Having a second crack

Labor’s latest move to amend the imputation credits system has reignited fervent discussion within the financial services industry. Todd Wills dives into the debate surrounding the proposal, examining the potential consequences and impacts as it makes its way through the Senate.

In the constantly evolving world of fiscal policy, it appears changes to the franking credit regime are back on the bargaining table. Within four months of assuming office, Assistant Treasurer and Financial Services Minister Stephen Jones announced the government had introduced draft legislation seeking to amend the Income Tax Assessment Act to potentially render dividends distributed under certain conditions, unfrankable.

The proposal has taken many by surprise as the Albanese government had given multiple assurances prior to the last federal election it wouldn’t be touching the system. However, the tax reform policy involving franking credits appears to have been resurrected, albeit in a less substantial form, from the proposal Labor put forward during the 2019 election campaign.

The Treasury Laws Amendment (2023 Measures No 1) Bill 2023, presently under review in the Senate, introduces two noteworthy measures that will reshape the utilisation of franking credits in the corporate realm. The first measure, Schedule 4, aims to align the tax treatment of off-market share buybacks by listed public companies with on-market share buybacks.

The second measure, Schedule 5, seeks to restrict the franking of certain distributions funded through capital raisings that fall outside a regular or typical dividend cycle. These proposed amendments hold the potential to redefine how franking credits are employed in the corporate landscape in Australia. Given the ALP’s turbulent relationship with franking credits, it’s only natural to question its decision to pursue this course. Jones has framed both measures as ‘minor’ adjustments aimed at enhancing the integrity and fairness of the imputation credits system. During the bill’s second reading in the House of Representatives, he argued off-market share buybacks essentially result in a budget subsidy that assists companies in acquiring their own shares at discounted prices. He contends such arrangements are effectively subsidised by Australian taxpayers.

Regarding Schedule 5, he argues its purpose is to prevent companies from raising capital without a genuine commercial purpose and using that capital to finance special franked dividends. He asserts such actions exploit a tax loophole, which the amendment aims to address.

While both of these measures are new, it is worth noting the genesis of this proposal originated on the opposite side of the Australian political spectrum. The policy aims to address a specific integrity issue brought to light in ATO Taxpayer Alert (TA) 2015/2.

The ‘mischief’ alluded to in the alert concerned certain companies manipulating the franking credit system and using arrangements that may be in contravention of taxation anti-avoidance laws. The TA cited examples of large corporations who engaged in fully underwritten capital raisings and swiftly distributed the raised funds as franked dividends to their shareholders.

However, back in 2015 this policy was never formally implemented.

Now the current proposal has faced significant resistance from various sectors within the financial services industry. The amendment is currently undergoing thorough examination by the Senate and was subsequently referred to the Economics Legislation Committee, which handed down its report in May.

While Schedule 4 received considerable community and industry support, and was recommended to be passed without amendments, the committee noted industry concerns have prompted the need for substantial revisions to address the provisions of Schedule 5.

A step too far

The bulk of the criticism surrounding the new initiative revolves around the belief it transcends the original scope of TA 2015/2 in a number of key ways and ventures into territory beyond the specific issues it originally intended to solve. This is the view of SMSF Association chief executive Peter Burgess, who argues the proposals are overly broad and should be refined to specifically target instances of illegal corporate behaviour.

“The ATO was very clear in delivering a message to the marketplace as to the kind of behaviour it thought was unacceptable. We haven’t seen that type of behaviour since then and the taxpayer alert back in 2015 seems to have dealt with that behaviour,” Burgess says.

“The concern we have with these particular amendments is they go much further than the behaviour the taxpayer alert was intending to target and it’s also a concern many others in the industry have raised. These amendments will unintentionally capture many genuine practices that have nothing to do with tax avoidance and manipulating the franking credit system.”

In response to a question posed by Liberal Senator Andrew Bragg, Treasury conceded the point made by Burgess that “the ATO has not observed taxpayers engaging in this behaviour in any significant way” and suggested the majority of both public and private companies have been complying with the TA since its announcement.

Treasury further argued since the majority of companies were already in compliance with the existing rules, they would not be affected by the specific legislation under consideration.

Throughout the submissions to the Senate, the phrase 'unintended consequences' emerged as a recurring theme, reflecting the industry’s apprehensions about the purported far-reaching effects anticipated from the proposal. From the retail mum and dad investor, to small and medium-sized companies, and the Australian economy itself, the proposal has been heeded as a game changer at multiple levels.

Wilson Asset Management chief financial officer Jesse Hamilton for instance warns restricting the ability of corporate entities to use franking credits may have much wider implications for the tax system.

“Schedule 5, in my opinion, is potentially more damaging than what could have been proposed in 2019. In 2019, you had an issue of inequity where different people at different stages in their life, and depending on where they had their super, were treated differently with Labor’s proposal. And I think the Australian public saw the inequity in that approach,” Hamilton notes.

“This piece of legislation is more worrying, because it has, in my opinion, wider impacts to the franking system. It’s targeting the source and going after companies and their ability to pay a franked dividend, which I see having longer-term structural problems for the Australian economy and Australian investors.

“If we start tinkering with the system, lots of unintended consequences start to fall out from that. Starting to put limitations on companies will mean that if they can’t pay franked dividends, then the whole incentive system changes. Companies are incentivised to pay tax in Australia and if companies can’t distribute that franking credit and the tax paid down to shareholders, I think it’s logical to assume that they might look to either minimise or defer that tax.”

A proposal in need of some serious revision

Many of the concerns about the unintended consequences of Schedule 5 arise from how it will be interpreted and applied in practice. Critics have lamented that Treasury appears to have overlooked those impacts when drafting key criteria contained within the bill.

In their Senate submission, Listed Investment Companies and Trusts Association (LICAT) chief executive Ian Irvine and chairman Angus Gluskie acknowledged the legitimate intention of the measure while expressing concerns about its lack of clarity in execution.

“The proposed legislation as drafted would appear to inadvertently catch many thousands of situations of legitimate company operation and could accordingly delay or significantly discourage the normal processes of capital raising, investment and economic growth within Australia. That is, the legislation does not sufficiently distinguish between acceptable activities and the mischief it properly seeks to address,” LICAT’s submission states.

As numerous commentators point out, this represents one of the core shortcomings of the current bill. The proposed provisions lack clarity in determining which dividends can be classified as frankable or unfrankable in relation to capital raising, creating significant ambiguity for the industry.

The inclusion of the ‘established practice’ test is one example. This provision stipulates dividends paid by a company to shareholders would be classified as unfrankable if they deviate from the company’s regular dividend distribution cycle.

Institute of Public Accountants technical policy general manager Tony Greco points out the potential hurdles the inclusion of Schedule 5 and the accompanying established practice test could impose on new, small to medium-sized and growing companies.

“The way the amendment was drafted covers too many ordinary transactions. Many companies that don’t have a normal dividend pattern could fall foul of these provisions. Start-up companies, for example, haven’t paid a dividend in the past and they don’t generally have a normal dividend history,” Greco acknowledges.

“There are also private companies, where as part of their succession planning they may want to bring in new shareholders, but they also want to reward the old shareholders. And then you’ve also got listed entities who may use dividend reinvestment plans who could potentially get caught up in this as well.

“So you are going to penalise those sorts of entities that want to engage in a dividend and sometimes they have to raise capital to be in a position to reward their shareholders who took the risk to invest in these entities.”

Introducing another criterion, the ‘purpose and effect’ test requires a capital raising primarily serves the purpose of funding a distribution or a portion thereof.

Institute of Financial Professionals Australia (IFPA) senior tax specialist Frank Drenth expresses concerns about the problematic nature of the test’s details.

“It’s sort of a sudden-death rule. Even if a small part of a distribution is funded by capital raising, the whole of the distribution becomes unfranked, which is troubling. It’s a disproportionate penalty that’s being implemented because of some subjects of judgment that someone is making,” Drenth observes.

“The other problem with the legislation is the fact it’s self-executionary and doesn’t require the commissioner to make a finding, so we’ve got this self-assessment regime. The shareholder thinks it’s a franked dividend and they have to look at all the transactions throughout the company and determine whether the distribution is caught by this.

“How are you supposed to find out enough about the intentions of the company in making the distribution? That just can’t work in practice.”

Trustees on the hook

Beyond the purported effects on companies and individual shareholders, Burgess reveals members of SMSFs are more likely to notice an impact as they often use franking credits as an income strategy and substantial source of revenue.

“Franking credits are very attractive to superannuation members and in particular self-managed superannuation fund members in the pension phase who are not paying any tax. It’s a very important source of income in retirement and it’s very effective for superannuation funds because they only pay a maximum tax rate of 15 per cent,” he explains.

“And if they’ve got members in the pension phase, they’re not paying any tax. So the refund of franking credits enables funds to firstly reduce their tax if they were paying tax, and if they’re not paying any tax, to bolster the income retirement of members.”

To support this view he cited a University of Adelaide study performed in conjunction with the SMSF Association earlier this year that showed SMSF members in the pension phase exhibit a strong inclination towards investing heavily in Australian equities. He suggests SMSF members may need to re-evaluate their investment strategies if Schedule 5 is implemented as it currently stands if the benefit of receiving franking credits plays a part in their Australian equities bias.

“To the extent these SMSF members have investments in small to medium-sized private companies, they may need to begin to reassess what impact this amendment could potentially have on the income that the fund will receive, particularly for those funds that have members in the pension phase,” he advises.

“Funds may hold in their portfolio some small to medium-sized private companies, which don’t have a track record of paying regular dividends and are reinvesting to grow. These types of investments are going to potentially become riskier with the implementation of these amendments.

“So there may need to be some assessment made on what is the likely impact on the fund’s income and we believe that’s another unintended consequence. We don’t think these amendments should be discriminating against those types of companies.”

Worth the risk?

Some have questioned whether the measure is worth the potential pitfalls as Senate forward estimates reveal the government is likely to generate $10 million a year from the initiative.

“It’s interesting the measure kind of goes under the radar because it’s only got a $10 million forward estimate per revenue generator. So it feels like it’s a non-issue. It doesn’t feel like much versus Schedule 4, which was put forward as part of the budget process in October last year at $550 million,” Hamilton reveals.

Drenth too questions the merit of implementing a measure that extends far beyond the intended resolution of the original issue and believes the risks outweigh the benefits.

“There’s nothing inherently bad about paying your dividends out and franking credits to shareholders. I would say you should be able manage your capital however you desire. You should be able to capital raise and you should be able to borrow,” he notes.

“There’s a feeling policymakers have had for the last 30 years where they recognise there’s a flow through from the companies to the individual shareholders, but they don’t want too much to flow through.

“So if that’s seen as a mischief, then that mischief is still there. I would argue it’s not a mischief at all. Is $10 million a year really worth upending the capital markets in this way? I wouldn’t think so.

“Schedule 5 should really be abandoned altogether. For $10 million a year, it doesn’t seem worth it to create all of this uncertainty.”

Currently the exact form of the measure remains uncertain and its fate in parliament is yet to be determined. No doubt the eyes of the financial services industry will be keenly observing this process, eager to see how the process plays out.