Introduction

On 10 April 2014, the Government released the draft Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Draft Bill), containing proposed amendments to the Corporations Act 2001 and the Australian Securities and Investments Commissioner Act 2001, described as 'minor deregulatory proposals' to'streamline' the legislation and 'improve [its] efficient operation, reduce compliance costs for business and business productivity generally'.

The Draft Bill contains, among other things, amendments to the test for payments of dividends in section 254T of the Corporations Act and associated amendments.

This article discusses the proposed changes to section 254T and the tax implications.

Executive summary

1. The proposed changes in the Draft Bill will replace the current 'net assets' test for dividends in s 254T (inserted in 2010, replacing the 'profits' test) with a pure solvency test and will expressly provide that a company may reduce its share capital by paying or declaring a dividend, provided it is an 'equal reduction'.
2. Arguably, this should make it clear (or clearer) that a company can declare or pay a dividend out of amounts other than profits, including out of share capital, provided it is solvent (notwithstanding the Commissioner of Taxation's view that a 'dividend' requires profits, as discussed below).
3. As noted in the explanatory notes to the Draft Bill, the changes should not affect the tax treatment of dividends. The relevant issues for tax purposes are whether the payment is a 'dividend' (defined in the tax legislation as any distribution to a shareholder, except to the extent it is debited to the company's 'share capital account'), whether the dividend is assessable (which is now generally the case, given the 2010 amendment making a 'dividend' assessable even if it is paid out of something other than profits) and whether it is frankable (which it will not be if it is sourced directly or indirectly from share capital).
4. However, some changes may be necessary to Taxation Ruling TR 2012/5 (dealing with s 254T and the assessment and franking of dividends from 28 June 2010), given the Commissioner's view that the current s 254T does not authorise the declaration or payment of a dividend otherwise than out of profits.

Proposed changes to section 254T

Current section 254T

Since 28 June 2010, section 254T has provided as follows:

1. [Payment of dividend] A company cannot pay a dividend unless:

   (a) The company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; [emphasis added]

   (b) The payment of the dividend is fair and reasonable to the company's shareholder's as a whole; and

   (c) The payment of the dividend does not materially prejudice the company's ability to pay its creditors.

   Note 1: As an example, the payment would materially prejudice the company's ability to pay its creditors where the company would become insolvent as a result of the payment.

   Note 2: For a director's duty to prevent insolvent trading on payment of dividends, see s 588G.

2. [Accounting standards] Assets and liabilities are to be calculated for the purpose of the section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).

The 'net assets' test in current s 254T (which replaced the profits test under former s 254T) was introduced because of concerns about the impact of changes to accounting standards on the calculation of 'profits' and therefore the ability to pay dividends under former s 254T.

Proposed new section 254T

The dividend test under proposed new s 254T in the Draft Bill will be as follows:

254T Circumstances in which a dividend may be declared or paid

Declaration of dividends

1. A company must not declare a dividend unless, immediately before the dividend is declared, the directors of the company reasonably believe that the company will, immediately after the dividend is declared, be solvent. [emphasis added]
   Note: For a director's duty to prevent insolvent trading on payment of dividends, see s 588G.

Payment of dividends without declaration

2. A company must not pay a dividend unless, immediately before the dividend is paid, the directors of the company reasonably believe that the company will, immediately after the dividend is paid, be solvent.
   Note: For a director's duty to prevent insolvent trading on payment of dividends, see s 588G.

In short, the new test for declaration or payment of dividends will be purely a solvency test, rather than a 'net assets' test (as currently) or a 'profits' test (as prior to 28 June 2010).

The explanatory notes accompanying the Draft Bill say the rationale for replacing the net assets test with a pure insolvency test is that 'net assets' are not necessarily an effective measure of a company solvency, which should be the relevant test.

Further, the current requirement in s 254T for net assets to be calculated in accordance with accounting standards puts an additional compliance burden on companies that are not otherwise required to apply accounting standards, which will no longer be necessary under the proposed new solvency test.

It is also noted that the current s 254T does not expressly provide for payment of dividends without declaration.

Share capital reductions by way of dividend

Part 2J of the Corporations Act makes it difficult for a company to pay a dividend out of anything other than profits. The Draft Bill proposes that dividends paid in accordance with s 254T will be exempted from the capital maintenance provisions, provided it is an 'equal reduction'.

New section 254TA will be inserted to deal with share capital reductions by way of dividends. This will provide that a company may reduce its share capital by declaring or paying a dividend if:

• it is declared or paid in accordance with s 254T; and
• the reduction of capital is an equal reduction - that is, it relates only to ordinary shares and applies, on same terms, to all holders of ordinary shares pro rata to the number of ordinary shares, except for differences due to certain matters. This mirrors the requirements in s 256B of the Corporations Act for an equal reduction of capital.

New reporting requirements

New reporting requirements will apply for directors in relation to any dividends that are not paid out of profits, by way of proposed changes to s 300(1) (dealing with information that the must be included in the annual directors' report).

It is proposed that the directors' report will need to include the following additional details in relation to any dividends or distributions paid to members during the year otherwise than out of profits:

• details of the source of any dividends paid otherwise than out of profits' (proposed new s 300(1)(b)); and
• where any such dividends have been paid during the year - board policy for determining the amount and source of dividends (proposed new s 300(1)(ba)).

The explanatory notes describe these additional reporting requirements as 'an important integrity measure' and say they will not increase the company's compliance burdens as they replace the current requirement to formally seek shareholder approval at the AGM in order to distribute share capital.

Submissions

Submissions on the Draft Bill are due by 16 May 2014.

Will profits be necessary for a dividend?

One issue with the current s 254T was that it seemed to still require that dividends be paid out of profits since under the existing case law a payment must be paid out of profits in order to be a dividend. Thus the Commissioner said in TR 2012/5 (at paragraph 36):

'The better view appears to be that for the purposes of the Corporations Act and company accounting, dividends can only be paid from profits and not from 'amounts other than profits'. The new section 254Tof the Corporations Act imposes three specified additional prohibitions on the circumstances in which a dividend can be paid, as inherently a dividend can only be paid out of profits, having regard to the ordinary and legal meaning of the word dividend.'

Proposed new s.254T does not itself clarify this issue. It still operates in respect of a 'dividend', which was precisely the issue with the current s 254T.

Proposed s 254TA obviously contemplates a reduction of capital by way of dividend, but only if the dividend satisfies s 254T, which itself may, on what the Commissioner refers to as the 'better view', require the dividend to be paid out of profits.

The Draft has not directly clarified this issue (e.g. by adding an interpretive provision stating that there is no longer any requirement that a dividend be paid out of profits). However, the proposed amendment to s 300(1)(a) refers to 'dividends or distributions paid to members during the year, including details of the source of any dividends paid otherwise than out of profits' - this (and similar wording in proposed s 300(1)(ba)) may be taken by implication to clarify that dividends may be paid otherwise than out of profits.

We consider the better view of the proposed new provisions is that, by necessary implication, it would no longer be a requirement that a dividend be paid out of profits. It would, however, be preferable for the amendments to include a clear statement to that effect.

In either case we expect that some change will be required to TR 2012/5.

Tax implications

The explanatory notes say the proposed amendments are not designed to change existing taxation requirements in relation to dividends.

Presumably, therefore, the principles and examples in TR 2012/5 (dealing with 'Section 254T and the assessment and franking of dividends paid from 28 June 2010') should largely remain relevant to the proposed new s 254T.

However, some of the discussion in that Ruling may need to be amended, including to acknowledge that the test in proposed new s 254T is not a profits test (given the Commissioner's view in the Ruling, as noted above, that the current s 254T still requires the company to have profits available for distribution). ¹ 

Relevant tax issues

The relevant tax issues are as follows:

1. whether a distribution by a company to a shareholder is a 'dividend' as defined in s 6(1) of the Income Tax Assessment Act 1936 (Cth) (1936 Act);
2. if so, whether the dividend is assessable to the recipient under s 44 of the 1936 Act ; and
3. whether the dividend is 'frankable' under the imputation provisions in Part 3-6 of the Income Tax Assessment Act 1997 (Cth) (1997 Act) (together with the 1936 Act, the Tax Act), in particular whether the dividend is unfrankable by virtue of s 202-45(e).

What is a 'dividend' for tax purposes?

A 'dividend' is defined in s 6(1) of the 1936 Act as any distribution made by a company to its shareholders and any amount credited to any of its shareholders, not including any amount so paid or credited that is debited against an amount standing to the credit of the company's 'share capital account'.

'Share capital account' is defined in s 975-300 of the 1997 Act as an account that the company keeps of its share capital (or any other account, whatever called, that was created on or after 1 July 1998, where the first amount credited to that account was an amount of share capital) but for most purposes excludes a share capital account that is 'tainted' (i.e. generally, where an amount has been transferred from another of the company's accounts to the share capital account).

In Commissioner of Taxation v Consolidated Media Holdings Ltd [2012] HCA 55 the High Court unanimously held that the 'Share Buy-back Reserve' account to which the company (Crown Limited) debited an amount of $1 billion in relation to a buy-back of its shares was a 'share capital account' for the purposes of the Tax Act. The High Court said it was sufficient that the account was either a record of a transaction into which the company had entered in relation to its share capital or a record of its financial position in relation to its share capital and held that the share capital account in that case consisted of both the Shareholders Equity Account (to which the company' share capital had been credited) and the Share Buy-back Reserve Account (to which the buy-back price was debited), taken together. Accordingly, none of the buy-back price was a 'dividend' and the taxpayer therefore realised a capital gain on disposal of its shares under the buy-back.

When is a dividend assessable?

Subsection 44(1) of the 1936 Act provides that the assessable income of a shareholder in a company includes a dividend paid by the company to the shareholder out of profits derived by the company (in the case of non-resident shareholders, only if the profits are derived from sources in Australia). Consequentially to the 2010 changes to s 254T (potentially enabling a dividend to be paid out of an amount other than profits), a new subsection 44(1A) was inserted in the 1936 Act, providing that a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits for the purposes of the Tax Act. As a result of that amendment, if a distribution satisfies the definition of 'dividend' in s 6(1), it will be assessable to a resident shareholder under s 44, regardless of its source and the only issue should be whether it is frankable.

A distribution (e.g. a return of capital) that is not assessable as a dividend can, however, give rise to a capital gain under the CGT rules.²

When is a dividend frankable?

Under s 202-45(e) of the 1997 Act, a dividend is not frankable if it is sourced, directly or indirectly from a company's share capital account.

How are these issues affected by s 254T?

Since the 2010 amendment of s 44, none of the above 3 tax issues should depend on whether the distribution is a dividend properly declared or paid in accordance with s 254T.

However, as the Commissioner notes in TR 2012/5 (discussed below), the question of whether an amount has been debited to the share capital account requires consideration of what the company has done with its share capital as a matter of accounting and for company law purposes and the effect of the tax provisions is, broadly, that a return of capital for company law purposes is excluded from taxation as a dividend for income tax purposes.³

As the Commissioner also points out, the case law in relation to dividends and taxation was predominantly decided in light of previous accounting standards and provisions of the Corporations Act, which differ significantly from those now in force (given the changes resulting from IFRS and consequent changes to the Corporations Act) and the links between the Corporations Act and the Tax Act in respect of concepts such as share capital and profits are less explicit than they previously were.⁴

The Commissioner says in TR 2012/5 that, where a company has a deficiency of net assets below its share capital, determining whether a dividend can be paid out of an unrealised profit, and whether it would be frankable, are questions of fact and law that will depend on the specific circumstances and may depend on the interpretation of s 254T. If the proposed changes in the Draft Bill are enacted, the only issues in relation to the dividend under the Corporations Act would be the company's solvency and whether s 254TA is satisfied. Arguably, however, the tax treatment does not depend on s 254T.⁵

To the extent the 2010 amendments to s 254T and the proposed amendments in the Draft Bill enable a dividend to be paid out of something other than profits, this may mean that:

• if a dividend that is paid in accordance with s 254T can be, and is, debited against the company's untainted 'share capital account' within the meaning of the Tax Act, then (to that extent) it will not be a 'dividend' for tax purposes;
• if such a dividend is not debited against the share capital account, it will be a dividend for tax purposes and assessable under s 44 but whether it is frankable will depend on whether it is sourced directly or indirectly from share capital for the purposes of s 202-45(e) - it may be that more dividends will be potentially unfrankable under this provision if the proposed changes under the Draft Bill make it more likely that dividends will be sourced otherwise than from profits and regarded as sourced from share capital.

Taxation Ruling TR 2012/5

This Ruling sets out the Commissioner's views on the taxation of dividends paid in compliance with s 254T from 28 June 2010, including the definition of 'dividend' and the assessment and franking of dividends under the Tax Act.

The Ruling states as follows:

1. A company is not prevented by s 202-45(e) from franking a dividend in the following circumstances:

• merely because the company has unrecouped accumulated accounting losses from prior years or has lost part of its share capital, if the dividend is paid out of profits recognised in the company's accounts and available for distribution; or
• the dividend is paid out of an unrealised capital profit of a permanent character recognised in its accounts and available for distribution, provided the company's net assets do not exceed its share capital by at least the amount of the dividend,

provided, in both cases, the dividend is paid in accordance with the company's constitution and without breaching s 254T or Part 2J.1 of the Corporations Act.

2. A company is prevented from franking a distribution (even if it is labelled a dividend) where that distribution is a reduction or return of share capital, including an unauthorised reduction or return of share capital that does not comply with s 254T or Part 2J.1 - depending on the particular facts and circumstances of the payment, such distribution is either:

(a) not a dividend and therefore taxed under the capital gains tax (CGT) provisions; or

(b) a dividend that is unfrankable under s 202-45(e) and assessable under s 44.

3. Whether or not profits are available for distribution as a dividend and whether profits have been distributed as a dividend in compliance with the law depend on the operation of the Corporations Act, the constitution of the company and the acts or omissions of its directors and members and not on the terms of the Tax Act. Accordingly, the Ruling does not deal with these matters, although it does include some 'practical observations' on these matters.

The Ruling contains 6 examples, covering the following situations:

1. Interim dividend determined and final year dividend declared, both paid out of profits netted against accumulated losses but sourced from available current year profits, as evidenced by the companies accounts and the contemporaneous, legally effective directors' resolutions approving those accounts and the dividend payments - both treated as assessable, frankable dividends.
2. Final dividend declared and paid out of profits carried to a profits reserve and there are accumulated losses - assessable, frankable dividend.
3. Company determines to pay dividend out of expected current year profits that have not yet been booked in the final accounts - Ruling says either not a dividend for tax purposes and/or the Corporations Act or, if it is a dividend, it is unfrankable (same conclusions would apply if amounts not able to be recognised in the accounts).
4. Distribution sourced from an unrealised gain carried to a permanent and unrealised profit reserve in the company's accounts but company does not have any current or retained earnings - Ruling says if distribution does not cause net assets to be less than share capital, it is assessable and frankable dividend but if it does cause net assets to be less than share capital, it is either not a dividend or is an assessable but non-frankable dividend.
5. Distribution partly out of retained earnings and partly out of share capital –amount debited against share capital is not a dividend for tax purposes and balance is an assessable, frankable dividend.
6. Company has share capital of $180 and accumulated losses of $50 and therefore net equity and net assets of $130, directors determine to pay dividend of $100 and create a 'dividend reserve' against which dividend is debited - Ruling says either not a dividend for tax purposes (as debited against share capital) or, if it is such a dividend, it is non-frankable and goes on to say (at para 86):

'In circumstances where a company has a deficiency of net assets below its share capital, whether a dividend can be paid out of an amount other than profits and whether it would be a frankable distribution are questions of fact and law, the answers to which depend on the specific facts and circumstances of the loss of subscribed capital, the nature of the unrealised profit, whether the company's account reveal other profits and losses and the interpretation of s 254T of the Corporations Act.'

The results in respect of examples 1, 2 and 5 should be the same under proposed new section 254T but this is perhaps less clear in relation to examples 3, 4 and 6.