Reduction in corporate tax rate for LICs

By Allan Mortel - August 31, 2017

This bulletin outlines the application of the reduction in corporate tax rate legislation for Listed Investment Companies (LICs).

We are of the view that both legislative amendments and further ATO guidance are required to provide certainty for LICs, and for corporate taxpayers more broadly.

We will be making submissions to both the Government and the ATO to provide certainty for both companies and their shareholders including proposing the specific exclusion of LICs from the scope of this legislation.

The underlying basis for our submission will to be to ensure that LICs have a level playing field with managed funds who, with the principle of character retention, do not have a problem with trapped franking credits that this legislation currently imposes on LICs.

This bulletin follows on from previous general bulletins on this legislation from Matthew Hall on 26 May 2017 ('Reduction in corporate tax rate - are you eligible?') and Mitchell Killen on 2 August 2017 ('Reduction in company tax rate - but what is the impact in franking credits?').

What are the corporate tax rate changes?

The new legislation reduces the corporate tax rate for companies that are carrying on a business with aggregated turnover below the relevant threshold for the applicable income year (worked out at the end of the income year). The turnover thresholds and the applicable income year are outlined in the following table.

Income year
       

Annual aggregated turnover threshold

Company
tax rate (%)

2016-17

$10 million

27.5

2017-18

$25 million

27.5

2018-19 to 2023-24

$50 million

27.5

2024-25

$50 million

27

2025-26

$50 million

26

2026-27 onwards

$50 million

25

  • Please note that the government has introduced a separate bill that proposes to progressively reduce the corporate tax rate for all entities, which is proposed to be phased in by 2023-24.  This has not been legislated by parliament.

What is aggregated turnover?

Generally speaking, the aggregated turnover only includes total ordinary income that the company derives in the income year in the ordinary course of carrying on a business. According to case law and an ATO taxation ruling, most (if not all) LICs would generally be regarded by the ATO as carrying on a “business of investing”.  Therefore, most investment income derived by a LIC would likely be included in the ‘aggregated turnover’ test for LIC’s.  The determination of aggregated turnover can be a complex exercise depending on the specific circumstances and tax profile of the LIC.  For example, if the LIC determines its investment portfolio is trading stock for income tax purposes, the aggregated turnover generally speaking is determined on a gross proceeds basis.  Alternately, if the LIC determines its portfolio is on revenue account for income tax purposes, the turnover may be calculated on a net profit basis. Accordingly, we recommend you undertake a comprehensive analysis of your income streams to determine the relevant turnover for tax purposes and consult with your Pitcher Partners advisor.

Impact on dividends already paid to shareholders?

Where a company has already paid fully franked dividends to shareholders during the 2016-17 year, it needs to determine whether the franking (imputation) rate is 30% or 27.5%. 

Please note that the tax rate applied to determine the calculation of tax liability at year end could be different to that used for determining the franking (imputation) rate applied to dividends paid in the year.

The determination of the appropriate franking (imputation) rate for dividends paid in the 2016-17 year requires calculating whether the previous income year’s aggregated turnover (i.e. for the 2015-16 year) exceeds the current year’s aggregated turnover threshold (i.e. being $10 million for the 2016-17 year).

That is:

  • If 2015-16 aggregate turnover exceeds $10 million, then dividends paid in 2016-17 can be franked to 30%.
  • If 2015-16 aggregate turnover is below $10 million, then dividends paid in 2016-17 can only be franked to 27.5%.

There are potentially adverse consequences if the LIC does not comply with the provisions.

Impact on franking (loss of 2.5%)?

A company will frank its dividends based on the prior year aggregated turnover, rather than the current year aggregated turnover.  This can result in companies having a different tax rate as compared to their franking rate (and may result in franking errors).  This may impact companies that transition to a new (lower) tax rate and have retained earnings that have already been taxed at a higher rate.

The following table provides an example of the potential impact of the reduction in the corporate tax rate on franking accounts and dividend payments.

 

Retained Earnings

Franking Account Balance

 

Balance before change in tax rate

2,000,000

857,143

Franking earned at 30%

Fully franked dividend payment at the lower rate (27.5%)

(2,000,000)

(758,621)

Franked at 27.5%

Closing balance

0

98,522

Trapped franking Credit

Trapped franking credits will only be able to be utilised to the extent that the profit reserve increases without a corresponding tax payment (for example: (1) where profits are quarantined at the beginning of a year, but the company suffers losses later in the year; or (2) where the company derives income that may not be taxable (e.g. exempt foreign income or tax deferred distributions from managed investment schemes)).

Impact on current and deferred tax balances?

Current and deferred tax balances should be recorded at the company tax rate the Company anticipates will apply to it when the Company expects the tax asset or liability to be utilised. Where utilisation is expected to occur when the company’s annual aggregated turnover is expected to be less than the applicable aggregated turnover threshold, the applicable lower tax rate(s) should be used.

Impact on tax returns?

We have been in discussions with the ATO on how they intend to monitor compliance with this legislation and are seeking further clarity on this.  Accordingly, care should be taken to ensure that the relevant disclosures in the company tax return are completed correctly in the event of an ATO audit or review.

Future corporate tax and franking rates (for years commencing after 30 June 2017)

For years commencing after 30 June 2017, the eligibility for the reduced corporate tax rate will depend on whether the entity qualifies to be a ‘base rate entity’.  This refers to an entity whose actual annual aggregated turnover for the relevant year is below the relevant threshold for the year in question. For example, in the year ended 30 June 2018, the threshold will be $25 million, and an entity with annual aggregated turnover below this threshold will be a base rate entity subject to the 27.5% corporate tax rate.

From a franking perspective, the relevant franking rate will continue to be based on the prior year aggregated turnover compared to the current year threshold.

Both legislative amendments and further ATO guidance are required to provide certainty

We are of the view that both legislative amendments and further ATO guidance are required to provide certainty for LICs, and for corporate taxpayers more broadly. We will be making submissions to both the Government and the ATO to provide certainty for both companies and their shareholders.

The underlying basis for our submission will to be to ensure that LICs have a level playing field with managed funds who, with the principle of character retention, do not have a problem with trapped franking credits that this legislation currently imposes on LICs.


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