Private ruling: Ability to frank non-share dividend
Published: November 2012
Ruling period: 1 July 2012 to 30 June 2013
Date scheme commenced: An earlier income year

Ruling: Q1: Will a non-share dividend paid on the mandatory convertible notes issued by the Company be regarded as an undebited non-share dividend as defined in section 215-20 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that the non-share dividend paid was recognised as an expense for accounting purposes? | A1: No | Q2: Should the available frankable profits of the Company, immediately before the payment of a non-share dividend on the mandatory convertible notes, determined for the purposes of section 215-15 of the ITAA 1997, include the balance of any expense accrued to pay the non-share dividend that exists at that time? | A2: Yes. | Q3: If the accrued expense in respect of the payment of the non-share dividend is reversed against the profits of the Company immediately before the payment of the non-share dividend, and then recognised against profits on payment of the non-share dividend, should the available frankable profits of the company immediately before the payment of the non-share dividend on the mandatory convertible notes be determined, for the purposes of section 215-15 of the ITAA 1997, after the reversal of the accrued expense? | A3: No.

Relevant facts and circumstances: The Company is an Australian incorporated company that is listed on the Australian Securities Exchange (ASX). In 2XXX, the Company issued mandatory convertible notes. The notes mandatorily convert into ordinary shares in the Company at a future date at a set conversion price, although this is subject to standard anti-dilution adjustment clauses. Interest accrues on the mandatory convertible notes and is paid every 6 months via principal capitalisation. The Company will recognise the payment by increasing the face value of the note, the increase is treated as a new convertible note, with a term equal to the time remaining on the original mandatory convertible notes. The journal entry that will be made for accounting purposes to recognise the capitalisation of the amounts distributed on the notes is: DR Interest Payable xx CR Convertible Note Debt (liability) xx CR Convertible Note Equity (equity) xx An amount will then be expensed in respect of the distribution that has been made. The journal entry to reflect this will reduce the profit and is recorded as: DR Interest Expense xx DR Convertible Note Debt (liability) xx CR Interest Payable xx The distribution of interest is not debited against the non-share capital account or share capital account. The convertible notes are equity interests for Division 974 of the ITAA 1997.

Relevant legislative provisions: Subdivision 215B of the Income Tax Assessment Act 1997 Section 215-20 of the Income Tax Assessment Act 1997 | Subsection 215-20(1) of the Income Tax Assessment Act 1997 | Section 974-115 of the Income Tax Assessment Act 1997 | Section 974-120 of the Income Tax Assessment Act 1997 | Section 995-1(1) of the Income Tax Assessment Act 1997 | Section 15AA of the Acts Interpretation Act 1901 | Paragraph 15AB(1) of the Acts Interpretation Act 1901

Reasons for decision: Summary: Will a non-share dividend paid on the mandatory convertible notes issued by the Company be regarded as an undebited non-share dividend as defined in section 215-20 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that the non-share dividend paid was recognised as an expense for accounting purposes? No A non-share distribution Section 995-1 of the ITAA 1997 defines a non-share distribution as having the meaning given by section 974-115 of the ITAA 1997. Section 974-115 of the ITAA 1997 states: 974-115 A company makes a non-share distribution to you if: (a) you hold a *non-share equity interest in the company; and (b) the company: (i) distributes money to you; or (ii) distributes other property to you; or (iii) credits an amount to you; as the holder of that interest. The Company makes a payment of interest on the convertible notes. This distribution is recognised as an expense and is added to the face value of the convertible note (the interest is capitalised). The Company have made a non-share distribution for the purposes of section 974-115 of the ITAA 1997 as they have credited an amount to the holder of the convertible note (the non-share equity interest). A non-share dividend Subsection 995-1(1) of the ITAA 1997 defines a non-share dividend as having the meaning given by section 974-120 of the ITAA 1997. Section 974-120 of the ITAA 1997 states: 974-120(1) Subject to subsection (2), all *non-share distributions are non-share dividends. 974-120(2) A *non-share distribution is not a non-share dividend to the extent to which the company debits the distribution against: (a) the company's *non-share capital account; or (b) the company's *share capital account. The payment of interest that the Company makes is not debited against the non-share capital account or share capital account. Therefore, the payment of interest on the note is a non-share distribution, and is also a non-share dividend. The ability to frank a non-share dividend The ability to frank a non-share dividend is determined by the rules in Subdivision 215-B of the ITAA 1997. A non-share dividend may be franked where the company paying the non-share dividend has adequate available frankable profits. Available frankable profits are calculated as provided in subsection 215-20(1) of the ITAA 1997 which states: 215-20(1) Use the following formula to work out the amount of a *corporate tax entity's available frankable profits at a particular time: Maximum frankable amount - committed shared dividends + undebited non-share dividends where: committed share dividends means the sum of: (a) the amounts of any *distributions that are not *non-share dividends and are paid by the entity at that time; and (b) if the entity has announced that it will pay distributions that are not non-share dividends at a later time, or is committed or has resolved (formally or informally) to paying such distributions at a later time - the amounts of those distributions. 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. undebited non-share dividends means the sum of the amounts of the franked parts of the *non-share dividends (worked out under subsection (2)) that: (a) were not debited to available profits; and (b) were paid within the preceding 2 income years or were paid under the same *scheme under which the entity pays the non-share dividend. There is no guidance in the words of the provisions that explain whether the term available profit in this provision means something different to profit. Under paragraph 15AB(1)(a) of the Acts Interpretation Act 1901 consideration may be given to extrinsic material such as the Explanatory Memorandum to the legislation introducing Subdivision 215-B of the ITAA 1997 to confirm the ordinary meaning of the phrase. Section 15AA of the Acts Interpretation Act 1901 provides: In the interpretation of a provision of an Act, a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object. The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (EM) gives guidance as to the treatment of a non-share dividend, it states: 2.75: In essence, a payment to a non-share equity interest holder that corresponds to a dividend paid to a shareholder is treated in the same way as a dividend. This is effected by the definitions of non-share distribution and non-share dividend, which are based on the definition of a dividend in the ITAA 1936. ………. 2.81 If a non-share distribution is a non-share dividend it is generally included in the assessable income of the non-share equity holder. Unlike dividends paid on shares, non-share dividends might be paid even if the paying company has no profits. Therefore, the inclusion of such dividends in assessable income does not depend on them being sourced from profits (as it does for shares). This is reflected in the amended section 44, which also include a clarificatory note providing a non-exhaustive list of some of the provisions of the income tax law to which the section is subject. ………….. 2.84 Non-share dividends are generally frankable in the same circumstances that dividends on shares (share dividends) are frankable. .. 2.85 Under the current law dividends on shares have to be paid out of realised profits to be frankable. Thus dividends debited to share capital or asset revaluation reserves are not frankable (see sections 46G to 46M of the ITAA 1936). Although non-share dividends debited to those sources will also be unfrankable, there is no general requirement that they be debited to realised profits to be frankable. This could give rise to opportunities to stream franking credits in circumstances where there is no such opportunity under the current law because the relevant company has no profits… 2.86 Therefore, to prevent the use of non-share dividends to stream franking credits, the ability to frank non-share dividends is capped by reference to 'available frankable profits'. These are profits that are available to pay frankable dividends (therefore they exclude unrealised profits) . If a company does not have any such profits then it will be unable to frank non-share dividends. [emphasis added] It is clear from the EM then that the available frankable profits are meant to reflect realised profits under the current law. We arrive at this conclusion because there is meant to be no difference between the application of the provisions for dividends paid for shares, and dividends paid on non-shares. Therefore, as dividends on shares must be paid out of realised profits, so too must dividends paid on non-shares if a taxpayer wishes to frank the distribution. This interpretation therefore establishes that the concept of available profits looks to realised profits as an integrity measure to prevent frankable dividends being paid from unrealised profit. The EM goes on to explain that the calculation method is meant to relieve the compliance burden under the self assessment system. As such paragraph 2.87 of the EM states. 2.87 …To avoid the complexities and compliance costs that could arise from the establishment of a notional account to record available frankable profits that have already been used to support the franking of a non-share dividend, a simple calculation method is used which focuses only on non-share dividends paid in the preceding 2 franking years (or under the same scheme). There is also guidance contained in the Explanatory Memorandum to the New Business Tax System (Consolidation and Other Measures) Act (No. 1) 2002 (Cth) which provides: 10.46 Section 215-15 makes distributions paid on non-share equity interests debited to non-profit sources (e.g. share capital or asset revaluation reserves) unfrankable. A company cannot frank non-share dividends unless it has available frankable profits. The purpose of this treatment is to ensure that non-share dividends are treated in the same way as dividends paid on shares debited to non-profit sources, so that these distributions cannot be used to stream franking credits. Section 215-10 replicates former section 160APAAAB. In considering the meaning of available profit in the calculation in subsection 215-20(1) of the ITAA 1997 we have taken an interpretation that promotes the purpose underlying the provision. We are required to do this as stated in section 15AA of the Acts Interpretation Act 1901 : In the interpretation of a provision of an Act, a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object. With this in mind it is the preferred view that available profit is analogous to profit as defined in TR 2012/5 such that the same outcome is achieved for franking distributions on shares, and franking distributions on non-share interests. The term undebited non-share dividends The question is whether the expense/cost for the non-share dividend paid on the mandatory convertible notes issued by the Company would be regarded as an undebited non-share dividend as defined in section 215-20 of the ITAA 1997 to the extent that the non-share dividend paid was recognised as an expense for accounting purposes. The answer to this question is no. The underlying rationale for this conclusion is that the amount of expense for the non-share distribution can not be undebited non-share capital because the recording of the expense itself has already reduced the available profit (realised profit) of the company. In this context, it is considered that the term undebited non-share dividend is meant to, recognise amounts paid in respect of non-share distributions which have not otherwise reduced profits, as many non-share distributions will not have to reduce available profits due to their legal form in contrast to the treatment of a share. This construction is considered consistent with the broad purpose of the legislation as already described In the present situation, the Company reduces the amount of profits that would otherwise be available for distribution by the accounting expense outlined previously, and thus the calculation of available profits will already be reduced. As such, the amounts expensed in this fashion will not fall within the meaning of the term 'undebited non-share dividends' for the purposes of sections 215-15 and 215-20 of the ITAA 1997. Should the available frankable profits of the Company, immediately before the payment of a non-share dividend on the mandatory convertible notes, determined for the purposes of section 215-15 of the ITAA 1997, include the balance of any expense accrued to pay the non-share dividend that exists at that time? Yes | Detailed Reasoning - Reasons for decision: Section 215-15 of the ITAA 1997 outlines the circumstances in which non-share dividends should be regarded as unfrankable. Subsection 215-15(1) states that - 215-15(1) If: (a) a *corporate tax entity pays a *non-share dividend; and (b) immediately before the payment, the amount of the *available frankable profits of the entity is nil, or less than nil; the non-share dividend is unfrankable . In this case, the Company pays a distribution which falls into the definition of a non-share dividend. Section 995-1 of the ITAA 1997 defines 'available frankable profits' as having the meaning given by section 215-20 and affected by subsection 215-25(1). 215-20(1) Use the following formula to work out the amount of a *corporate tax entity's available frankable profits at a particular time: Maximum frankable amount - committed shared dividends + undebited non-share dividends where: committed share dividends means the sum of: (a) the amounts of any *distributions that are not *non-share dividends and are paid by the entity at that time; and (b) if the entity has announced that it will pay distributions that are not non-share dividends at a later time, or is committed or has resolved (formally or informally) to paying such distributions at a later time - the amounts of those distributions. 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. undebited non-share dividends means the sum of the amounts of the franked parts of the *non-share dividends (worked out under subsection (2)) that: (a) were not debited to available profits; and (b) were paid within the preceding 2 income years or were paid under the same *scheme under which the entity pays the non-share dividend. 215-20(2) The amount of the franked part of a *non-share dividend is worked out using the following formula: *Franking credit on the dividend x 1 - *corporate tax rate corporate tax rate The Explanatory Memorandum to the New Business Tax System (Debt and Equity) Bill 2001 (EM) relevantly states at paragraphs 2.84 to 2.86 that - 2.84 Non-share dividends are generally frankable in the same circumstances that dividends on shares (share dividends) are frankable. .. 2.85 Under the current law dividends on shares have to be paid out of realised profits to be frankable. Thus dividends debited to share capital or asset revaluation reserves are not frankable (see sections 46G to 46M of the ITAA 1936). Although non-share dividends debited to those sources will also be unfrankable, there is no general requirement that they be debited to realised profits to be frankable. This could give rise to opportunities to stream franking credits in circumstances where there is no such opportunity under the current law because the relevant company has no profits… 2.86 Therefore, to prevent the use of non-share dividends to stream franking credits, the ability to frank non-share dividends is capped by reference to 'available frankable profits'. These are profits that are available to pay frankable dividends (therefore they exclude unrealised profits). If a company does not have any such profits then it will be unable to frank non-share dividends. Thus, section 215-20 of the ITAA 1997 was introduced to prevent streaming opportunities that might otherwise arise due to the fact that non-share dividends need not be paid out of profits. It is also apparent from the EM that the introduction of non-share dividends was not intended to increase opportunities for the release of franking credits. To that end, section 215-15 of the ITAA 1997 essentially provides that a non-share dividend will not be frankable to the extent that, immediately before the payment, the 'available frankable profits' of the company are less than the amount of the non-share dividend. That is to say, an entity was not to be entitled to distribute more franking credits in total after the amendments than they could have distributed before the amendments, though they were to be entitled to distribute that amount in a wider variety of ways, i.e., to frank a wider class of payments. The maximum amount of franking credits distributable before the amendments was limited to the profits available for distribution by way of dividend at any given point in time. In our understanding, for the purposes of determining the limit to the ability of an entity to frank "non-share dividends", one is to hypothesise the maximum franked actual dividend a company could lawfully distribute to its shareholders (i.e., the whole of its available profits): that amount, the maximum frankable amount, is the limit. 'Available frankable profits' therefore is linked to the definition of 'maximum frankable amount' in the calculation contained above in subsection 215-20(1) of the ITAA 1997. 'Maximum frankable amount' is defined within that subsection as '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'. That is, the taxpayer must have available profits out of which frankable share dividends could be paid. Further to the EM, we considered Federal Commissioner of Taxation v Sun Alliance Investments Pty Ltd (in Liq) 2005 ATC 4955 ( Sun Alliance ) and Federal Commissioner of Taxation v Slater Holdings Ltd (No 2) 84 ATC 4883 ( Slater Holdings ) to assist us in the definition of "available profits". In Sun Alliance , the High Court referred to an earlier decision of the court in Webb v Australian Deposit and Mortgage Bank Ltd (1910) 11 CLR 223. In that case, Higgins J at 241 said: The truth is, that the meaning of 'profits' is not rigid and absolute; it is flexible and relative - relative to each company; and in ascertaining the meaning of the word in any context, we must consider the whole context. Commenting on this statement by Higgins J, the majority joint judgement in Sun Alliance stated at paragraph 71: It is apparent that Higgins J was saying no more than that there is no universal legal meaning of the term "profits" applicable in every circumstance for every purpose. In Slater Holdings , Gibbs CJ noted at 4889: It is not always easy to determine what are profits out of which dividends ought to be paid. Although profit, in its ordinary sense, often means the excess of returns over the outlay of capital, Farwell J said in Bond v Barrow Haematite Steel Company (1902) 1 Ch 353, at pp 365-366, that the question whether there are profits available "is to be answered according to the circumstances of each particular case, the nature of the company, and the evidence of the competent witnesses. The above cases are authority for the view that the term "profits" is a flexible concept and should be considered in the correct context in order to obtain its proper meaning. From these cases there is no suggestion, however, that profits means something different from the amount revealed by the proper use of accounting concepts and the accounting equation, viz profit = revenue - expenses. Therefore, taking into account the correct context of the phrase "available frankable profits" in relation to section 215-15 of the ITAA 1997 we are required to look at the accounting concept of profits. Therefore, the relevant sections are essentially integrity provisions and the concept of 'available profits' should have regard to - · An accounting concept of profits - in particular, regard should be had to the proper attribution of expenses that are not paid to accounting periods; and · Dividends on shares having to be paid out of such profits. In the present circumstances, the non-share equity interest is treated as a liability for financial accounting purposes and part of the distribution is treated as an interest expense. That is, because the non-share dividend has the legal form of interest, financial accounting practices would require that the interest obligation be accrued and taken into account in determining the entity's accounting profits for the period. It is only after the profit figure has been determined in this fashion that the 'available profits' of the entity can be determined. This view is consistent with the view expressed by the Commissioner soon after the introduction of Division 974 at the National Tax Liaison Group meeting held on 5 September 2002. The minutes of that meeting provide the following comments in a similar situation to the present: "In the example provided (outcome B), the non-share equity interest is treated as a liability for financial accounting purposes and the distribution is treated as an interest expense. The ATO understands that, because the non-share dividend has the legal form of interest, financial accounting practices would require that the interest obligation be accrued and taken into account, in determining the entity's accounting profits for the period, before actual payment as a non-share dividend [for tax purposes]. Therefore, in the example put, there would have been no available profits immediately before the payment of the interest/non-share dividend. The ATO believes that follows from a plain reading of the provisions in the light of accounting practice, having particular regard to the meaning of the defined terms discussed above. Given the structure of the existing provisions, and the definitions adopted, the ATO does not believe that the issue can be readily dealt with by interpretation." | Detailed Reasoning - Conclusion: Therefore, the available frankable profits of the Company will include the balance of any expense accrued to pay the non-share dividend that exists immediately before the payment of a non-share dividend on the mandatory convertible notes for the purposes of section 215-15 of the ITAA 1997. | Detailed Reasoning - Question 3: If the accrued expense in respect of the payment of the non-share dividend is reversed against the profits of the company immediately before the payment of the non-share dividend, and then recognised against profits on payment of the non-share dividend, should the available frankable profits of the Company immediately before the payment of the non-share dividend on the mandatory convertible notes be determined, for the purposes of section 215-15 of the ITAA 1997, after the reversal of the accrued expense? | Detailed Reasoning - Answer: No | Detailed Reasoning - Reasons for decision: Section 215-15 of the ITAA 1997 outlines the circumstances in which non-share dividends should be regarded as unfrankable. Subsection 215-15(1) states: If: (a) a *corporate tax entity pays a *non-share dividend; and (b) immediately before the payment, the amount of the *available frankable profits of the entity is nil, or less than nil; the non-share dividend is unfrankable . The Company pays a distribution which is a non-share dividend. In this situation the concept of 'available frankable profits' determines if a company will be able to frank the distribution of the non-share dividend. Section 995-1 of the ITAA 1997 defines 'available frankable profits' as having the meaning given by section 215-20 of the ITAA 1997 at a particular time. The Company has advised that it is possible that the interest payable balance, being the 'interest payable' account may be reversed immediately before the payment of the distribution on the convertible notes on the certain date late 2012. The reversing entry would have the effect of reducing the expenses recognised in the profit and loss statement of the Company on a temporary basis. The ATO understands that financial accounting practices would require that the interest obligation be accrued and taken into account in determining the entity's accounting profits for the period. Such that in preparing end of year accounts this reversal entry would need to be reversed to recognise the interest payable for the remainder of the convertible notes. The Commissioner does not accept that the temporary change in the expenses recognised by the Company mean that the Company has increased profits just before payment of the distribution on the notes. The Commissioner is of this view as it is essential that a company maintain proper evidence of legally effective directors' resolutions and accounts that establish that profits are available for distribution as a dividend, and are properly applied to dividend distributions at the relevant time. The adjustment that is being considered and may be made by the Company is temporary, and would not occur if the accounts were calculated in accordance with accounting standards in force at that time for an accruals taxpayer. | Detailed Reasoning - Conclusion: If the Company were to carry out a reversing entry immediately before the payment of the non-share dividend, the available frankable profits of the Company immediately before the payment of the non-share dividend on the mandatory notes would not change. The Commissioner would, in determining the available frankable profits for the purposes of section 215-15 of the ITAA 1997, rely on accounts that were calculated in accordance with accounting standards in force at that time for an accruals taxpayer.

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