Depending on whether entities can access the lower rates, this may impact the overall tax payable by the group, and may also have an impact on franking credits, especially where a company transitions between being a passive entity (at a 30% tax rate) to a base rate entity (at the lower rate).
The effect of these changes and whether entities are able to access the lower rates should be considered in year-end tax planning conversations for 30 June 2020.
Which entities have access to the lower corporate tax rate?
Corporate tax entities (companies, public trading trusts and corporate limited partnerships) that are base rate entities are liable to pay tax on their taxable income at a lower tax rate, rather than the standard 30% tax rate that applies to other companies.
What is a base rate entity?
A base rate entity for a particular year of income is an entity that has:
- aggregated (group) turnover of less than $50m for the year; and
- no more than 80% of its total assessable income for the year that consists of amounts of “base rate entity passive income” (e.g. certain kinds of passive income that is listed in the legislation such as interest, dividends, net capital gains and rent).
A company can be a base rate entity one year and not the next depending on satisfaction of these criteria. For example, an entity’s aggregated turnover may increase above or decrease below $50m or its proportion of passive income to total assessable income may increase above or decrease below 80%.
What are the upcoming changes to the tax rates?
The corporate tax rate applicable to base rate entities is legislated to be reduced as follows:
2019-20 income year
2020-21 income year
2021-22 income year onwards
What are the implications for year-end tax planning?
Am I a base rate entity?
As a starting point, it is important to consider whether an entity will be a base rate entity for the year, which requires consideration of the size of group turnover (aggregated turnover) and the types of income derived. This may be impacted by trust distributions that a company receives for the year as there can be a tracing of character of the items to the underlying trust income.
Permanent reduction in corporate tax
For companies that are in a taxable position, a falling tax rate could mean that any deferral of taxable income may also result in a permanent reduction in company tax. Assessable income deferred to the following year or deductions brought forward to the current year (e.g. through trading stock elections, writing off of bad debts, scrapping of depreciating assets) can ultimately result in tax being payable for 30 June 2021 rather than 30 June 2020 and reduce total company tax payable on such amounts by 1.5%. Ultimately, this difference may be clawed back when a dividend is paid, depending on the franking or imputation rate at the time and the level of franking credits. The extent of this difference is more significant for a company that transitions in and out of being a base rate entity (i.e. a change from 30% to 26% tax rate).
Interaction with FITOs
Foreign income tax offsets (FITO) are non-refundable and cannot be carried forward such that a company either uses or loses the FITO that arise in the current year. Where a company makes a tax loss, the FITO is essentially wasted. Bringing taxable income forward to the year in which the FITO arises to prevent this outcome can lead to permanent tax savings (by utilising the FITO in the current year and increasing deductions in the subsequent year).
One way a company may do this is to choose not to deduct prior year tax losses that may otherwise be available in order to use the FITO and continue to carry forward the tax loss rather than use the loss and lose the FITO.
How does this impact the ability to frank dividends?
The maximum franking credit that can be allocated to a frankable distribution is determined by the corporate tax rate for imputation purposes. This is determined by whether or not the entity was a base rate entity in the prior income year. If the company was a base rate entity in the prior year, its imputation rate in the current year will be the base rate in the current year (e.g. a 27.5% tax rate in 2020 income year would mean a 26% maximum imputation rate in the 2021 year). Where the imputation rate decreases between income years, this can lead to a wastage of franking credits, which cannot be allocated to taxed profits in later years. This would also result in the effective tax rates for individual shareholders on corporate earnings to exceed their marginal tax rates.
This could be more pronounced where the company paid tax at 30% and seeks to distribute the after-tax profits on or after 1 July 2021 where its maximum imputation rate has fallen to 25%.
How can the franking issues be managed?
Companies in this situation of falling imputation rates may consider distributing franked dividends before year-end to manage any potential wastage but would need to monitor the balance of their franking account as credits for June instalments and the final tax payable may not have yet arisen. This is particularly so where instalments have been varied or refunded as a result of COVID‑19.
There may be other entities in the group that are not base rate entities and pay tax at 30%. Distributing franked dividends at 27.5% to such companies to preserve franking credits (e.g. via a discretionary trust) comes at a short-term cost as it may result in 2.5% “top-up tax”.
It is possible for a 27.5% taxpayer to frank dividends at 30% over a span of two income years (e.g. by becoming a base rate entity in the following year such that it can frank at 30% in the year after that). However, this may not be feasible for companies that predominantly derive active business income.
Note lastly, that where a company is completely dormant for an income year such that it has $0 of assessable income, its imputation rate in the following income year will be the base rate (e.g. 25%).
What are the next steps?
With changes to the corporate tax rate imminent for many taxpayers, there are potential opportunities available to maximise benefits of bringing forward or deferring taxable income. However, there are several practical considerations for managing the risks of franking credits being wasted as a result of these tax rate changes.
It is critical to consider your position and how the rules apply, before 30 June. Contact a Pitcher Partners representative for more information and support.