ATO ID 2005/38: NZ franking companies and the benchmark rule
Date of decision: 27 January 2005
Year of income: Year ended 30 June 2004
Business line: Private Groups and High Wealth Individuals

Issue
Does the payment of a distribution on capital notes that is unfranked represent a breach of the benchmark rule in section 203-25 of the Income Tax Assessment Act 1997 (ITAA 1997), where franked dividends have already been paid in the same franking period?

Decision
Yes. As the two payments are made in the same franking period and represent frankable distributions, the benchmark rule requires that they be franked at the benchmark franking percentage.

Facts
NZ Co is a New Zealand company that has made an election to enter the Australian imputation system. It has issued capital notes that are classified as debt for New Zealand tax law purposes but are characterised as non-share equity interests for the purpose of Australian tax law. For New Zealand tax purposes, payments on these interests are not frankable, and are deductible. However, for Australian tax law purposes these payments are frankable and are not deductible. NZ Co also has a single class of ordinary shareholders. NZ Co pays a dividend on its ordinary shares franked to 100% with Australian franking credits. NZ Co later makes a payment on the capital notes in the same franking period. However, this distribution has no Australian franking credits attached to it. Both distributions are paid out of retained profits.

Reasons for decision
Summary: Subsection 215-1 of the ITAA 1997 provides that the imputation system applies to a non-share equity interest in the same way as it applies to a membership interest. As the capital notes are characterised as non-share equity interests for Australian tax purposes, the imputation system -which includes the benchmark rule - will apply to them in the same way as to ordinary shares. Both the distribution on the ordinary shares and the distribution on the capital notes are frankable distributions under section 202-40 of the ITAA 1997. The benchmark rule in section 203-25 of the ITAA 1997 states that an entity must not make a frankable distribution whose franking percentage differs from the entity's benchmark franking percentage for the franking period in which the distribution is made. The first frankable distribution made in the franking period is the distribution paid on the ordinary shares. This was franked to 100% and sets the benchmark franking percentage for the franking period in accordance with section 203-30 of the ITAA 1997. Therefore, the payment of the unfranked distribution on the capital notes will breach the benchmark rule. The consequences of breaching the benchmark rule are set out in section 203-50 of the ITAA 1997. A debit will arise in NZ Co's franking account under paragraph 203-50(1)(b) of the ITAA 1997 because the distribution on the capital notes will be taken to have been 'under-franked'.

Legislative references: Income Tax Assessment Act 1997 section 202-40 section 203-25 section 203-30 section 203-50 subsection 215-1(1)
Subject references: Underfranked dividends Benchmark franking percentage Frankable distribution Benchmark rule Non-share equity interest