Legislation introduced on capital management measures

17 February 2023

In brief

On 16 February 2023, the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 (Bill) was introduced into Parliament. The Bill contains previously announced tax measures in relation to:

amending the off-market share buy-back rules for listed public companies; and
preventing frankable distributions funded by certain capital raising activity.

These changes are likely to have significant consequences for companies’ capital management strategies, in particular for listed public companies. Companies should consider how these changes impact their ability to return funds to shareholders, including how to obtain certainty on the tax outcomes for ‘out of cycle’ franked distributions.

In detail

Changes to the off-market share buy-back rules for listed public companies

The amendments to the off-market share buy-back tax rules were first announced in the Government’s October 2022-23 Federal Budget and apply to off-market buy-backs announced to the market by listed public companies after 7:30pm, by legal time in the Australian Capital Territory, on 25 October 2022 (i.e. Federal Budget night).

Exposure draft law was released on 17 November 2022, which was summarised in our Tax Alert. The rules are now contained in Schedule 4 of the Bill. The legislation before Parliament is broadly consistent with the exposure draft law. In brief:

The legislation seeks to align the tax treatment of off-market share buy-backs undertaken by listed public companies with the tax treatment of on-market share buy-backs.
Under the existing rules, listed public companies who undertake an off-market buy-back can treat part of the buy-back price as a dividend (often fully franked) for tax purposes. The capital component of the buy-back price was typically based on average capital per share (ACPS); the balance of the buy-back price was the dividend component. Where the dividend component was fully franked, companies could undertake an off-market buy-back of their shares at a discount (up to 14% based on the ATO’s Practice Statement PS LA 2007/9). The legislation now prevents any part of the buy-back price from being treated as a dividend, likely ending the practice of discounted off-market buy-backs.
Further, the legislation also includes an integrity measure similar to that for on-market buy-backs. This requires listed public companies that undertake an off-market buy-back to debit their franking account by an amount equal to the debit that would have arisen if the company had undertaken an off-market buy-back under the existing rules (i.e. to the extent the buy-back price is not debited to the company’s share capital account). Companies that undertake on-market buybacks can currently choose to debit all of the on-market buy-back price against their share capital based on PS LA 2007/9. Given the intent of the measure is to align the tax treatment of off-market buy-backs with on-market buy-backs, we would expect that this practice will be able to continue for both on-market and off-market buy-backs.
To ensure alignment in tax outcomes across the capital management activities of listed public companies, a distribution by a listed public company that is “consideration for” the cancellation of a membership interest in itself, as part of a selective reduction of capital, is unfrankable and will give rise to a franking debit. The Explanatory Memorandum to the Bill notes that the reference to ‘selective reduction of capital’ is intended to be broad and includes any reductions of capital that in substance result in a disproportionate cancellation of membership interests. There is no guidance on what distributions will be taken to be “consideration for” the cancellation of membership interests.

Preventing frankable distributions arising out of certain capital raising activity

The integrity measure dealing with franked distributions and capital raisings was first announced in the Mid-Year Economic and Fiscal Outlook 2016-17 with limited details. No exposure draft law had been released until almost 6 years later on 14 September 2022.

The original focus of the measure was to prevent scenarios which the ATO considered were problematic in Taxpayer Alert TA 2015/2 (Franked distributions funded by raising capital to release franking credits to shareholders). However, the exposure draft law (which was summarised by us here) was much broader in its scope.

The legislation, now contained in Schedule 5 of the Bill, has made some changes compared to the exposure draft.

In broad terms, a distribution will be unfrankable where:

the distribution is not consistent with an established practice of the entity making distributions of that kind on a regular basis;
there has been an issue of equity interests in the entity or another entity (importantly, this equity issuance can occur at any time before or after the time of the distribution); and
it is reasonable to conclude in the circumstances that:
- the principal effect of the issue of any of the equity interests was to directly or indirectly fund some or all of the distribution; and
- 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 the distribution or part of the distribution.

A significant change compared to the exposure draft is that it must be reasonable to conclude that both the principal effect and purpose tests are satisfied, rather than just one of these. The change is explained as ensuring that the provisions apply in a “targeted way”.

It remains the case, however, that (i) the provision is self-executing; (ii) the principal effect/purpose tests still focus on the funding of the distribution rather than obtaining a tax benefit; and (iii) the provision can be engage even if only a small portion of the dividend is funded with the capital raising and will impact the entire dividend.

There are also now some further factors to be taken into account in determining the principal effect and purpose of the issue of equity interests. These factors include:

The nature and extent of the relationship between the entity that makes the distribution and the entity that issues the equity interests (if different) will be important when considering whether the capital raising has funded the distribution.
Whether the entity that receives the distribution is the same entity that is issued the equity interest. That is “Where the arrangement involves the raising of equity from the same or substantially the same members receiving the franked distributions, this suggests that the arrangement may be artificial in nature. This is because it does not materially change the economic position of the entity or its members other than to release the franking credits.”
Where the issue of equity interests and the distribution both took place in the context of a sale or acquisition, this may suggest there is a clear commercial motivation unrelated to the franking of distributions.
Where the entity has a large amount of franking credits relative to its profits and/or share capital this would suggest that the arrangement to make special distributions to shareholders that require capital raising from shareholders is artificial in nature and may attract the operation of the measure.

The Explanatory Memorandum also contains some detailed examples of when the integrity measure should or should not apply:

Examples which attract the operation of the integrity measure include:
- Where a company pays a special dividend to shareholders a month after raising new capital from shareholders of the same amount, where there has not been a significant change in the company’s circumstances or its shareholders
- Where a company with a large balance of franking credits uses an underwritten dividend reinvestment plan to fund a once-off special dividend.
Examples which do not attract the operation of the integrity measure include:
- Where a company returns capital 12 months after it had raised it with the intention of funding a proposed acquisition that was ultimately unsuccessful
- Where an APRA regulated body issues hybrid instruments (equity interests) for the purpose of ensuring its regulatory capital requirements are met and has a regular practice of paying distributions with franking credits attached on existing shares and other equity interests.

In the original announcement and the exposure draft law, the measure was intended to have effect for distributions from 19 December 2016. Helpfully, the measure will now only commence for distributions that occurred on or after 15 September 2022 (i.e. after the exposure draft was released on 14 September 2022).

The Takeaway

The removal of the dividend component from off-market buy-backs is likely to end the practice of discounted off-market buy-backs. Publicly listed companies will need to revisit their capital management strategies on how they return funds to shareholders.

Given the breadth of the integrity measure dealing with franked distributions and capital raisings, taxpayers will need to carefully consider in what circumstances this could apply as the provision is self-executing, unlike the anti-avoidance rules in s.177EA which requires an exercise of the Commissioner’s discretion before it applies. As noted above, the rule can apply even if only a small portion of the dividend is funded with the capital raising or the capital raising occurs after the distribution is paid. This will be particularly important for special dividends. It would be prudent for taxpayers to engage with the ATO (for example, seek rulings) in order to obtain certainty of the tax outcomes prior to undertaking any ‘out of cycle’ franked distributions.