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12 MARCH 2019

The New Company Tax and Franking Regime

What we will cover

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• Background to the corporate tax changes

• Corporate tax rates

• Franking rates

• Future years

• Planning and practicalities

• ATO guidance

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Introduction

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• Government has moved to reduce company tax rates for small companies. Speed of those cuts has recently been increased.

• Who wins?• Companies that retain profits for growth and investment

• Non-resident shareholders

• Who loses?• Resident shareholders – more top-up tax

• Companies with trapped franking credits

Introduction

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Income yearAggregated turnover

thresholdLower tax rate

Tax rate for all other

companies

2015-16 $2m 28.5% (SBE) 30%

2016-17 $10m 27.5% (SBE) 30%

2017–18 $25m 27.5% (BRE) 30%

2018–19 to 2019–20 $50m 27.5% (BRE) 30%

2020–21 $50m 26.0% (BRE) 30%

2021–22 $50m 25.0% (BRE) 30%

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Company tax rate for the 2017 income year

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• Corporate tax rate for 2017 is 27.5% provided the company is a small business entity (SBE):

• The company carries on a business in the 2017 income year

• Aggregate annual turnover was less than $10 million

• Three ways to meet the aggregate turnover test:

• Actual aggregate turnover for the 2016 income year was less than $10 million

• Actual aggregate turnover for the 2017 income year was less than $10 million

• Reasonable estimate of the company’s aggregated turnover for the 2017 income year (based on information that existed at 1 July 2016) was less than $10 million

• Aggregate annual turnover is the sum of the company’s annual turnover for that tax year plus turnover of connected or affiliated entities

• Exclude inter-company transactions

• Turnover includes only income derived from the ordinary course of business (exclude extraordinary profits, such as capital gains)

The 2017 income year: what is a business?

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• TR 2017/D7: When does a company carry on a business?

• A company should be regarded as carrying on a business under general principles if the company aims to make a profit and has a genuine prospect of making a profit

• Where a company has no purpose or prospect of making a profit and its activities lack a commercial character, it is unlikely to be carrying on a business.

• Per the Ruling, a passive investment company a passive investment company can still qualify as an SBE

• This can potentially include ‘bucket’ companies that receive and invest trust distributions with the purpose and prospect of making a profit.

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The 2017 income year: what is a business?

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• TR 2017/D7: When does a company carry on a business?

• The following “passive” activities should qualify as carrying on a business:• Company owns a single commercial property let to third party tenant at market rates on

normal commercial terms, producing a profit each year

• Company holds a portfolio of listed shares which are held with the purpose of earning income from dividends

• Company leases a small fleet of charter boats to a third party under a commercial leasing agreement, producing a profit each year

• Holding company has only one asset; shares in a trading company.

• Company receives distributions of income from a related trust, which are then lent back to the trust in return for interest paid at a commercial rate of interest secured against the assets of the trust (note: a typical “bucket company” scenario)

The 2017 income year: what is a business?

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• TR 2017/D7: When does a company carry on a business?

• The following “passive” activities would not qualify as carrying on a business:• Company dormant for several years. It derives a small amount of interest on retained

earnings which are less than expenses incurred, being ASIC fees. There is no intention to resume business.

• Newly incorporated company investigates the viability of carrying on a business in future

• Company receives distributions of income from a related trust, but does not loan the distributions back to the trust. It does nothing that would give it an entitlement to any type of profit

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Amending 2017 Returns

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• TR 2017/D7 was published in October 2017 (ie, in the 2018 tax year)

• Many 2017 (as well as 2016) returns will have been lodged based on the ATO’s ‘old’ understanding of what constitutes ‘carrying on a business’:

• Income tax returns for passive investment and bucket companies would be lodged applying the 30% tax rate

• May be necessary to go back and amend 2017 and 2016 returns

• ATO is not proposing to apply any compliance resources to either companies or their shareholders where the wrong tax rate has been applied unless the company’s decision as to whether they were carrying on a business was plainly unreasonable (see PGC 2018/8).

• The ATO will not impose penalties on a company that gives members an incorrect distribution statement provided it gives written notice to members clearly showing the correct amount of franking credit (sent to members in the same way the original distribution statement was provided, eg email).

2017 Franking Percentage

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• Franking percentage for 2017 dividends calculated based on the corporate tax rate for imputation purposes (a new concept)

• This is the rate of tax the company would pay in 2017 based on the assumption its aggregated turnover is the same as it was in 2016.

• If the company is a new one, corporate tax rate for imputation purposes is automatically 27.5%

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2017 Franking percentage - example

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• Company carries on a business and:• Company’s aggregated turnover for 2016 was less than $10 million:

• Maximum franking rate is 27.5% because it is assumed that the company has the same turnover for 2017

• Company’s aggregated turnover for 2016 was at least $10 million:

• Maximum franking rate is 30% because it is assumed that the company has the same turnover for 2017 (and hence isn’t an SBE)

• Actual corporate tax rate may however be 27.5% if actual turnover for 2017 is less than $10 million because corporate tax rate can be determined by current year turnover (even though franking rate is 30%)

• If company is not carrying on a business in 2017, franking rate is automatically 30%

Poll:

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In the 2017 income year, E Co had an aggregate turnover of $24 million and assessable income that was 55% Base Rate Passive Income

In the 2018 income year, E Co had an aggregate turnover of $28 million and assessable income that was 62% Base Rate Passive Income

What is the company’s corporate tax rate and franking percentage for 2018?

• a) Corporate tax rate is 27.5% and franking percentage is 30%

• b) Corporate tax rate is 30% and franking percentage is 30%

• c) Corporate tax rate is 30% and franking percentage is 27.5%

• d) Corporate tax rate is 27.5% and franking percentage is 27.5%

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2018 company tax rate

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• Lower company tax rate applies if the company is a base rate entity (BRE):• Aggregate turnover for the 2018 income year is less than $25 million and

• No more than 80% of the company’s assessable income is base rate passive income

• Prior-year turnover is no longer relevant

• “Carries on a business test’ is also no longer relevant

• Note that BRPE is considered at a company level but aggregate turnover is considered at a group level

What is base rate passive income (LCR 2018/D7)?

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• Dividends, excluding non-portfolio dividends

• Where a company holds a voting interest of at least 10% in the company paying the dividend, this will be a non-portfolio dividend (and hence not BRE passive income)

• Exclusion applies only where non-portfolio dividend is paid direct from company to company (not through an intermediate entity, eg a trust)

• Franking credits attached to portfolio dividends

• Non-share dividends

• Interest (except interest received carrying on a business of providing finance, eg a bank)

• Rent

• Royalties

• Gains on qualifying securities

• Net capital gains

• Trust and partnership distributions to the extent referable to BRE passive income of the trust or partnership

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Base Rate Passive Income Example

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• Emu Pty Ltd earns 100% of its income from trading activities. Turnover in 2018 is $5 million and it qualifies for the lower 27.5% corporate tax rate.

• The company is wholly owned by the Koala Discretionary Trust to which it pays franked dividends.

• The trust distributes all the franked dividends to Wombat Pty Ltd, the corporate beneficiary of the trust, which has no other income for the year.

• If dividends were paid directly from Emu Pty Ltd to Wombat Pty Ltd they would be non-portfolio dividends (and hence not BRE passive income).

• However the dividends are paid through a trust and hence the exemption for non-portfolio dividends does not apply.

• Wombat’s corporate tax rate is 30% since 100% of its income is base rate passive income.

Base rate entity practical points

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• When a company receives income from a trust or partnership, trace through to the ultimate paying entity to determine the nature of the income that was derived by the trust or partnership. This could involve tracing through multiple levels of ownership (eg, company ► trust ► trust ► company)

• Company will qualify for the lower 27.5% tax rate if:• It doesn’t carry on a business

• Up to 80% of its income is passive income

• Company will not qualify for the lower 27.5% tax rate if:• It does carry on a business

• More than 80% of its income is passive income

• One-off events (like capital gains) can alter BRE passive income percentage year by year

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Rent and royalties

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• Per LCR 2018/7, rent includes only payments relating to land or premises• This excludes lease income

• Royalties can include payments for the right to use industrial, commercial or scientific equipment:

• This could include lease income

Bucket companies in 2018

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• Question of whether bucket company is carrying on a business is no longer relevant

• Bucket company now needs to consider its BRE passive income percentage.

• Three scenarios:• 100% trading trust distributes to a bucket company. None of the income assessable to the

bucket company from the trust will be BRE passive income

• Trust’s income is all BRE passive income (eg rent or dividends). All of the income assessable to the bucket company from the trust will be BRE passive income

• Trust income is a mixture of BRE passive income and non-BRE passive income. Only so much of the amount assessable to the bucket company that relates to the BRE passive income will be BRE passive income

• Provided the BRE passive income of the bucket company is 80% or less of its assessable income, it will still qualify for the 27.5% tax rate provided the turnover test is also satisfied

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Example: Passive investment company tax rates 2016-2018

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• Company owns five investment properties leased on commercial terms producing rental income of $300,000. No other assets or income

• 2016 tax rate:

• Turnover less than $ 2million

• Invested for profit therefore carrying on a business

• Qualifies as an SBE with a tax rate of 28.5%

• 2017 tax rate:

• Turnover less than $10 million

• Invested for profit therefore carrying on a business

• Qualifies as an SBE with a tax rate of 27.5%

• 2018 tax rate:

• Turnover less than $25 million

• BUT 100% of income is BRE passive income

• Does NOT qualify as a BRE so tax rate is 30%

2018 Franking percentage

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• Franking percentage for 2018 dividends calculated based on revised definition of the corporate tax rate for imputation purposes

• This is the rate of tax the company will pay in 2018 based on the assumption that • its aggregated 2018 turnover is the same as it was in 2017 and

• the company’s 2018 mix of BRE passive income and active income is the same as it was in 2017

• If the company would be a BRE in 2017, franking rate in 2018 is 27.5%

• If the company would not be BRE in 2017, franking rate in 2018 is 30%• Aggregate turnover in 2017 was more than $25m or

• More than 80% of turnover in 2017 is passive

• If the company is a new one, corporate tax rate for imputation purposes is automatically 27.5%

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Poll:

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In the 2018 income year, C Co had an aggregate turnover of $48 million and assessable income that was 82% Base Rate Passive Income

In the 2019 income year, C Co had an aggregate turnover of $46 million and assessable income that was 75% Base Rate Passive Income

What is the company’s corporate tax rate and franking percentage for 2019?

• a) Corporate tax rate is 27.5% and franking percentage is 30%

• b) Corporate tax rate is 30% and franking percentage is 30%

• c) Corporate tax rate is 30% and franking percentage is 27.5%

• d) Corporate tax rate is 27.5% and franking percentage is 27.5%

2019 and beyond

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• Same rules apply for 2019 and all future years:• Base rate entity

• Turnover threshold continues to increase (up to $50m for 2018-19 and beyond)

• Tax and franking rate continues to fall

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Trapped franking credits - example

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• Company with taxable profits of $1000 in the 2015 year.• Paid tax of $300 (at 30% rate)

• Profits left over $700

• Pays a fully franked dividend in 2016 of $350 and allocates franking credit of $150 (assuming 30% franking credit)

• Pays a further fully franked dividend in 2017 of $350 but can only allocate franking credit of $133 (assuming 27.5% franking credit)

• The 2017 dividend leaves the Australian resident shareholder with a higher personal tax bill (because of the lower franking credit)

• The remaining franking balance of $17 is potentially lost unless:

• The franking rate for the company goes back up to 30%:

• Company turnover in future exceeds the BRE turnover threshold

• Company disposes of the business and therefore no longer meets BRE test

Franking credits planning points

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• With corporate tax rates set to fall in future years, companies need to consider the timing of dividend payments to prevent trapped franking credits and extra tax for resident shareholders

• Consider bringing forward dividend payments to take advantage of the 27.5% franking rates before rates fall to 26% (2020-21) and 25% (2021-22)

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Tax Return disclosures

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• 2017 Company Tax Return:• New label F1.

• If the company was an SBE (based on the company carrying on a business and having an aggregated turnover in 2016 or 2017 of less than $10 million), mark this label to calculate tax at 27.5%

• 2018 Company Tax Return• New label F2

• Label F1 still needs to be marked if the company is an SBE (to access other small business concessions) but this label is no longer relevant to the calculation of the tax rate. Instead, mark label F2 if the company is a BRE. If F2 is left blank, tax will be calculated at 30%.

Questions?

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• You can type them in the “Questions” box now

• Or contact me via:

• Mark Chapman

• Director of Tax Communications, H&R Block

• mchapman@hrblock.com.au

• 0415 844 388