On 13 Feb 2018, the ATO issued its first Tax Alert for the 2018 year: TA 2018/1. It says that the ATO are reviewing arrangements that are intended to provide imputation benefits to Australian taxpayers who are not the true economic owners of the shares.
Arrangements the Alert does apply to
The ATO give an example (set out in full below) of the type of arrangement they are looking at.
- It involves an Australian taxpayer (investor) with a long position in Australian shares (ie. shares it actually owns).
- that investor lends those shares to another party, in return for cash collateral equal to the market value of the parcel. Under the securities lending rule, the lender can keep the dividend and franking credits.
- the investor then multiplies the franking credits it receives by buying the parcel it lent, with the cash collateral.
- you will see, from the example, taken from the Alert, that it becomes very complicated to pass all tax rules (including, particularly the 45 day holding rule) and involves the use of derivatives.
- It essentially creates a circular flow of shares, with multiple franking credits, even though there is little or no economic exposure to the second parcel of shares.
The taxpayer/investor may be an Australian individual, superannuation fund, MIT or other trust.
That is, taxpayers are relying on an existing long shareholding to claim additional franking credits on a second parcel of shares at zero or nominal risk, such that the franking credits are, generally, the only return, of significance, that the taxpayer receives on that second parcel.
Transactions to which this Alert does not apply
This Alert does not apply to isolated securities lending transactions, or derivative contracts, that a taxpayer may enter into in connection with an existing parcel of shares.
It is only intended to apply where the purported combined effect of entering into one or more, such transactions, is the entitlement of the taxpayer, to the benefit of franking credits, where they have no, or only nominal, exposure to an additional parcel of shares, as outlined in this Alert.
The Alert states that the benefits of imputation should only be available to the true economic owners of shares and only to the extent that the owners can use the franking credits themselves. The ATO is concerned that the arrangements described in TA 2018/1 may involve taxpayers inappropriately receiving the benefits of imputation in breach of rules designed to maintain the integrity of the imputation system, such as s 207-145 of the ITAA 1997 (no gross-up or tax off-set for manipulated distributions) and s 177EA of the ITAA 1936 (dividend stripping for franking credit benefit).
The ATO said it is currently reviewing these arrangements, but will continue to undertake compliance activity and engage with affected taxpayers whilst developing its technical position.
Study questions (answers available)
- Is the thrust of TA 2018/1, that the ATO is reviewing arrangements that are intended to provide imputation benefits to Australian taxpayers who are not the true economic owners of the shares?
- Is an example of this type of arrangement, lending shares and then buying them from the borrower, to create a second parcel of shares, on which to claim the franking credits (whilst not being economically exposed to the second parcel)?
- Are there anti-avoidance provisions that could tackle this?
- Are they s207-145 of the ITAA36 and s177EA of the ITAA97?
Example 1 from Tax Alert (warning – it’s complicated…)
Figure 1: Inception
Investor A holds a parcel of 100 XYZ shares (Parcel 1) that will pay a fully franked dividend. The expected dividend is $2.
Prior to XYZ’s ex-dividend date, the following steps occur:
- Step 1(a) and (b): Investor A lends Parcel 1 to Supplier B under a standard securities lending transaction ( Stock Loan 1 ) in return for cash collateral of $100. The term of the transaction expires on XYZ’s ex-dividend date with the 100 XYZ shares returned to Investor A on a cum-dividend basis. The securities lending transaction is intended to comply with section 26BC of the ITAA 1936.
- Step 2(a) and (b): Investor A uses the $100 cash collateral to purchase 100 XYZ shares from Supplier B (directly or indirectly).
- This acquisition will be deemed a new acquisition of 100 XYZ shares (Parcel 2) for tax purposes. To settle the sale, Supplier B sells the 100 XYZ shares it borrowed under the securities lending transaction. The buy and sell transactions settle on the same day.
- The buy and sell transactions are matched and reported to the ASX as a special crossing rather than being conducted on the open ASX market.
- Step 3: Investor A enters into an option collar (or a similar derivative product) where they will have the right or obligation to sell Parcel 2 on an ex-dividend basis back to Supplier B on a predetermined date. This collar will settle after XYZ’s record date. The strike price for the collar is set such that Investor A has little or no risk of loss and opportunities for gain in respect of Parcel 2 (that is, movements in the market value of the XYZ shares). Parcel 2 is expected to be delivered to Supplier B through the exercise of the collar mechanism upon settlement.
- The value of the dividend that XYZ is expected to pay is factored into the strike price of the option collar.
Just prior to the ex-dividend date, Investor A:
- physically holds one parcel of 100 XYZ shares (Parcel 2). Under the holding period rule, the day after the date of acquisition will count as day 1 for Parcel 2
- is considered not to have disposed of Parcel 1 for imputation purposes by virtue of the securities lending transaction and the operation of subsection 160APHH(8) in Division 1A of former Part IIIAA of the ITAA 1936
- as a result of these steps, has funded the acquisition of Parcel 2 by lending out Parcel 1 for cash collateral, and effectively increased their shareholding in XYZ shares for taxation purposes (Parcels 1 and 2). The pricing of the collar leaves Investor A with no or only nominal economic exposure to Parcel 2 on a stand-alone basis.
Figure 2: Ex-dividend date
On the ex-dividend date, the following steps occur simultaneously:
- Step 4(a) and (b): Investor A lends 100 ABC shares to Supplier B in return for cash collateral of $100 under a standard securities lending transaction (Stock Loan 2). This funds Investor A’s obligation to return the $100 cash collateral to Supplier B upon the expiry of Stock Loan 1.
- Step 5(a) and (b): Supplier B borrows 100 XYZ shares (cum-dividend) from a third party under a standard securities lending transaction (Stock Loan 3) in return for non-cash collateral in the form of the 100 ABC shares Supplier B borrowed under Stock Loan 2. Supplier B is required to make a dividend equivalence payment on the 100 XYZ shares to the third party.
- Step 6(a) and (b): Supplier B uses the 100 XYZ shares borrowed under Stock Loan 3 to return 100 XYZ shares to Investor A.
- Step 7: The collar entered into between Investor A and Supplier B is exercised on this date, but does not settle until after the record date.
At the end of this day, Investor A:
- physically holds and is shareholder of record for two parcels of 100 XYZ shares (200 XYZ shares in total) that carry dividend entitlements
- has held Parcel 2 for the requisite 45 day period and is deemed to have continuously held Parcel 1, the stock returned from Stock Loan 1, for at least the same period if not longer, and
- receives franked dividends in respect of two parcels of shares.
Figure 3: After record date
Just after the record date of the XYZ shares:
- Step 8(a) and (b): The collar settles on an ex-dividend basis and Investor A delivers Parcel 2 XYZ shares to Supplier B in return for a cash payment that will generally be calculated on the basis of the original cum-dividend purchase price adjusted for the amount of the expected dividend. In this simplified example, the collar strike price is $98.
- Step 9(a) and (b): Upon the expiry of Stock Loan 3, Supplier B returns to the third party the 100 XYZ shares (Parcel 2) it received upon settlement of the collar. The third party returns the 100 ABC shares.
- Step 10(a) and (b): Upon the expiry of Stock Loan 2, Investor A uses the proceeds from the collar and the receipt of the Parcel 2 dividend to repay the cash collateral and Supplier B returns the 100 ABC shares.
At the end of the transaction:
- Investor A physically holds a parcel of 100 XYZ shares.
- Investor A has derived an additional franked dividend in respect of the Parcel 2 shares, but has made an approximately identical loss on its ownership of the Parcel 2 shares, leaving its net return (before fees) being the additional imputation benefit received.
- Supplier B has made a matching gain on its borrowing and sale of the XYZ shares, allowing it to meet its obligation to make a dividend equivalence payment to the third party counterparty to Stock Loan 3.