07 Dec 2018
7 December 2018
The 45-day rule – where are you?
Having regard to last week’s preamble and many other commentaries, most everyone will know that franking credits from dividends can reduce or eliminate the tax that you have to pay on your investment earnings. Thus, if you receive franked dividends on Australian publicly listed shares, the 30% effectively pre-paid tax on the dividends can be used as an offset against any tax which is otherwise payable.
As explained last week, currently, if the franking credit exceeds the tax otherwise payable, a refund is available and that is what remains under challenge by Labor.
When the dividend imputation system was introduced way back in 1987, it quickly became obvious that the system could be played by investors buying shares on the last day that dividends would be attached to the shares (called the last “cum-dividend date”) and selling them the following day without the dividend attached (called selling “ex-dividend”). This would result in the investor receiving the dividend but most commonly with an equivalent loss in capital if as expected the share price dropped by an equivalent amount so as to reflect the lack of the dividend. Nonetheless the investor qualified for the franking credit in full with only an overnight risk in holding the stock. This presented a significant opportunity for investors to game the system by holding the shares for one day over the ex-dividend date.
To counter this, on 1 July 2000, a 45-day rule was implemented. Under this rule, the investor is required to hold the shares “at risk” for at least 45 calendar days, not including the day the stock was acquired or disposed of in order for the franking credit to be available.
The at-risk requirement involves an assessment of the taxpayer’s overall position in relation to the shares and effectively requires that the taxpayer would have to have a minimum 30% exposure. In other words – hedging by buying put options (ie the right to sell the shares at a pre-determined price for a set period into the future) to cover the share position could only cover 70% of the total exposure. Each day that the overall exposure is under 30% does not count towards the required 45 days.
Investors with a total of no more than $5,000 in franking credits in any given year are not subject to the 45-day rule. That exemption does not however apply to self-managed superannuation funds (SMSFs).
The 45-day rule, while superficially sounding quite straightforward, can raise some complicated issues in regard to timing and the hedging that is, or is not allowed.
Intriguingly, the 45-day rule itself was contained within Division 1A of the former Part IIIAA of the Income Tax Assessment Act 1936 which was itself repealed with effect from 1 July 2002.
How is it then that in 2018, taxpayers are bound by a 45-day rule which is contained in legislation that was repealed in 2002?
In part, the answer lies in a Tax Determination issued by the ATO – namely, TD 2007/11. In that determination, the ATO considers that the 45-day holding period rule described above, has been imported into the Income Tax Assessment Act 1997 via the so-called anti-manipulation rule contained in section 207-145(1)(a). To cut a long story short, that subsection appears to drag back all the repealed provisions (including the provision which defines a qualified person as someone effectively who has held the shares for the requisite 45-day period) such that the repealed provisions are resurrected effectively as current law.
The ATO believes that this does solve the problem and accordingly the 45-day rule still stands as part of the law. In fairness, the ATO does canvas alternative views to the effect that the qualified person test cannot apply in the current environment. Obviously, they reject such views and on balance, I suspect that the ATO is correct.
Nonetheless the situation can only be described as highly unsatisfactory and it remains a complete mystery why something so fundamental as the 45-day rule has not been properly rewritten into the 1997 Act. In that context, I have tracked down a media release dated 14 December 2013 in which the then Assistant Treasurer rejected a proposal to rewrite the relevant qualifying person provisions into the 1997 Act. Exactly why that was so unequivocally rejected remains somewhat of a mystery.
In my view, to expect people in 2018 to rely on laws that were effectively repealed in 2002 but saved by a reversal of the repeal by another legislative provision is quite frankly absurd. The law needs to be as clear as possible and as accessible as possible especially when dealing with something so fundamental.
The law should be changed so as to have the 45-day rule specifically stated in the 1997 Act. This area of the law is not peripheral to the circumstances of many taxpayers. It needs to be spelt out directly and clearly in the current legislation. Relying on the indirect and obtuse process that one is required to engage in through section 207-145 (as outlined above) is just not acceptable.
As always, we welcome your thoughts via the Vine Feedback inbox.
Bob Deutsch, CTA
Note regarding last week’s preamble (TaxVine 46, 30 November 2018)
In relation to last week’s preamble, it has been pointed out to me that leaving aside the trustee/fairness duties that I alluded to, the trustee of a superannuation fund must pass on the benefit of any franking credit to the relevant pension phase members. If it fails to do so, the franking rebates are denied in full.
It is said that this is the outcome of section 160APHJ(8) of ITAA 1936 and in particular sub-paragraph(c) which, if I understand the argument correctly, is to the effect that if the trustee of a fund fails to pass on the benefit of the franking credits to the rightful owners, by for example providing full value to them in some form, the benefit of the franking credit rebates are completely denied.
Having regard to today’s preamble, readers will quickly note that s 160APHJ has been repealed but resurrected by s 270-145 ITAA 1997.
In any event, the provision is highly obscure and needs to be read at least 3 times in conjunction with sub-section (5) of section 160APHJ and various other provisions of the now repealed imputation provisions in order to make any sense of it. Even then, I am not entirely convinced that it does achieve the outcome of denying the franking credits in the situation envisaged.
Nonetheless, it is important to identify and apply this provision, and it may be the one provision that really gets you to the bottom line that the pension side asset holders must be property compensated for any franking credits that are used effectively for the benefit of the accumulation-side members.
I leave the matter there for others to ponder and comment.