936 (ITAA 1936) and Income Tax Assessment Act1997 (ITAA 1997) (together, the Tax Act) contain various provisions in relation to dividends. In particular:

• A 'dividend' is defined in the Tax Act as including any distribution of money or property made by a company to any of its shareholders as shareholders, subject to certain exceptions, most importantly where the amount of moneys paid or the value of property credited is debited against an amount standing to the credit of the 'share capital account' of the company (provided the share capital account is not 'tainted'). This definition is inclusive and generally wider than the corporations law concept of a dividend. In short, a distribution by a company to a shareholder is prima facie a 'dividend' for tax purposes unless it is paid out of the share capital account.
• Section 44 of the ITAA 1936 provides when a dividend is assessable to the shareholder. In short, a dividend paid out of profits derived by the company is assessable to the shareholder under s 44(1)(a). New s 44(1A), which was inserted after the amendment to s 254T, provides that a dividend paid out of an amount other than profits is taken to be a dividend out of profits - this was to ensure that a dividend paid in accordance with new s 254T out of an amount other than profits (if that is possible) is assessable. It is important to note, however, that the amount must still be a 'dividend' as defined in the Tax Act, as discussed above.
• The dividend franking rules provide that a dividend is not frankable to the extent that it is sourced, directly or indirectly, from a company's share capital account (s 202(45)(e) of the ITAA 1997). As any amount that is a 'dividend' under the Tax Act will be assessable by virtue of s 44(1A), the main tax issue will generally be whether the dividend is frankable.
• For capital gains tax (CGT) purposes, a CGT event G1 happens when a company makes a payment to a shareholder in respect of a share in the company, not involving a cancellation or disposal of the share, and some or all of the payment is not a dividend and not otherwise assessable to the taxpayer. In that case, the shareholder's cost base in the shares for CGT purposes is reduced by the amount of the non-assessable amount and a capital gain will arise to the extent of any excess over that cost base.

Ruling

Dividends that are not prevented from being franked

TR 2012/5 says that, assuming they are paid in accordance with the company's constitution and without breaching the Corporations Act, the following dividends are assessable and frankable:

1. A dividend paid out of current year (CY) profits recognised in the accounts (e.g. trading profits, dividends received from other companies, realised and unrealised profits recognised in the statement of financial performance/profit & loss account) and available for distribution as a dividend - regardless of whether the company has accumulated prior year (PY) loses or a net deficiency of share capital. This is a welcome retreat from a view expressed earlier by the Commissioner that a dividend could no longer be paid from CY profits where the company had PY losses.
2. A dividend paid out of an unrealised capital profit of a permanent character recognised in the accounts and available for distribution, even if the company has unrecouped PY losses, but only if the company's net assets exceed the share capital by at least the amount of the dividend. Where there is a net deficiency of assets below share capital, the Ruling says that whether the company can pay a frankable dividend will depend on the circumstances of the loss of capital, the nature of the unrealised profit, other profits and losses disclosed in the accounts and the interpretation of s 254T.

In both cases above, the relevant profits must be:

• recognised in the accounts; and
• available for distribution as a dividend.

These concepts are discussed further below.

Unfrankable distributions

The Ruling says that a distribution that is a reduction or return of capital (whether or not authorised under the Corporations Act) is not frankable and is either:

• An assessable dividend that is unfrankable because it is sourced directly or indirectly from share capital; or
• Not a dividend for tax purposes and therefore subject to the CGT rules (potentially giving rise to an immediate or deferred capital gain for the shareholder).

The Ruling gives the examples of an amount paid from unbooked or underived profits, internally generally goodwill, a negative reserve account or an amount of 'other comprehensive income' in the accounts (see further below).

Recognition of profits

The Ruling says that profits can be recognised in either the annual financial statements for the previous year or properly prepared half-yearly or interim accounts for the current year.

For this purpose, companies (including proprietary companies) will need to calculate their assets and liabilities in accordance with accounting standards, regardless of whether they are otherwise required to do so.

It is noted that Australian accounting standards have recently been revised, following the introduction of new international financial reportingstandards (IFRS) in 2005. In particular, AASB 101 ('Presentation of Financial Statement') was revised with effect for annual accounting periods commencing on or after 1 January 2009 (subject to early adoption), one of the main changes being the 'statement of comprehensive income'. 'Comprehensive income' is, essentially, the change in equity (or net assets) of the enterprise for the reporting period from transactions etc. other than with owners of the enterprise. It consists of amounts that would have been recognised in what was previously known as the 'income statement' or 'profit and loss' (P&L) account, as well as 'other comprehensive income', being amounts not recognised in the income statement/P&L (including certain unrealised gains and losses) and can be presented as a single statement or separate statements.

Profits available for distribution

The Ruling says that profits cease to be available for distribution if they are applied against accumulated losses. This will prima facie be the case if the profit is offset or netted against accumulated losses in the accounts, but the presumption can be rebutted by an appropriately worded directors' resolution (as discussed below).

The Ruling says a company can ensure that a CY profit is available for distribution by either:

1. Carrying the profit to a separate profits reserve; or
2. If the profits are offset or netted against accumulated PY losses - passing a legally effective directors' resolution declaring or determining to pay the dividend at the same directors' meeting at which the accounts are approved. It should be noted, however, that in this case the profits will not be available in subsequent years.

The Ruling says the sourceof profits from which a dividend is paid should be recorded in either the directors' minutes of the dividend resolution (or accompanying documentation) or notes to the accounts.

Documentation

It is essential for companies to maintain proper records and evidence of directors' resolutions and accounts to establish that profits are available for distribution as a dividend and properly applied to the dividend.

Consolidated groups

The Ruling makes it clear that the company paying a dividend must itself have sufficient profits available for payment as a dividend at the relevant time. That is, the profits must be recognised in the company's own accounts and it is not sufficient that there are profits in the consolidated accounts. It may therefore be necessary for dividends to be paid up by subsidiaries to the parent company to ensure it has profits to distribute as a dividend to its shareholders.

This is also the case if the group that is consolidated for tax purposes, as the 'single entity rule' under tax consolidation does not apply for this purpose.

Examples

The Ruling gives a number of examples to illustrate the principles outlined in the Ruling.

Summary of key points

• A distribution by a company to a shareholder will notbe a 'dividend' under the Tax Act if it is paid out of the company's share capital account (provided the share capital account is not 'tainted'). Such a distribution will generally be subject to the CGTrules.
• A distribution that is a 'dividend' under the Tax Act will generally be assessable to the shareholder, but whether it is frankable will depend (among other things) on whether it is sourced directly or indirectly from the company's share capital account.
• A dividend paid out of CY profits where there are accumulated PY losses is not necessarily prevented from being frankable.
• A dividend paid out of unrealised profits of a permanent character can also be frankable, provided the company's net assets exceed its share capital by at least the amount of the dividend.
• The relevant profits must be recognised in the company's accounts (either final or interim accounts) and available for distribution as a dividend (and not, for example, appropriated against accumulated PY losses).
• Companies will need to keep their accounts in accordance with accounting standards, even if they are not otherwise required to do so.
• To ensure CY profits are (and remain) available for distribution where there are retained PY losses, it may be preferable to transfer the CY profits to a separate profit reserve account.
• The parent of a company group (including a tax consolidated group) can only pay a dividend to its shareholders from its own profits (e.g. from dividends received from subsidiaries).
• Somedistributions may either not be dividends for tax purposes (and therefore subject to the CGT rules) or be assessable but unfrankable dividends, depending on the circumstances and proper interpretation of s 254T, for example, distributions paid out of:
  • unrealised profits, where the company's net assets do not exceed its share capital by at least the amount of the dividend;
  • expected CY profits that are not yet booked;
  • negative reserve accounts; or
  • amounts of 'other comprehensive income'.
• Companies should keep proper records (in directors' resolutions and/or accounting records) of the source of distributions and the availability of profits for distribution as a dividend and ensure that resolutions for the declaration or determining of dividends are appropriately drafted.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).