ATO ID 2010/21: Frankable distributions and non-share dividends
Date of decision: 10 December 2009
Year of income: Year ended 30 June 2009
Business line: Private Groups and High Wealth Individuals

Issue
Can a non-share dividend be a frankable distribution when a company has no accounting profits or retained earnings?

Decision
No. Non-share dividends are unfrankable if a company has no accounting profits or retained earnings.

Facts
A company engages in the business of trading in financial instruments. Due to a large negative movement in the value of its instruments, the company reported an accounting loss for the financial year. However, the company has taxable income in the corresponding income year. The company issues an instrument which give rise to non-share equity interests in the company and pays a distribution on the instrument based on its net operating profit, excluding unrealised gains and losses. The company is prohibited from declaring any dividend on its ordinary shares by section 254T of the Corporations Act 2001 (Corporations Act) as it has no accounting profits or retained earnings [1] .

Reasons for decision
Summary: Prior to 28 June 2010 section 254T of the Corporations Act requires all dividends 'be paid out of profits of the Company'. The effect of this provision is that a company may pay dividends out of its accounting profits or retained earnings. Although profits are no longer referred to in section 254T of the Corporations Act the concept of profits as the source of dividend payment continues to be relevant to the payment of a dividend in compliance with section 254T, and to the assessment and franking of dividends for taxation purposes. However, not all amounts that are paid by a company that are dividends for the purposes of the Corporations Act or taxation purposes are frankable. The Explanatory Memorandum to the Corporations Amendment (Corporate Reporting Reform) Act 2010 states at paragraph 3.18 that: 3.18 Subject to the operation of the current imputation integrity rules, theses distributions will be frankable under section 202-40 of the ITAA 1997. According to subsection 202-40(2) of the Income Tax Assessment Act 1997 (ITAA 1997), a non-share dividend is a frankable distribution to the extent that it is not unfrankable. Paragraph 215-15(1)(b) of the ITAA 1997 provides that a non-share dividend is unfrankable if, immediately before the payment, the amount of the available frankable profits of the entity is nil, or less than nil. A company's available frankable profits at a particular time is worked out using the following formula in subsection 215-20(1) of the ITAA 1997: Maximum frankable amount - [Committed share dividends + Undebited non-share dividends] where: maximum frankable amount means the maximum amount of *frankable *distributions (other than *non-share dividends) that the *corporate tax entity could pay at that time having regard to its available profits at that time. Maximum frankable amount - [Committed share dividends + Undebited non-share dividends] Subsection 215-20(1) of the ITAA 1997 was enacted in the New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 and was intended as a rewrite of section 160APAAAB of the Income Tax Assessment Act 1936 (ITAA 1936), itself introduced by the New Business Tax System (Debt and Equity) Act 2001 as part of the 'Debt/Equity rules' contained in Division 974 of the ITAA 1997. According to paragraph 2.85 of the Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (the EM), the purpose of section 160APAAAB of the ITAA 1936 was to prevent the use of non-share dividends to stream franking credits in circumstances where there was previously no such opportunity, by introducing 'the general requirement that they be debited to realised profits to be frankable.'. That is, section 160APAAAB of the ITAA 1936 and subsequently subsection 215-20(1) of the ITAA 1997 were intended to restrict a company's ability to pay frankable non-share dividends to the conditions which would need to be met for the company to pay a dividend on its ordinary equity. The purpose of section 160APAAAB of the ITAA 1936 and subsection 215-20(1) of the ITAA 1997 indicates that the expression 'available profits' in subsection 215-20(1) refers to the profits from which a company can pay dividends. This purpose will be given effect to if the term 'profits' in that context is construed as accounting profits or retained earnings, so that it includes any unrealised gains and losses recognised directly in profit and loss. There is no basis for construing the expression 'available profits' so as to necessarily exclude unrealised gains and losses since a company's capacity to pay dividends is already calculated after regard to any unrealised gains and losses recognised directly in profit and loss. Therefore, because the company has no accounting profits or retained earnings, it has no 'available profits' for the purposes of subsection 215-20(1) of the ITAA 1997 and will not be able to pay frankable non-share dividends. Therefore, distributions paid by the company on the instrument will be unfrankable.

Legislative references: Income Tax Assessment Act 1997 subsection 202-40(2) subsection 215-15(1) section 202-30
Other references: EM to the New Business Tax System (Debt and Equity) Bill 2001
Subject references: Frankable dividends