Dividend washing arrangements on a special ASX market were popular between non-resident taxpayers who cannot use the franking credits, and resident taxpayers who derive a greater benefit from the franking credits, such as superannuation funds, tax exempt not-for-profit entities and shareholders with a low marginal tax rate.
Since 1 July 2013, there has been specific legislation to prevent it, but what of dividend washing arrangements before that date? A recent decision in the Administrative Appeals Tribunal (AAT) means that they also fall foul of the general anti-avoidance provisions in section 177EA of the Income Tax Assessment Act 1936 (ITAA 36) (David Lynton as trustee for the David Lynton Superannuation Fund [2017] AATA 694).
Anyone who engaged in dividend washing arrangements before the introduction of section 207-157 of the Income Tax Assessment Act 1997 (ITAA 97) and did not amend their income tax returns before 28 May 2014 should discuss with their tax advisers how to engage with the Australian Taxation Office in order to mitigate penalties and interest, even if the time limit to amend the return has passed. The ATO has the ability to go back further than the amendment period and in the current environment it seems that ATO is frequently excising this right.
Dividend washing arrangements - a refresher
When the Government introduced the specific section to deal with dividend washing, section 207-157, it described it as:
"a type of scheme by which a taxpayer can obtain multiple franking credits in respect of a single economic interest by selling an interest after an entitlement to a franked distribution has accrued and then immediately purchasing an equivalent interest with a further entitlement to a corresponding franked distribution".
The major problem, it said, is that dividend washing schemes are not consistent with the policy intention of the imputation system, which is to "put members of the corporation in the same positions as if they earned the corporate income themselves and that distributed income was subject to withholding prior to being paid". The member is then taxed at their marginal tax rate and receives an offset for the franking credit, being the corporate tax paid. If the franking credit exceeds the marginal tax rate, the member will receive a refund of the tax paid or can use that offset to reduce their tax liability from other sources. Accordingly, where the taxpayer has a low marginal tax rate, such as a complying superannuation fund, and receives a franking credit it can obtain a significant tax advantage, particularly where the refundable offset may be acquired twice in the same income year and there has been no change in the economic risk of holding the shares.
At the time it introduced section 207-157 into the ITAA 97, special markets on the ASX were widely used to enable taxpayers to enter into arrangements that have dividend washing characteristics. Section 207-157 was intended to overcome any uncertainty regarding the position of dividend washing as captured under anti-avoidance legislation. Broadly, section 207-157 will apply to deny the franking credits where a shareholder receives a franked distribution in respect of a substantially identical interest which they sold before acquiring the current interest. There is a safe harbour of $5,000.
How section 177EA applies to dividend washing
Section 177EA is a general anti-avoidance provision in Part IVA that enables the Commissioner to make a determination to cancel the franking credits attached to a franked dividend. If the Commissioner does make a determination, then the dividend is treated as an unfranked dividend. As such, the taxpayer will not receive the franking credits nor is the taxpayer required to gross up the dividend when calculating taxable income.
For section 177EA to apply, the following conditions need to be satisfied:
- there is a scheme for the disposition of membership interests;
- in a corporate tax entity;
- a frankable distribution is paid or payable to the taxpayer in respect of the membership interest;
- the taxpayer receives an imputation benefit as a result of the distribution; and
- having regard to the relevant circumstances, it would be concluded that the person entered into the scheme for a not incidental purpose of receiving the imputation benefits.
Generally, where the Commissioner asserts that the arrangement is a dividend washing arrangement under section 177EA the first four elements will be present.
There would be a clear disposal of the legal ownership in the ex-dividend shares and purchase of cum-dividend shares in a company. As the purchase price of the cum-dividend shares has been increased for the dividend and franking credits, the distribution will be a frankable distribution and the taxpayer will receive a tax offset equal to the franking credits. Consequently whether a dividend washing arrangement exists will depend on the degree to which the factors in section 177EA(17) are present and demonstrate that the taxpayer had a not incidental purpose of entering into the arrangement in order to receive the franking credits.
The test in section 177EA(17) is an objective test and it lists the relevant circumstances to consider when determining if the taxpayer had a not incidental purpose, including:
- the extent and duration of the risks of loss, and opportunities for profit or gain that accrue to them as a member;
- whether the taxpayer derives a greater benefit from receiving the imputation benefits;
- whether any amount was calculated by way of the imputation benefits; and
- the period the taxpayer held the membership interests in the corporate tax entity.
The fact that the test only requires a not incidental purpose is what captures taxpayers in a dividend washing arrangement. When entering into the arrangement to buy and sell the shares in the same company the taxpayer may have other valid commercial reasons. However, provided the purpose to obtain the franking credits is not incidental purpose, as a opposed to a dominant purpose, the taxpayer will be caught under section 177EA.
Lynton's case
Lynton's case involved David Lynton, or his broker, as Trustee for his superannuation fund entering into transactions on a special ASX market to sell shares on an ex-dividend basis and purchase shares on a cum-dividend basis. The only economic rationale for entering into these transactions was to obtain the benefit of the franking credits - without the double franking credit, there was a net loss on the transactions in question.
As a complying superannuation fund, the Fund is only taxed at a flat 15% rate and, accordingly, derives a greater benefit from the refundable franking credits than an ordinary taxpayer. The franking credits can be used to offset taxable income from other sources of income or to receive a refund of the franking credits.
Dividend washing, the intersection with franking credit trading, and the way forward
Lynton's case appears to have been chosen by the ATO as being in the nature of a test case, as it is undoubtedly a dividend washing arrangement on all fours with the example set out in Taxation Determination 2014/10. Unfortunately, the taxpayer was aggressively self-represented, to the extent that his case appeared to be limited to one that the 1936 Act predated the concept of dividend washing, and could not therefore apply to it. He clearly did not have a clear understanding of the administration of the ITAA 36 and could not formulate a credible argument for section 177EA not to apply to a dividend washing arrangement.
Regardless, given the context of section 177EA it is likely that it would normally apply to dividend washing arrangements of the type found in Lynton.
One could argue that where the taxpayer intends to hold the shares for the next 12 months that they are bearing the economic risks of being a member of the company. As such, the taxpayer should receive the benefit of the dividends and the franking credits on the shares. However, where the taxpayer is constantly engaging in this these arrangements, the taxpayer is never bearing the economic risk of holding the two parcel of shares. The taxpayer is effectively receiving two lots of dividends and franking credits for the same number of shares but only bearing the economic risks of holding the one parcel of shares. This is contrary to the stated intention of the imputation system.
It is worth noting that the Explanatory Memorandum to Taxation Laws Amendment Bill (No.3) 1998 states that the intention for section 177EA is a catch-all provision to target franking credit trading and dividend streaming. Therefore the question is whether dividend washing arrangements are a form of franking credit trading.
Franking credit trading is defined in the Explanatory Memorandum to be "broadly the franked distributions are diverted from the real owners of interests in companies, who have no use or a relatively limited use from franking benefits, to a person who has a relatively greater use for them, but who is not in substance the owner of an interest in the company". Accordingly, given that dividend washing is the purchase of a share on a cum-dividend basis (presumably) from a taxpayer who cannot fully utilise the franking credits, it is arguable that dividend washing is a type of franking credit trading.
Whatever the correct characterisation of dividend washing, it is now clear that both section 207-157 and section 177EA will apply to dividend washing arrangements. Section 177EA is contained in Part IVA, which in theory is a "provision of last resort", so where there is more specific legislation, that legislation will be applied first. Consequently, the ATO will seek to apply section 207-157 before section 177EA, which will only apply to dividend washing arrangements where it is not captured under section 207-157.