Legislation passed by Parliament today limits the scope of the reduced company tax rate.
Applying from 1 July 2017, the Bill prevents a company from applying the lower 27.5% company tax rate if more than 80% of its income is passive in nature. This also has an impact on the maximum franking rate that applies to dividends paid by companies in the 2018 income year onwards.
This is yet another change for practitioners to get across because there is now an extra test that adds a layer of complexity when determining what company tax rate should apply. This is not just a gross turnover test but a test that requires you to analyse the components of that turnover.
Company tax rate
For the 2018 income year a company will qualify for the 27.5% tax rate if it classified as a base rate entity for that year. A company will be a base rate entity if:
- Its aggregated annual turnover in the 2018 income year was less than $25m; and
- No more than 80% of its assessable income for the year was “base rate passive income”.
Base rate passive income is defined to include the following types of income:
- Dividends, except non-portfolio dividends;
- Franking credits on the dividends referred to above;
- Non-share dividends;
- Interest (although there are some exceptions for some companies);
- Gains on qualifying securities;
- Net capital gains;
- Income received from a partnership or trust to the extent that it is referable to base rate entity passive income derived by the partnership or trust.
Where a company receives income from trusts or partnerships, you will need to trace through to determine the nature of the income that was derived by that trust or partnership, and this might need to be done on multiple levels. For example, Trust 1 might distribute income to Trust 2, which then distributes income to a company.
Whether dividends are treated as passive income will depend on the shareholding percentage involved. At a very high level, if the company holds less than 10% of the shares in the company paying the dividends then the dividend should be treated as passive income.
There is some uncertainty around how the tracing rules should be applied when it comes to deductions or losses within the relevant trusts or partnerships. It is not clear at this stage whether you are required to trace through to the gross income derived or whether you should trace to net amounts. Hopefully the ATO will provide some clarification on this shortly.
These changes mean that companies that only hold rental properties will not qualify for the lower tax rate, even if the rental activities amount to a business under general principles. However, a company that receives distributions from a related trust could still qualify for the lower rate if 20% or more of its total income is attributable to trading profits (directly or indirectly through the trust).
Under the new rules, it will no longer be necessary to determine whether the company carries on a business in its own right under ordinary principles to determine its tax rate. However, this would still be relevant in determining whether a company can access the lower corporate tax rate for the 2017 year as well as other concessions that are available to small business entities - the ATO released TR 2017/D7 that explores this concept in the context of companies.
Maximum franking rate
The Bill also makes changes to the maximum franking percentage rules. In determining a company’s maximum franking rate for a particular income year from the 2018 income year onwards you need to look at the tax rate that would apply in the current year if the following assumptions are made:
- The company’s aggregated turnover in the current year is the same as in the previous year;
- The company’s assessable income in the current year is the same as in the previous year; and
- The company’s passive income in the current year is the same as in the previous year.
For example, if a company paid a franked dividend in the 2018 income year its maximum franking percentage will be based on a 27.5% rate if:
- The company’s aggregated annual turnover in the 2017 year was less than $25m; and
- 80% or less of the company’s assessable income in the 2017 year was passive income.
If the company did not exist in the previous income year then the maximum franking rate will be based on a 27.5% rate.
If a company paid a dividend in the 2018 income year and this was initially franked to 30% but the new rules mean that the maximum franking rate should have been 27.5% then it will be necessary to inform the shareholders of the correct franking rate and ensure that the company’s franking account balance is adjusted accordingly.
In the 2017-18 income year, Bear Co has:
Therefore, for the 2017-18 income year, 92.59 per cent of Bear Co’s assessable income is base rate entity passive income. Consequently, for that income year, Bear Co’s corporate tax rate is 30 per cent (even though its aggregated turnover is only $8 million).
Bear Co proposes to pay a dividend to its shareholders in the 2018-19 income year. For the purpose of working out its corporate tax rate for imputation purposes for the 2018-19 income year, Bear Co must assume that its aggregated turnover, base rate entity passive income and assessable income are the same as for the 2017-18 income year.
As 92.59 per cent of its assessable income was base rate entity passive income for the 2017-18 income year, Bear Co’s corporate tax rate for imputation purposes is 30 per cent. Therefore, Bear Co’s corporate tax gross-up rate for that income year will be 2.33 (that is, (100% — 30%)/30%).
Bear Co makes a fully franked distribution of $100 per share in the 2018-19 income year. The maximum franking credit that can be attached to that distribution is $42.91 (that is, $100/2.33). Bear Co makes the dividend payment on 31 March 2019.
Amy holds 50 shares in Bear Co and receives a dividend of $5,000. Franking credits of $2,145 are attached to the dividend. For the 2018-19 income year, Amy includes $7,145 in her assessable income in relation to the dividend she has received from Bear Co — that is:
Amy is entitled to a refundable tax offset equal to the amount of the franking credits. Amy’s total assessable income for the 2018-19 income year is $30,000 (so that her marginal tax rate is 19 per cent). Therefore, (ignoring Medicare levy) the tax payable by Amy on the franked dividend is $1,357.55. The excess franking credits ($787.45) will be:
Emma also holds 50 shares in Bear Co and receives a dividend of $5,000. Franking credits of $2,145 are attached to the dividend. For the 2018-19 income year, Emma includes $7,145 in her assessable income in relation to the dividend she has received from Bear Co — that is:
Emma is entitled to a refundable tax offset equal to the amount of the franking credits. Emma’s total assessable income for the 2018-19 income year is $120,000 (so that her marginal tax rate is 37 per cent). Therefore, (ignoring Medicare levy) the tax payable by Emma on the franked dividend is $2,643.65. Consequently, Emma will need to pay additional tax of $498.65 on the franked dividend that she has received from Bear Co.
Michael Caruthers, Tax Director, Knowledge Shop