Full steam ahead: Federal Government presses ahead with capital management measures

The Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 (“Bill”) was recently introduced into Federal Parliament.

The proposed measures in the Bill include previously announced measures that seek to:

• prevent certain distributions that are funded wholly or partly by a capital raising from being frankable; and
• align the tax treatment of off-market share buy-backs by listed public companies with on-market share buy-backs.

Key takeaways

• The changes will adversely impact the capital management programs of many listed companies.
• At a practical level, many companies may need to look differently at how they manage their capital requirements.
• There are some welcome changes to these measures compared with the previous exposure draft legislation. However, there are a number of elements which continue to be of concern, particularly in relation to preventing certain distributions that are funded by a capital raising from being frankable.
• The ultimate impact of the measures will depend upon the manner in which the legislation is administered by the Australian Taxation Office (“ATO”). Therefore, guidance from the ATO is critical.

A summary of our key observations is contained in the table below.  More details then follow.

Key observations

Franked distributions and capital raisings

Application of the measure

During the consultation process, the Federal Government received criticism for proposing that the measure would apply retrospectively to distributions made on or after 19 December 2016.

The criticism mainly related to the significant impact the provisions would have on shareholders who had received franked distributions and made good faith decisions on that basis.

The provisions will now instead apply from 15 September 2022, being the day after the exposure draft legislation was released for consultation.  

Higher threshold for the measure to apply

A significant change from the exposure draft legislation is in relation to the final requirement for a distribution to be unfrankable.  It must now be reasonable to conclude, having regard to all relevant circumstances, that:

• the principal effect of any of the equity interests issued was the funding (directly or indirectly) of the distribution (or any part thereof); and
• any entity issuing (or facilitating the issue of) any of the equity interests had the purpose (not including an incidental purpose) of funding the distribution (or any part thereof).

The exposure draft legislation proposed that only one of these tests needed to be satisfied.

The change should narrow, to some extent, the scope of the measure.

However, there remain a number of concerns with the measure.  In particular, it is still the case that the entire distribution will be unfrankable when the principal effect and purpose tests are satisfied in relation to only:

• a portion of the capital raised from an issue of equity interests; or
• part of a franked distribution.

In our view:

• it remains unclear why the measure is needed, and
• the effect of the measure remains disproportionate to the mischief sought to be addressed.

Additional matters for determining the principal effect and purpose of an issue of equity interests

The Bill includes additional matters to be taken into account in determining the principal effect of the issue of equity interests and the purpose of an entity involved in the issue of equity interests.  These include:

• if the entity that made the relevant distribution is not the same as the entity issuing the equity interests - the nature and extent of the relationship between the entities;
• the extent to which the entities that receive the relevant distribution are the same as the entities to which equity interests were issued. Where they are at least substantially the same, the EM sets out that this indicates that the arrangement may be artificial in nature because it does not materially change the economic position of the entity or its members other than to release the franking credits.  As set out in our previous Alert on the exposure draft legislation (that can be found here), we consider the financial position of the company raising funds and paying distributions is different before and after the transactions in a real and potentially substantive way; and
• how historical franking surpluses or deficits of the entity that made the relevant distribution compare to the historical profit or loss and the share capital account balance of the entity.

Some clarity around dividend reinvestment plans

In our Alert on the exposure draft legislation, we flagged that a strict reading of the proposed measure may mean that it captures distributions accompanied with a dividend reinvestment plan (“DRP”).

The EM provides an example of a fully underwritten DRP that funds a special dividend.  The example provides, in the absence of evidence that the capital raising from the DRP was for a purpose other than to fund the special dividend, that it would be reasonable to conclude that the principal effect and purpose tests are satisfied in relation to the arrangement.

While the clarification is welcome, the example leaves open how the measure would apply where the DRP in respect of a special dividend is not underwritten.   The EM flags that the underwriting ensures that no change in financial position occurs.  On this basis, a non-underwritten DRP in respect of a special dividend might be expected to fall outside the scope of the measure, given the possibility of a shift in the financial position of one or more participants in the arrangement.

It remains unclear how the measure would apply to a DRP that funds a dividend other than a special dividend.  While it is expected that the measure would not apply – the measure is aimed at distributions that are not consistent with an established practice of the entity of making distributions of that kind on a regular basis – there might be circumstances where the measure nonetheless applies.  It would be helpful if the ATO were to provide further guidance on this matter.

Off-market share buy-backs and share cancellations as part of selective reductions of capital

No substantive change from the exposure draft legislation

There are no substantive changes between the exposure draft provisions and those contained in the Bill.

Therefore, our key observations that we set out in our previous Alert on this measure (that can be found here) remain applicable.  For example:

• It will be important that the ATO administers ancillary tax provisions (such as the ‘capital streaming’ rules in section 45B of the Income Tax Assessment Act 1936 (Cth)) in the context of off-market share buy-backs by listed public companies in the same way as it currently does for on-market share buy-backs. This is to prevent unintended consequences and to not distort capital markets and capital management decisions.
  
  It would be helpful if the ATO were to provide guidance on this issue to ensure there is proper alignment, from a legal and ATO administrative perspective, between off-market and on-market buy-backs.  

• Given the breadth of the term “selective reduction of capital”, there is the potential for the amendments to apply to a pro-rata (equal) reduction of capital that, for some reason unrelated to tax, is a selective reduction of capital.
• The measure is likely to practically result in listed public companies debiting the entire purchase price in respect of a buy-back or selective reduction of capital to share capital to ensure that the company’s franking account is not debited.

Off-market share buy-backs may remain relevant

While the measure may signal the end of discounted off-market share buy-backs by listed public companies, our experience is that there may still be commercial and practical reasons why off-market share buy-backs are still used by listed public companies in preference to on-market share buy-backs.  For example, a listed public company that cannot buy-back a sufficient volume of shares on-market due to trading window or other market limitations may still choose to buy-back its shares off-market.