Determining an individual’s entitlement to franking credits might not be as straightforward as many believe. Adrian Hanrahan examines a recent Administrative Appeals Tribunal of Australia decision.
Determining the eligibility of a tax offset in relation to a franking credit can be a complex area, especially if you need to give consideration to the trust they flow through, whether the beneficiary is a qualified person or has an indefeasible and vested interest in the trust.
In this paper we will consider each of these requirements, and look at how they play out in the context of a recent decision by the Administrative Appeals Tribunal of Australia (AATA).
ELIGIBILITY OF FRANKING CREDITS
To be eligible for a tax offset in relation to a franking credit, the Income Tax Assessment Act (1936) requires the beneficiary of a dividend distribution to be a “qualified person”. A beneficiary who is not a qualified person is not entitled to a tax offset.
A taxpayer can be a qualified person by meeting any of the following three criteria:
1. Hold shares (or interests in shares) for a prescribed number of days (at risk) during a qualification period (see Note 1).
2. Hold interests in shares through a widely held trust for an approved number of days (see Note 2). This allows beneficiaries to apply the test at unitholder level of the trust, as opposed to tracing through to their interest in the shares.
3. Elect to have franking credit ceilings applied (see Note 3).
For the purpose of this paper, we will focus on the first qualification.
ANTI-AVOIDANCE RULES
Taxpayers are not eligible for the tax offset if the anti-avoidance rules are triggered.
The anti-avoidance rules include the holding period rule (HPR) and the related payments rule. These two rules also apply in relation to beneficiaries of trusts and partners of partnerships.
The holding period rule
The HPR is satisfied where a taxpayer holds at risk shares (or an interest in shares), in which a dividend is paid, for at least 45 days in the qualification period (see Note 4).
In the case of preference shares, a taxpayer is required to hold at risk the shares for a period of 90 days in the qualification period.
This rule does not apply if the taxpayer meets the small shareholder rule (see below).
The related payments rule
This rule applies to a taxpayer if he/she makes (or is likely to make) a related payment. A related payment is a payment that passes on the benefit of the franked dividend to another taxpayer (see Note 5).
If this rule applies, and the taxpayer does not hold the shares at risk for a period of 45 days (90 days for preference shares), the taxpayer is prevented from receiving a tax offset in relation to the franking credits.
This rule still applies even if the taxpayer meets the small shareholder rule.
The qualification period
The qualification period begins the day after the acquisition of the shares and ends on the 45th day after the day on which the shares go ex dividend.
In actual fact, the periods are 47 days and 92 days (because the days of acquisition and disposal are excluded from the calculation).
Small shareholder rule
Taxpayers who claim $5000 or less in franking credits a year are exempt from the HPR.
RISK REDUCTION
If a taxpayer has materially diminished his/her risk of loss, or opportunity for gain, in relation to his/her holding of shares, that period will not be counted towards the period for which the taxpayer has held the shares at risk.
A holding of shares subject to a risk reduction strategy (that is, hedging, holding options, et cetera) may affect a taxpayer’s ability to qualify for franking credits.
Taxpayers are considered to have exposure to the risks of loss, or opportunity for gain, where the “net position” (measured by delta) is 0.3 or greater (see Note 6).
The net position is calculated by adding the deltas of the taxpayer’s long and short position in relation to the shares.
What is considered a position?
A “position” is an arrangement that has a delta in relation to a share. Examples include:
• a short sale of shares;
• an option to buy or sell shares;
• a non-recourse loan to buy shares; and
• an indemnity or guarantee in respect
of shares.
For the purposes of the Income Tax provisions:
• A long position has a positive delta
of 1.
• A short position has a negative delta.
Calculating the net position
To determine a taxpayer’s net position, the delta of the short position is deducted from the delta of the long position.
What does positive or negative delta mean?
Positive delta means that the position will rise in value if the underlying security rises, and drop in value if the underlying security falls.
Negative delta means that the position will theoretically rise in value if the stock price falls, and theoretically drop in value if the stock price rises.
Looking at the signs alone does not tell the full story. Using the example of options, if a taxpayer is long a call or a put (that is, purchased to open a position), then the put will be (-) delta and the call (+) delta. The signs are reversed for short put and short call.
