Changes to Small Company Tax
One of the most confusing pieces of legislative policy to emerge in recent times concerns the simple concept of the small business entity corporate tax rate.
Much has been written in the press and elsewhere about the confusion of whether a small company is taxed at 30% or 27.5%, and what franking rate applies.
Draft legislative changes to introduce a “bright line” test for working out whether a small company can use the 27.5% tax rate were recently introduced into Parliament. Although this proposed test may settle the confusion for the 2018 and later income years, it still leaves the 2017 income year in some doubt.
To work out whether a small company can use the lower rate of tax for the 2017 income year, it is necessary to conclude, firstly, whether the company is “carrying on a business” and, secondly, that its aggregate turnover is lower than $10 million. In a draft taxation ruling (TR 2017/D7), the Taxation Office has taken a very wide approach to this concept and (surprisingly) concluded most companies may indeed be “carrying on a business”.
No doubt, it is this liberal view which caused the Government to change the rules for the 2018 and later income years.
Under proposed new rules for 2018 and onwards, the “carrying on a business test” will be removed and replaced with a new “base rate entity passive income” test. So, to access the 27.5% tax rate for the 2018 income year, for example, a small company would need to show that its aggregated turnover was less than $25 million and that no more than 80% of its assessable income is “passive”. Passive income includes portfolio dividends, interest, rent, and net capital gains.
Now for the confusing part – the selection of what rate to use for franking a dividend in a given year will rely on a number of assumptions and requires the use of a separate test to that set out above. For example, to decide which rate (27.5% or 30%) should apply to attach franking credits to a dividend paid in the year ending 30 June 2018, you need to make the following assumptions and measure the outcomes against the 2018 aggregated turnover ($25 million) and passive income tests:
- that the company’s aggregated turnover for the 2018 income year will be the same as for the prior year;
- that the company’s passive income for the 2018 income year will be the same as for the 2017 year; and
- that the company’s assessable income for 2018 will be the same as for the 2017 year.
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So, for example, if a company has a 2017 income year aggregated turnover of $11 million and of that more than 80% was passive, a dividend paid in the 2018 year will be franked at 30%. If 80% or less was passive, then the lower franking rate of 27.5% applies. And this is so, regardless of the rate of tax that the company paid for the 2017 income year.
One of the potential outcomes of these rules, as this example shows, is that even though a company applied the 30% tax rate in calculating its tax payable for the 2017 income year, it may only be able to frank dividends in the 2018 income year using the 27.5% rate. If the company earned, say, $11 million in assessable income in the 2017 year of which more than 80% was passive, its tax rate for 2017 would have been 30%, but its 2018 franking rate is only 27.5% as its assumed 2018 turnover is less than $25 million.
As a result, in a case like this, imputation credits may become trapped in a small company.
Each small company will therefore now need to carefully monitor its aggregated turnover and passive income levels to work out which tax rate, and which franking rate, to use in any given income year.
Confusing…to say the least!
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