Legislation has been introduced into Federal Parliament that will amend the tax law to ensure that a company will not qualify for the lower company tax rate of 27.5% if more than 80% of its assessable income is passive income. However, the amendment will apply prospectively from the 2017/18 income year, which differs to the 1 July 2016 start date in the exposure draft law released last month.
This combined with a new draft tax ruling indicates that many small passive investments companies, whether or not its passive income is greater than 80% of its assessable income, will be entitled to the 27.5% tax rate for the 2016/17 income year and 28.5% tax rate for the 2015/16 income year. Where these companies have paid tax at the 30% rate, they may be entitled to claim a refund of the extra tax paid. Where their tax returns for these years have not yet been lodged they should ensure their tax returns show they are small business entities to ensure they are taxed at the lower rates. However, care needs to be taken as the change in the tax rate for these companies may also affect the franking credits available for dividends that were paid in the 2016/17 income year.
The different start date is just one of a number of changes as compared to the exposure draft law including the adoption of certain recommendations BDO suggested in our submission on the draft law, whilst other issues remain outstanding as discussed below. The ATO has simultaneously released TR 2017/D7 on when a company ‘carries on a business’, which indicates that most passive investment companies are carrying on business. The draft ruing is discussed further below.
Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) bill 2017
Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (new law) was introduced into the House of Representatives on 18 October 2017 and will amend the current tax law to ensure that from 1 July 2017 a company will not qualify for the lower company tax rate of 27.5% if more than 80% of its assessable income is passive income (such as interest, dividends or royalties). This is a ‘bright line’ test that will replace the previous requirement that a company be ‘carrying on a business’.
The Bill has been introduced relatively quickly as the exposure draft law (draft law) was only issued on 18 September 2017. BDO lodged a submission addressing various problems with the new concept of ‘base rate entity passive income’ and imputation issues in the draft law.
The new law contains changes as compared to the draft law signalling adoption of several recommendations suggested by BDO, which is pleasing, but several issues remain outstanding and this BDO Tax Technical Update summarises the new law and also revisits those issues that have not been addressed and which will require attention.
New ‘base rate entity passive income’ definition
The measures in the new law are intended to clarify that predominantly passive investment companies cannot access the currently enacted lower company tax rate from 1 July 2017. Specifically, the amendments to ensure a corporate tax entity will not qualify for the lower corporate tax rate if more than 80% of its assessable income is of a specifically defined ‘passive’ nature. This is a change compared to draft law, which referred to 80% or more of its assessable income being passive.
This new concept of ‘base rate entity passive income’ (passive income) includes, among other things, portfolio dividends (dividends on shares with less than 10% voting interest), franking credits, net capital gains, rent, interest, royalties, and certain amounts that flow through a partnership or a trust (to the extent that it is attributable to an amount of passive income).
BDO requested the inclusion of more examples in the EM therefore it is pleasing that it now contains eight examples with two on amounts derived by trusts, four examples that illustrate the operation of the passive income test and two examples on the operation of the imputation system.
The definition of ‘base rate passive income’ includes dividends from a company other than non-portfolio dividends (within the meaning of section 317 of the ITAA 1936, which is a dividend paid to a company where the company has at least 10% of the voting power in the company paying the dividend. However, there is no tracing through to the type of income received by the dividend paying company so that all non-portfolio dividends will not be treated as passive income even if they are paid out of passive income of the dividend paying company. In such a scenario, the passive income of the dividend paying company would not be taken into account in the 80% passive income test of a recipient company resulting in situations where a corporate group could qualify for the lower tax rate where more than 80% of the group’s income was passive income. BDO identified this issue in our submission but there has been no change between the draft law and final law. However, anyone looking to take advantage of this apparent loophole should consider whether the general anti-avoidance provisions would apply in their circumstances.
Dividends through a trust
The passive income that a company receives through one or more interposed trusts or partnerships will also be passive income unless the dividends are ‘non-portfolio dividends’. However, as mentioned above, the definition of non-portfolio dividends in section 317 requires the dividend to be received by a company. It appears that where the dividend is received by a trust it will not be able to be a ‘non-portfolio dividend’ even if the trustee holds 10% or more of the voting power. This appears to be in contradiction with a comment at paragraph 1.12 of the EM, which indicates that a trust can receive a non-portfolio dividend. However, comments in the EM cannot override the clear words of the legislation. Therefore, unless the law is changed before it passes through Parliament, it appears all dividends received through a trust will be passive income.
Rent and royalties
The definition of passive income in the new law includes interest income, royalties and rent. There are existing provisions that ensure that interest derived by an entity that is from the ‘active conduct of a business’ or banking business or money lending business will not be treated as passive income. However, it appears that the same exclusion does not apply to rent or royalties that come from the active conduct of a business. Therefore, under the changes in the new law rent and royalties will constitute passive income irrespective of the extent of activities that would otherwise point to an active business i.e. companies which are in the business of actively deriving rent and royalties will be considered passive investment companies.
Capital gains and disposal of assets
The definition of passive income in the final law refers to ‘net capital gains’ which BDO recommended in our submission as the draft law referred to ‘capital gains’ without reducing for capital losses (current or previous year) or small business active asset reduction. Assessable income only includes ‘net capital gains’ which are capital gains after reducing for capital losses and CGT concessions etc. Without the change in the final law this would have resulted in passive income amounts exceeding assessable income amounts. It could be said that the 80% threshold formula was previously ‘comparing apples and oranges’ but now the ‘80% test’ now ‘compares apples with apples’ (or assessable income with assessable income).
BDO was also of the view in our submission on the draft law that capital gains realised on the disposal of active business assets should not be treated as passive income but this is still an issue. As the sale of a business gives rise to a capital gain, under the new law, this will be treated as passive income. A company in this position may find it difficult to derive sufficient active income in its final trading year and it would be inequitable for such a company to not qualify for the lower tax rate, however it will be at risk of so doing if the capital gain on its active assets increases its passive income above the 80% threshold.
Franking credits are also now explicitly included in the definition of passive income which BDO recommended in our submission as they were not so included in the draft law. The clarification eliminates the previous mismatch resulting in an amount of real income (disregarding franking credits) being more than the 80% passive income amount permitted under the new definition of passive income to the extent of the effect of this includes franking credits.
Aggregate turnover hurdle
One of the thresholds in determining whether a company is entitled to the 27.5% tax rate is that its ‘aggregate turnover’ must be less than the ‘annual aggregate turnover threshold’ ($10 million for 2016/17). The aggregate turnover of a company includes the annual turnover of company and its connected entities. Before the ATO published its view on passive investment companies carring on business, many taxpayers may have assumed that the annual turnover of the company and companies connected to it would not include their passive income because it was not thought to be ‘income received in the ordinary course of carrying on a business’. However, now the ATO’s view is that most companies are carrying on business, this ‘passive income’ would generally be included in the business income, so many of these companies will have to recalculate their aggregate turnover to include its ‘passive income’ in business income, which may result in the company being over the aggregate turnover threshold. This is an issue for entitlement to the lower tax rates for all of 2015/16 and 2016/17, 2017/18 and future years. This is also an issue for entitlement to the other small business entity concessions (including the small business CGT concessions and the under $20,000 asset write off etc.).
Prospective amendment going forward
The amendments will apply prospectively from the 2017/18 income year which is a change from the draft law and will provide clarity for planning purposes. The passive income test will replace the previous requirement in section 23AA of the Income Tax Rates Act 1986 that a company be ‘carrying on a business’. In the 2016/17 income year however, a company irrespective of whether it is a passive investment company will need to be carrying on a business and have a turnover under $10 million to qualify for the 27.5% tax rate. However, given the ATO’s view on companies carrying on business, as discussed below, such companies can now confidently lodge tax returns as small business entities or where they have already lodged the return can request an amended assessment. The final law also does not affect the treatment of the 28.5% tax rate for the 2015/16 year, which continues to have an aggregate turnover threshold of $2 million. Prior to the ATO’s draft ruling re carrying on business, most of these companies were not thought to be carrying on business and would have self-assessed themselves as being taxed at the 30% rate. They can now consider asking for an amended assessment to be taxed at the 28.5% rate.
ATO ruling TR 2017/D7 on ‘carrying on a business’
On 18 October 2017 the ATO simultaneously released draft taxation ruling TR 2017/D7 (‘draft ruling’) on when a company ‘carries on a business’ (within the meaning of section 23AA of the Income Tax Rates Act 1986), which indicates that companies that are established and maintained to make profits for its shareholders will generally be carrying on business even if the company’s activities primarily consist of passive receiving rent or returns on its investments and distributing them to its shareholders. This would appear to cover most passive investment companies.
The draft ruling includes several examples of common scenarios. The examples of companies not carrying on a business include:
- A dormant company with retained profits and bank account, on which it derives small amounts of interest that only covers its holding costs (e.g. ASIC fees)
- A company engaged solely in the preliminary activity of investigating the viability of carrying on a particular business
- A family company’s only income is trust distributions from a discretionary family trust, which it distributes part in cash to its shareholders and the balance is held in a non-interest bearing bank account pending distribution to shareholders. The company has no other assets
- A family company with an unpaid present entitlement (UPE) from a family trust and has not demanded payment from the trust and nor has it entered any arrangement with the trust to receive any profit from the UPE.
The examples of companies that are carrying on business include a family company that has a UPE from a family trust but, in distinction to the example 4 above, it has entered into an agreement with the family trust to loan the UPE funds to the trust in return for a commercial rate of interest secured against the assets of the trust. This example is not exactly in line with the usual situations in relation to such UPE’s that are either compliant with Division 7A loan agreement or Sub-trust arrangements as per PS LA 2010/4, which do not always require the loans to be secured. However, it appears from the other comments in the ruling that as long as the Division 7A loan or sub trust arrangement was seen as a profitable way of investing the company’s assets it should result in the company carrying on a business. This is also supported by a number of other examples where the company is investing its assets to receive passive income where it is concluded that the company is carrying on business.
However, as the ATO says in the draft ruling, the answer ultimately turns on an overall impression of the company’s activities, having regard to the indicia of carrying on a business.
It is also interesting to note that the draft ruing says the concept of a company carrying on business is considered ‘within the meaning of section 23AA of the Income Tax Rates Act 1986’. However, section 23AA is being amended (as indicated above) to exclude the reference to ‘carrying on a business’ for the 2017-18 and future years and section 23AA does not apply to the 2016/17 and previous year. Therefore, this draft ruling is only relevant in principle generally to the concept of ‘carrying on a business’. It is expected that the ATO will correct this in the final ruling and instead say it is to be considered “within the meaning of ‘small business entity’ under s328-110 of the ITAA 1997”, which is the relevant test for determining eligibility to the lower tax rates for the 2015/16 and 2016/17 income years.
- It is imperative for any company seeking to apply the lower tax rate to carefully consider the circumstances in which it operates, and the nature of its assessable income.
- The examples in TR 2017/D7 should be carefully considered. The due date for submissions on TR 2017/D7 is 1 December 2017.
- The ATO has advised that it will adopt a facilitative approach to compliance in relation to the ‘carrying on a business’ test for the 2016-17 year and 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 unreasonable’.