Changes to the Corporations Law in 2010 were supposed to make it easier for companies to pay dividends to shareholders.

However recent draft fact sheets released by the Tax Office seemingly wipe out the positive changes introduced by the amendments. Whether this due to a lack of communication between the top corporate regulators, a design fault in the existing law, or because the Tax Office is obstinately refusing to come to the party, one thing is clear: a breakthrough is needed so that the Corporations Law amendments can have their intended effect.  

The 2010 changes to the Corporations Law were sensible. Amended to make it easier for corporations to pay dividends to shareholders. Before the change, it was only possible to pay shareholders a dividend ‘out of profits' (‘the profits test'). Since the change, in theory dividends can be paid providing there is no detriment to the ongoing operations of the company - the ‘balance sheet test'. But the Tax Office's recent draft fact sheets seem to contradict the Corporations Law Amendments. Until a breakthrough is made that enable the Corporations Law amendments to have their intended effect, uncertainty reigns.

What are the Corporations Law amendments?

New section 254T of the Corporations Law provides that a company can pay a dividend providing:

• The company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient to allow for its payment 
• The payment is fair and reasonable to the shareholders of the corporation as a whole
• The payment of the dividend does not materially prejudice the company's ability to pay its creditors

Before the amendments, companies had to meet the ‘out of profits' requirement before they could pay a dividend, yet the legal principles that surrounded ‘out of profits' were cumbersome, ambiguous and uncertain. This often stymied directors of relatively cashed up corporations from making the decision to pay dividends.

Companies depended on the regulator, through the issue of relevant accounting standards, to determine the concept of "profit" from which a dividend could be paid. After ASIC adopted AIFRS as its accounting standard in 2005, a different concept of ‘retained profits' emerged, causing even more confusion amongst directors as to the levels of retained profits that a company had at its disposal. The uncertainty was exacerbated by movements in the fair value of assets and vague legal precedents. 

As a result, many directors chose not to pay dividends as it was not possible to satisfy the ‘out of profits' requirement. Sadly, this had potentially deleterious effects on the economy as a whole. The above amendment to s 254T is supposed to remove this impediment.

Tax Office fact sheets

On 21 June 2011, the Tax Office released two draft fact sheets dealing with:

• Dividends and the new s254T and s44(1A) (‘Draft Fact Sheet 1')
• New s254T and the franking of dividends (‘Draft Fact Sheet 2')

The tax legislation defines a dividend to be any distribution by a company to its shareholders other than where an amount is debited to the share capital account. Section 44 of the Tax Act (1936) was recently amended to accommodate the changes to the Corporations Law described above. New s44(1A) provides that "a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits".

However, in Draft Fact Sheet 1 the Tax Office states "[the] changes to section 254T of the Corporations Law have not altered what is defined as a dividend for tax purposes or the process for determining what is a taxation law dividend".

Furthermore, in an example in Draft Fact Sheet 1, a company pays a dividend by debiting accumulated losses. The Tax Office states here that ‘the better view' is that "this distribution reduces share capital and, if properly authorised, the distribution must be regarded as debited to share capital". In addition, s44(1A) "will apply to deem the [distribution] dividend to be ‘out of profits' and therefore assessable as a dividend in the hands of the shareholder. Further, it should be noted that such a ‘dividend' would be considered to be an unfrankable distribution for the purposes of paragraph 202-45(e) of the ITAA 1997".

In practical terms this means that a dividend allowable under the new Corporations Law rules will be a deemed dividend - assessable in the hands of the shareholder and not frankable when paid by the corporation.

Draft Fact Sheet 2 sets out a very similar interpretation to Draft Fact Sheet 1. It states that where "a company's net assets are less than its share capital and it purports to debit an account such as accumulated losses or a negative reserve account, that would indicate that the distribution was sourced indirectly out of share capital".  In other words, the distribution would be assessable as a dividend in the hands of the shareholder, but again not frankable.

Consequences of the Tax Office's position

Broadly, the interpretation adopted by the Tax Office in the Draft Fact Sheets is that companies will continue to be able to pay franked dividends but only out of profits, notwithstanding the changes to the Corporations Law discussed above. If the position in the draft fact sheets is finalised, the positive Corporations Law amendments have been effectively exorcised by the Tax Office.

In addition, where a corporation attempts to pay dividends using the Corporations Law amendments, there is an increasing likelihood that shareholders will face the double-edged sword that for tax purposes the distribution will be assessable in the hands of the shareholder but paradoxically unfrankable.