The Parliament recently introduced legislation that seeks to tax corporate entities at the full 30% tax rate where more than 80% of the company’s income for the year is base rate passive income.
A recap of the current law
In May 2017, the Parliament passed changes to the legislation that reduced the corporate tax rate of companies with aggregated turnover of less than $10m to 27.5% from 1 July 2016. This threshold is set to increase to $25m in the 2018 financial year and $50m in the 2019 financial year. However, in a recent draft ATO Interpretative Decision, following on from the decision in Bywater (see RSM Insights 20 March 2017), the Commissioner made the following comment:
“This ruling is not concerned with what amounts to carrying on business. However, generally, where a company is established or maintained to make profit or gain for its shareholders it is likely to carry on business. This is so even if the company only holds passive investments, and its activities consist of receiving rents or returns on its investments and distributing them to shareholders.”
It was argued within the industry that companies holding passive investments would be eligible for the lower 27.5% tax rate, provided their aggregated turnover was less than the relevant threshold. It seems that this outcome was not the intention of the policy and the Parliament has now moved to legislatively determine circumstances where passive income earning companies will be entitled to the lower tax rate.
What does base rate passive income include?
- Dividends and franking credits received from companies unless the company holds more than 10% of the interests in the dividend paying company;
- Non-share dividends from companies;
- Interest, royalties and rent derived;
- Gains on certain qualifying securities;
- Net capital gains; and
- Amounts of partnership or trust income that is base rate passive income as previously defined.
The Parliament had previously considered applying the legislation with retrospective effect from 1 July 2016, however, the proposed legislation is to take effect from 1 July 2017. This is a common-sense outcome and will avoid the potential issues with companies having to re-visit 2017 dividend statements that may have already been issued as a result of the changes.
Is this a positive change?
The 80% passive income threshold appears to be quite generous to companies. There is also a carve out of non-portfolio dividends which is proposed to be included to try and assist holding companies gain access to the lower rate on dividends from subsidiaries.
However, as a result of the proposed legislation, there will be a need for trusts and partnerships to clearly identify the nature of the income that is distributed to the partners and beneficiaries in order to track the character for recipient companies. Similarly, companies will need to consider whether they qualify for the 27.5% rate following an analysis of their income streams.
As the base rate passive income test is applied each year, companies with predominantly passive incomes or trading companies that are selling capital assets may need to manage their net capital gain position in order to access the lower tax rate.
How will franked dividends be impacted?
For the purposes of franking dividends, companies can assume their aggregated turnover and base rate passive income is the same as the prior year which should provide some certainty following completion of their financial statements and income tax returns during a year. Whilst there may be a delay between year-end and the completion of the necessary statements, it will be obvious to many companies whether they are likely to fall within the 27.5% or 30% taxation categories for the purposes of franking dividends.
However, those companies that straddle the 80% passive income line may find that they alternate between having a 27.5% tax rate in one year, to a 30% tax rate in the following year, particularly where, for example, they derive larger capital gains from the sale of an investment. As the base rate passive income percentage effectively carries forward for franking purposes, taxpayers may need to manage their dividends paid to shareholders in those years where the higher franking rate applies. This could provide some opportunities for taxpayers to utilise some franking credits that have been built up during a 30% tax period.
As we transition through the aggregated turnover thresholds, companies with aggregated turnover with less than $25m may find that they are now restricted to franking their dividends at the 27.5% rate. This might result in a trapping of franking credits in the company that had built up at the higher 30% tax rate. Companies with aggregated turnover between $25m and $50m might consider reviewing their dividend strategy during the 2018 year in order to ensure that dividends can be franked at that higher 30% rate.
What action should I take now?
As we are now close to halfway through the current financial year, companies expecting to generate a large amount of base rate passive income should carefully consider if they qualify for the reduced corporate tax rate.
Speak to an RSM tax advisor today to determine how these changes may impact you.