Closing the “dividend washing” loophole

The government has released a discussion paper on preventing dividend washing. In the 2013–2014 Federal Budget on 14 May 2013, the government announced reforms to close, with effect from 1 July 2013, a loophole that it says currently enables sophisticated investors to engage in so-called “dividend washing”. The government says this is a process that allows sophisticated investors to effectively trade franking credits, and can result in some shareholders receiving two sets of franking credits for the same parcel of shares. This is outside the intent of the dividend imputation system, the government has warned.

Among other things, the paper: (i) explains how dividend washing occurs, and how it circumvents the dividend imputation integrity rules; (ii) canvasses legislative options the government is currently considering to prevent dividend washing; and (iii) provides background information on dividend washing.

How dividend washing occurs

The paper says dividend washing allows shareholders who place a relatively low value on franking credits (such as non-residents) to effectively sell their franking credits to shareholders who place a relatively high value on franking credits (such as superannuation funds, income tax-exempt not-for-profit entities, and other shareholders with low marginal tax rates) generally for non-taxable consideration (because of, for example, portfolio share profit exemptions for non-residents). The transactions may in some circumstances be on revenue account for the resident participants, meaning that deductible losses in respect of the share transactions are available to offset dividend income.

The process occurs in the period after a share goes ex-dividend. During this period, shares are generally traded on an ex-dividend basis, which means that the right to the recently announced dividend is retained by the vendor of the shares. However, during this period, trading participants of the Australian Securities Exchange (ASX) are also able to request the establishment of special cum-dividend markets for the two business days after a share goes ex-dividend. When shares are traded in these markets, the right to the recently announced dividend is transferred to the purchaser of the shares.

“Dividend washing” involves shareholders who place a relatively high value on franking credits selling shares on an ex-dividend basis and purchasing shares on a cum-dividend basis (in the period after a share goes ex-dividend). This enables these shareholders to receive two sets of dividends; one set is retained during the sale of ex-dividend shares, and the other is obtained during the purchase of the cum-dividend shares. The government says the problem with this situation is that the shareholders are then also able to claim the two sets of franking credits attached to the dividends, despite having only ever held, in substance, one parcel of shares at any point in time. The government considers this to be outside the intent of the imputation regime as some shareholders are able to obtain a disproportionately high level of franking credits, given their shareholdings.

Legislative options

The discussion paper says the legislative response that the government decides upon will:

• prevent shareholders from receiving two sets of franking credits for the same effective parcel of shares through dividend washing;

• ensure there are negligible impacts on legitimate market activities; and

• result in a minimal level of uncertainty and complexity for taxpayers.

The government says it recognises that special cum-dividend markets exist for legitimate reasons, and says it “has no intention [of] preventing the establishment of special cum-dividend markets or affecting legitimate market activities”. Therefore, any legislative response will be targeted at preventing dividend washing in the simplest and most efficient manner possible. The paper identifies three potential approaches:

• Modifying the holding period rules. This approach would involve modifying the holding period rules to address the break in ownership that is achieved through dividend washing. The modification would be targeted to the period between the ex-date and record date for a dividend. In this period, the modification to the “last in, first out” (LIFO) rule would ensure that when a shareholder sells ex-dividend shares and then purchases cum-dividend shares in the same company, the purchase of the cum-dividend shares are taken to have occurred immediately before the shares went ex-dividend.

• Adding a criterion to Pt IVA. This approach would involve amending Pt IVA of the Income Tax Assessment Act 1936 for the imputation system by allowing the Commissioner to take into account the timing of trades when determining whether a franking credit should be claimable. Specifically, this approach would involve adding a criterion to s 177EA(17) of Pt IVA to highlight that the timing of trades is a relevant factor when determining if a scheme was designed with a tax avoidance purpose.

• Creating a specific double franking credit integrity rule. This approach would involve inserting a specific double franking credit integrity rule into Pt IVA. In effect, the rule would operate similarly to the modifications to the holding period rule, but would be housed in Pt IVA. The rule would apply to ensure that when a shareholder sells an ex-dividend share after a share goes ex-dividend and then purchases a cum-dividend share before the record date, only one set of franking credits may be claimed.

Date of effect

The changes are intended to apply from 1 July 2013.

Comment

Public consultation closed on 17 June 2013. This very short comment period and the proposed date of effect suggest that the government may intend to introduce and pass this legislation in the last two weeks of Parliament’s sittings (17–27 June 2013).

Source: Treasury Discussion Paper, “Preventing dividend washing”, June 2013, www.treasury.gov.au/ConsultationsandReviews/Submissions/2013/Dividend-Washing.