Eligibility for the lower company tax rate and access to imputation credits clarified

Uncertainty had arisen earlier this year as to whether companies with passive investments (including ‘bucket’ companies) would be eligible for the lower company tax rate of 27.5% based on the requirement in section 23AA of the Income Tax Rates Act 1986 that they were “carrying on a business.”

On 18 October 2017, the Government released two documents to clarify eligibility for the lower company tax rate:

• the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (the Bill) was introduced into Parliament which, if passed and assented to, will apply for the 2018 and later income years; and
• the Australian Taxation Office (ATO) released Draft Taxation Ruling TR 2017/D7 that outlines the ATO’s preliminary view on when a company will be carrying on a business for purposes of eligibility for the lower company tax rate in the 2017 income year.

The Bill if legislated will amend section 23AA of the Income Tax Rates Act 1986 with a ‘bright line’ test for eligibility to the lower company tax rate with effect from 1 July 2017. The test will ensure that a corporate tax entity that meets the aggregated turnover threshold ($25 million for the 2018 income year) will not qualify for the lower company tax rate if more than 80% of its assessable income is directly or indirectly sourced from passive income (such as interest, rent, dividends, royalties, or net capital gains).

For the 2017 income year, section 23AA of the Income Tax Rates Act 1986 is unchanged. That is, to be eligible for the lower company tax rate a corporate tax entity will need to be “carrying on a business” and have aggregated turnover of less than $10 million. There is no restriction on the amount of passive income that may be derived by the corporate tax entity.

For dividend imputation purposes, the tax rate used in franking calculations will be based on the company tax rate for the current income year, but assuming that aggregated turnover, passive income, and assessable income are the same as in the prior year. We consider the interaction of the company tax rate changes and imputation system below.

The measures have the effect of adding considerable complexity and compliance burdens for tax advisors in the administration of the company tax and imputation systems for the next 7 years until a flat single corporate tax rate is again expected to apply.

Bright line test for the 2018 income year onwards

 A company will qualify for the lower company tax rate if no more than 80% of its assessable income for that income year is “base rate entity passive income” and the aggregated turnover of the entity for that income year is less than the threshold for that year.

Broadly, “base rate entity passive income” means:

• distributions by corporate tax entities, other than dividends paid to the company by another company where the first company owns a greater than 10% interest;
• non-share dividends (distributions on instruments classified as equity for tax purposes);
• franking credits;
• interest, royalties, and rent;
• gains on certain debt securities issued at a discount;
• net capital gains; and
• partnership or trust distributions to the extent that partnership or trust income is traceable (directly or indirectly) to “base rate entity passive income”.

The proposed legislation includes some key differences to the Government’s earlier exposure draft legislation:

• the start date is 1 July 2017 (rather than 1 July 2016);
• the removal of the requirement to “carry on a business”;
• clarification of the definition of base rate entity passive income by:
  • including franking credits;
  • excluding amounts of exempt income or non-assessable non-exempt income (as those amounts do not form part of assessable income); and
  • ‘capital gains’ now being ‘net capital gains’, thereby excluding disregarded capital gains and allowing for capital losses.

If the Bill is passed and assented to as currently tabled before Parliament:

• a ‘bucket company’ in receipt of distributions of active income (or that has less than 80% of base rate passive income) will be eligible for the lower company tax rate;
• a company that actively manages (for example) a portfolio of rental properties would not be eligible for the lower tax rate if rental income (and other ‘base rate entity passive income’) is more than 80% of income; and
• companies that sell a business and make a net capital gain may not be eligible for the lower company tax rate due to the net capital gain being passive income. 

The tracing requirement for companies in receipt of trust and partnership distributions may result in increased compliance costs in terms of accounting fees and a need to amend trust deeds and pro forma resolutions.

TR 2017/D7: when does a company carry on a business within the meaning of section 23AA of the Income Tax Rates Act 1986?

For the purpose of providing guidance on when a company is “carrying on a business” for the 2017 income year, the ATO released TR 2017/D7 that contains the ATO’s preliminary views on that question, together with examples.

TR 2017/D7 will only be relevant for the 2017 income year and section 23AA.  TR 2017/D7 only applies to companies (other than companies limited by guarantee) incorporated under the Corporations Act 2001, and excludes companies in their capacity as trustee of a trust, corporate limited partnerships, and public trading trusts.

TR 2017/D7 runs to 25 pages and includes many examples. However, TR 2017/D7 concludes that where a company (or NL company) is established and maintained to make a profit for its shareholders, and invests its assets in gainful activities that have both a purpose and prospect of profit, it is likely to be carrying on a business in a general sense and therefore to be carrying on a business within the meaning of the section 23AA.

A Media Release by the Hon Kelly O’Dwyer stated that the ATO will adopt a facilitative approach to compliance in relation to the “carrying on a business” test for the 2017 year. That is, the ATO will not select companies for audit based on their determination of whether they were carrying on a business in the 2017 income year, unless their decision is plainly unreasonable.

Comments on TR 2017/D7 are due by 1 December 2017. 

Imputation and the lower company tax rate

The two-tiered company tax rate system has implications for franking distributions. This is best illustrated by some examples.

Pursuant to Subdivision 202-D of the Income Tax Assessment Act 1997, the maximum franking credit on a distribution is equal to:

Amount of the frankable distribution x                     1                     
                                                                applicable gross-up rate

The ‘applicable gross up rate’ is the ‘corporate tax gross-up rate’ of the entity making the distribution for the income year in which the distribution is made.

Section 995-1 defines the ‘corporate tax gross-up rate’ as the amount worked out using the following formula: 

100%  -  Corporate tax rate for imputation purposes of the entity for the income year
Corporate tax rate for imputation purposes of the entity for the income year

That ‘corporate tax rate for imputation purposes’ is the tax rate that applies for the income year:

• assuming the entity’s aggregate turnover for the income year is the same as for the previous income year; or
• if the entity did not exist in the previous income year, the ‘default’ corporate tax rate of 30%.

The Bill amends the definition of ‘corporate tax rate for imputation purposes’ but only so far as to assume that the corporate tax entity’s aggregate turnover, passive income, and assessable income (as those terms are used in determining eligibility for the lower corporate tax rate) are the same as in the previous year.

The effect is that if a company:

• is on a 30% tax rate in the 2017 income year, subject to the third point below, the maximum franking credit on dividends in the 2018 income year will be 30%;
• is on a 27.5% tax rate in the 2017 income year, the maximum franking credit on dividends in the 2018 income year will be 27.5% irrespective of the company’s 2018 turnover; and
• is on a 30% tax rate in the 2017 income year, and the company’s turnover in 2017 is less than the 2018 turnover threshold of $25 million (and the company does not have more than 80% of passive income), the maximum franking credit on dividends in the 2018 income year will be 27.5%.

The following examples assume that the Bill will be passed in its current form and in all examples the company has taxable income of $1 million. 

Example one: 30% tax rate in 2017, 30% franking rate in 2018

In the 2017 income year a company had a turnover of $8 million comprising solely of passive income and therefore was on a corporate tax rate of 30% for 2017 (despite having less than $10 million of turnover in 2017).

The ‘corporate tax rate for imputation purposes’ assumes the company’s turnover (and composition) for 2018 is the same as in 2017 (that is, $8 million of passive income). Therefore, the ‘corporate tax rate for imputation purposes’ in 2018 is 30%.

If the company pays a cash dividend of $700,000 during the 2018 income year ($1,000,000 of taxable income less 30% tax), the ‘corporate tax gross-up rate’ will be 2.3333 (that is, (100% - 30%)/30%). The maximum franking credit that can be attached to the dividend is $300,000 (that is, $700,000 / 2.3333).

For a shareholder on a marginal tax rate of 45% (ignoring the Medicare levy), the grossed-up dividend will be $1,000,000 ($700,000 + $300,000), tax on the grossed-up dividend will be $450,000, and the shareholder will have a franking credit offset of $300,000 and top-up tax to pay of $150,000. (Top-up tax of 15% on the grossed-up dividend).

Example two: 27.5% tax rate in 2017, 27.5% franking rate in 2018

A company had turnover of $8 million of active income in the 2017 income year and so was on a corporate tax rate of 27.5% for 2017.

The ‘corporate tax rate for imputation purposes’ assumes the company’s turnover (and composition) for 2018 was the same as in 2017 (that is, $8 million of active income). Therefore, the ‘corporate tax rate for imputation purposes’ in 2018 is 27.5%. (This would be the case even if the company’s actual turnover in 2018 increased to (for example) $100 million).

If the company pays a cash dividend of $725,000 during the 2018 income year ($1,000,000 of taxable income less 27.5% tax), the ‘corporate tax gross-up rate’ will be 2.6364 (that is, (100% - 27.5%)/27.5%). The maximum franking credit that can be attached to the dividend is $275,000 (that is, $725,000 / 2.6364).

For a shareholder on a marginal tax rate of 45% (ignoring the Medicare levy), the grossed-up dividend will be $1,000,000 ($725,000 + $275,000), tax on the grossed-up dividend will be $450,000, the shareholder will have a franking credit offset of $275,000 and top-up tax to pay of $175,000. (Top-up tax of 17.5% on the grossed-up dividend compared with 15% if the dividend was franked to 30%).

Example three: 30% tax rate in 2017, 27.5% franking rate in 2018

A company had turnover of $15 million of active income in the 2017 income year and therefore was on a corporate tax rate of 30% for that income year. For the 2018 income year the turnover threshold for the lower 27.5% corporate tax rate increases to $25 million.

The ‘corporate tax rate for imputation purposes’ assumes the company’s turnover (and composition) for 2018 was the same as in 2017 (that is, $15 million of active income). Therefore, the ‘corporate tax rate for imputation purposes’ in 2018 is 27.5% as the $15 million turnover is less than the $25 million threshold. The 27.5% rate for imputation purposes is despite the company paying tax in the 2017 income year at 30%.

If the company pays a cash dividend of $700,000 during the 2018 income year ($1,000,000 of taxable income less the 30% tax for 2017), the ‘corporate tax gross-up rate’ will be 2.6364 (that is, (100% - 27.5%)/27.5%). The maximum franking credit that can be attached to the dividend is $265,517 (that is, $700,000 / 2.6364).

For a shareholder on a marginal tax rate of 45% (ignoring the Medicare levy), the grossed-up dividend will be $965,517 ($700,000 + $265,517), tax on the grossed-up dividend will be $434,483, the shareholder will have a franking credit offset of $265,517 and top-up tax to pay of $168,966. The company will also have a balance in its franking account of $34,483. (Perhaps the company could have borrowed to pay a larger dividend?)

The following table summarises the above examples:

	Example one	Example two	Example three
Australian resident company
Turnover in the 2017 income year	$12,000,000 passive	$8,000,000 active	$15,000,000 active
Taxable income in 2017	$1,000,000	$1,000,000	$1,000,000
Corporate tax rate for the 2017 income year	30%	27.5%	30%
“Corporate tax rate for imputation purposes” for the 2018 income year	30%	27.5%	27.5%
Corporate tax gross-up rate for 2018 income year	2.3333 (i.e. (100%-30%)/30%)	2.6364 (i.e. (100%-27.5%)/27.5%)	2.6364 (i.e. (100%-27.5%)/27.5%)
Maximum franking credits	$300,000	$275,000	$265,517
Company pays dividend to resident Australian shareholder
Cash dividend	$700,000	$725,000	$700,000
Grossed-up dividend to resident shareholder	$1,000,000	$1,000,000	$965,517
Tax on grossed-up dividend	$450,000 (45%)	$450,000 (45%)	$434,483 (45%)
Franking credit offset to the shareholder	$300,000	$275,000	$265,517
Top up tax payable by the shareholder	$150,000	$175,000	$168,966
Cash after tax	$550,000	$550,000	$531,034
Franking credit balance	Nil	Nil	$34,483

The examples illustrate that in an imputation system of corporate and shareholder taxation, lowering corporate tax rates has no effect on the tax burden for Australian resident shareholders – the higher top-up tax offsets the lower corporate tax. However, lower corporate tax rates can have positive economic effect for foreign resident shareholders depending on the tax treatment in their country of residence due to fully franked dividends paid to foreign residents being exempt from further Australian tax.

Key observations on the above proposed measures can be summarised as follows:

• Distributions from trusts and partnerships will retain their character for the purposes of determining whether or not the amount is base rate entity passive income of the corporate tax entity.  This will require some complex calculations in diversified trusts and partnerships and where deductions cannot be specifically traced to specific income streams.
• Non-portfolio dividends continue to be specifically excluded in circumstances (if any) where they would be assessable income.  Therefore, corporate tax entities that derive dividends from companies in which they have a voting interest at least 10 per cent should exclude these amounts from the 80 per cent calculation.
• The threshold test will need to be applied annually. As such, a corporate tax entity that is close to the 80 per cent passive income threshold may have differing rates of tax between income years, which could cause consequent franking issues.
• The new rules could also penalise companies in an income year where active assets or an active business has been sold (which would be a classified as a “passive income” capital gain).
• For dividend imputation purposes, the corporate tax gross up rate used in franking calculations will continue to be based on the corporate tax rate for the income year, but assuming the aggregated turnover, passive income and assessable income amounts for the previous year.

For further information or advice, please contact:

Rod Payne
Principal
T: 03 5226 8541
E: rpayne@ha.legal

Dianne Sisak Penjalov
Senior Associate
T: 03 5226 8582
E: diannes@ha.legal