Loss of Franking Credits
377As I have stated, part of the settlement with the Commissioner involved the deduction from Holdings' franking account in the amount of $5,014,286.00 (see [155]).
378The nature of franking debits and the franking account maintained by a company was explained by Gageler J in Mills v Federal Commissioner of Taxation [2012] HCA 51; 87 ALJR 53 at [12] to [13] as follows:
"The imputation system in Pt 3-6 of the ITAA 1997 partially integrates the income tax liabilities of Australian corporate tax entities and their Australian members. The main object of the Part is expressed to be 'to allow certain *corporate tax entities to pass to their *members the benefit of having paid income tax on the profits underlying certain *distributions'. Other objects of the Part are expressed to be to ensure that the imputation system it establishes is not used 'to give the benefit of income tax paid by a *corporate tax entity to *members who do not have a sufficient economic interest in the entity' or 'to prefer some members over others when passing on the benefits of having paid income tax' as well as to ensure that 'the *membership of a corporate tax entity is not manipulated to create either of [those] outcomes'. An asterisk is used in the 1997 Act to indicate that the relevant term is defined elsewhere.
By operation of Pt 3-6 of the ITAA 1997, every corporate tax entity has a 'franking account', which is 'used to keep track of income tax paid by the entity, so that the entity can pass to its members the benefit of having paid that tax when a distribution is made'. A corporate tax entity, if not a mutual insurance company and if not acting in a capacity of trustee, is a 'franking entity'. The franking account of a franking entity that satisfies an Australian residency requirement for an income year typically receives a 'franking credit' when the entity pays income tax or receives a franked distribution in respect of the year, and typically receives a 'franking debit' when the entity receives a refund of tax or franks a 'frankable distribution'. Distributions and non-share dividends are frankable distributions unless they fall within one of a number of specified categories of 'unfrankable distributions', the object of which is 'to ensure that only distributions equivalent to realised taxed profits can be franked'. Part 3-6 of the ITAA 1997 applies to a non-share equity interest in the same way as it applies to a membership interest, and it applies to an equity holder in an entity who is not a member of the entity in the same way as it applies to a member of the entity. A franking entity franks a distribution by allocating a franking credit to it in which case the amount of the franking credit is to appear on a statement that accompanies the distribution. As a general rule, an amount equal to the franking credit on the distribution is included in the member's or the equity holder's assessable income and the member or equity holder is entitled to a tax offset equal to the same amount. In some cases, the member or equity holder needs to satisfy an Australian residency requirement for the general rule to apply." (references omitted)
379By way of elaboration of the operation of an entity's franking account, s 200.15 of ITAA1997 describes the account in the following terms:
"The franking account
(1) A franking account is used to keep track of income tax paid by the entity, so that the entity can pass to its members the benefit of having paid that tax when a distribution is made.
(2) Each corporate tax entity has a franking account.
(3) Typically, a corporate tax entity receives a credit in the account if the entity pays income tax or receives a franked distribution. A credit in the franking account is called a franking credit.
(4) Typically, a corporate tax entity receives a debit in the account if the entity receives a refund of tax or franks a distribution to its members. A debit in the franking account is called a franking debit." (emphasis added)
380Thus the purpose of the franking account is to enable the entity to pass to its members the benefit of the tax already paid by the entity. Further, each franking credit forms part of a pool of credits in the franking account which is credited and debited during the life of the corporate tax entity. It is from that pool that such credits are distributed to shareholders. It is only in the simplest of examples that it might it be possible to identify some franking credits distributed in one period as referable to a particular amount of profit earned in another. In the judgment of the Full Court of the Federal Court in Mills v Federal Commissioner of Taxation [2011] FCAFC 158; 198 FCR 89 at [28] Edmonds J noted that: "[i]n none of the provisions of Div 205 is there a tracing of franking credits to any particular fund of profits or any particular source of profits". Although his Honour was in dissent in the Full Court of the Federal Court nothing in the majority's judgment was at variance with that statement and, in any event, the result in the Full Court in Mills was overturned by the High Court's judgment noted above.
381Consistent with these provisions, Holdings maintained a ledger recording the various entries in its franking account. However a franking account is not an accounting concept but is instead a creature of statute. Absent any internal ledger maintained by Holdings, it would still exist by operation of the ITAA 1997 and its balance at any time would be ascertainable by applying the legislation to the events as they unfolded. That said, the ledger maintained by Holdings records that Holdings first accrued a franking credit in March 2005 arising from the processing of its FY05 tax return.
382From 1 July 2005 Holdings lodged PAYG forms on a quarterly basis. Thereafter franking credits accrued on quarterly basis if Holdings' PAYG return reported profit. The account was debited when franked dividends were distributed and when a full year's tax return was lodged and reconciled with the quarterly PAYG returns. At least in the period up to June 2010 fully franked dividends were recorded as having been declared on 28 June 2007, 6 July 2007, 19 December 2008, 22 January 2009, 29 October 2009 and 30 April 2010. The ledger records franking account balances on 30 June 2005, 30 June 2006, 30 June 2007, 30 June 2008, 30 June 2009 and 30 June 2010 of $9,887.00, $5,940,175.00, $15,316,251.00, $20,663,251.00, $19,357,091.00 and $13,975,038.00 respectively. The ledger records the deduction of $5,014,286.00 being made on 30 June 2010. This is inconsistent with the Deed and the deduction should be taken to have occurred as at the date the Deed was entered into.
383Mr Symond contends that the deduction of $5,014,286.00 from Holdings' franking account as a result of the settlement with the Commissioner caused compensable damage to him which should be valued at its full "face value" in the manner calculated by Mr Potter (see below). Three issues arise in respect of that contention.
384First, Mr Donaldson SC submitted that a comparison of Mr Symond's position in the events that happened with his position under Scenario 2, confirms that he has not suffered any loss as a result of the deduction of $5 million from Holdings' franking account. I have already described how, under Scenario 2, Holdings' franking credits would have been exhausted at the end of FY05 and FY06 as a result of Holdings distributing all the profit received from the AHLUT. In the events that transpired dividends were not declared in any of those years. In those circumstances it can be expected that the balance of Holdings' franking account in the events that transpired would exceed the balance of the franking account in Scenario 2 as at 30 June 2007. Hence, Mr Donaldson SC submitted that, even if the deduction of an amount from the company's franking account otherwise resulted in compensable loss to Mr Symond, he has not suffered any loss when comparing the franking account balance under Scenario 2 with that in the events that occurred.
385In a sense I have already addressed an aspect of this submission in my analysis of the "Benefit of the Restructure". I concluded that the depletion of franking credits for FY05 and FY06 had the result that part of the benefit Mr Symond derived from not receiving dividends under the Restructure in FY05 and FY06 was permanent rather than temporary (see [364] to [370]). I found that benefit should be calculated on the basis that the total net distributions out of Holdings for the period 30 June 2004 to 30 June 2011 under Scenario 2 was the same as in the events that occurred (at [366]). I identified the manner in which that distribution is to be assumed to have occurred (at [374] to [375]).
386When the comparison is undertaken in that manner, the submission of Mr Donaldson SC falls way. The deduction from the franking account of $5,014,286.00 represents a further adverse aspect of the "real world" when compared with Scenario 2. It might be that under Scenario 2 Holdings' franking account balance as at 30 June 2007 or early 2008 would have been less than in the events that took place. However, leaving aside the deduction of $5,014,286.00, by 30 June 2011 Holdings' franking account balance under Scenario 2 would have been restored to at least its level in the "real world", as less dividends were distributed in the period FY07 to FY11 under Scenario 2. In fact the franking account balance of Holdings under Scenario 2 would probably be greater by that time than in the events that transpired because by then the same level of net dividends would have been distributed but they would not all have been fully franked as they were in the events that transpired.
387The second issue is whether a deduction from Holdings' franking account effected a loss to Mr Symond and, if so, how should that value be assessed? It should be noted that the deduction was imposed prior to the sale of his one third interest to the CBA.
388Mr Donaldson SC submitted that Mr Symond had not suffered any loss because the evidence suggested that it was unlikely that Holdings would ever pay an unfranked dividend. This submission reflected Ms Jones' evidence. In her report Ms Jones stated that "no loss has been suffered whilst there are sufficient franking credits to distribute full franked dividends". She noted that Holdings' franking account would have only gone into debit as at 30 June 2008 if it had fully distributed all profits as at 30 June 2008, a circumstance she regarded as unlikely given the cash needs of the business and the then forthcoming sale to the CBA. She stated that she had no basis for verifying what she said was Mr Potter's assumption that the debit to Holdings' franking debit materially impacted CBA's purchase of 33% of Holdings.
389In cross examination Ms Jones conceded that the deduction of the franking credits meant that there was a loss to the shareholder of some value:
"PAYNE: As a valuer, if a resident taxpayer and [sic] came to you and said as a valuer, Ms Jones, all things being equal this company in the actual world having $5 million less in its franking account than in the hypothetical world, you would tell them: Buy the hypothetical company, wouldn't you?
WITNESS JONES: Yes.
PAYNE: It's worth more?
WITNESS JONES: That's correct, yes."
390In his reports Mr Potter sought to value the loss to Mr Symond occasioned by the deductions to the franking account. In his first report Mr Potter addressed the impact of the deductions to Holdings' franking account as a result of the settlement with the Commissioner under each of Scenarios 1 and 2. I am only concerned with the latter. He concluded that the loss of franking credits was a matter that was capable of affecting the free cash flow to shareholders and thus represented a loss of value. He also concluded that 33% of that lost value was crystallised by the sale by Mr Symond on 31 October 2008. He considered that the balance of the loss would crystallise at some future time, being the distribution of dividends to which franking credits did not attach or the sale of the remaining stake of his shareholding in Holdings.
391Mr Potter calculated the value to a shareholder of the lost franking credits as the difference in their tax position on the basis that they were a resident taxpayer paying tax at the highest marginal rate who received a dividend that was fully franked as compared with the same dividend that was wholly unfranked. In the case of the former, the shareholder would pay 46.5% of the grossed up dividend (ie the net dividend and the franking credit). In the case of the latter the shareholder would pay 46.5% of the net dividend. In the case of a franking credit of $5,014,286.00 he calculated the difference to the taxpayer as $2,582,357.00. At this stage I note that this amount assumes that all of the lost franking credits were or would have been distributed. Mr Potter regarded the uncertainty about the time frame over which that distribution would have occurred as being reflected in the absence of any allowance by him for pre-judgment interest.
392Mr Potter was cross examined on this topic as follows:
"DONALDSON: You suggest in your reports that value attaches to franking credits or that a shareholder or a potential shareholder in a company would regard the availability of franking credits as valuable because of the capacity for those franking credits to facilitate the payment of a tax effective income stream.
WITNESS POTTER: That's right the value of a business or asset is the extent to which it generates after tax income for a shareholder.
DONALDSON: Any assessment of a potential purchaser of this company as to the value of the franking credits that were eliminated under the settlement with the ATO would depend upon that person's assessment of the likelihood that the reduction of the franking account would materially impact on the company's capacity to produce that tax effective income stream?
WITNESS POTTER: I think that would be correct as a proposition.
DONALDSON: The factors that such a person would have in mind in making that assessment would be the company's history in terms of the earning of profits and payment of tax?
WITNESS POTTER: History is often used as a guide, yes.
DONALDSON: And more particularly the extent to which franking credits have accumulated because the dividend policy of the company has resulted in dividends not absorbing the whole available franking credits?
WITNESS POTTER: Yes, there are other factors I think that would be looked at.
DONALDSON: Certainly in the case of this company it is evident, isn't it, that it has accumulated substantial franking credits between 2007 and 2012?
WITNESS POTTER: It depends on the time horizon you would look at. If we're talking about a purchaser in 2008, I think they would have regard to an earlier history along the time frame of performance that the company had. If you are looking at a purchase today, I think you said 2007, you might limit, five years might be a bit short for such a large acquisition - sorry five years might be a bit short. You would look at history and the reason why I make that point is there is a history of losses going back in time for this company.
DONALDSON: There has been a history of consistent profits since 2007?
WITNESS POTTER: Sorry, looking at it today?
DONALDSON: Yes.
WITNESS POTTER: Today, yes.
DONALDSON: And there's been a history of not distributing whole of that profit by way of dividend?
WITNESS POTTER: That's correct.
DONALDSON: And there's been a history accordingly of accumulating franking credits?
WITNESS POTTER: That's correct.
DONALDSON: And I'd suggest to you that any hypothetical purchaser looking today at this company would conclude that the likelihood of the company paying a dividend that it couldn't frank due to the state of its franking account was remote?
WITNESS POTTER: Someone looking at it today might take that view but as I said earlier there are other ways to use franking credits shared by banks and things and [the] CBA exhibited a practice of doing that so one would argue franking credits are of value to [the] CBA." (emphasis added)
393This questioning moved from identifying the impact of a reduction of franking credits on the "likelihood" that the reduction of the franking account "would materially impact on the company's capacity to produce" a "tax effective income stream" to considering the "likelihood of the company paying a dividend that it couldn't frank". The latter is only one circumstance in which a deduction from the franking account balance could affect the former. It is a circumstance that could arise if Holdings returned to the level of results that prevailed in the period from the late 1990s to the early 2000s. Another circumstance that could affect the tax effective income stream is where the reduction in franking credits operates as a disincentive to declare dividends at a particular level, even though profits were being earned.
394Further, at the end of this passage Mr Potter adverted to the possibility of using franking credits to effect share buy backs, and pointed to the CBA as having used its franking credits in that way. It was suggested by Gadens that the ability of the CBA to utilise Holdings' franking credits for use in its own share buy backs could only occur if it owned 100% of Holdings (and thus presumably some form of consolidation could occur). Assuming the correctness of that proposition, it still means shares in Holdings represent a less attractive proposition to a potential purchaser of the entire company than they would if the same company had an additional $5,014,286.00 in franking credits.
395I regard the evidence of both Ms Jones and Mr Potter as confirming that the deduction of franking credits as at 30 June 2006 represented a loss of something of value attaching to the shares owned by Mr Symond. As conceded by Ms Jones, an investor who is a resident taxpayer would regard the shares in a company with a higher franking account as more valuable than an otherwise identical company with a lower franking account balance. The above discussion illustrates various reasons (or contingencies) that support that assessment. The higher franking account balance means that the shares are at least more attractive to a potential corporate purchaser who may want to acquire the whole company and distribute them. The higher franking account may make the company more inclined to distribute a higher level of dividends than would otherwise be the case. The higher franking account means that the company has more scope to distribute franked or partly franked dividends from existing profits even if losses are subsequently incurred. The circumstance that the company subsequently earns substantial tax profits and does not distribute all of its profits as dividends thereby acquiring a large franking account balance does not render the franking credits worthless.
396The remaining question is what value, if any, can be attributed to the deduction from Holdings' franking account as a result of the settlement with the Commissioner?
397Consistent with the approach noted above, Gadens pointed to the high level of profitability of Holdings in the period after the Deed which generated a significant level of franking credits, not all of which were used. Gadens submitted that the "overwhelming likelihood, on the basis of the available evidence, is that the company will never pay a dividend that it is unable to frank".
398I have referred above to the pooled nature of franking credits. Gadens' submission was to the effect that until the pool is drained or close to draining no loss is occasioned to the shareholder. Its approach in effect separates the credits lost by reason of the settlement with the Commissioner from the remaining credits earned by Holdings, and treats them as the last credits to be distributed. It means that their deduction does not represent any loss to the shareholder until the pool is about to drain but when it does that represents the full extent of the value in the hands of the shareholder. However, why should this be so? Why not treat the franking credits as being distributed on a first in first out or proportionate basis? Why discount the possibility that the dividend distribution would have been higher had more credits been available? Further, why assume that there is no possibility that Holdings will commence to incur losses but seek to distribute dividends? Are not all these potentialities as well as others reflected in the concession made by Ms Jones that, all other things being equal, shares in a company with $5,014,286.00 more in franking credits are more valuable than shares in another company without?
399I regard Gadens' approach as flawed for two reasons. First it is inconsistent with the pooled nature of franking credits. As I have stated, it attempts to compartmentalise the credits that would be available had they not been deducted by the Commissioner. Second, it seeks to apply a "but for" approach to determining the value that was lost by reason of the deduction to the franking account. In effect Gadens contends that the proper approach is to ask whether, but for that deduction, would or will Mr Symond receive some dividend that will instead only be partially franked or wholly unfranked? However, in Sellars v Adelaide Petroleum NL [1994] HCA 4; 179 CLR 332 at 355 the High Court stated:
"However, in a case such as the present, the applicant shows some loss or damage was sustained by demonstrating that the contravening conduct caused the loss of a commercial opportunity which had some value (not being a negligible value), the value being ascertained by reference to the degree of probabilities or possibilities." (emphasis in original)
400I have already concluded that the loss of franking credits was something of value to a shareholder of Holdings. It follows that its assessment is to be undertaken by reference to the "degree of probabilities or possibilities". I have already referred to a variety of possibilities relevant to the assessment of the loss flowing from the deduction to the franking account.
401This brings me back to Mr Potter's description of the method for valuing franking credits. I have already described the contents of Mr Potter's first report dealing with this topic. In his second report Mr Potter responded to Ms Jones' report including the comments that I have noted above. He maintained that, had the franking account not been debited, Mr Symond would have attributed a greater value to the future cash flows of the business that he sold to the CBA in October 2008. Mr Potter referred to parts of the CBA's annual reports which indicate that it proposes to fully frank the dividends it declares. He also noted that companies have used franking credits to partially fund share buy backs and that the CBA had conducted three such buy backs between 1998 and 2004 utilising franking credits of approximately $1.2 billion. He also noted that the CBA derived profits from some sources that did not generate franking credits (eg offshore earnings) and thus, to distribute fully franked dividends utilising these profits, more franking credits were required. He concluded that the CBA had a significant appetite for franking credits and that it would attribute value to the franking credits in Holdings' franking account.
402In addressing the benefit of the Restructure I found that, in the absence of evidence concerning the sale to the CBA, it could not be assumed that retained profits were treated by it in any particular manner when determining the purchase price ([370]). Similarly, while I am prepared to infer that the CBA probably attributed some value to the franking credits, I am not prepared to infer that they attributed any particular value, much less full face value (as calculated by Mr Potter (see [391])), to Holdings' franking credits.
403In his second report, Mr Potter drew support for his contention that franking credits were a source of value to investors from what he stated were "leading valuation academics and practitioners". He referred to and annexed a joint article from Professor Bob Officer and Mr Neville Hathaway entitled "The Value of Imputation Tax Credits", and a chapter from the text "The Valuation of Businesses, Shares and Other Equity" by Mr Wayne Lonergan entitled "Imputation". He cited those authors as support for the proposition that franking credits have value. He also cited Professor Officer's and Mr Hathaway's article as support for the proposition that "franking credits are worth an amount that is equal to their face value". Having regard to their opinions, he adhered to the proposition stated in his first report that the lost value of the debited franking credits was $2,582,357.00, being their full face value with no allowance for pre-judgment interest to accommodate the uncertainty as to the timing of the loss flowing from the deduction to the franking account.
404Professor Officer's and Mr Hathaway's article identified three stages in the "life" of imputation credits. The first was their creation when company tax is paid. The second was their distribution when franked dividends are "paid" to shareholders. The third was their redemption when shareholders lodge their personal tax returns. They also noted that the personal taxation rate of the recipient shareholder was irrelevant to the value that should be attributed to imputation credits. The authors were able to determine on the basis of ATO data that, for the entirety of the Australian corporate sector for the period 1987/88 to 1999/2002, there was a distribution ratio of 71% for franking credits; ie for every $1 in franking credit that was generated 71c thereof was distributed to shareholders. They estimated that 40% of the distributed credits was ultimately redeemed by taxpayers. In addition the authors measured the value of imputation tax credits for listed companies by measuring dividend "drop offs", being the change in "value of a share price when stocks go ex-dividend". They observed that fully franked stock drop off more ex-dividend than unfranked stock. They determined that the stock market was valuing franking credits in respect of listed stock at "about 51% of [their] face value".
405Mr Lonergan was sceptical of the accuracy of this and other "drop off" analyses. He also explained the apparent discounting of the face value of the franking credit by the stock market as follows:
"The marginal investor on the Australian sharemarket represents a mixture of Australian resident, tax exempt, and offshore investors. Accordingly, the gamma of the Australian investors will lie between zero and one. Various studies [including the study of Officer and Hathaway] have shown that the market value of imputation credits lies between 50 per cent and 82 per cent of their face value ..."
406Professor Officer's and Mr Hathaway's paper seeks to use the drop off value analysis to determine the impact of distributed franking credits on the market value of listed shares. In effect this approach addressed the second and third stages of the life of an imputation credit that they identified. Mr Lonergan identified the reasons why the share market does not attribute to distributed franking credits their full face value, namely the differing tax status of investors on the Australian share market. In the case of Holdings, the tax status of Mr Symond (and the CBA) is known, in that they are both Australian residents. Both would have no reason to attribute anything but face value to distributed credits. Thus, to this extent, I accept Mr Potter's evidence as to the value of distributed franking credits.
407However, this leaves the transition between the first and second stage of the life of an imputation credit noted by Professor Officer and Mr Hathaway, namely the distribution rate of earned franking credits. Professor Officer and Mr Hathaway considered the value of distributed franking credits, not the value to shareholders of earned franking credits. Their analysis demonstrates that the latter do not inevitably translate into the former, as Mr Potter appears to assume they do. It would follow from their analysis that, absent any evidence about a particular company, a shareholder or potential shareholder might at least start by treating each $1 in earned franking credits as representing 71c in distributed franking credits.
408Ms Jones' approach is to only treat the loss of franking credits as causing loss to the shareholders when the pool of franking credits is about to run dry, which she states has no likelihood of happening in the case of Holdings. By attributing to the shareholder the full value of the loss of the credits Mr Potter also assumes or asserts that they must run dry at some point. In my view the proper approach is to treat the diminution in the entire volume of the pool as what effected a loss to the shareholder and attempt to place a value on each credit in the pool.
409Over time a company will distribute franking credits that it earns at a particular rate, or at least an average will emerge. If a company whose shareholders are all resident taxpayers has a practice of distributing all profits as dividends then, as $1 in franking credits is earned at one point, it will translate to $1 in franking credits distributed to the shareholders at a later point. A loss of $1 to the franking account balance will translate to $1 less in franking credits being distributed to the shareholder. According to Mr Potter this would represent a loss of 51.5c in tax to a shareholder such as Mr Symond. If the company never distributes dividends, then a deduction in the franking account will occasion no loss to the value of the shares save for their reduced attractiveness to a potential suitor for 100% of the shares in the company.
410If, on average over time, a company distributes half of its earned franking credits then, if $1 in franking credits is earned, it will translate to 50c in franking credits being distributed to the shareholders. A loss of $1 to the franking account balance will translate to a 50c reduction in the face value of the franking credits distributed to the shareholder (and an extra tax payment of 25.75c by a resident taxpayer paying the highest marginal rate). If the period of time is sufficiently long, then the determination of such an average rate may provide a reasonably good guide to an investor as to the appropriate value to attribute to the franking account balance: "[p]ast events are not a certain guide to the future, but in many areas of life proof that events have occurred often provides a reliable basis for determining the probability - high or low - of their recurrence" (Minister for Immigration & Ethnic Affairs v Guo [1997] HCA 22; 191 CLR 559 at 574).
411Such an approach would reflect the past incidence of a number of the possibilities that I have adverted to above. The circumstance that in a particular year or years the company made losses but still distributed profits is a matter that would tend to increase the rate at which earned franking credits were distributed. Similarly the use of franking credits as part of share buy backs would also tend to increase the distribution rate. Conversely, the circumstance that in a particular year or years a company made substantial profits but only distributed a small portion of them is a matter that would tend to decrease the rate at which earned franking credits were distributed.
412In the events that occurred, during the period 30 March 2005 to 30 June 2011 Holdings distributed $29,132,772.00 in franking credits. A calculation of the credits that it earned in the same period is not straightforward on the material available to me. I have adopted the approach of calculating 30% of the tax profit for the years up to 30 June 2010 and three quarters of the following year. This seeks to reflect the fact that Holdings was lodging quarterly PAYG returns and earning credits quarterly. It means that as at 30 June 2011 franking credits for the last quarter's profit for that year would not be available to distribute. This yields a figure of $80,716,845.00 in earned credits (30% of $269,056,153.00) and $75,702,559.00 after the deduction of $5,014,286.00. The distribution rate was 38.5% ($29,137,772.00 / $75,703,559.00).
413This analysis yields a figure for the distribution rate that in my view is too low for a number of reasons. First, it excludes the period prior to 2005 when losses were incurred. This is especially relevant if the matter is being considered from the perspective of the time of the settlement with the Commissioner when those losses would have been quite recent. Second, the last year that was partially included (2011) was very profitable for Holdings, yet the level of dividend distribution was the same as the previous year. Third, it takes no account of the possibility of CBA moving to 100% ownership and consolidating the franking credits. Bearing those matters in mind I consider that a distribution rate of 50% should be adopted.
414If this rate is applied to the value to Mr Symond of the deduction to the franking account as calculated by Mr Potter, it yields a figure of $1,291,178.50. Thus, I assess the value of the imposition of a $5,014,285.00 deduction to the franking account on his shareholding as $1,291,178.50. While this reasoning would ordinarily result in interest on that amount being allowed from the date of the Deed, I will defer that date to 1 January 2011 to accommodate the point addressed at [386]. That date approximates the time at which the balance of the franking account under Scenario 2 would have equated to the accounting balance in the events that transpired if no deduction had been made from the latter.
415The third issue arises from Mr Donaldson SC's submission that, assuming some value could be attributed to franking credits, a deduction to the franking account is only "an injury to the company affecting its value and is a reflective loss to shareholders that cannot be recovered in an action by a shareholder". In support of that submission Mr Donaldson SC cited Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204 at 222 to 223, Gould v Vaggelas [1985] HCA 85; (1984) 157 CLR 215 at 219 to 220 per Gibbs CJ, and Mercedes Holdings Pty Ltd v Waters (No 3) [2011] FCA 236 at [38] per Perram J. For the reasons that follow, I reject the submission.
416The so called principle of "reflective loss" is part of the common law of Australia. In Gould v Vaggelas at 219 Gibbs CJ stated that pursuant to that principle a party "cannot recover damages which are merely a reflection of a loss suffered by the company, [although] they may recover damages for the loss which they personally have suffered and which is separate and distinct from the loss suffered by the company". His Honour specifically cited Prudential Assurance Co Ltd with approval. In Chen v Karandonis [2002] NSWCA 412 at [34] to [53] Beazley JA (with whom Heydon and Hodgson JJA agreed) cited Prudential Assurance and the subsequent judgment of the House of Lords in Johnson v Gore Wood & Co [2000] UKHL 65; [2002] 2 AC 1.
417In Johnson at 35 to 36 Lord Bingham of Cornwall summarised the relevant principle as follows:
"These authorities support the following propositions. (1) Where a company suffers loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. No action lies at the suit of a shareholder suing in that capacity and no other to make good a diminution in the value of the shareholder's shareholding where that merely reflects the loss suffered by the company. A claim will not lie by a shareholder to make good a loss which would be made good if the company's assets were replenished through action against the party responsible for the loss, even if the company, acting through its constitutional organs, has declined or failed to make good that loss. So much is clear from Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] 1 Ch 204, particularly at pp 222-223, Heron International [Ltd v Lord Grade [1983] BCLC 244], particularly at pp 261-262, George Fischer [(Great Britain) Ltd v Multi Construction Ltd [1995] 1 BCLC 260], particularly at pp 266 and 270-271, Gerber [Garment Technology Inc v Lectra Systems Ltd [1997] RPC 443] and Stein v Blake [[1998] 1 All ER 724], particularly at pp 726-729. (2) Where a company suffers loss but has no cause of action to sue to recover that loss, the shareholder in the company may sue in respect of it (if the shareholder has a cause of action to do so), even though the loss is a diminution in the value of the shareholding. This is supported by Lee v Sheard [1956] 1 QB 192, 195-196, George Fischer and Gerber. (3) Where a company suffers a loss caused by a breach of duty to it, and a shareholder suffers a loss separate and distinct from that suffered by the company caused by a breach of a duty independently owed to the shareholder, each may sue to recover the loss caused to it by breach of the duty owed to it but neither may recover loss caused to the other by breach of the duty owed to that other." (emphasis added)
418At 62 Lord Millett discussed the first and second of these propositions. At 66 to 67 his Lordship stated:
"Reflective loss extends beyond the diminution of the value of the shares; it extends to the loss of dividends (specifically mentioned in Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch 204) and all other payments which the shareholder might have obtained from the company if it had not been deprived of its funds.
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On the other hand, [the shareholder] is entitled (subject to the rules on remoteness of damage) to recover in respect of a loss which he has sustained by reason of his inability to have recourse to the company's funds and which the company would not have sustained itself." (emphasis added)
419At 36 to 37 Lord Bingham applied these principles to the various heads of damage that had been pleaded by the appellant in that case. The appellant claimed that he and a company had jointly retained solicitors who then negligently conducted litigation on behalf of the company. The company compromised its claim against the solicitors and then the appellant sued them separately. It is unnecessary to describe his heads of damage in detail, but one is described as an "additional tax liability" which his Lordship described as a "personal loss" and stated "it would not [be struck] out". Of course a loss of a franking credit results in an additional tax liability to a shareholder. That said, the nature of the appellant's tax liability in Johnson was not discussed further.
420In this case the reflective loss principle can only be invoked if the "company", namely Holdings, has suffered loss and the shareholder, namely Mr Symond, has not "suffered [a loss] which is separate and distinct from the loss suffered by the company". I have described the nature of franking credits and the franking account above. Nothing in the ITAA1997 (or elsewhere) suggests that franking credits are an asset of the company that maintains the franking account. Franking credits are not listed as an asset on Holdings' balance sheet and it cannot buy or sell them. As I have stated, the franking account is a statutory concept which records the amount of tax credits that can be made available to shareholders. The ledger of Holdings recording franking credits and debits is merely a record reflecting the contents of that account. The debiting of the franking account does not involve the direct occasioning of loss to the company. Instead it results in the loss of amounts that the company "can pass to its members" (s 200.15(1) of ITAA1997). A deduction to the franking account represents a separate and distinct loss suffered by the shareholder(s) and not by the company.
421The chapter from Mr Lonergan's book that I have referred to includes a discussion of whether a positive franking account balance for a listed company makes the company more attractive to investors and thus may lower its cost of capital. He is sceptical of the latter contention on the basis that the size and level of foreign investor interest drives the cost of capital in this country, and such investors do not utilise franking credits. This scepticism appears unjustified in the case of Holdings, as its actual and likely investors are Australian residents. In any event, assuming that the presence of franking credits does lower the cost of capital for Holdings that does not mean that the company suffers a direct loss from the loss of franking credits. If anything it would only suggest that the company suffers its own form of reflective loss arising from the direct loss occasioned to the shareholders but not vice versa.