Specific integrity rule to address dividend washing
Banking on Tax, Issue 11
In the 2013-14 Budget papers, the previous Government announced it would close a legislative loophole that allows sophisticated investors to engage in so-called ‘dividend washing’. Following submissions from a number of parties, the Government announced that it would achieve this objective by inserting a specific integrity rule into the imputation provisions. The current Government confirmed on 6 November 2013 that this measure will proceed as announced by the former Government.
What is dividend washing?
When shares are traded on an ex-dividend basis, the right to the announced dividend is retained by the seller of the shares. However, Trading Participants of the Australian Securities Exchange (ASX) can request that special cum-dividend markets be established for the two business days after a share goes ex‐dividend. The special cum-dividend markets were originally developed to enable cum-dividend shares to be acquired and delivered after the ex-dividend date to satisfy delivery under option arrangements exercised before the shares went ex-dividend. The right to the dividend is transferred to the purchaser of the shares when shares are traded on a cum-dividend basis.
Generally, dividend washing occurs where a shareholder sells shares on an ex-dividend basis and purchases shares on a cum-dividend basis. In this situation, the shareholder receives two dividends. However, the shareholder may also be able to claim two sets of franking credits attached to the dividends, despite effectively only holding one parcel of shares at all relevant times.
Circumvention of the imputation regime
The imputation system seeks to prevent shareholders from trading in franking credits through the following provisions:
- The holding period and related payment rules (former Division 1A of Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936))
- The general anti-avoidance rules (Part IVA of the ITAA 1936).
The holding period rule requires shareholders to hold ordinary shares at risk for 45 days (90 days for preference shares) in the “qualification period” starting on the day after the shares were acquired and ending 45 days (90 days) after the day the shares go ex-dividend, in order to claim franking credits attached to the dividend. The holding period rules also include a “last-in first-out” (LIFO) rule, which deems shares on which a dividend has been paid and which have been sold after the ex-dividend date to be the most recently purchased shares.
By selling the ex-dividend shares before purchasing the cum-dividend shares (or just buying cum-dividend shares), the LIFO rule may not apply. So long as the shares are held at risk for the requisite amount of time, the shareholder may then be able to claim two sets of franking credits. Both parcels of shares need to be held for 45 days (90 days) starting the day after the day the shares were acquired and ending on the 45th day (90th day) after the day the shares go ex-dividend to qualify for the franking credits attached to the dividend.
If the specific integrity rule in the imputation provisions (the holding period rule) does not apply to deny the franking credits on the second parcel of shares, Australia’s anti-avoidance provisions in Part IVA of the ITAA 1936 would need to be considered in assessing whether or not a taxpayer is ultimately likely to receive both sets of franking credits.
Legislative approach to deny franking credits from dividend washing
The Government released a Discussion Paper on 3 June 2013, which considered three potential approaches to prevent dividend washing. A number of submissions were made on the Discussion Paper. Subsequent to this consultation process, the former Government announced that a specific integrity rule to prevent dividend washing would be inserted into the imputation provisions. As outlined above, the current Government will proceed with this change.
The integrity rule will apply where an entity (or its associate) disposes of shares on an ex-dividend basis and then acquires substantially identical shares on a cum-dividend basis in the period between the ex-dividend date and the record date (usually four days after the ex-dividend date). The franking credit attached to the dividend on the cum-dividend parcel of shares will not be included in assessable income and a tax offset will not be allowed for the franking credit (i.e. the entity will be treated as if it had received an unfranked dividend on the shares purchased cum-dividend).
It is intended that this integrity rule will have application from 1 July 2013, and will apply to investors that have franking credit tax offset entitlements in excess of $5,000. Further consultation on the integrity rules is expected to occur following release of exposure draft legislation.
ATO approach until the integrity rule is enacted
According to the media release by the Australian Tax Office (ATO) on 3 October 2013, it is the ATO’s view that dividend washing is ineffective under the current anti-avoidance provisions. Under paragraph 177EA(5)(b) of the ITAA 1936, we understand that the Commissioner takes the view that he can deny the franking credits received on either or both parcels of shares, on the basis that the arrangement is a scheme entered into for the purpose of obtaining franking credit benefits. The ATO intends to release a public ruling on this issue.
We further understand that the ATO is currently in the process of reviewing ASX records to determine taxpayers that might have been involved in dividend washing and brokers or advisers that might have been involved.