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End the uncertainty around company tax rate with a legislative fix, says BDO

02 August 2017

Give small business companies the choice whether they are taxed at 27.5% or 30%.

Two of the major Australian accounting industry bodies (CPA and CA) have1 today called for a clarification on whether passive investment companies are small business companies for the 27.5% tax rate.  However, there appears to be difference of opinion over whether this clarification should be in the form of legislative change with the CPA indicating that some of these companies may prefer to be taxed at the 30% rate rather than the 27.5% rate.  However these companies can’t choose which tax rate they want to pay, according to leading accountant, BDO Australia.

Companies can’t choose to be or not to be a small business entity, it is automatic if they meet the relevant requirements including the current $10 million turnover test.  However, BDO agrees with the CPAs that some small companies may prefer to pay tax at the 30% rate instead of 27.5%.  However, providing for this choice would require a legislative change.

In early July, the Minister for Revenue and Financial Services, Hon Kelly O’Dwyer MP, announced that the “policy decision made by the Government to cut the tax rate for small companies was not meant to apply to passive investment companies.”

The Minister said: “As always it is up to the ATO to determine how the law applies and in this case whether a company is carrying on a business or not. If any further direction is required on the Government's policy intention by the ATO it will be provided by the Government.”

BDO National Tax Director, Lance Cunningham said that confusion still reigns as the ATO has been left to interpret the legislation but we still have to wait for the “further direction” from the Government of its policy intention.  Who is going to blink first?

“Business needs clarity when preparing their 2017 tax returns and deciding whether to request amended assessments for the 2016 assessments for these passive investment companies .”

“The Tax Office has already made its interpretation clear on its website that most passive investment companies will be carrying on business2sup>. Therefore, unless the ATO changes its interpretation to be in line with the Government’s intended policy outcome, the Government needs to either:

  • Go along with the ATO’s interpretation and accept the 27.5% tax rate for passive investment companies (which seems unlikely);
  • Change the law to clarify that passive investment companies are not taxed at the 27.5% rate; or
  • Change the law to allow small business companies to choose whether to apply the 27.5% rate or the 30% rate.  

This third option may actually be preferable for many small business companies, including those that are actively carrying on business, as they may prefer to be taxed at the 30% tax rate.  The company tax rate reduction is causing a lot of problems for small business without any real tax advantage overall. This is because the company tax is really just a withholding tax because when the company profits are paid out to resident shareholders as franked dividends the tax cut for the company is usually clawed back in top up tax for the shareholder.  There is also the loss of franking credits that some companies suffer as a result of the lower tax rate.”

1 http://www.afr.com/news/policy/tax/company-tax-rate-confusion-creates-chaos-20170801-gxmyun
2 https://www.ato.gov.au/General/New-legislation/In-detail/Direct-taxes/Income-tax-for-businesses/Reducing-the-corporate-tax-rate/.


Background:

  • Companies with a turnover of less than $10 million receive a reduction in their tax rate (from 30% to 27.5%) for the 2016/17 financial year.
  • Government figures estimate around 3 million small businesses are now classified in this lower tax rate.
  • The franking credit rate for year end 30 June, 2017 will be 27.5% where the company’s aggregate turnover for the previous year (2016) was <$10 million. Therefore, dividends paid by these companies after 30 June 2016 have a maximum franking percentage of 27.5%.
  • The extra overall tax happens when the company becomes entitled to the lower tax rate in the current year (because of the increase in the turnover threshold). 
  • If, in the current year, the company pays a franked dividend out of profits that were taxed at the higher tax rate in previous years, the company may be unable to pay out all of the franking credits created from that tax payment (i.e. the franking credits will be trapped in the company). 
  • When a company pays tax at the 30% tax rate, it generates franking credits calculated at 30%.  However, when the company reverts to the 27.5% tax rate, its ability to pay franked dividends is limited to 27.5%, even though the profits used to pay the dividend were taxed at 30%.  When the dividend is paid to a resident shareholder, the franking credit is limited to 27.5%, which can result in an overall tax increase of about 2% (as illustrated in the example below).
  • The change can actually result in a tax increase, with an overall tax rate for companies and shareholders of up to 51%. (see example below).
  • This tax increase will happen to more and more SME’s each time the reduced tax threshold increases, which will be for companies with a turnover up to $25 million on 30 June 2018 and then $50 million on 30 June 2019.  It also can also happen at any time that a company that is paying tax at 30% in one year and then in the following year the company’s turnover decreases below the 27.5% tax rate threshold.