The change in the company tax rate from 30% to 27.5% is welcome news for many small to medium sized businesses. However, what seems like a simple and positive change has some real underlying complexities and numerous traps for companies of all sizes. In many instances, the changes may actually result in a tax increase.
For 2017 the reduced rate applies to businesses with less than $10M in turnover. For 2018 the turnover threshold is lifted to $25M and then to $50M in 2019, however additional conditions for the reduced rate also likely need to be met from 2018 onwards.
During the 2018 financial year, and again in the 2019 financial year, businesses, investment companies and trusts using corporate beneficiaries, will need to review their current tax planning and dividend strategies to maximise their ability to access the reduced rate and to also ensure that this tax cut does not become a tax rise.
Working out your tax rate
As a starting point, your company tax rate is determined based on turnover, which seems like a simple enough proposition.
However, it is not just the turnover of the company that is relevant – turnover is aggregated with the turnover of all connected entities and affiliates. For a more complex group, in particular when trusts are involved, working out who is connected with an entity is not a straightforward exercise.
Turnover is based on ordinary income (i.e. a tax concept of income), not accounting income. Understanding variances between tax and accounting income, and ordinary and statutory income, will be important. Timing differences in recognition of income and differences in the calculation of gains are two examples. These types of variances could take an entity in to, or out of, the reduced company tax rate with flow on effects to their dividend distributions.
From 2018 onwards, it is proposed that companies earning more than 80% of their income from ‘passive’ sources would not qualify for the reduced company tax rate, irrespective of their turnover. The proposed definition of ‘passive’ income is complex and is yet to be legislated.
More detail on the changes can be found here.
Some of the key impacts
One of the areas where adverse outcomes are most likely is the use of corporate beneficiaries. Most corporate beneficiaries have built up a bank of franking credits which are key to managing the tax rate on the dividends paid when the structure is unwound. There is a strong likelihood that a corporate beneficiary could benefit from the reduction in the company tax rate, but a flow on effect is that the rate at which it can frank dividends also likely reduces to 27.5%. This is despite having historically paid tax and generated the franking credits at 30%. The difference results in the effective tax rate on the dividend increasing by 2.5%. This is an immediate increase in tax payable and the dollar value impact could be very substantial.
There are ways to manage and mitigate this impact, but it is very much a case by case assessment. For some situations, creating a new corporate beneficiary may solve the issue. For other situations the answer is more complex.
For corporate groups, it is possible to have a subsidiary with a 30% tax rate that pays dividends to a holding company with a 27.5% tax rate, resulting in an immediate loss of franking credits for the 2.5% differential. Excess franking credits can be converted to tax losses, but unless there are other sources of income the losses may not be able to be utilised. This situation is most likely to arise where a subsidiary company holds investment assets, and may best be addressed through a restructure of ownership of that entity.
Step 3 of the Allocable Cost Amount calculation (which is used to reset the tax costs bases of assets when a tax consolidated group is formed) is based on the extent to which the retained profits can be distributed as franked dividends. A decrease in the company tax rate will increase the Step 3 amount (usually producing better outcomes), but an increase in the company tax rate, as will be experienced by growing businesses, will reduce the Step 3 amount and likely produce a poorer outcome on formation of a tax consolidated group. Timing of the decision to form a tax consolidated group will be key, particularly in takeover and merger transactions.
Tax effect accounting
The tax rate change will also impact on tax effect accounting calculations. A change in the corporate tax rate will require deferred tax assets and liabilities to be restated, and may require some forecasting of future turnover and from this, the expected tax rate in subsequent years. The changes to the accounting standards for revenue recognition will add further complications. Most businesses with financial covenants or reporting obligations, whether to banks, regulators, licencing bodies or otherwise, will need to assess the impact of the tax rate change and other accounting standard changes on their financial covenants, ratios, etc.
The company tax rate impacts a range of decisions made in a business acquisition transaction. One example is the adjustment to the purchase price made for employee leave provisions. Particularly in the services industry, these liabilities can be substantial. A vendor will normally seek the adjustment to be tax effected, with the default being at 30%. The purchaser needs to make sure the tax is determined at the right rate given their circumstances, otherwise they will end up over-paying for the acquisition.
New companies will default to a 27.5% franking rate in their first year, regardless of their actual tax rate. New companies paying dividends in their first year of operations already need to be particularly careful to not create a deficit in their franking account balance and the change in the tax rate adds another level of complexity. A potential mismatch in tax rates could arise in corporate groups where a new subsidiary is established that makes dividend distributions within the group, potentially triggering a tax liability on that dividend.
Large one off gains
Companies that receive, or are expecting to receive, a large one off gain (such as a capital gain) will need to determine if that gain will cause them to fail the ‘passive’ income requirements, and hence become a 30% taxpayer (thereby increasing their tax cost for the gain and all other income in that year). The change in tax rate then has an impact on the rate at which dividends can be franked in the following year, which may necessitate re-thinking of the timing of dividend payments.
Eligibility for the reduced tax rate is self-assessed, but effectively disclosed by the information provided in the income tax return and the tax rate paid. Importantly, there is no ability to “opt out” of these rules, meaning all taxpayers that are companies are going to need to assess the impact that the changes in the tax rate and the effect on franking of dividends will have on their tax planning and dividend strategies.
The laws implementing the tax rate change for 2017 have been enacted, as have the increases in the turnover threshold to $25M in 2018 and $50M in 2018. Further increases in the tax turnover threshold have been proposed, but not yet legislated. Laws implementing the ‘passive’ income requirements and some of the changes to the franking credit rules have been drafted but are yet to be passed by Parliament. It is expected that these rules will be finalised early this year.
If you need assistance in understanding how this change will affect you and your tax position, please contact us.
Disclaimer: The contents of this article are in the nature of general comments only, and are not to be used, relied or acted upon with seeking further professional advice. William Buck accepts no liability for errors or omissions, or for any loss or damage suffered as a result of any person acting without such advice. Liability limited by a scheme approved under Professional Standards Legislation.