Reduction in corporate tax rate - retrospective rules introduced yet again

By Peter Gillies - October 26, 2017

The Government and ATO have yet again changed the rules as to when an entity will be required to apply the reduced corporate tax rate of 27.5% for 30 June 2017 and 30 June 2018. The rules apply retrospectively and can result in a refund of tax (where company tax has been paid at 30%) as well as a liability for tax (where franking credits on dividends should only have been 27.5%). It is critical that all corporate entities review these changes.

Overview

The government has introduced legislation into Parliament (Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (“the Bill”) clarifying when the reduced corporate tax rate of 27.5% will apply to companies for the 30 June 2018 income year (i.e. 2017/18) and subsequent income years. 

For 30 June 2017 (i.e. 2016/17), the ATO has also released a draft ruling setting out its view on when a company would be regarded as carrying on a business and thus will be required to apply the reduced corporate tax rate for that income year only. 

Both documents dramatically change when the reduced corporate tax rate will apply and accordingly all companies should review their position to understand the impact of these changes. Please note, this article does not deal with companies that have substituted accounting periods.

What are the criteria for the 2016/17 income year?

A company will be entitled to the 27.5% corporate tax rate for 2016/17 if the company carries on business in that year and its aggregated turnover for that year is less than $10 million.  The corporate tax rate for a company that does not satisfy these requirements will remain 30 per cent.

When does a company carry on a business for 2016/17?

The ATO has released a draft ruling (TR 2017/D7) providing guidance on when a company carries on a business for this purpose.  In doing so, the draft ruling examines a number of examples: a company with unpaid entitlements from a discretionary trust, a company holding rental properties, a company holding a share portfolio, and a holding company owning shares in a trading subsidiary.   

We note that a very liberal interpretation has been taken by the ATO as to when a company is carrying on a business.  While cautioning that it is a question of fact, the draft ruling indicates that a company is likely to be carrying on a business where it is established and maintained to make a profit and invests its assets in gainful activities that have both a purpose and prospect of profit.

As noted above, the draft ruling contains multiple examples addressing when a corporate beneficiary of a discretionary trust would be regarded as carrying on a business.  In brief, the ATO have a preliminary view that a corporate beneficiary would be regarded as carrying on a business if the company derives commercial returns from the unpaid present entitlement (e.g. interest income).

What if there is an error for the 2016/17 income year?

In response to the uncertainty around the ‘carrying on a business’ test prior to the release of the draft ruling, the ATO have announced that they will adopt a ‘facilitative approach’ to compliance in relation to that issue for the 2016-17 year.  In particular, the ATO have placed the following statement on their website

“We will not select companies for audit based on their determination of whether they were carrying on a business in the 2016-17 income year, unless their decision is plainly not reasonable”. 

We note that it is unclear from this statement whether a corporate beneficiary that has applied a 30% tax rate for corporate tax and franking would be allowed to retain the rate or would be required to amend all tax returns.  We are currently seeking clarification on this issue from the ATO.

What are the criteria for the 2017/18 and later income years?

For 2017/18 and later years, the legislative amendments contained in the Bill will apply.  A company will be entitled to the reduced corporate tax rate if its aggregated turnover is under the relevant threshold and no more than 80 percent of the company’s income is passive income. 

There is no requirement that the company carry on a business to access the reduced rates for 2017/18 and later years.  The corporate tax rate for a company that does not satisfy these requirements will remain at 30 per cent. 

Relevant thresholds and tax rates

Income Year

Aggregated Turnover

Tax Rate (%)

2017/18

$25 million

27.5%

2018/19

$50 million

27.5%

2024/25

$50 million

27.0%

2025/26

$50 million

26.0%

2026/27

$50 million

25.0%

Please note, aggregated turnover of a company includes turnover of other entities that are connected with, or affiliates of, the company (as defined in the tax legislation). For completeness, legislation is currently before Parliament to implement the second phase of the government's Enterprise Tax Plan, which will seek to progressively extend the reduced tax rate to all companies (i.e. which will remove the turnover limits).

What constitutes passive income?

In broad terms, the passive income of a company will comprise dividends (and attached franking credits), interest, rent, royalties and net capital gains.  In addition, a company’s entitlement to assessable income consisting of partnership or trust income will be regarded as passive income to the extent it is referable to an amount that is passive income as defined. 

Further, the Bill requires tracing through interposed partnerships and trusts in determining whether the amount flowing to the company is referable to passive income.  Helpfully, the Explanatory Memorandum that accompanied the Bill confirms that an amount flowing through a trust will retain its character.  Thus, trading profits distributed by a trust to a corporate beneficiary (whether directly or through one or more interposed trusts) will not be regarded as passive income of the corporate beneficiary.

Are there any exclusions from passive income?

Importantly, non-portfolio dividends – those received by a company holding at least 10% of the voting shares in the dividend paying company – are specifically excluded from passive income.

What is an example of how the provisions apply?

Following is a simple example demonstrating how the provisions apply.  Assume that there are three entities in a group, Trust A, Trust B and Company C.  For the 30 June 2018 income year, Trust A derives $2 million of business income and $100,000 of interest income.  Trust B derives $3 million of dividend income from portfolio shares, $1 million of franking credits and $500,000 of net capital gains (after the 50% discount). 

Trust A distributes 100% of its income to Trust B.  Trust B distributes all income (other than the capital gains) to Company C.  Company C derives no other income.  Assume there are no differences between tax and accounting amounts, other than franking credits.

In this example, Company C will be deemed to have derived assessable income of $6.1 million.  Of this, $4.1 million (or 67.2% of total assessable income) would be attributable to passive income from Trust A and Trust B. As this is less than 80%, and given that Company C’s aggregated turnover for 30 June 2018 is less than $25 million, Company C would be eligible for the lower tax rate of 27.5%.

Do the changes affect franking?

They do! Again, the answer depends on whether the focus is on the franking rate for 2016/17 or 2017/18 and later years.  Please note that if the dividend is paid on or before 30 June 2017, the rules for 2016/17 apply. If the dividend is paid on or after 1 July 2017, the rules for 2017/18 apply.

What are the franking rules for 2016/17?

For 2016/17, the franking rate is based on the applicable company tax rate for that year worked out on the assumption that the company’s aggregated turnover was equal to its aggregated turnover for 2015/16. 

If the aggregated turnover for 2015/16 was less than $10 million and the company carried on business in 2016/17, the franking rate would be calculated by reference to the 27.5 per cent rate.  If one of those requirements was not satisfied, the franking rate would be calculated by reference to the 30 per cent rate.

What happens if you get the franking credit incorrect?

It is conceivable that dividends paid on or after 1 July 2017 (with respect to 30 June 2017) may have been franked at 30% instead of 27.5%.  As outline earlier, the ATO has outlined it will not be looking to audit such cases.  Furthermore, a draft practice statement (PCG 2017/D7) provides for reduction in penalties and interest in such cases.  If you believe you may be impacted by this change, please speak to your Pitcher Partners advisor.

Are there any special rules for a new company?

There is one important proviso to the franking rules outlined above.  That is, the company must have existed in the prior year.  Where a company did not exist in the relevant prior year, the franking rate for the year is determined by reference to the relevant reduced corporate tax rate.

Thus, a company incorporated on 1 July 2017, would be required to frank any dividend paid in the 2017/18 year by reference to the 27.5 per cent rate.

What are the next steps?

Due to the many permutations, it is critical that clients carefully consider their position.  This includes reviewing whether the ‘carrying on business’ requirement is satisfied in respect of 2016/17 in light of the draft ruling; whether dividends paid in 2016/17 and 2017/18 have been franked at the correct rate and (if not) what corrective action should be taken; and how the changes in the Bill impact the existing group structure.

Clients should contact their Pitcher Partners representative to review their situation and determine what action is required well before 30 June 2018.


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