Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 481

The proposal on capital raisings and franking is misguided

The Government currently proposes two changes to legislation involving franking credits. 

1. Preventing franked distributions when funded by certain capital markets raisings

Federal Treasury recently completed a consultation process on a Bill that amends taxation law to prevent certain franked distributions that are funded by capital raisings. In its background document, Treasury says this on imputation:

"The imputation system has the effect of allowing income tax paid by Australian corporate tax entities to be taken into account when determining the taxation of their resident members on the distributed profit of the entity. When an Australian corporate tax entity distributes profits to its resident members, it can also pass on a credit for income tax it has paid. This is done by franking the distribution ... If an entity is unable to frank a distribution and makes an unfranked distribution instead, the receiving entity includes the amount of the distribution in its assessable income, but it is not entitled to a tax offset."

The Bill proposes an integrity measure to prevent this distribution of franking credits where a distribution to shareholders is funded by particular capital raising activities, such as when distributions are made outside or additional to the company's normal dividend cycle.

2. The 2022 Budget clamp down on off-market buybacks

No specific details other than to “align the treatment of off-market buybacks with on-market buybacks” have been announced, but it is expected that no franked payments will be allowed as part of an off-market buyback (that is, it will be a capital return).

The following article, written as a submission to Treasury before the Budget announcement, explains why the first proposed change above is wrong but the second proposal has merit.

***

1. The proposed legislation [the first item above] on disallowing franking on certain capital raisings is misguided and addresses the wrong problem. It also unnecessarily complicates tax legislation via the discretion given to the ATO to determine when franking of dividends involved is to be disallowed. It is not the (near) simultaneous raising of equity to finance a distribution to shareholders which is the problem. It is the streaming of dividends which should be the concern.

2. A much simpler solution to the problem of preventing streaming of franking credits (with its inherent cost to government tax revenue) would be to abolish the ability of companies to undertake what we have called TOMBS (Tax-driven Off Market Buybacks). Companies wishing to make returns of capital (one component of TOMBS) would still be able to do so via buybacks where the amount involved is treated solely as a return of capital. Companies wishing to pay franked dividends which would reduce their franking account balances (FABs) would be able to do so by way of a special franked dividend paid pro-rata to all shareholders.

There is nothing inherently wrong with raising cash needed to do so by issuing new equity. Under the imputation tax system, company tax paid is meant to be a prepayment of investor level tax, and unused franking credits in a company’s FAB are a withholding of tax credits due to shareholders.

3. The original ATO Taxpayer Alert (TA 2015/2) from which this proposed legislation stems, posed the problem as being the linking of an equity capital raising with:

“[a]t a similar time …, the company makes franked distributions to its shareholders, in a similar amount to the amount of capital raised. This may occur as a special dividend or through an off-market buy-back of shares, where the dividend forms part of the purchase price of the shares.”

The ATO forecast that implementing a ban on these practices (as proposed in the draft legislation) would resulting in a saving to tax revenue in the order of $10 million p.a.

4. This is a trivial amount compared to the cost to tax revenue arising from the use of TOMBS. In our research1 on TOMBS, we estimated that in 2018 the tax revenue cost from TOMBS conducted in that year alone to be in the order of $2 billion. Recent calculations we have made for the years 2019 and 2020 (years which had many fewer TOMBs, partly due to the COVID pandemic in 2020) suggest that the tax cost for those two years together was in the order of $500 million.

These costs arise regardless of whether or not the company needs to undertake an equity issue to finance the cash outflow involved – indicating that the focus of the legislation on the 'near simultaneous' equity raising is addressing a trivial, rather than the real, problem.

5. The ATO Taxpayer Alert also refers to concerns over special franked dividends where the cash outflow is essentially financed by a cash inflow from a separate equity raising. This is misguided. For example, a company may have a positive franking account balance, be legally able to pay a dividend, but not have cash on hand. There is nothing inherently wrong with raising cash via an equity issue to pay a franked dividend. For example, the company may have had a period during which it was profitable and paying tax, but adopting a low dividend payout ratio due to opportunities to profitably invest the available cash flow. Subsequently it may find itself in a position where it is profitable and 'asset rich' but 'cash poor' and wishing to reward existing shareholders for forgoing past dividends and associated franking credits. There is nothing inherently wrong with raising cash via an equity issue to pay a franked special dividend.

6. We conclude that the proposed legislation [proposal one above] is inferior to an alternative course of action which:

a. Effectively bans TOMBS by legislating that off-market share buybacks involve only a return of capital and no dividend component. (This is more consistent with practices found in other jurisdictions. The inclusion of a dividend component is solely an artifact of dividend imputation and willingness of the ATO to allow a franked dividend component).

b. Does not place unnecessary restrictions on the use of special franked dividends by companies – particularly by not precluding simultaneous equity raisings.

 

Submission to the Treasury Consultation, September 2022 by Christine Brown, Emeritus Professor of Finance, Monash University and Kevin Davis, Emeritus Professor of Finance, The University of Melbourne.

1 Christine Brown and Kevin Davis “Tax-driven Off Market Buybacks (TOMBs): Time to Lay them to Rest” Australian Tax Forum, 35, 2, Jun 2020: 232-257.

 

Christine Brown and is Emeritus Professor of Finance at Monash University and Kevin Davis is Emeritus Professor of Finance at The University of Melbourne. Kevin’s free e-text reference book 'Bank and Financial Institution Management in Australia' is available on his website. Kevin was also a member of the Financial Systems Inquiry ('The Murray Report') in 2014.

 

RELATED ARTICLES

Retained profits a conspiracy against super and pension funds

The potential and perils of increasing franking credits

The when and why of four million Australian retirees

banner

Most viewed in recent weeks

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

Latest Updates

Property

Coalition's super for housing plan is better than it looks

Housing affordability is shaping up as a major topic as we head toward the next federal election. The Coalition's proposal to allow home buyers to dip into their superannuation has merit, though misses one key feature.

Planning

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Retirement

More people want to delay retirement and continue working

A new survey suggests that most people aged 50 or over don't intend to stop work completely when they reach retirement age. And a significant proportion of those who delay retirement do so for non-financial reasons.

Economy

US debt, the weak AUD and the role of super funds

The more the US needs capital and funding, the higher its currency goes. For Australia, this has become a significant problem as the US draws our capital to sustain its growth, putting pressure on our economy and the Aussie dollar.

Investment strategies

America eats the world

As the S&P 500 rips to new highs, the US now accounts for a staggering two-thirds of the world equity index. This looks at how America came to dwarf other markets, and what could change to slow or halt its momentum.

Gold

What's next for gold?

Despite a recent pullback, gold has been one of the best performing assets this year. What are the key factors behind the rise and what's needed for the bull market in the yellow metal to continue?

Taxation

Consulting on the side? Don't fall into these tax traps

Consultants must be aware of the risks of Personal Service Income rules applying to their income. Especially if they want to split their income or work through a company.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.