We all remember the 2019 franking credit proposals that contributed materially to the Labor Party's election loss and helped to deliver Scott Morrison's "miracle". A major problem with that proposal was that it had many unintended consequences. The same can be said for Labor’s new proposal to stop the payment of franked dividends funded by raising capital.
Paying company dividends
In basic terms, before a company can pay a dividend, it needs to:
- Make a profit and
- Pay tax.
The after-tax amount is credited to retained earnings and a dividend can be paid to shareholders. The situation may arise, however, where a company has spent its earnings on operating the business and, as a result, doesn’t have the cash to pay a dividend. In such circumstances, where the directors consider payment of dividend important, they may seek to raise funds through borrowing money or issuing more capital.
According to Treasury documents, the new Government proposal purports to:
“… prevent companies from attaching franking credits to distributions to shareholders made outside or additional to the company's normal dividend cycle, to the extent the distributions are funded directly or indirectly by capital raising activities that result in the issue of new equity interests.”
On the face of it, many would think this sounds reasonable. However, like with a lot of tax legislation, the problem rests in the detail and practical implications.
Devil in the detail
The proposal will make the job of a company director more difficult given its far-reaching application. Paragraph 1.33 of the explanatory documents states the following in relation to a capital raising:
“It is not necessary that the relevant purpose be the sole, dominant or primary purpose, only that it is more than incidental to some other purpose.”
In other words, if it can be argued that the capital raising has some relationship to the dividend, then the entire dividend could be deemed unfranked.
Anyone who has watched how listed companies operate will see that their capital requirements are constantly changing. One minute they might be paying dividends and returning capital to shareholders. The next minute, due to a market change or business challenge, they may need to borrow money or raise capital to shore up their balance sheet. A few months later, they might be able to again return money to shareholders.
The Westpac example
An example quoted in the press in recent weeks is the November 2019 dividend paid by Westpac. A franked dividend of 80 cents was issued on the same day that the bank announced a $2.5 billion capital raising. The funds from the capital raising were received prior to the dividend being paid. But under the Government proposal, a dividend payment must be unfranked if funded from a capital raising even if the company has franking credits available for distribution.
Will Westpac be caught by this proposal, which is backdated to 2016? I think the answer is 'possibly'. There are some arguments for and against. What is clear, however, is if they didn’t pay the dividend, then the capital raising could have been smaller.
But was Westpac undertaking a contrived arrangement? Was the bank carrying out some mischief that needs to stop?
I think most would agree that Westpac did nothing wrong. Banks have always balanced the paying of franked dividends to shareholders with the need to raise capital at times to secure their balance sheet.
This quandary that Westpac directors face if this new legislation is introduced will be repeated in boardrooms throughout Australia. There should be nothing wrong with a company raising capital to strengthen their balance sheet. There also should be nothing wrong with a company paying retained profits to shareholders as fully franked dividends.
A recipe for worse outcomes
Giving the Tax Office the discretion to question the motives of directors is likely to result in worse outcomes as decisions are made to meet legislative requirements instead of meeting the interests of the business and shareholders.
The Treasury document states that the purpose of these changes is to:
“ … prevent entities from manipulating the imputation system to obtain access to franking credits”.
It needs to be noted there is already strong anti-avoidance legislation in place to stop manipulation without intruding on the decision making of boardrooms.
It is clear that governments needs to be vigilant in relation to tax legislation as companies seek to exploit loopholes. However, it is my understanding that the ‘problem’ this legislation is trying to fix is not widespread. As a result, it is feared that business and shareholders will be worse off without any perceptible improvement to the tax system.
Matthew Collins is a director of Keystone Advice Pty Ltd and specialises in providing superannuation tax, estate tax and structural advice to high net wealth individuals and their families. This article is general information and does not consider the circumstances of any individual investor. It is based on a current understanding of related legislation which may change in future.