Banks, investment managers and self-managed superannuation funds have warned that a wide range of franked dividends paid to shareholders could be disallowed by the Australian Taxation Office under the Albanese government’s crackdown on capital raisings and share buybacks.

The Australian Banking Association has told the government that certain equity capital raisings and dividend reinvestment plans could be “deemed unfrankable”, despite the activity being required to meet the banking regulator’s capital rules to make the big lenders “unquestionably strong”.

To avoid double taxation, franking credits can be released from companies to shareholders for corporate tax already paid, often benefitting retail investors and superannuation funds.

The government has proposed two measures to curtail franking credits connected to capital raisings and share buybacks to save the budget an estimated $600 million over four years.

Labor’s proposed changes are more modest than its far bigger proposed crackdown on $11.4 billion of refundable franking credits that contributed to its 2019 election loss.

Companies, shareholders and tax lawyers are now most concerned about the proposed crackdown on out-of-cycle franked dividends funded by capital raisings to release excess franking credits on company balance sheets.

NAOS Asset Management, which invests more than $300 million for 7000 shareholders, said the tax avoidance legislation was too broadly drafted and would prevent companies paying fully franked dividends linked to legitimate capital raisings.

“Small to mid-cap Australian companies... are likely to be unfairly impacted,” NAOS managing director Sebastian Evans said.

Small companies are more likely to be growing faster and reinvesting, not immediately paying out profits as dividends.

But when they raised further equity capital in the future to support growth projects and pay out franked dividends, the tax avoidance measure could hit the companies and their shareholders, Mr Evans said in a submission to a Senate committee reviewing the proposed law.

“These companies are less likely to have an ‘established practice’ of paying regular dividends, and the current wording is so broad that any capital raising, at any point in time, could potentially prevent the payment of future franked distributions.

“This will significantly increase balance sheet risk across a large cohort of smaller companies.”

The Senate economics committee will hear from investors, tax lawyers and business groups at public hearings in Sydney on Tuesday.

The Australian Banking Association said in a submission it accepted that capital raisings should not be undertaken for the sole purpose of funding the distribution of franking credits.

“However, the current scope of this bill creates some uncertainty whether certain capital raisings could be deemed unfrankable despite those capital raisings not being intended to fund any dividend or distribution,” ABA head of economic policy Emma Penzo said.

“It is clear that APRA intended (and intends) for banks to use dividend reinvestment plans and other capital raising activities to support their capital position whilst separately continuing to pay franked dividends or distributions.”

The ABA wants the legislation amended to clarify the impact on capital raisings that indirectly or partially fund franked dividends, “to avoid an unnecessarily broad scope”.

Bankers also want “clarification of the impact on dividend reinvestment plans”.

The Self Managed Superannuation Fund Association said it supported measures to prevent tax avoidance and the “manipulation” of the franking system.

“However, we are concerned that the amendments... will inadvertently catch many normal and legitimate situations,” the association said.

New companies which have only recently commenced operations and have no
established record of paying dividends may not satisfy the “established practice” test for paying franked dividends following capital raisings.

“The reinvestment of company profits and the raising of capital to pay dividends, for many companies, is merely prudent cash flow management and has nothing to do with tax avoidance or the manipulation of the franking system,” SMSF Association chief executive Peter Burgess said. 

“The raising of capital simply provides liquidity from previously earned profits enabling a dividend to be paid from those profits.”

Assistant Treasurer Stephen Jones has said franking credits on corporate balance sheets were not supposed to be used as an asset by raising capital to immediately pass surplus franking credits to shareholders.

The government in September proposed stopping companies paying shareholders fully franked dividends that are funded by capital raisings after the ATO raised concerns following a Tabcorp transaction in 2015.

The measure, estimated by Treasury to save the budget a modest $10 million a year, was originally proposed by Scott Morrison as treasurer in 2016 but was never followed through.

Separately, the government in the October budget proposed closing a loophole used by some of Australia’s largest companies to “stream” franked dividends to low-tax shareholders such as superannuation funds.

The integrity measure would align the tax treatment of off-market share buybacks undertaken by listed public companies with the treatment of on-market share buybacks.

For more than a decade, big companies have been buying back their shares from shareholders off-market, often at a discount to the sharemarket price.

The companies have compensated the investors for the price shortfall by streaming franking credits as a large portion of a dividend and capital return to shareholders.

The strategy is, in effect, a capital return, dressed up as a franked dividend, enabled by a share buyback.

About 32 listed companies have completed 47 such transactions since 2006-07, according to Treasury. These include BHP, Rio Tinto, Commonwealth Bank of Australia, Westpac, Woolworths, JB Hi-Fi, Metcash and Caltex.

Some off-market share buybacks have been as high as between $6 billion and $8 billion, and some companies have resorted to this several times.

Corporate tax professionals have been more accepting of the government’s move to level the playing field between off-market and on-market share buybacks.