The non-portfolio dividend exemption reforms were foreshadowed in response to perceived abuses arising from the debt/equity tax rules not being applied to the pre-existing section 23AJ dividend exemption, which instead relied on voting power attaching to legal form shares. This disconnect allowed for returns on debt interests, such as redeemable preference shares issued by foreign subsidiaries to Australian companies continuing to be treated as non-assessable non-exempt 'dividends' and also the debt interest itself being controlled foreign entity debt for thin capitalisation purposes. The alignment of the non-portfolio dividend exemption to the debt/equity tax rules now prevents this perceived abuse, whilst conversely allowing for non-share equity interests to now qualify for the non-portfolio dividend exemption.
The reforms also include the repeal of section 404 for portfolio dividends received by a controlled foreign company, which has been debated for many years and will affect many structures where portfolio share investments are pooled in a single controlled foreign company.
The reforms however do address another imbalance in now allowing the non-portfolio dividend exemption to be available where foreign dividends flow through interposed trusts and partnerships. Whilst this is a welcomed change, further reform would be beneficial to ensure a similar alignment applies for dividends suffering prior attribution that flow through interposed trusts and partnerships, as well as amending the Capital gains tax (CGT) participation exemption to treat assets held via interposed trusts and partnerships as active foreign business assets.
As the Exposure Draft does not include transitional rules for the non-portfolio dividend exemption reforms and has an expected start date of 1 July 2014, taxpayers should review their existing arrangements to determine the treatment of future returns from foreign companies.