Contents
- What counts as a dividend
- When will a dividend be assessable
- The disadvantages of the imputation system
- What about deemed dividends
- Anti-streaming rules and anti-manipulation rules
- The debt and equity rules
The payment of dividends or other profit distributions from a company to shareholders will be assessable income to the recipient shareholders. The assessable dividend will need to be grossed-up for the value of franking credits. Thereafter, the taxpayer will be entitled to a tax offset for the tax already paid by the company on the profits which support the dividend payment. For an individual shareholder, the offset can result in a cash refund. For a corporate shareholder, the offset will be non-refundable. That is, the franking credits may reduce the company tax liability but cannot result in a cash refund.
The impact of franking credits on tax outcomes for the shareholder can be summarised with an example:
Abbie is a shareholder of Abbie Pty Ltd. On 1 August 2023, she is paid a dividend of $100,000. The dividend is partially franked with 20,000 franking credits attached. Abbie has no other assessable income or deductions. Therefore, in her tax return of 2023-2024, her assessable income will be $120,000. As she has no deductions, her taxable income will also be $120,000. The tax on her taxable income is $29,467 (excluding medicare levy) less the franking tax offset. Abbie’s tax payable for 2023-2024 is $9,467.
The ‘power’ of franking credits to produce beneficial tax outcomes for shareholders is particularly on display where personal tax rates are less than corporate rates. In fact, a taxpayer can theoretically achieve a refund position despite the dividend receipts.
Example:
On this occasion, Abbie is paid a $70,000 dividend with 30,000 franking credits attached. Her assessable income is grossed-up to $100,000 and as she has no allowable deductions her taxable income is also $100,000. The tax on her taxable income is $22,967 payable (excluding Medicare levy). This is offset by $30,000 being the value of franking credits attached to the dividend. Abbie receives a cash refund from the ATO of $7,033 despite having received a $70,000 dividend!
The impact of franking credits on tax outcomes for the company making the distribution can be summarised as follows:
- The dividend payment is not deductible (with exception for non-equity shares).
- The company franking account is debited (reduced) for the value of the franking credits attached to the dividends.
Note that the amount of dividend and franking credits can generally be determined by referring to distribution statements issued by a company to a shareholder.
Note also that the dividends will be assessable to the taxpayer even where those dividends are not ‘received’ per se and are instead re-invested under a dividend reinvestment plan.
What counts as a dividend
A dividend is defined broadly to include:
- Any distribution made by a company to any shareholders, whether in money or property.
- Any amount credited by a company to any shareholders as shareholders.
Note in particular that a dividend can include property which is distributed in-specie to a shareholder. The dividend amount will be equal to the market value of the property transferred.
Monies paid or credited to a shareholder which are sourced from the company share capital account will not be a dividend but instead a return of capital. The share capital account essentially represents the amount shareholders invested (‘paid up’) into the company to obtain their shareholdings. It is illogical for a return of capital to be taxed as a dividend in the same way as it would be illogical for someone to deposit $100 into a bank account and then withdraw the full $100 only for that amount withdrawn to be taxed as though the withdrawn funds were a form of profit.
When will a dividend be assessable
For a ‘dividend’ (per the above definition) to be assessable, it must be paid ‘out of profits’. This will generally be the case as the tax law provides that a dividend paid out of an amount other than profits is taken to be paid out of profits. This includes dividends sourced from revenue profits, capital profits, gifts received by the company and potentially unrealised profits, noting the general consensus that unrealised profit must have a degree of permanence before a payment sourced therein would constitute a payment out of profits.
The disadvantages of the imputation system
The dividend imputation system means tax-preferred amounts (e.g. discounted capital gains) within the company do not retain their tax-advantaged character when they are distributed to a shareholder. This is different from the situation in respect of trusts and partnerships, where tax-preferred amounts can retain their tax-advantaged status at the beneficiary or partner level. For example, if a corporate beneficiary is streamed a discounted capital gain from a trust, the company is unable to distribute the discounted capital gain to the shareholder such that the benefit of the discount is available for use by the shareholder. Rather, the entire tax-free or tax-discounted amount will effectively be an assessable (undiscounted) dividend in the hands of the recipient shareholder.
Another disadvantage of the imputation system is that foreign shareholders are not entitled to utilise franking credits as a tax offset. There is some consolation for the company and foreign shareholders in that there is no withholding tax obligation imposed in respect of fully franked dividend. Unfranked dividends to foreign shareholders are generally otherwise subject to a dividend withholding tax at a rate of either 15% or 30%.
What about deemed dividends
- Payments made by a company to a shareholder or their associates. This does not include payments made to shareholders who are being remunerated / compensated for acting in their capacity as director or employee, provided they are not being paid excessively.
- Loans from the company to a shareholder or their associates that are not repaid by the company tax return lodgement date. As an alternative to the repayment requirement, the company can arrange for the loaned monies to be made subordinate to the terms of a complying loan agreement. Note that the term ‘loan’ can extended to financial accommodations afforded to shareholders or their associates.
- Forgiven debts for shareholders or their associates.
- Private use of company assets for shareholders or their associates.
Anti-streaming rules and anti-manipulation rules
There are a number integrity measures including the anti-streaming and anti-manipulation rules which are designed to deter taxpayer arrangements which exploit weaknesses in the imputation system.
Probably the most commonly encountered integrity measure is the ‘qualified person rule’, also known as the ‘45 day rule’. The rule is designed to ensure that those who benefit from franking credits are those that bear the risk of the underlying shares, including the risk that those shares could change in value.
Specifically, shares must be held for a continuous period of 45 days during the ‘qualification period’ in order for the shareholder to utilise the franking credits. It is preferrable to view this as 47 days, as the day of the acquisition and disposal of the shares is not included in the 45 day test period. The qualification period begins the day after the shares are acquired and ends 45 days after the ex-dividend date. The ex-dividend date being the last day on which acquisition of a share will entitle a shareholder to receive an impending dividend payment.
Note that if the taxpayer satisfies the small shareholder exemption, essentially by being entitled to 5,000 or less in franking credits for the income year, that person is considered a ‘qualified person’ even if they fail the 45 day rule.
Without the qualified person rule it is easy to imagine the imputation system being exploited by shareholders entering into schemes which involve purchasing shares just prior to the ex-dividend date, receiving a dividend and the associated benefit of attached franking credits and immediately thereafter selling the shares.
The debt and equity rules
It is uncommon but worth keeping in mind the possibility of dividend being treated as interest for tax purposes under the debt and equity rules. The rules which address this concept are contained in Division 974 of the Income Tax Assessment Act 1997. A debt classification that causes the returns on equity (i.e. dividends) to be treated as returns on debt (i.e. interest) is referred to as a ‘non-equity share’.
A non-equity share classification will generally only occur where there is a non-contingent obligation for the company to return an amount to the shareholder which is at least equal to the amount previously contributed by the shareholder to the company to acquire their shares. For distributions to shareholders in relation to non-equity shares the imputation system is essentially switched off. Any distribution to a shareholder would generally be deductible for the company as though the amount was an interest expense. The distribution would be assessable income to the shareholder as though the amount was interest income. No franking credits could be attached to the distribution.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.