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You only frank once (YOFO)

Tax Telegraph, August 2013

You only frank once (YOFO)A loophole in the Australian tax laws has allowed the practice of ‘dividend washing’ to flourish overtime.

Dividend washing effectively involves sophisticated investors trading in franking credits by selling shares ex-dividend and then immediately buying equivalent shares cum-dividend, which still carry the right to a dividend and franking credits. Treasury estimates that these practices have the effect of reducing Australian tax revenue by roughly $20 million per annum and that the revenue reduction is likely to increase if dividend washing practices are not addressed. The ASX facilitates the trading by allowing certain large cap stocks to trade for two days cum-dividend after the shares go ex-dividend.  
In essence the practice of dividend washing results in an investor receiving two sets of franking credits for effectively one parcel of shares.

Let’s consider a simple example of a super fund in pension mode engaging in dividend washing.  If we assume the fund holds 1000 shares in a Big 4 bank that have an ex-dividend price of $75.00 and provide for a dividend of $7.00 per share, then the relevant cash flows would be as follows:

Dividend received on original shares $7,000
Sale of original shares $75,000
Acquisition of shares in cum-dividend market (82,000)
Dividend received on new shares $7,000

Under this arrangement the fund has a net cash inflow of $7,000.  However, assuming the dividend was franked, the taxpayer would have received two lots of franking credits $3,000 (i.e. a total of $6,000), this is despite the fact that the fund only held one parcel of 1000 shares at any point in time. The fund would receive a franking credit benefit of $6,000. Therefore, taxpayers such as superannuation funds, charities and individuals with tax losses would benefit from the refund of excess franking credits.

Generally the practice occurs between a foreign investor, who is unable to utilise franking credits and an investor who is taxed at a low marginal rate and is eligible for a refund of excess franking credits, such as a superannuation fund, not-for-profit entity or low income individual. It may also be attractive to small shareholders with less than $5,000 of franking credits who are exempt from the holding period rules. Each of these parties obtains a benefit by being taxed at a rate of less than 30% and receiving a refund for any franking credit offsets in excess of their income tax payable.

The Treasurer is looking to modify the existing rules to remove the loophole that allows dividend washing to take place.

Australian tax laws currently have a number of integrity measures in place that attempt to circumvent dividend washing schemes, the most common being the holding period rule.
The holding period rule requires investors to hold ordinary shares for more than 45 days or a preference share for 90 days, at risk, before they qualify for a franking credit benefit.

Furthermore, the holding period rule has a ‘last-in, first-out’ (LIFO) policy which operates to ensure that when investors sell shares the last shares purchased are taken to be sold first. The holding period rule prevents investors from purchasing shares immediately before they go ex-dividend, receiving the dividend and claiming the franking credits and then proceeding to sell the shares a few days later.

Dividend washing practices evade the LIFO rule by creating a short break in ownership of the shares by selling all the ex-dividend shares prior to purchasing the cum-dividend shares. Provided that both parcels of shares are held at risk for more than 45 days, the investor can claim two sets of franking credits.

The integrity measures also include anti-avoidance rules that aim to protect the operation of the imputation system from schemes that avoid the franking credit rules. The anti-avoidance rules were designed to be a ‘catch-all’ mechanism that deals with schemes not specifically identified by other rules; however the operation of the rules and deterrence of dividend washing relies on the Commissioner’s identification and examination of a dividend washing scheme and the relevant facts in order for the anti-avoidance rules to be applied.

Proposed approach to prevent dividend washing:

The Assistant Treasurer released a discussion paper in early June 2013 that outlined three proposed approaches that could be used to prevent dividend washing which were as follows:

1. Modifying the holding period rules

This approach modifies the LIFO rule to address the break in ownership period by ensuring that after sale of ex-dividend shares and subsequent repurchase of cum-dividend shares, the cum-dividend purchase is taken to have happened immediately before the shares went ex-dividend. This modification would deem the actual disposal of the ex-dividend shares to in fact be a disposal of the cum-dividend shares under the proposed modified LIFO rule.

2. Adding a criterion to the anti-avoidance provisions for the imputation system

The proposed additional criteria would allow the Commissioner to take into account the timing of share trades when determining whether an investor is entitled to claiming a franking credit.

3. Creating a specific double-franking credit integrity rule

This approach is similar to the modification of the holding period rules; however the modifications would be inserted into the current anti-avoidance rules. There is some concern for this approach as the anti-avoidance provisions are normally reserved for rules that are general, rather than specific, in nature.

Since going to press the Assistant Treasurer has announced that the Government proposes to prevent dividend washing by inserting specific integrity measure into the Income Tax Assessment Act 1997. The proposed measure is yet to be legislated, however it has been confirmed that the measure will only be applicable to investors with franking credit offset entitlements greater than $5,000. 

If you believe that the proposed changes may impact you, please contact your local Deloitte Private tax advisor.

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