The practice known as ‘dividend washing’ has recently come under scrutiny and has received considerable press. Last month the ATO published a discussion paper outlining its proposed action in response to what it sees as a significant loss of revenue.
In practical terms, what is it?
Generally speaking, dividend washing enables a shareholder to receive two sets of franking credits in respect of the same parcel of shares.
Once the shares in a company go ‘ex-dividend’, the seller of those shares retains the right to receive the dividend (and the franking credits) attaching to those shares. In other words, to be entitled to a dividend a shareholder must have purchased the shares before they go ‘ex-dividend’.
During the ex-dividend period, Trading Participants of the ASX can request a special ‘cum-dividend’ market in which the entitlement to the dividend is transferred with the shares. If a shareholder buys shares whilst they are ‘cum-dividend’ they are entitled to the recently announced dividend. These markets were originally initiated to address timing constraints in options markets. When an option is exercised, there is sometimes not enough time to deliver the cum-dividend stock prior to the ex-dividend cut-off.
Cum-dividend markets present an opportunity to investors who are non-residents for tax purposes and cannot make use of franking credits attaching to their shares.
It is at this point that the dividend washing occurs. An investor sells its shares ex-dividend and immediately buys shares in the same company in the cum-dividend market. The investor is entitled to a dividend in respect of both parcels of shares and two sets of franking credits.
The ATO argues that such a practice results in a cost to revenue
because the holder of the shares receives two sets of franking credits, while holding only one parcel of shares at any point in time.
One response suggested by the ATO is to deem the disposal of ex-dividend shares (during the ex-dividend trading period) to be a disposal of cum-dividend shares. This is achieved by artificially moving the purchase of the cum-dividend shares to a point in time prior to the sale of the ex-dividend shares.
With limited exceptions, a shareholder is only eligible to receive franking credits if it has held the shares at risk for more than 45 days. This holding period rule operates on a ‘last-in first-out’ basis. The ATO’s proposed response means the holder will not be entitled to franking credits in respect of the purchased cum-dividend shares because the holder is deemed to have purchased the cum-dividend shares before having sold the ex-dividend shares, making those cum-dividend shares the ‘last in’ and sold within less than 45 days.
The ATO released a discussion paper in June 2013 and submissions are available here. On 28 June 2013 Treasury announced that it would address dividend washing by inserting a specific integrity rule in the tax lax. This rule will restrict the entitlement of sophisticated investors to franking credits in certain circumstances. Treasury will release exposure draft legislation for comment.
Steven Humphries, Trent Le Breton and Jacqueline Winters of McCabes’ Sydney office advise on M&A, private equity, capital raising and general corporate law. The team, together with the corporate team in our Newcastle office, has extensive experience documenting and negotiating various transaction types including share and asset sales, acquisitions, corporate reconstructions, as well as IPO’s, placements and other public and private capital raisings.