Journal of Australian Taxation
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THE 45 DAY HOLDING PERIOD RULE - THE ULTIMATE WALNUT CRUSHER
By Mark J Laurie, Liam Collins and John Murton
Franking credit trading, or investing with a view to maximising imputation credits, was highlighted in the Government's 1997 budget as a practice which posed a substantial threat to the viability of Australia's imputation system. The measures proposed to address this perceived threat have colloquially been branded as the "45 day rule". For many, the measures have proven complex and costly to administer and have the potential to affect "innocent" investment activities. This article examines the policy underlying and the operation of the measures. It discusses what the measures will mean for resident investors and critically reviews their place in Australian taxation law. The authors submit that the rules are unnecessary in light of the general franking credit anti-avoidance measures contained in s 177EA of the Income Tax Assessment Act 1936 (Cth) ("ITAA36") and are out of step with other proposed reforms to the Australian taxation system.
Dividend imputation was incorporated into the Australian taxation system on 1 July 1987. The basic premise underlying an imputation system is the prevention of double taxation of company profits in the hands of resident shareholders. This is achieved by imputing tax paid at the company level to resident shareholders in the form of credits and rebates. The view of recent governments has been that a degree of "wastage" (eg, franking credits flowing to non-residents), was always an intended feature of the Australian system.
The current perception in Canberra appears to be that franking credit trading, or investing with a view to maximising imputation credits, poses an increasing threat to the revenue base, and must be addressed.
The response, a series of complex qualifications to an investor's entitlement to franking rebates and credits, has proven to be robust. The provisions have colloquially been branded "the 45 day rule" or "the holding period rule". The measures are consistent with cl 15.27 of the Taxation of Financial Arrangements document, released in 1996. They apply an integration approach (or taxing shares and any derivatives relating to those shares as one security) to the taxation of investments in resident companies.
There are legitimate concerns amongst many that the measures are difficult to apply, costly to administer and may expose "innocent" investors to double taxation.
The holding period rule and associated measures represent a classic case of the Government using a sledgehammer to crack a walnut. The measures may in fact represent the ultimate walnut crusher - leaving the remnants of what was edible (the franking credits and rebates), difficult to find amongst the mess.
There are two principal elements to the measures, which can be broadly summarised as follows:
▪ the formula based ceiling election - which is only available to certain institutional investors and limits the investor's entitlement to franking credits and rebates to a ceiling that is calculated by reference to the investor's average portfolio of shares.
On 31 December 1997, the Federal Government released draft legislation to give effect to the holding period rule. Prior to the official release, many participants in the superannuation and funds management industries and the tax profession (the groups that were potentially to be most affected by the rules) were consulted. These groups made several recommendations and raised the likely practical implications of the proposed rules. These comments were considered by the Government and, to some extent, incorporated into the draft legislation.
After the draft legislation's official release on 31 December 1997, taxpayers and their advisers considered the rules in more detail and began to comprehend the administrative burden and potential for misapplication they presented.
The draft legislation was first presented to Federal Parliament in Taxation Laws Amendment (No 5) Bill 1998 ("TLAB5") on 2 July 1998 in a substantially amended form. The thrust of the rules had not changed, although the revisions (mainly to clarify or address some of the identified compliance problems) did have substantial effect. Additionally, TLAB5 now contained the previously unseen related payments rule.
A federal election was then called, and TLAB5 lapsed. After its re-election, the Government re-introduced the measures in Taxation Laws Amendment (No 4) Bill 1998 ("TLAB4"), which was first presented to the House of Representatives on 3 December 1998. Several amendments to TLAB4 have been recently proposed by the Government.
The Budget night speech and the Explanatory Memorandum to TLAB4 both comment that one of the underlying principles of the imputation system is that the benefits of imputation should only be available to the true economic owners of shares. They also suggest that the benefits of imputation should only be available to the extent that those taxpayers are able to use the franking credits themselves - a degree of wastage of imputation credits is an intended feature of Australia's imputation system. It would appear therefore, that the policy underlying the holding period rule does not reconcile with the policy behind recent proposals to introduce refundable franking credits.
Throughout TLAB4, reference is made to the holding period rule regulations, which will be released after the provisions are enacted. Until their release, practitioners must imply from the Bill how the rules apply in practice. Whilst TLAB4 is not yet law, some aspects of the provisions are to apply from 13 May 1997.
This article is based on TLAB4 as it was presented to Parliament on 3 December 1998 and incorporates the amendments put forward by the Government. It is subject to any changes to TLAB4 as it completes the parliamentary process and the requirements of the regulations.
Generally speaking, the holding period rule is to apply to shares or interests in shares acquired on or after 1 July 1997. The holding period rule as it relates to beneficiaries of a trust is, in the most part, to apply from 31 December 1997.
The rules apply to any related payment made after 13 May 1997, irrespective of whether the relevant shares or interest in shares were acquired before or after that time.
The difficulty with a 1 July 1997 start date is that at 30 June 1998 and in the lead up to 30 June 1999, the holding period rule has yet to become law, though taxpayers are expected to assume that it will. In the meantime, systems have to be introduced to monitor the potential loss of credits or rebates. Trusts that distribute their income shortly after 30 June will find themselves making those distributions in a situation where they are unsure of the precise amount of rebates that can be distributed to unitholders.
The Australian Taxation Office ("ATO") has released ATO Compendium No 98/4, "Franking Credit Trading Measures Status Report", in which it is stated that in light of this uncertainty, the ATO would take a "flexible approach to the administration of the new rules for the first year in which they apply". This first year of operation, that is 1997/98, is now over, and practitioners must comply strictly with what have proven to be extremely complex measures.
ATO Compendium No 98/4 also provides that "...provided that trustees and custodians have satisfied themselves that they have the standard of compliance set forth above we see no reason for them to issue qualified statements to their beneficiaries concerning the availability of franking." Despite these assurances, it would be prudent to qualify any distribution statement on the basis that TLAB4 is not yet law.
In order to be eligible for a dividend rebate under s 46 or a franking credit or franking rebate under Pt IIIAA of the ITAA36, TLAB4 requires the recipient of the dividend/distribution to be a "qualified person". A taxpayer who is not a qualified person is not entitled to a franking credit or rebate. A person can be a qualified person in a number of different circumstances.
Essentially, this can occur in one of five ways which are listed below.
Under this proposed section, the taxpayer will be a qualified person where the taxpayer holds:
▪ "at risk" (to be "at risk", a taxpayer must be exposed to at least 30% of the risks of loss and opportunities for gain in respect of the relevant shares or interest in shares);
▪ for the requisite period - 45 days in the case of ordinary shares, 90 days in the case of preference shares;
▪ during a specified period (depending on whether a related payment is made).
Special rules are to apply in respect of partners of a partnership and beneficiaries of a trust. Partners and beneficiaries of a non-widely held trust are required to "look through" the partnership/trust and test their proportionate interest in the underlying investments. A concession is available to beneficiaries of a widely held trust.
Additionally, the provisions deem a disposal to have taken place in a number of circumstances - essentially where a "connected person" (eg, an associate) disposes of a "related security" (eg, shares in the same company). This adds another layer of complexity to the testing process.
This test only applies to beneficiaries of a widely held trust and essentially entitles the beneficiaries to test at the unit level rather than tracing through to their ultimate interest in the shares held on their behalf. Where a beneficiary of a widely held trust has held their units "at risk" for the requisite period, they will be a qualified person in respect of any distributions to which they are presently entitled.
This test will only be relevant in very specific circumstances. It is not expected that this test will be widely applied, and should not present any significant commercial impracticalities.
This test (sometimes referred to as the "carve-out test" or formula based ceiling election) applies to certain "institutional investors" (eg, superannuation funds and insurance companies), for whom compliance with the holding period rule would be unreasonably onerous. The election applies a formula based ceiling to the taxpayer's entitlement to franking credits and rebates. The taxpayer is a qualified person only to the extent that the franking credits and rebates claimed are equal to or below the ceiling. Any credits/rebates in excess of the ceiling are not available to the taxpayer.
This test only applies to individuals and operates in much the same manner as the formula based ceiling outlined above. Notably, the value of the ceiling is a flat $2,000 (as opposed to a formula based calculation), reduced by $4 for every $1 by which the $2,000 ceiling is exceeded.
We now focus on each of these methods of becoming a qualified person in detail. Whilst we address the technical issues in some depth, we have also addressed the practical implications, based on our experiences, and consider the policy underlying the new measures.
Under proposed s 160APHO, a taxpayer is a qualified person where they hold the relevant shares or interest in shares for a continuous period (not counting the day on which the taxpayer acquired the share or, if the taxpayer disposed of the shares, the day on which the disposal occurred) of not less than:
▪ if the shares are preference shares - 90 days.
In practice, the periods are 47 and 92 days respectively, because the days of acquisition and disposal are excluded from the calculation. For ease of explanation, this article will refer to 45 or 90 day periods.
Although not stated in the Explanatory Memorandum, it is understood that the distinction between the holding period of ordinary shares and preference shares is because similar provisions exist in respect of the United States' intercorporate dividend rebate system. Additionally, preference shares are a less risky form of investment and the payment of a dividend is more predictable.
The provisions are complex and require practitioners to have a strong understanding of the key terms on which they are based. Proposed s 160APHD is the central definition section for the new rules, although some key definitions are contained within their own sections.
The key terms are briefly outlined below and addressed in more detail later in the article.
▪ Qualification Period - Either the primary qualification period (which applies if no related payments have been made) or the secondary qualification period (which applies if a related payment has been made). This is the period that the holding period rule is "tested" over.▪ Primary Qualification Period - The relevant "test" period if no related payments were made in relation to the relevant dividend/ distribution. The period beginning on the day after the day the share or interest in the share was acquired and ending:
▪ if the shares are not preference shares - on the 45th day after the day the share or interest became ex-dividend; or
▪ if the shares are preference shares - on the 90th day after the day the share or interest became ex-dividend.▪ Secondary Qualification Period - The relevant "test" period if a related payment was made in relation to the relevant dividend / distribution:
▪ if the shares are not preference shares - the period beginning on the 45th day before, and ending on the 45th day after, the day on which the shares or interest became ex-dividend; or
▪ if the shares are preference shares - the period beginning on the 90th day before, and ending on the 90th day after, the day on which the shares or interest became ex-dividend.▪ Qualified Person - A person is a "qualified person" in relation to a specific dividend paid on a share. A person can be a "qualified person" in one of the five ways outlined above. The relevant proposed sections are 160APHO, 160APHP, 160APHQ, 160APHR and 160APHT.
▪ Widely Held Trust - This is a fixed trust that is not a closely held fixed trust. A widely held trust also includes a trust that is entitled to make the formula based ceiling election under the regulations and a trust that is held (to the extent of at least 75%) by persons who are themselves eligible to make the formula based ceiling election. As a result, unitholders in wholesale investment vehicles can utilise the widely held trust concession (detailed in Part 3).
▪ Closely Held Fixed Trust - This is a fixed trust where not more than 20 entities (counting a trust as one entity - that is, not looking through to the ultimate beneficiaries), and counting associates as one entity, have interests in the trust that together entitle them to not less than 75% of:
▪ the beneficial interests in the income of the trust; or
▪ the beneficial interests in the capital of the trust.▪ Position - A position in relation to a share or interest in a share is anything that has a delta in relation to the share or interest. "Delta" is undefined, but is a financial term that measures the change in price of one security relative to another.
▪ Long Position - Anything with a positive delta in relation to the shares or interest. For example, a share purchase, a bought future, a bought call option or a sold put option.
▪ Short Position - Anything with a negative delta in relation to the shares or interest. For example, a share sale, a sold future, a sold call option or a bought put option.
▪ Net Position - The sum of the taxpayer's long and short positions in relation to the shares or interest, calculated on the basis of their deltas.
▪ Material Diminution of Risk and Opportunities for Gain - Where the taxpayer has, on a particular day, in respect of shares or an interest in shares, a net position in relation to the shares or interest which exposes the taxpayer to less than 30% of the risks and opportunities. The regulations may prescribe what constitutes a material diminution.
▪ A Connected person - This includes the taxpayer and an associate who disposes of shares or an interest in shares under an arrangement with the taxpayer. Where the taxpayer is a company, a connected person includes any other company that is in the same wholly owned group.
▪ A Related Security - The relevant shares/units themselves, and any shares, or interest in shares held by "connected persons":
(i) that are "substantially identical securities" in relation to the relevant shares/units over which the formula based ceiling election has not been made; and
(ii) in respect of which a "connected person" has been paid, or is entitled to be paid, a franked dividend/distribution correspond-ing to the dividend/distribution paid on the relevant shares/units.▪ Substantially Identical Securities - Property that is fungible with or economically equivalent to the relevant shares/units. "Fungible with" means property which can be parcelled with the relevant share/unit. Examples include other shares in the same company of the same class and other shares in the same company of a different class which is similar to the class of the relevant shares.
As indicated above, the rules will perhaps have the most impact on those operating in the superannuation and funds management industries, purely because of the extent of share transactions within those industries. As these industries perhaps present some of the "worst case" scenarios, we will comment specifically on the impact on superannuation funds and fund managers. The comments, however, are equally relevant to any taxpayer involved in investment.
The determination of the holding period is made by reference to a qualification period. A taxpayer must hold the shares or interest in shares for the 45 or 90 day holding period (whichever is relevant) during the qualification period for the particular franked dividend/distribution in question. The duration and timing of the qualification period will depend on whether the taxpayer or an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend distribution.
If no related payment has been made, the relevant qualification period, known as the primary qualification period, is the period beginning on the day after the share or interest in the share is acquired and ending on the 45th or 90th day (depending on whether a preference share is involved) after the shares or interests went ex dividend: proposed s 160APHD. Alternatively, if a related payment has been made, the relevant qualification period, known as the secondary qualification period, is the period beginning on the 45th (or 90th if relevant) day before the shares or interest in shares went ex dividend and ending on the 45th (or 90th) day after the shares or interest in shares went ex dividend. Usually, it would be expected that the primary qualification period will exceed the secondary qualification period. As a result, it should prove easier to satisfy the holding period rule where no related payments have been made.
Where a related payment has not occurred in respect of a particular dividend/distribution, the holding period rule is a once and for all test. In other words, if a dividend/distribution received on a share/interest satisfies the holding period rule, any subsequent dividends received on that share will also satisfy the holding period rule.
If the holding period rule is failed in respect of a dividend/distribution on a share/interest, the next dividend/distribution (which may be paid six months later) will not automatically fail the test. The next dividend/distribution is tested independently. If it passes the holding period rule and no related payments are made, all subsequent dividends/distributions will also pass the test.
However, where the taxpayer or an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend/distribution, the holding period rule is not a once and for all test. In this case, the rule is applied to a share or interest in a share over the secondary qualification period. That is, the holding period rule is applied each time the taxpayer receives a franked dividend or entitlement to a franked distribution on which a related payment has been made: proposed s 160APHO(1)(b). In this way, taxpayers are prevented from satisfying the original test for the holding period and then passing on the benefit of the franking credits/rebates to another taxpayer.
Assuming no related payments have been made, the holding period is measured from the day after the share or interest is acquired to the day before the taxpayer disposes of the share or interest. A disposal can occur by simply selling the shares (or interest in shares) or it can be deemed under proposed s 160APHI to have occurred through the disposal of "related securities" by "connected persons" (discussed in detail below).
Furthermore, in determining the holding period, proposed s 160APHO(3) requires those days on which the taxpayer has materially diminished risks of loss and opportunities for gain in respect of the shares or interest to be excluded. The exclusion of those days is not taken to be a break in continuity of the period for which the taxpayer held the shares or the interest in shares.
Beneficiaries of a widely held trust are specifically exempt from applying this aspect of the rule: proposed s 160APHO(4). A concession is provided to these beneficiaries (see further Part 3).
In determining the holding and qualification periods in which shares or interest in shares are held, it is necessary to determine when the shares or interest were acquired and disposed of.
Proposed s 160APHH provides details on various circumstances where an acquisition or disposal may or may not occur under proposed Div 1A of Pt IIIAA.
Generally speaking, the date of acquisition/disposal for the holding period rule calculation under a typical share contract is the date of contracting, not settlement: proposed s 160APHH(1). Other situations covered by proposed s 160APHH include:
▪ Issuing of bonus shares: proposed s 160APHH(2) - This subsection provides that if any part of the bonus shares is, or is taken to be, an assessable dividend, the bonus shares are taken, for the purposes of the holding period rule, to have been acquired when they were issued. Otherwise, the bonus shares are taken to have been acquired when the original shares were acquired. Notably, there are no similar provisions in respect of share rights.
▪ Shares or interests distributed in satisfaction of an interest in a trust or partnership (including shares issued for an instalment receipt): proposed s 160APHH(3) - This subsection essentially allows taxpayers to use, for the purpose of testing the holding period rule, the original acquisition day for shares which are distributed to them in specie from a trust or partnership.
▪ Shares or interests passing to an executor or administrator: proposed s 160APHH(4) - This subsection is to apply to avoid unnecessary complication and upon the death of the holder of shares or an interest in shares by deeming the executor or administrator to have acquired the shares or interest at the time the deceased originally acquired them.
▪ Shares or interest held by a person under a legal disability transferred to a trustee: proposed s 160APHH(5) - This subsection prevents unfair disadvantages being imposed on taxpayers that become subject to a legal disability and transfer legal ownership of shares/interests to a trustee. Essentially, the trustee is deemed to have held the shares/interest from the time the individual originally acquired them.
▪ Shares or interests being transferred to a bare trustee: proposed s 160APHH(6) - This subsection enables a taxpayer to transfer a share or an interest in a share to a trust, of which it is the sole beneficiary, and not "reset the clock" for testing the holding period rule.
Section 160APHH also outlines a number of situations where acquisitions and disposals are deemed not to have taken place for the purposes of the holding period rule. They include:
▪ situations which satisfy s 26BC(4) of the ITAA36 (security lending arrangements): proposed s 160APHH(8);
▪ a change of trustee: proposed s 160APHH(9); and
▪ a transfer of the shares or interest in shares between companies within the same wholly-owned group: proposed s 160APHH(10).
Taxpayers must test that their shares/interests are held "at risk" on a daily basis. This is achieved by determining whether the taxpayer has a material diminution of the risks of loss and opportunities for gain. Subject to what is contained in the regulations, proposed s 160APHM provides that this will occur where a taxpayer's net position on that day has less than 30% of the risks of ownership and opportunities for gain. The taxpayer's net position (as defined above) is determined using the financial concept known as "delta": proposed s 160APHM(3).
As the term "delta" is not defined in TLAB4, it appears that the Government considers it is used commonly enough that it is unnecessary to define. For those in the finance industry, delta measures the percentage change in the price of one security relative to the percentage change in the price of another. A security's delta can range from -1.0 (perfect negative correlation - for every 10% increase in the price of the base security, the price of the derivative decreases by 10%) to +1.0 (perfect positive correlation - for every 10% increase in the price of the base security, the price of the derivative increases by 10%).
For example, a bought call option over a share (which is the right, but not the obligation, to buy the share at a date in the future for a pre-determined price) will have a positive delta in respect of the underlying share. This is because, as the market price of the share rises, so too does the value of the right to purchase that share at a lesser price. Conversely, if the market price of the share drops, the value of the option also drops as the market price falls gradually closer to (and may fall below) the exercise price of the option. The reverse is true for a sold call option.
As an example, consider the following extract from the Explanatory Memorandum to TLAB4:
4.67 For example, a taxpayer who holds 1,000 shares in a company and writes a call option with a delta of 0.6 in respect of those shares will not have materially diminished risk with respect to the shares because the net position of the taxpayer in relation to the shares would be in excess of 0.3. To determine the net position, the delta of the sold call option is subtracted (because it is a short position) from the delta of the shares (the delta of a share against which the delta of an option or other derivative is calculated is, by definition,+1). Accordingly, the net position of the taxpayer in relation to the shares is:
[(1,000 x 1) - (1,000 x 0.6)]/1,000 = 0.4
4.68 In contrast, a taxpayer who holds 1,000 shares and writes a call option with a delta of 0.9 will have materially diminished risk with respect to the shares because the net position of the taxpayer in relation to the shares is 0.1.
Being, [(1,000 x 1) - (1,000 x 0.9)]/1,000 = 0.1.
The percentage change in the price of the option will depend, inter alia, on the option's pricing relative to the price of the share.
Although the term may be commonly understood by those in the finance industry, the value of the delta may be calculated differently depending on the taxpayer's perception of the relationship between the derivative and the underlying share. It is understood that the Government expects the taxpayer will use the same delta for tax purposes as it used in entering into the relevant transaction. Nevertheless, difficulties will arise for taxpayers who enter into transactions for which there is no readily ascertainable delta.
If a taxpayer uses a fund manager, it may be able to rely on the manager to provide details on the delta, provided they are prepared to furnish the information. Many large superannuation funds and trusts use custodians to provide them with accounting and tax information on their investments. The custodians will usually not be privy to information such as deltas, other than those publicly available.
TLAB4 will require a significant change in the way fund managers communicate with custodians. Fund managers will need to "tag" the transactions through detailed asset recording systems and specialised reporting in order for the taxpayer or custodian to ascertain the deltas relevant to each transaction and their effect. With the large number of transactions that occur in industries such as superannuation and funds management, this may prove impractical.
Another issue arises in determining the effect of delta on the taxpayer's net position where a taxpayer hedges only a portion of its holding in a company. For example, assume a taxpayer holds 1,000 shares and takes a hedge over only 600 of them. Assume the taxpayer is indifferent to which of the 1,000 shares the hedge relates. In determining whether a material diminution of risk exists, it is not clear from TLAB4 whether the taxpayer should focus on the whole 1,000 shares or merely the 600 that have been effectively hedged. The correct approach may prove essential in determining a taxpayer's entitlement to franking credits.
From discussions with the ATO, it appears that its answer to this problem is that it depends on the "intention" of the taxpayer. The reference to "in respect of shares or interest in shares" in proposed s 160APHM is taken by the ATO as support for this view. The volume of transactions in industries such as funds management and superannuation will make it difficult for this to be recorded on a transaction by transaction basis. In many instances the taxpayer, as opposed to the fund manager, will not be aware of the purpose of a specific transaction.
Whilst this approach appears to be consistent with the policy underlying the rules, it will be difficult to implement in practice. A taxpayer's "intention" is a subjective criterion, the nature of which could affect its entitlement to franking credits. Another difficulty is proving this intention - taxpayers should consider preparing a file note to detail the purpose of each hedge entered into.
Subject to what is contained in the regulations, a "position" is defined in proposed s 160APHJ as anything that has a delta in relation to the shares or interest. Several examples are provided, including a short or future sale of the shares or interest, an option to buy or sell the shares or interest and the purchasing of property that is substantially similar to, or related to, the shares or interest. The examples cited are not exhaustive.
A net position is defined in proposed s 160APHJ(5) as the sum of the taxpayer's long and short positions in the shares or interest, calculated on the basis of their deltas.
It is the taxpayer's "net position" that is tested for a material diminution of risk. Therefore, the concepts of "position" and "net position" are integral to the operation of the rules.
A short position in relation to shares or an interest in shares is defined in proposed s 160APHJ(3) as a position that has a negative delta in relation to the shares or interest. Examples cited are a short sale, a sold future, a sold call option, a bought put option, and a sold share index future.
A long position in relation to shares or an interest in shares is defined in proposed s 160APHJ(4) as a position that has a positive delta in relation to the shares or interest. Examples cited are a share purchase, a bought future, a bought call option, a sold put option, and a bought share index future. Proposed s 160APHJ(4) also provides that, to avoid doubt, shares or interest in shares are treated as having a delta of +1 in relation to themselves.
As discussed above, a taxpayer's net position is adjusted for each security's delta. For example, consider another example from the Explanatory Memorandum to TLAB4:
4.69 It is possible to combine several options with a holding of shares to materially diminish risk with respect to those shares. For example, a taxpayer who holds 1,000 shares in a company and writes a call option with a delta of 0.5 and buys a put option with a delta of 0.4 will have materially diminished risk with respect to the shares. To determine the net position, the deltas of the call and put option are subtracted (because they are short positions) from the delta of the shares. Accordingly the net delta of the shares and options is:
[(1,000 x 1) - (1,000 x 0.5) + (1,000 x -0.4)]/1,000 = 0.1
4.70 Derivatives with different deltas should be added on a weighted basis. For example, if, in respect of a particular shareholding, a shareholder buys one call option with a delta of 0.4, two put options with a delta of 0.3 and three put options with a delta of 0.2 then, in respect of the shares, the total delta of the options is:
[(1,000 x 0.4) + (2,000 x -0.3) + (3,000 x -0.2)]/1,000 = -0.8
Therefore the net position in relation to the shares is:
-0.8 + 1 = 0.2
The related payments rule was first officially proposed on 13 May 1997, and is to apply to related payments made after 13 May 1997 (irrespective of when the shares/interests were originally acquired). The existence of a related payment impacts, inter alia, over which qualification period the holding period rule must be tested. Where a taxpayer (or an associate of a taxpayer) has made, is under an obligation to make, or is likely to make, a related payment, the secondary qualification period (being the period beginning on the 45th/90th day before and ending on the 45th/90th day after the day on which the shares or interest became ex-dividend) applies. Otherwise, the primary qualification period (being the period beginning on the day after the share or interest was acquired and ending on the 45th/90th day after the share or interest became ex-dividend) applies.
The term "related payment" is defined in proposed s 160APHN. The definition is extremely broad and is not limited to the examples cited therein. A related payment can be made by the taxpayer or an associate. Notably, the secondary qualification period may apply where the taxpayer or an associate has not actually made a related payment - the secondary qualification period will apply where either the taxpayer or an associate is under an obligation to make, or is likely to make, a related payment. The related payment can occur over a dividend paid in respect of shares, or over a distribution made in respect of interests in shares, held by the taxpayer: proposed s 160APHN(1). Proposed s 160APHN(2) states that:
The taxpayer or associate is taken, for the purposes of this Division, to have made, to be under an obligation to make, or to be likely to make, a related payment in respect of the dividend or distribution if, under an arrangement, the taxpayer or associate has done, is under an obligation to do, or may reasonably be expected to do, as the case may be, anything having the effect of passing the benefit of the dividend or distribution to one or more other persons.
More specific examples of what a related payment is, are outlined in proposed s 160APHN(3):
Without limiting subsection (2), the doing of any of the following by the taxpayer or an associate of the taxpayer in the circumstances mentioned in subsection (4) may have the effect of passing the benefit of the dividend or distribution to one or more other persons:(a) causing a payment or payments to be made to, or in accordance with the directions of, the other person or other persons; or
(b) causing an amount or amounts to be credited to, or applied for the benefit of, the other person or other persons; or
(c) causing services to be provided to, or in accordance with the directions of, the other person or other persons; or
(d) causing property to be transferred to, or in accordance with the directions of, the other person or other persons; or
(e) allowing any property or money to be used by the other person or other persons or by someone nominated by the other person or other persons; or
(f) causing an amount or amounts to be set off against, or to be otherwise applied in reduction of, a debt or debts owed by the other person or other persons to the taxpayer or associate; or
(g) agreeing to treat an amount or amounts owed to the other person or other persons by the taxpayer or associate as having been increased.
Pursuant to proposed s 160APHN(4), the circumstances referred to in subsection (3) are where:
(a) the amount or the sum of the amounts paid, credited or applied; or
(b) the value or the sum of the values of the services provided, of the property transferred or of the use of the property or money; or
(c) the amount or the sum of the amounts of the set-offs, reductions or increases;
as the case may be:
(d) is, or may reasonably be expected to be, equal to, or
(e) approximates or may reasonably be expected to approximate; or
(f) is calculated by reference to;
the amount of the dividend or distribution.
The definition is such that a related payment can occur without an actual payment from one entity to another. As the Explanatory Memorandum to TLAB4 indicates, "any method of passing the benefit of a dividend to another person may be a 'related payment' within the meaning of the section."
On pages 142-143 of the Explanatory Memorandum to TLAB4, examples are provided of some of the situations where a related payment would arise. The comments made relating to the interaction between the related payments rule and futures contracts warrants further examination. In relation to futures generally, the Explanatory Memorandum states at page 143 that:
...the theoretical price of a share under a futures contract is usually calculated by taking the current market price, adding interest on the outstanding share price for the term of the contract, and subtracting expected dividends: the subtraction from the price of the expected dividends is a related payment.
It would appear that justification for this view is based on proposed s 160APHN(6), which states that:
If an amount is taken into account in any way in favour of, or is notionally accredited to, a person in fixing a price or value, or in determining another amount, the first-mentioned amount is taken, for the purposes of this section, to be credited to the other person.
Essentially, a Share Price Index ("SPI") future is a contract between two parties that requires one to pay to the other the value of the All Ordinaries Index on a particular day in the future multiplied by $25. For example, if the value of the All Ordinaries Index on a particular day was 2,950, the corresponding SPI futures contract would be valued at $25 x 2,950, or $73,750.
As the All Ordinaries Index broadly represents the Australian share-market as a whole, SPI futures are widely used throughout the investment industry as a means of hedging domestic investment risk.
If proposed s 160APHN is interpreted broadly by the ATO (eg, all SPI futures are taken to be related payments), a number of issues will arise.
First, the related payments rule and the concept of material diminution of risk do not seem to fit together neatly. Under the related payments rule, the degree to which a derivative and the relevant share or interest in a share must be connected is not specified. At para 4.101 of page 144 of the Explanatory Memorandum to TLAB4, it indicates that a SPI futures contract should have a close correlation to the share portfolio of the taxpayer for a related payment to arise. However, the material diminution of risk test has a 30% correlation threshold. Circumstances could arise where a related payment could exist, even though there is no material diminution of risk.
The second implication of a related payment occurring is that the holding period is tested over the secondary qualification period - this is determined each time a franked dividend is received. A broad interpretation of the term "related payment" could mean that the secondary qualification period (rather than the primary qualification period) becomes the more relevant qualification period for many taxpayers who hedge using SPI futures.
Thirdly, the existence of a related payment will prevent a taxpayer, that is otherwise entitled (eg, a superannuation fund), from utilising the formula based ceiling election.
Proposed s 160APHR(3) states that an election does not have any effect in respect of a particular dividend or distribution if:
(a) the taxpayer or an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the dividend or distribution; and
(b) the payment was or will be a payment of a prescribed kind.
Subject to further regulations or regulations to the contrary, a payment of a prescribed kind will only be:
(i) an obligation under a securities lending arrangement (other than such an obligation to which section 160AQUA applies); or
(ii) an obligation under an arrangement of a kind known as an equity swap.
Proposed s 160APHR(3) renders an election ineffective only in respect of the dividend/distribution on which the related payment was made. Thus, a related payment in respect of one dividend/distribution should not taint the whole "discrete fund".
Another difficulty in the interaction of the formula based ceiling election and the related payments rule is that the ceiling is calculated on a discrete fund by fund basis (see further Part 5), whereas the related payments rule is tested on a share or an interest in a share basis.
Proposed s 160APHD defines an interest in relation to shares or other property to mean any legal or equitable interest in the shares or other property. Accordingly, a taxpayer that is a unit holder in a unit trust that owns shares has an interest in those shares. Prima facie, this suggests that a taxpayer must trace through a trust or trusts to determine its interest in the underlying shares.
Proposed s 160APHG outlines the basis upon which an acquisition, a holding and a disposal of an interest in shares occurs. Proposed s 160APHG(1) and (2) relate to partnerships and s 160APHG(3) and (4) relate to trusts that are not widely held trusts. Widely held trusts are dealt with separately in s 160APHG(5) - (8), because the widely held trust concession (see further Part 3) alters the tracing rules as they relate to beneficiaries of a widely held trust.
Under proposed s 160APHG, a "disposal" of shares by a partner in a partnership or beneficiary of a non-widely held trust can occur by either the partnership/trustee selling its underlying shares or the partner/beneficiary ceasing to be a partner/beneficiary.
A problem can be encountered with non-widely held trusts where within 45 days of a beneficiary acquiring a unit in the trust, the trustee disposes of an underlying share. In accordance with proposed s 160APHG(4), the beneficiary will be considered to have acquired proportionate interest in all the underlying shares of the trust. The action of the trustee in selling any of those underlying shares that were held at the time the beneficiary acquired the unit will result in the beneficiary being considered to have disposed of an interest in those underlying shares: proposed s 160APHG(3). As a result, the beneficiary will not be a qualified person in respect of that interest in those shares.
A curious situation arises in circumstances where the trustee of a non-widely held trust has bought the underlying shares before 1 July 1997. From the trustee's perspective, the holding period rule should not apply. However, it appears that the beneficiary's interest in the shares may need to be tested if the beneficiary's units were acquired after 31 December 1997. This being the case, the trustee needs to provide details of all shares it has on hand at the time the beneficiary buys a unit, any subsequent sales of those shares and details on the beneficiary's share of the distributions from the trust.
This gives rise to compliance issues, particularly in the common case where there are a number of interconnecting trusts. The action of a trustee at one level can have an impact at another level. In order for a beneficiary at the end of a chain of trusts to determine whether there has been a disposal of its interest in shares, information of acquisitions and disposals by each trustee in the chain would need to be passed through each trust to the ultimate beneficiary.
Bearing in mind that the movement of the beneficiary in and out of the end trust can also represent a disposal, the taxpayer may find it has a complicated matrix of disposals to contend with. In cases where there are interconnecting non-widely held trusts and considerable movement in the unitholders, it may well be practically impossible to track whether a beneficiary has held an interest in a share for the required period under proposed s 160APHO.
A situation that does not seem to be covered by proposed s 160APHG is the impact on an existing partner/beneficiary where further partners are admitted or further units/beneficial interests are issued. Although it is clear that the new partner or unitholder/beneficiary has acquired an interest in a share, there is nothing in proposed s 160APHG(1)-(4) that states that the continuing partners or beneficiaries have disposed of a proportion of their interest in the underlying shares. Discussions with the ATO reveal that it is intended that proposed s 160APHG would apply to such a situation for partnerships and non-widely held trusts. Careful consideration needs to be given in these circumstances as to the timing of the admission of new parties and what impact it might have for the existing interested parties.
The position in respect of a beneficiary of a widely held trust is intended to differ under proposed s 160APHG. However, the application of this proposed section to widely held trusts is dealt with under Part 3 of this article.
An interest in a share for the purposes of proposed s 160APHG is calculated by reference to proposed ss 160APHK (which relates to partners) and 160APHL (which relates to beneficiaries).
The method of calculation of the interest in a share is consistent in each case (being a partnership, non-widely held trust and widely held trust):
INTEREST = A x B/C
Where:
A = The partnership / trust holding (the total of the shares / interests held by the partnership / trust which have received a dividend or distribution).
B = The partner's / beneficiary's share of the dividend income.
C = The dividend income (broadly, being any amount included in the partnership's/trust's assessable income that is or is attributable to a dividend).
Whilst the calculation of the interest in a share is consistent for these three taxpayers, the application of this interest varies, depending on proposed ss 160APHG, 160APHK and 160APHL.
Broadly speaking, the effect of an interest in a share can be summarised as follows:
A position of the partnership in relation to the partnership holding is deemed to be a position of the partner if the position relates to the partner's interest in the share.
In order to be a "qualified person" a taxpayer must, inter alia, have sufficient exposure to the risks of loss and opportunities for gain in relation to the share or interest in the share. Special "deeming" rules apply to beneficiaries of a non-widely held trust: proposed new s 160APHL:
▪ the beneficiary has a long position equal to their interest in the shares with a delta of +1;
▪ the beneficiary has a short position equal to its long position determined above and a long position in so much of its actual holding as is a fixed interest (the Commissioner will be given the power to deem certain interests to be fixed and indefeasible); and
▪ a position taken by the trustee in relation to the beneficiary's interest in the share is taken (proportionately) to be a position of the beneficiary. Essentially, the "net position" of a beneficiary is equal to its fixed (vested and indefeasible) interest in the corpus of the trust, adjusted for any positions taken.
These provisions require detailed tracing calculations, which may be most easily explained with a simple example.
Assume that a non-widely held trust has two beneficiaries, each of which has a 50% fixed entitlement to the income and corpus of the trust. Assume the trust has 1,000 shares in a company and that no hedging is entered into by either the trust or the beneficiaries individually. Each beneficiary is a qualified person in relation to their half of the trust holding. The net position of each beneficiary, pursuant to proposed s 160APHL, is:
Long position of
interest in shares 50% x 1,000 500
Short position of
interest in shares 50% x 1,000 (500)
Long position of
fixed entitlement 50% x 1,000 500
500
Divided by 500
shares 500/500 100%
If, on the other hand, one beneficiary received 50% of the income but only had a fixed interest in 10% of the trust holding, it would not be a qualified person, because its net position would be less than 30%:
Long position of
interest in shares 50% x 1,000 500
Short position of
interest in shares 50% x 1,000 (500)
Long position of
fixed entitlement 10% x 1,000 100
100
Divided by 500
shares 100/500 20%
The beneficiary's interest in the relevant share is taken to be a long position with a delta of +1.0. This provision operates in conjunction with proposed s 160APHP to form the basis for the widely held trust concession, discussed in Part 3.
As outlined above, a beneficiary only has an interest in the shares to the extent that it has a fixed (vested and indefeasible) interest in the trust holding. As a result, beneficiaries of a discretionary trust cannot be "qualified persons" in relation to any shares acquired by the trust after 31 December 1997, unless:
▪ the trust is a deceased trust estate: proposed s 160APHL(10)(b);
▪ the beneficiary takes positions in relation to the interest which provide them with 30% of the exposure in relation to the interest (and they have passed the holding period rule in relation to the interest); or
▪ the beneficiary is an individual who has made the $2,000 ceiling election under proposed s 160APHT.
Beneficiaries of a split trust (where some of the beneficiaries are entitled to the income of the trust and others to the corpus of the trust) will have their entitlement to franking credits limited to their interest in the corpus of the trust.
The measures relating to discretionary and split trusts apply to shares or interest in shares acquired after 31 December 1997 unless the trust is a widely held public share trading trust. For widely held public share trading trusts, the measures only apply to trusts established after 31 December 1997.
Where the requirements of Sch 2F of the ITAA36 are satisfied, a discretionary or split trust may make the family trust election. As it relates to the holding period rule, the effect of this election is to remove the requirement in calculating the beneficiary's net position of subtracting the beneficiary's interest in the trust holding and adding the beneficiary's fixed interest. As a result, the beneficiary's entitlement to income forms the only basis for determining its interest in the trust holding.
The family trust election imposes several restrictions on the trust, and should not be made lightly.
A taxpayer is deemed to have disposed of a share or interest in a share where a "connected person" (including the taxpayer) disposes of a "related security": proposed s 160APHI.
The purpose of these provisions is to prevent taxpayers circumventing the holding period rule by choosing to dispose of a security that has been held for more than 45/90 days, rather than one that was acquired within 45/90 days.
For example, a taxpayer may have acquired 100 shares on 31 August 1997. It acquires another 100 shares on 31 October 1997 and a dividend is paid in respect of both parcels of shares on 15 November 1997. The taxpayer then wants to sell 100 shares on 30 November 1997. Rather than selling the shares acquired on 31 October 1997 (and hence breach the holding period rule), the taxpayer sells the shares acquired on 31 August 1997. The related security rules prevent the taxpayer from claiming franking credits on all 200 shares. The taxpayer will only be entitled to credits on the first purchased 100 shares. The rules operate on a last-in first-out ("LIFO") basis: proposed s 160APHI(4).
The wording of proposed s 160APHI is rather complex, considering the relatively simple nature of what it is attempting to achieve. Proposed s 160APHI(1) refers to the securities upon which the holding period is being determined. These securities are referred to as the primary securities. Proposed s 160APHI(1) then explains that a disposal of a primary security can be a disposal of certain other securities and vice versa.
Primary securities are a subset of a larger class of securities known as "related securities". Related securities are defined in proposed s 160APHI(2) to mean:
(a) the primary securities; and
(b) any shares, or interests in shares, held by connected persons:
(i) that are substantially identical securities in relation to the primary securities; and
(ii) in respect of which a connected person has been paid, or is entitled to be paid, a franked dividend or a franked distribution or, in the case of a connected person that is a company, a rebateable dividend or a rebateable distribution, being in either case a dividend or distribution corresponding to the dividend or distribution paid on the primary securities;
but does not include shares or interest in shares:
(c) in relation to which an election is in force under section 160APHR; and
(d) which were not acquired or disposed of for the purpose, or for purposes that included the purpose (whether or not the predominant purpose), of avoiding the application of this section. (emphasis added)
"Connected persons" are defined in proposed s 160APHI(3) to mean:
(a) the taxpayer;
(b) if, at a time during the qualification period, an associate of the taxpayer, under an arrangement to which they were parties, disposed of shares of an interest in shares - the associate;
(c) if the taxpayer is a company - another company that is in the same wholly-owned group.
Substantially, identical securities are defined in proposed s 160APHF to mean property that is fungible with or economically equivalent to, the value of the shares or interest in shares in a company ("the relevant company").
Substantially identical securities include (but are not limited to):
▪ shares of a different class where there is no material difference between the classes or other shares are exchangeable at a fixed rate for the relevant shares;
▪ shares in another company that holds predominantly shares in the company of the same class as referred to above; and
▪ shares in another relevant company that are exchangeable at a fixed rate for the shares in the relevant company.
A substantially identical security can also be a vested and indefeasible interest in a trust or an interest in a partnership that holds predominantly the same class of shares.
Although the proposed definition does not mention it, it would appear that, in practice, delta will be the relevant measure to determine the existence of a substantially identical security. The Explanatory Memorandum to TLAB4 at para 4.44 provides the example of a converting preference share with a delta of +0.9 to the ordinary share as being a substantially identical security.
It will be difficult for a large investor's different fund managers to monitor disposals in light of these provisions. Where several independent fund managers are used, in order to protect the taxpayer's entitlement to franking credits, each manager must communicate with the others before any disposal can take place. Clearly, this is impractical.
The requirement of a "predominant" holding of shares in a company is not defined. Is it simply more than 50% or some other percentage? What does a "material difference" mean? Although the holding period rule is meant to be an objective test, the test could, in some instances, be subjective, as the application of some provisions is unclear.
By virtue of the definitions of "connected person" and "related securities", a deemed disposal can occur in respect of a taxpayer where an associate disposes of a substantially identical security. For this to occur:
▪ an arrangement between the taxpayer and associate; and
▪ during the qualification period, a franked dividend or franked distribution is paid or payable on the substantially identical security.
If no such dividend or distribution occurs, proposed s 160APHI cannot apply.
An associate is defined in proposed s 160APHD as an associate under the definition contained in s 318 of the ITAA36 and also includes the controller of a trust and a member of the same wholly-owned group (determined in accordance with subdiv 975-W of the Income Tax Assessment Act 1997 (Cth) ("ITAA97")). A controller of a trust is in turn defined in proposed s 160APHD as a person:
(a) who beneficially owns, or is able in any way, whether directly or indirectly, to control the application of more than 50% of the interests in the trust property or in the trust income; or.
(b) who has power to appoint or remove the trustee of the trust; or
(c) according to whose directions, instructions or wishes, the trustee of the trust is accustomed or under an obligation, whether formal or informal, to act.
Another way a deemed disposal can occur is where a company within a wholly-owned group disposes of a share. In these circumstances, there does not have to be an arrangement. There is potential for this aspect to operate unfairly, because in many instances two companies in the same group will be acting completely independently of each other and using different systems.
With the exception of investment companies and insurance companies, it will not be common for a disposal to be deemed to have occurred for companies in wholly-owned groups. Problems could arise where within the one corporate group there is a life insurance and general insurance company, each with significant shareholdings operating independently.
Recently, this aspect of the holding period rule has been amended to ensure a more equitable application - see further Part 7.
The rules relating to deemed disposal by associates could potentially catch investors in trusts where the trustee disposes of a substantially identical security to that acquired by a taxpayer within 45 days of the acquisition. However, the associate rules may not be necessary in this case because the taxpayer could be considered to have disposed of an interest in a share or an interest in a substantially identical security through the actions of the trustee, irrespective of whether an arrangement exists.
In addition to the problems associated with a trustee disposing of shares within 45/90 days of a unitholder acquiring the units, there are also problems with trusts and substantially identical securities. This can occur where a taxpayer acquires say a BHP share, already has a unit in a unit trust which has been held for several years and the trustee of the trust disposes of a BHP share (the substantially identical security) within 45 days of the taxpayer buying the BHP share.
Although the trustee may have held its BHP share for several years, the action by the trustee could jeopardise the taxpayer's entitlement to franking credits/rebates on any BHP dividends the taxpayer becomes entitled to in the time between the acquisition and sale. To monitor this situation, the taxpayer would need to obtain details of every single share transaction of the trustee and match them with its own.
Amendments described in the Supplementary Explanatory Memorandum to TLAB4 (discussed in Part 7) may adequately address this inequity.
Proposed s 160APHP provides that:
(1) A taxpayer who has held an interest in shares as a beneficiary of a widely held trust is a qualified person in relation to any dividend paid on the shares to which a distribution from the trust to the taxpayer is attributable if:(a) where neither the taxpayer nor an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the distribution - during the primary qualification period in relation to the taxpayer in relation to the interest; or
the taxpayer has held an interest in the shares as a beneficiary of the trust for a continuous period (not counting the day on which the taxpayer acquired the interest or, if the taxpayer has disposed of the interest, the day on which the disposal occurred) of not less than 45 days.
(b) where the taxpayer or an associate of the taxpayer has made, is under an obligation to make, or is likely to make, a related payment in respect of the distribution - during the secondary qualification period in relation to the taxpayer in relation to the interest;
(2) In calculating the number of days for which the taxpayer continuously held the interest, any days on which the taxpayer has materially diminished risks of loss and opportunities for gain in respect of the interest are to be excluded, but the exclusion of those days is not taken to break the continuity of the period for which the taxpayer held the interest.
The intention of this "concession" is to allow beneficiaries of widely held trusts to simply look at their interest in the trust, rather than the trust's underlying shares or interest in shares. Provided the beneficiary holds the units in the widely held trust for more than 45/90 (depending on whether the interest being tested relates to ordinary or preference shares) days over the primary/secondary qualification period and there is no material diminution of risk, the franking credits distributed to the beneficiary will not be denied.
Essentially, the concession means that a beneficiary of a widely held trust treats their units in the same manner as they would if they were shares in an investment company. That is, beneficiaries are not required to "look through" and take up a proportionate position of the holdings of the widely held trust.
The trustee of a widely held trust must determine its own exposure under the holding period rule or formula based ceiling (if applicable). Any franking credits that the widely held trust is denied cannot be passed on to the beneficiaries. That is, there are two separate levels of testing required.
Despite the obvious intention of the concession, the route to attain the intended result is a fairly tortuous one.
Proposed s 160APHD defines a "widely held trust" at a particular time to mean:
(a) a trust that, at that time, is neither a closely held fixed trust nor a non-fixed trust; or
(b) a trust the trustee of which is the subject of a declaration that is in force under regulations made for the purposes of paragraph 160APHR(1)(j); or
(c) a unit trust if, at that time:(i) at least 75% of the units are held by a person who is, or persons each of whom is, a person referred to in any of paragraphs 160APHR(1)(a) to (j) or a prescribed person in relation to the trust; and
(ii)all of the units carry the same rights; and
(iii)if the units are redeemable, they are redeemable for a price determined on the basis of the trust's net asset value, according to Australian accounting principles; and
(iv)the trust engages only in qualifying activities within the meaning of subsection 160APHR(11).
Broadly, "qualifying activities" are defined in proposed s 160APHR(11) as arm's length investment activities.
A "closely held fixed trust" is defined in proposed s 160APHD as a trust that:
...at a particular time, if at that time, it is a fixed trust and not more than 20 entities (as defined in section 960-100 of the Income Tax Assessment Act 1997 and counting entities who are associates as one entity) have interests in the trust that together entitle them to not less than 75% of:The term "entity" is defined in s 960-100 of the ITAA97 as being:
(a) the beneficial interests in the income of the trust; or
(b) the beneficial interests in the capital of the trust.
(1)(a) an individual;
(2) The trustee of a trust or of a superannuation fund is taken to be an entity consisting of the person who is the trustee, or the persons who are the trustees, at any given time.
(b) a body corporate;
(c) a body politic;
(d) a partnership;
(e) any other unincorporated association or body of persons;
(f) a trust;
(g) a superannuation fund.
It is apparent from the use of the term entity that, in determining whether a trust is a widely held trust or not, it is not intended to trace through superannuation funds or trusts to the underlying membership or beneficiaries. This approach is consistent with some areas of the tax law - eg, Div 166 of the ITAA97, and appears to be inconsistent with others - eg, the trust loss provisions.
This inability to trace through means that many wholesale and some retail trusts may be considered closely held trusts, because the unit holding of the trust is dominated by a small number of large investors. However, if 75% or more of those investors are themselves eligible to make the formula based ceiling election, the trust may be a widely held trust. The same issues may be encountered by new trusts that have not achieved the critical numbers by the relevant distribution time.
If the trust is not a widely held trust, the trustee will need to supply details of purchases and sales of shares and interests in shares together with details of derivatives entered into. This becomes exceedingly complicated where the investments are via a number of trusts. One trust's systems may not be compatible with another, thereby necessitating manual input of data. This could be extremely time consuming and likely to result in errors.
Where the ultimate unitholders of a non-widely held trust are individuals who have little or no understanding of these measures, they could find themselves thoroughly confused with their obligations in respect of tracing. There is an obvious competitive advantage for a widely held trust, due to the fact that its beneficiaries need to do very little other than monitor the period during which they hold units in the trust.
Another problem in not being a widely held trust is that many managers of these trusts would be reluctant to furnish specific details on the trust's buy/sell activities. This potential reluctance is understandable, as detailed investment disclosures could quickly erode competitive advantages.
A "non-fixed trust" is defined in proposed s 160APHD to be a trust that is not a fixed trust. The definition of a "fixed trust" is contained in Sch 2F (s 272-65) of the ITAA36. It is defined as a trust where all of the income and capital of the trust is the subject of fixed entitlement held by persons. Trust deeds should be carefully examined to determine whether any part of the trust income is distributed on a discretionary basis. If so, it may jeopardise the franking credits available to those beneficiaries with only an entitlement based on the trustee's discretion.
As stated earlier, the reporting requirements for a widely held trust will not be as significant as for a closely held trust. As a result, most trusts will endeavour to achieve the widely held trust status.
Proposed s 160APHQ provides a concession for taxpayers who receive an entitlement to franking credits on shares that were issued in relation to a winding up. Practically, this provision will not be relied upon as often as the other methods of becoming a "qualified person". It is only a viable option where the relevant company is about to be wound-up - a process that typically takes more than 45 days to complete in any event.
The formula based ceiling election or "carve out" is a concession provided to institutional investors such as superannuation funds and very large retail investment managers. The concession is provided to "low revenue risk" taxpayers who, given the extent of their share turnover, would have undue difficulty in applying the holding period rule.
As the name suggests, a ceiling is applied to the level of franking to which a taxpayer is entitled. Any franking credits/rebates received in excess of the ceiling are denied. If the franking credits/rebates received do not exceed the ceiling, they can be claimed in full. Any "surplus" below the ceiling cannot be carried forward or offset against ceiling deficits on other funds.
In order to avail itself of this "concession", the taxpayer must make an election pursuant to proposed s 160APHR(1). The election applies to the year of income specified in the election and all later years of income. It is irrevocable without the Commissioner's consent.
Subject to the regulations specifying otherwise, the only taxpayers that can make the election pursuant to proposed s 160APHR(1) are:
(a) a listed widely held trust;
(b) an unlisted very widely held trust;
(c) a life assurance company;
(d) a general insurance company;
(e) a friendly society;
(f) certain registered health benefits organisations;
(g) a complying (non-excluded) superannuation fund;
(h) a complying (non-excluded) ADF;
(i) a pooled superannuation trust;
(j) a taxpayer that is declared by regulation to be eligible; and
(k) a trust with at least 75% of its units held by entities that are themselves eligible to make the formula based ceiling election that engages only in arm's length investments.
Other entities may be added to this group by way of regulation. A notable omission at this stage is certain public offer unit trusts, that is unlisted widely held trusts.
Proposed Subdiv BA of Div 7 indicates that the formula based ceiling must be applied by a taxpayer on a discrete fund by discrete fund basis. The term "discrete fund" is not adequately defined. However, it appears that if a superannuation fund has say, two Australian equity managers, it can elect to have the formula based ceiling apply to the first fund manager and not the second. In this instance, the two funds are quite easily identifiable. It is not clear what happens if a taxpayer manages its own investments - whether it can notionally split its investments into two funds, say on a sectorial basis. Nor is it certain whether a fund manager can split its investments into two or more "discrete funds".
There is a strong argument that the term, as it is currently defined, would allow an investment managed by one fund manager, in certain circumstances, to comprise more than one "discrete fund".
Generally speaking, it appears that in circumstances where a separate asset overlay manager is used, the taxpayer does not have to have regard to that manager for the purposes of the formula based ceiling in respect of other discrete funds. However, the Commissioner can, inter alia, revoke the elections on the other funds where he has grounds to believe that the position of the asset overlay manager should be taken into account: proposed s 160APHR(10). The formula based ceiling is also unavailable where the taxpayer has entered into a scrip lending arrangement or equity swap: proposed s 160APHR(4).
If the taxpayer has two discrete funds and it elects to apply proposed s 160APHR to the first but not the second fund, by virtue of proposed s 160APHI(2)(c), the taxpayer can ignore the disposals made by the first fund in applying the holding period rule to the second fund. An exception to this rule is where there is a purpose of avoiding s 160APHI.
The interaction of the formula based ceiling election and the related payments rule is discussed in Part 2.6 above.
If an election is made in respect of shares and interests in shares in a discrete fund, the maximum franking credits/rebates that the taxpayer can claim in respect of those shares cannot exceed the ceiling amount. This term is defined in proposed subdiv BA as being the notional total credit amount in relation to the fund increased by 20% or some other percentage prescribed by the regulations.
The notional total credit amount is defined in proposed s 160AQZE(4) to be:
...the sum of the franking credits to which a taxpayer (the notional taxpayer) of the same kind or class as the electing taxpayer would be entitled under this Part in respect of dividends paid:
(i) during the year of income
(ii) on shares in the benchmark portfolio of shares that applies in respect of the fund;
if the notional taxpayer were a qualified person under section 160APHO in relation to the dividends.
Similar provisions exist for franking and dividend rebates under proposed s 160AQZF.
The benchmark portfolio of shares is defined in proposed s 160AQZH(1) as:
The benchmark portfolio of shares that is applicable in respect of a fund managed by or on behalf of a taxpayer is the portfolio of the shares and other securities used to calculate:
(a) the All Ordinaries Index published by the Australian Stock Exchange Limited; or
(b) if the regulations prescribe another index in relation to a class of taxpayers in which the taxpayer is included - the other index;
being a portfolio whose value is equal to the net equity exposure of the fund for the year of income.
The term "net equity exposure" is defined in proposed s 160AQZH(2) as the sum of the average values during the year of income of the long and short positions that the fund has in such of the ordinary shares, or in interests in such of the shares, included in the fund as are listed resident companies (in the case of the All Ordinaries Index). The average values have to be determined on a weekly basis on the same day each week, unless the regulations stipulate otherwise.
Where the All Ordinaries Index is the benchmark used, net equity exposure can only include ordinary shares in resident companies and positions in relation to such shares held by or on behalf of the taxpayer.
This section, as it is currently drafted, produces some curious results:
▪ Exchange traded derivatives - (such as SPI futures) must be included and adjusted for their delta in relation to the whole portfolio. The difficulty is determining the value of this delta, particularly when the portfolio is not strongly correlated with the All Ordinaries Index.
▪ Most listed property trusts - are not included, as they do not represent an investment in a listed resident company. This exclusion is understandable, as the taxpayer would not typically receive any franking credits/rebates on the units in the property trust.
▪ Unlisted investment trusts - are included in the net equity exposure to the extent they invest in listed resident companies (subject to the same restrictions as above). Of course, determining this extent of relevant investment may prove difficult. Where a fund has itself made the election and has units in a trust, it must effectively "look through" the trust to determine its net equity exposure. This is irrespective of whether the trust is widely held or not. However, the trust may not be prepared or even able to provide the fund with information on its exposure from its investment in the trust on a weekly basis.
Various industry bodies have made submissions to the Government seeking to have the valuation determined less frequently than weekly, as some investors (eg, fund managers) would have difficulty in compiling the information and/or it will become more costly to compile. The Government originally planned to have daily valuations. In discussions with the ATO, it appears that it is reluctant to extend the valuation dates to say, a monthly basis. The ATO did permit a monthly basis of determination for the first year of the rules' operation, 1997/98, where adequate systems were not in place.
Where the taxpayer uses the All Ordinaries Index as its benchmark portfolio, the ceiling amount is based on all ordinary shares (or interests in ordinary shares) in listed resident companies and relevant "positions" held by the taxpayer. If another benchmark portfolio is used, only resident company shares and interests in resident company shares that are included in the benchmark portfolio are included in the net equity exposure calculation. This will prevent taxpayers using a high dividend yielding index (eg, banking and insurance) in the calculation where they do not have a sufficient weighting to that index in their portfolio.
Another issue is whether the formula based ceiling applies to shares acquired prior to 1 July 1997. On one view, a taxpayer should be able to ignore dividends/distributions paid on a share/interest acquired pre-1 July 1997 in applying the ceiling. Technically, it appears that the pre-1 July 1997 shares are not included by virtue of clause 25, but practically they may have to be because it will be too difficult to exclude them. It is understood that the ATO's current view is that pre-1 July 1997 shares are to be included.
The franking rebate yield on the All Ordinaries Index is to be annually released by the ATO/ASX. For the year ended 30 June 1998, the franking rebate yield was 1.52%.
A discrete fund's "ceiling amount" for the year ended 30 June 1998 is determined as follows:
Ceiling Amount = A x B x C
Where:
A = Average weekly net equity exposure
B = 1.52%
C = 1.2
The RAC Employee Superannuation Fund ("RSF") holds, on average, $100 million of Australian equities in a discrete fund. Of this $100 million, an average of $95 million is invested in ordinary shares in listed resident companies and an average of $5 million is invested in shares in unlisted and non-resident companies.
RSF holds one million units in the Florence Investment Trust ("FIT"), which represents a 10% interest in the trust. The FIT has, on average, investments to the value of $200 million, comprising $100 million in ordinary shares in listed resident companies and $100 million in shares in unlisted or non-resident companies.
RSF also holds a derivative over its entire portfolio which hedges $15 million of exposure. The derivative's delta relative to the whole portfolio is -0.2.
RSF receives $2,000,000 imputation credits in the year.
To determine the ceiling amount in respect of RSF's discrete fund:
Net equity exposure: (Average value of long and short positions taxpayer has
in shares and interest in ordinary shares in listed residents)
= ($95m x 1) + ($10m x 1) - ($15m x 0.2)
= $102m
Ceiling
Amount: = $102m x 1.52% x 1.2
= $1.86m
Franking
Credits
Denied: = ($2m - $1.86m)
= $140,000
Under proposed s 160APHT, an individual can be a qualified person by electing to have a franking rebate ceiling applied in respect of him or her in relation to a specified year of income. If the election is made, proposed s 160AQZJ limits the maximum rebate available on all dividends and distributions to $2,000. This means that those individuals who are likely to receive franking rebates less than $2,000 can make the election and not have to apply the holding period rule. The election is only available if there are no related payments in respect of the relevant dividend/distribution.
Under proposed s 160AQZK, the maximum rebate is reduced by $4 for every $1 of franking rebate that exceeds $2,000. A taxpayer who has to deduct an amount from the $2,000 maximum will be entitled to claim as a deduction from assessable income the gross-up amount of the dividend to the extent that the rebate is denied (up to a maximum of $2,500).
Many individuals will not have a problem with the holding period rule because they do not turnover their shares. It is for this reason and through ignorance of the measures that most individual shareholders are unlikely to make the election provided by proposed s 160APHT.
Given the potentially wide-ranging impact of the rules on all resident taxpayers, substantial lobbying of the Government and discussions with the ATO were to be expected. As a result, the rules have been regularly revised and improved. Recently, a Supplementary Explanatory Memorandum and amendments to TLAB4 were released. Some of the amendments included:
▪ making it clear that a beneficiary of a widely held trust will be treated as holding an interest in any shares or interests in shares held by the trustee, whether or not the shares are held by the trustee during the same period as in which the taxpayer is a beneficiary. That is, if a beneficiary of a widely held trust receives a distribution attributable to shares held prior to it becoming a beneficiary and those shares are disposed of by the trustee shortly after the person becoming a beneficiary, he/she will be taken to have held the shares for as long as he/she holds an interest in the trust. This amendment will prevent the situation where a beneficiary is denied franking credits because of some actions of the trustee, over which it has no control;
▪ amending the bonus shares acquisition rules so that bonus shares that are taken to be acquired at the same time as the original shares will be subject to the material diminution of risk test - meaning that they will only be taken to have been held on days when the original shares were held "at risk";
▪ inserting new subsections into proposed s 160APHI so that a disposal of securities within a wholly-owned group will not be treated as a disposal of identical securities held by a company within the group;
▪ amending the rules so that where a company has made the formula based ceiling election and the ceiling has been exceeded, a franking debit will arise to the company's franking account;
▪ amending the rules to clarify that the formula based ceiling applies to dividends that went ex-dividend (as opposed to physically paid and assessable under s 44 of the ITAA36) during the relevant year of income; and
▪ inserting new provisions to clarify the manner in which a ceiling amount should be calculated under the formula based ceiling election where the "discrete fund" only existed for part of the year of income.
It is apparent from the Treasurer's press release on budget night 1997, that the Government has concerns about the affordability of the imputation system:
The underlying principles of the imputation system as introduced in 1987, and as reflected in its affordability, include: first, that tax paid at company level is in broad terms imputed to shareholders proportionately to their shareholdings; and second, that the benefits of imputation would be available only to the true economic owners of shares, and only to the extent that those taxpayers were able to use the franking credits themselves.
The amendments to address trading in franking credits and misuse of the inter-corporate dividend rebate are designed to restore the second underlying principle of the imputation system and address schemes in which shareholders are able to fully access franking credits without bearing the economic risk of share ownership.
The general franking credit anti-avoidance provisions contained in s 177EA of the ITAA36 deny the tax advantages of franking credit schemes. The application of s 177EA is extremely broad. For instance, rather than relying on a sole or dominant purpose test similar to s 177D, s 177EA merely requires that there be a purpose (other than an incidental purpose) of enabling the taxpayer to obtain a franking credit benefit. It is unclear why a tougher threshold is required for franking credits than that imposed by Pt IVA in respect of the determination of taxable income generally.
One of the requirements for s 177EA to apply is that there is a scheme for the disposition of shares or an interest in shares. Subsection
177EA(14) defines such a scheme as follows:
A scheme for a disposition of shares or an interest in shares includes, but is not limited to, a scheme that involves any of the following:
(a) issuing the shares or creating the interest;(b) entering into any contract, arrangement, transaction or dealing that changes or otherwise affects the legal or equitable ownership of the shares or interest;
(c) creating, varying or revoking a trust in relation to the shares or interest;
(d) creating, altering or extinguishing a right, power or liability attaching to, or otherwise relating to, the shares or interest;
(e) substantially altering any of the risks of loss, or opportunities for profit or gain, involved in holding or owning the shares or having the interest;
(f) the shares or interest beginning to be included, or ceasing to be included, in any of the insurance funds of a life assurance policy.
It is apparent from this definition that the general franking credit anti-avoidance provisions are likely to cover the types of activities that the holding period rule and related payments rule are attempting to prevent. It is unclear why our system needs two franking credit anti-avoidance measures.
The advantage of the holding period rule, from the Government's point of view, is that it is self-activating and does not require the ATO to actively seek out a taxpayer's intention for entering into an arrangement.
Additionally, the holding period rule does have an aspect of objectivity to it in the way it applies. The taxpayer has either held the share or interest for the requisite period or they have not. This aspect should not of itself pose too many difficulties in monitoring. However, it is the related security/connected person rules, tracing through trusts and the material diminution of risk tests that cause the compliance difficulties.
Section 177EA was sufficiently widely drafted to encompass the franking credit trading the holding period rule attempts to prevent. For this reason, it is submitted that the holding period rule and associated measures are unnecessary.
The purpose of this article is not to challenge the desire of the Government to tighten aspects of taxation law where it believes the revenue base is threatened. Indeed, that is the role of any responsible government. However, we have attempted to highlight some of the aspects of the proposed measures that will cause considerable problems and costs for taxpayers in attempting to comply with the rules. The superannuation and funds management industries will be particularly impacted due to the level of investment turnover they experience and the way their businesses operate.
New lines of communication will need to be opened up between taxpayers, their fund managers and their custodians. Trustees of investment trusts that are not widely held as defined will be required to inform the beneficiaries of details of acquisitions, disposals and derivative exposures. The situation is further complicated where there are several tiers of investment trusts.
A curious statement is made at para 4.157 of the Explanatory Memorandum to TLAB4:
It is not possible to provide any numerical data on the numbers of taxpayers in particular stakeholder groups or the extent of their interests. This is because shares are often held through complicated trust, nominee or group company arrangements, or funds are invested by fund managers on behalf of clients. Accordingly, underlying ownership is difficult to trace.
It is submitted that this is precisely the reason why many non-widely held trusts (and indeed, many other taxpayers) will have difficulties complying with the holding period rule.
In the absence of the holding period rule and related payments rule, the Commissioner is afforded substantial powers by s 177EA. It is submitted that this will adequately address any transaction that has a purpose of obtaining franking credits by trading, including situations where there is a material diminution of risk or a disposal of a substantially identical security.
A good tax system is fair, easy to understand, has low compliance costs and generates appropriate levels of revenue for the Government. For the holding period rule and associated measures, it appears that the last element has taken precedence, despite the fact that the Government has had some difficulty in calculating an exact estimate of revenue from the measures.
At present, Australia is experiencing wide-ranging changes to its taxation system. Most of the proposals currently being discussed are broadly based around two common concepts - simplification and fairness. As the foregoing hopefully demonstrates, the holding period rule and associated measures possess neither of these attributes - they are complex and difficult to apply and have the potential to operate unfairly.
Mark J Laurie is a partner in the Financial Services Group of the Melbourne office of PricewaterhouseCoopers. He has over 18 years of experience in the funds management and superannuation industries. In addition to previous roles as a partner with both Price Waterhouse and Coopers & Lybrand, Mark is a past Vice President of BT Australia. Mark's clients include fund managers, custodians and corporate and public sector superannuation funds.
Liam Collins is an adviser in the Financial Services Group of the Melbourne office of PricewaterhouseCoopers. He has advised some of the largest fund managers, custodians and superannuation funds in Australia on the application of the holding period rule and associated measures.
John Murton is a tax manager with the Foster's Brewing Group Limited. John's contribution to the article was made at a time when he was a director in the Financial Services Group of the Melbourne office of PricewaterhouseCoopers. John's clients included fund managers, custodians and superannuation funds.
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URL: http://www.austlii.edu.au/au/journals/JlATax/1999/12.html