Dividend Access Shares: An Ongoing Dividend Stripping Risk

What is dividend stripping?

Dividend stripping is an anti-avoidance concept designed to prevent arrangements that allow shareholders to extract the economic value of a company’s accumulated profits in a tax-advantaged form, rather than receiving those profits as taxable dividends.

Traditionally, dividend stripping involves a company with substantial undistributed profits transferring shares to another entity, which subsequently receives a dividend representing those profits. The original shareholder receives consideration reflecting the value of the profits, while the arrangement seeks to avoid the tax that would otherwise arise from distributing those profits directly to the shareholder.

Section 177E of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) specifically addresses dividend stripping. It applies to schemes that are by way of, or in the nature of, dividend stripping, as well as schemes that have substantially the same effect. The provision is particularly relevant to corporate restructures and arrangements involving special classes of shares that provide access to accumulated profits.

The imputation consequences of dividend stripping are also addressed by sections 207-145 and 207-155 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).

Dividend stripping and the courts

The traditional characteristics of dividend stripping were identified in Patcorp Investments Ltd v Federal Commissioner of Taxation (1976) 140 CLR 247 and subsequently considered in Federal Commissioner of Taxation v Consolidated Press Holdings Ltd (2001) 207 CLR 235.

Broadly, a traditional dividend-stripping arrangement involves the following features:

• a company has substantial accumulated profits that could otherwise be distributed as dividends;
• shares in the company are sold or allotted to another person or entity;
• the company distributes its accumulated profits to the purchaser or new shareholder by way of a dividend;
• the recipient is able to receive the dividend without bearing the tax that would otherwise arise, including through the availability of favourable tax treatment or franking benefits;
• the original shareholder receives a capital sum or other economic benefit reflecting the value of the accumulated profits; and
• the arrangement has the effect of avoiding tax that would otherwise apply to the distribution of those profits.

The central concern is that the economic value of accumulated profits is extracted while the transaction is structured to produce a more favourable tax outcome than an ordinary dividend paid to the original shareholder.

These principles remain relevant when assessing modern corporate restructures. However, section 177E also captures schemes that have substantially the effect of dividend stripping, raising questions about how far the provision extends beyond traditional arrangements.

That issue is particularly relevant to dividend access shares and has featured in the more recent litigation in Merchant.

Dividend access shares and the ATO’s position

Dividend access shares are a particular area of concern for the Australian Taxation Office (ATO). In Taxation Determination TD 2014/1, the ATO considered an arrangement involving a private company with significant accumulated profits that issued a special class of shares to an entity associated with the original shareholder.

The special shares carried dividend entitlements but had limited rights beyond receiving dividends. The company subsequently paid a substantial fully franked dividend to the holder of those shares, with further transactions resulting in the original shareholder or their associates obtaining the economic benefit of the company’s profits in a tax-free or substantially tax-free form.

The ATO concluded that the particular arrangement described in the determination constituted a scheme by way of, or in the nature of, dividend stripping where the relevant tax-avoidance purpose existed.

Features that may raise concerns include the issue of shares for nominal consideration, limited voting or capital rights, discretionary dividend entitlements, and the payment of substantial dividends to an entity associated with the original shareholder.

However, the use of different share classes or dividend rights does not, of itself, constitute dividend stripping.

The application of section 177E depends on the facts and circumstances of the arrangement, including its commercial and economic substance.

Franking credit implications

In addition to the potential application of section 177E of the ITAA 1936, dividend-stripping arrangements may have consequences under the imputation provisions of the ITAA 1997.

Sections 207-145 and 207-155 address the treatment of franked distributions made as part of a dividend-stripping operation. Where these provisions apply, the recipient may be denied the benefit of the franking credits attached to the distribution.

Accordingly, advisers should consider not only whether a dividend access share arrangement may constitute dividend stripping under section 177E, but also whether the associated franking benefits may be denied.

The analysis does not necessarily end when the shares are issued

The application of section 177E is not necessarily confined to the income year in which dividend access shares are issued.

Section 177A of the ITAA 1936 defines a “scheme” broadly to include an arrangement, plan, proposal, action, course of action or course of conduct. Accordingly, the relevant scheme may encompass a series of transactions extending beyond the initial issue of the shares.

For example, a company may issue B Class shares in one income year but make no distribution at that time. In a later year, the company may distribute a substantial proportion of its accumulated profits to the B Class shareholder.

The circumstances surrounding that later distribution may differ materially from those existing when the shares were originally issued. The subsequent use of the shares, the extent of the profits distributed and the ultimate destination of the dividend proceeds may therefore be relevant to determining whether the broader arrangement is by way of, or in the nature of, dividend stripping, or has substantially that effect.

This does not mean that every subsequent dividend necessarily constitutes a separate scheme or that every dividend paid on a special class of shares attracts section 177E. Rather, the relevant scheme must be identified by reference to the particular facts, and the arrangement must be considered as a whole.

The original commercial purpose for issuing the shares remains relevant, but it is not necessarily determinative of the treatment of subsequent distributions.

An arrangement initially implemented as part of a commercial restructure may require further consideration if the shares are later used to direct substantial accumulated profits to an associated entity in circumstances that produce the economic result contemplated by a dividend-stripping arrangement.

The developing position: Merchant

The scope of section 177E, particularly the limb dealing with schemes that have substantially the effect of dividend stripping, is also being considered in Commissioner of Taxation v Merchant & Anor; Merchant & Anor v Commissioner of Taxation.

In the dividend-stripping aspect of the dispute, related companies forgave substantial debts immediately before the debtor company was sold. The Commissioner argued that the debt forgiveness reduced the accumulated profits of the creditor companies while increasing the value of the debtor company, thereby having substantially the effect of dividend stripping.

The Full Federal Court found in favour of the Commissioner on the section 177E issue concerning the debt-forgiveness arrangements. The subsequent High Court appeal raises an important question: must a scheme substantially avoid tax on a substantial portion of a company’s accumulated profits to have substantially the effect of dividend stripping, or can the provision apply more broadly?

The issue is significant because it concerns the extent to which section 177E can apply to arrangements that do not follow the traditional model of transferring shares and distributing accumulated profits to a purchaser.

Although Merchant does not concern dividend access shares directly, its consideration of the scope of section 177E is relevant to advisers assessing alternative methods of extracting or reallocating the economic value of company profits.

What does this mean for advisers?

For advisers implementing corporate restructures or dividend access share arrangements, the analysis should not be treated as a once-and-for-all exercise completed when the shares are issued.

Where dividend access shares remain on issue over multiple income years, advisers should revisit the arrangement as subsequent distributions are made, particularly where substantial accumulated profits are directed to an associated entity. The analysis should take into account the circumstances surrounding each distribution and the broader arrangement of which it forms part, rather than treating the issue of the shares as determinative of the tax outcome.

Kara Bentley
Associate