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NOTE: In this article, all section references are to the Income Tax Assessment Act 1997.

On 8 February 2018, the Treasury Laws Amendment (Reducing Pressure on Housing Affordability No. 2) Bill 2018 was introduced into Parliament. Schedule 1 to the Bill contains a proposed measure to deny the CGT main residence exemption (MRE) to taxpayers who — at the time of the CGT event (i.e. when they enter into a contract to sell a dwelling that has been their main residence) — are a non-resident for tax purposes (hereafter referred to as simply ‘non-resident’).

This measure was announced in the 2017–18 Federal Budget in the following brief terms:

The Government will extend Australia’s foreign resident capital gains tax (CGT) regime by: … denying foreign and temporary tax residents access to the CGT main residence exemption from 7:30 PM (AEST) on 9 May 2017, however existing properties held prior to this date will be grandfathered until 30 June 2019; …

The Senate Economics Legislation Committee, which reported on the Bill on 23 March 2018, made the following recommendations:

Recommendation 1

The committee recommends that the Australian Government ensures that Australians living and working overseas are aware of the changes to the CGT main residence exemption for foreign residents, and the transitional arrangements, so they are able to plan accordingly.

Recommendation 2

The committee recommends that the bills be passed.

The Government announced on 18 December 2017, as part of the Mid-Year Economic and Fiscal Outlook 2017–18, that following consultation the Government has amended the proposal so that ‘temporary tax residents’ who are Australian residents will be unaffected. This is to ensure that only Australian tax residents, including temporary residents, can access the MRE. Accordingly, only foreign residents (i.e. non-residents for tax purposes) are affected by this measure.

The measure is proposed to apply to CGT events happening on or after 7.30 pm (AEST) on 9 May 2017. A transitional rule is proposed which will not deny the MRE to taxpayers who held the dwelling before 7.30 pm (AEST) on 9 May 2017 if they are non-residents at the time of the CGT event, as long as the CGT event happens on or before 30 June 2019. This gives taxpayers until 30 June 2019 to sell their homes without being affected by these changes.

While this measure appears to commence on 9 May 2017, the practical effect is that it could result in the retrospective denial of the MRE as far back as 20 September 1985: the commencement of the CGT regime and the MRE. Under these amendments, the availability of the MRE to a taxpayer is based on their tax residency status at the time of the CGT event, irrespective of the use of the dwelling or the taxpayer’s residency status throughout the ownership period.

Example

An Australian resident taxpayer, Ozzie, has always been a resident for tax purposes. He bought a dwelling in Australia on 1 July 1986 for $100,000 and used it as his home; it has never been rented out, and the dwelling has always been his main residence. On 30 June 2016, having decided to accept a job overseas, Ozzie reallocated offshore for an indefinite period and became a non-resident. At that time, Ozzie’s home was worth $2.2 million.

Ozzie decides to stay overseas. Five years later, on 30 June 2021, he sells the dwelling that, prior to moving overseas, had been his home for 30 years. Because Ozzie is a non-resident at the time of the CGT event, he is not entitled to the MRE — at all. Accordingly, he will have a taxable capital gain of $2.4 million.

This may be depicted as follows:

Ozzie cannot:

• claim a partial MRE for the number of days he actually lived in the dwelling;
• continue to treat the dwelling as his main residence after he vacates it (under the absence rule in s. 118-145) — which would otherwise allow him to continue to treat the dwelling as his main residence indefinitely if the property is not used for an income-producing purpose or for up to 6 years if he rents it out; or
• if he had decided to rent the property in 2016 when he departed Australia — reset/uplift the cost base of the dwelling to its market value (MV) on the date he first began to rent it (where that use occurs for the first time after 20 August 1996) under s. 118-192.

This is because all of these concessions are contained in the MRE rules and rely on the taxpayer being entitled to claim a partial MRE — and Ozzie is not entitled to any MRE.

Third element ownership costs

Had Ozzie instead acquired the dwelling after 20 August 1991, he would be entitled to include ownership costs — such as rates, repairs and maintenance, insurance and interest expenses — in the cost base of the property. But Ozzie never kept records of these costs because he didn’t think it was necessary; after all, everyone knows that the sale of a dwelling that is your main residence is not subject to CGT. Ozzie could not have foreseen all those years ago that the Government would propose to retrospectively deny him the MRE, causing the sale of his home to be taxable in the future based on his circumstances.

Accordingly, because it is unlikely that Ozzie can substantiate his third element ownership costs, he would not be able to include an estimate of these amounts in the cost base of the property, thereby increasing his taxable capital gain. Contrast this with a taxpayer who acquires a dwelling after these changes are enacted with the knowledge that, under the new rules, there is a possibility that they will not be entitled to the MRE — they would be in a position to prospectively retain all relevant cost base records from the date of acquisition to minimise their eventual taxable capital gain.

CGT event I1 not applicable

CGT event I1 (s. 104-160) happens when an individual stops being an Australian resident, causing a deemed disposal of their CGT assets at their market value and allows the taxpayer to choose to defer the tax on these assets.

However, CGT event I1 does not happen when Ozzie stops being an Australian resident, because CGT event I1 applies only to CGT assets that are not taxable Australian property — in this case, Ozzie’s dwelling continues to be taxable Australian property and therefore remains within the Australian CGT regime.

What about the CGT discount?

Ozzie will have a taxable capital gain of $2.4 million, without access to any MRE. Is he entitled to any CGT discount as a non-resident? Non-residents have not been entitled to the CGT discount since 8 May 2012.

Under s. 115-115:

• As Ozzie became a non-resident after 8 May 2012, he is entitled to a reduced discount, based on the number of days he was a resident. The law requires the calculation to be performed based on the number of days but for illustrative purposes and simplicity, years have been used here instead. So, given that Ozzie was a resident for 30 years out of 35 years of ownership, he will be entitled to a CGT discount of 42.85% instead of the full 50% discount.
• If Ozzie had become a non-resident before 8 May 2012, he would be entitled to apportion the CGT discount by applying it only to that part of the capital gain which had accrued to 8 May 2012 by determining the market value of the property on 8 May 2012. On the facts as given, Ozzie did not become a non-resident until 2016, so this market value rule is not available to him.

What if Ozzie moves back to Australia?

If Ozzie moves back to Australia after 30 June 2019 and re-establishes himself as a resident, then sells the dwelling, he would not be a non-resident at the time of the CGT event and he would be entitled to the MRE. Accordingly, he could access a partial MRE, the absence rule in s. 118-145 and the cost base-market value deeming rule in s. 118-192 as applicable.

It is notable that para. 1.23 of the Explanatory Memorandum to the Bill explains that the general anti-avoidance rules in Part IVA may be applied to arrangements that have ‘been entered into by a person for the sole or dominant purpose of enabling that person or another person to obtain the [MRE]’.

What if Ozzie dies while he is overseas?

If Ozzie dies while he is overseas, his interest in the dwelling will pass to the beneficiaries (simply referred to in this article as ‘the beneficiary’) of his deceased estate in accordance with the wishes set out in his will.

Assume that Ozzie dies on 3 June 2020, and Ozzie’s beneficiary sells the property on 12 November 2022.

Ozzie is a non-resident at the time of his death

Ozzie is a non-resident at the time of his death, so any portion of the MRE that Ozzie has accrued is not available to the beneficiary. This means that despite Ozzie residing in the property for 30 years as a resident, because he was a non-resident when he died, his beneficiary may not be able to claim any MRE — it will depend on their residency status at the time of the CGT event.

If the beneficiary is a resident at the time of the CGT event (i.e. when they sell the property), they will be entitled to the MRE that accrues in their own right, but not that of Ozzie.

If the beneficiary is a non-resident at the time of the CGT event, they will not be entitled to any MRE; not for the period that Ozzie resided in the dwelling, nor for the period following his death. This is irrespective of the beneficiary’s use of the dwelling or the beneficiary’s residency status throughout the ownership period.

This means that if the deceased was a non-resident at the time of death, and the beneficiary is a non-resident at the time of the CGT event, no MRE is available to the beneficiary.

Ozzie is a resident at the time of his death

Had Ozzie been a resident at the time of death (i.e. he re-established his residency before he died and was not a non-resident at the time of death), the MRE accrued by Ozzie will continue to be available to his beneficiary to the extent of:

• the period during Ozzie’s lifetime that he used the dwelling as his main residence;
• the period that occurs within two years of Ozzie’s death (or within such longer period allowed by the Commissioner); and
• the period following Ozzie’s death where the dwelling was the main residence of Ozzie’s spouse (assuming he had one) immediately before his death and/or an individual who had a right to occupy the dwelling under Ozzie’s will, regardless of the residency status of that spouse or individual.

However, the beneficiary — to whom the ownership interest in the dwelling passed under the will (but falling short of having a right to occupy the dwelling under the will) — is denied any component of the MRE that is attributable to the period following death when they lived in the dwelling as their main residence if they are a non-resident at the time of the CGT event.

So to summarise, if Ozzie’s beneficiary is:

• a resident at the time of the CGT event (i.e. on 12 November 2022) — they continue to be entitled to the MRE for any part of the exemption that they accrue in their own right (the cost base for the beneficiary will be Ozzie’s cost base immediately before his death);
• a non-resident at the time of the CGT event — they will be denied any component of the MRE that they accrued in their own right.

Is the MRE available to a beneficiary of a deceased estate who inherits the dwelling?
[fusion_table]

At time of CGT event, the beneficiary is a …	At time of death, the deceased is a …
	Resident	Non-resident
Resident	MRE available*	In relation to the deceased’s period of ownership
		* In relation to the period following the date of death
Non-resident	MRE available* but only in relation to: the period before the date of death during which the dwelling was the deceased’s main residence*; the period within two years of the date of death^; and the period after the date of death where the dwelling was the main residence of deceased’s spouse and/or an individual who had a right to occupy the dwelling under the deceased’s will. In relation to the period following the above	MRE not available

[/fusion_table]
^* Subject to normal MRE rules.
^ Or within such longer period allowed by the Commissioner.
[fusion_table]

[/fusion_table]

[fusion_table]

[/fusion_table]

What if Ozzie returns to Australia to die?

Assume that in February 2020 Ozzie is diagnosed with a terminal medical condition. He decides to return to Australia for medical treatment and to be close to his family and friends. Ozzie returns to Australia but is immediately confined to a hospital bed, where he spends the next four months until his death.

While in hospital, Ozzie — as part of attending to his estate planning and financial affairs — may arrange to sell the property before he dies in June 2020. Alternatively, he may still own the dwelling at the time of his death.

If Ozzie is a resident at the time of the CGT event or his death, he is entitled to the MRE, including the absence rule under s. 118-145. But if he is a non-resident at the time of the CGT event or his death, he is not entitled to any MRE.

Assume that immediately on Ozzie’s return to Australia he is transferred to a hospital, and dies without ever moving back into his home. Has Ozzie become a resident again, or is he still a non-resident at the time of the CGT event or the time of his death? This is a question of fact, but it may be problematic to establish that Ozzie has re-established his residency simply by virtue of his presence in Australia while he seeks medical treatment.

Suggested improvements

The author of this article raised the retrospectivity issue with Treasury following the release of the exposure draft legislation on 21 July 2017. If the Government’s new policy is that ‘foreign residents’ should be denied access to the MRE, then the Government is unquestionably entitled to change the law. Perhaps there is a view within the Government that ‘foreign residents don’t vote’ so no electoral seats are affected by this measure, or ‘they can afford it’. It is noted that Australian citizens living overseas, like Ozzie, are still entitled to vote.

But there is a difference between:

• a ‘foreign resident’ (i.e. a foreign citizen) who is a non-resident for tax purposes, buys property in Australia, treats it as their main residence and benefits from the MRE; and
• an Australian citizen who has always lived here, in the dwelling, paid income taxes for decades as a tax resident, then later in life for professional or personal reasons chooses to relocate overseas and become a non-resident, then sells the dwelling that was their home for so many years.

The author suggested to Treasury that the policy could be altered to make it equitable for Australian expatriates, so that the MRE could still generally be denied to non-residents, but that if the non-resident had previously been an Australian resident taxpayer, either one of the following concessions could be allowed:

1. reset the cost base of the property to its market value on the day they become a non-resident so that the capital gain is calculated only on the increase in value since they ceased to be a resident — in Ozzie’s case, this would equate to a taxable capital gain (before the CGT discount) of $300,000 instead of $2.4 million; or
2. allow a partial exemption for the number of days the taxpayer was a resident and lived in the dwelling as their main residence — in Ozzie’s case, this would reduce the taxable capital gain of $2.4 million by more than $2 million ($2.4m × 30/35 years — again using the number of years instead of days for simplicity).

However, the Bill introduced into Parliament on 8 February 2018 contains neither of these two concessions.

Final comment

More recently, the Senate Economics Legislation Committee has now recommended the Bill be passed without any amendments. This suggests that the outcome is aligned with the Government’s policy intent, but you can form your own opinion as to whether this outcome is intended or unintended.

What is not in question is that this proposed measure is draconian, retrospective and unfair.

Further reading

CPA Australia lodged a submission in response to the Senate Economics Legislation Committee inquiry into the Bill. In its submission, CPA Australia raised its concerns over the impacts the proposed measures will have on Australian citizens residing overseas and deceased estates.

We provide a link to the submission (see above) with the express permission of CPA Australia.

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The recent news cycle has extensively followed the astronomical growth — and the odd sharp dip — in the value of Bitcoin, the cryptocurrency phenomenon.

With an unprecedented level of public interest in Bitcoin and other forms of cryptocurrency, it is timely for tax advisers to consider how the Australian tax laws apply to taxpayers who have been early adopters of what may be — depending on which expert opinion piece you read — the game-changing future global medium of exchange, or the next ‘bubble’ to crash.

What is cryptocurrency … and why the hype?

Cryptocurrency is digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds.

Cryptocurrency is decentralised. Currently, no form of cryptocurrency is regulated by any government or financial institution. The transfer of funds does not involve a financial institution intermediary — and is generally anonymous.

Bitcoin … and its bridesmaids

The original and most famous cryptocurrency is Bitcoin. It was created in 2009 by an anonymous person or group using the pseudonym ‘Satoshi Nakamoto’. Now, nine years later, there are (according to Wikipedia) over 1,300 different cryptocurrencies available on the internet. While Bitcoin is still the predominant household name and dominates in terms of market capitalisation, other cryptocurrencies leaving a significant virtual mark include Ethereum, Ripple and Litecoin. These non-Bitcoin cryptocurrencies are commonly referred to as ‘altcoins’.

Is Bitcoin a doomed ‘bubble’ or a sure bet?

The notoriously volatile price of Bitcoin recently made the news headlines in the lead-up to Christmas when its price hit its historical peak at around USD 19,000 per Bitcoin on 17 December 2017. The remarkable aspect was not the price per se, but the fact that it had started the year with a low of below USD 1,000 in early January 2017. This is a 20-fold increase in value within a calendar year — albeit with less extreme highs and lows in between.

Just one month after the record high, on 16 January 2018, the price sharply dropped below USD 11,000. The vigorous yoyo-ing of the price — not just in recent months but also a familiar sight in earlier years — has captured the attention of the general public as well as tech and investment pundits.

Cryptocurrency also makes the news from time to time due to hackers stealing data from various online exchanges throughout the world — the most recent and largest example of which is the theft of 58 billion yen worth of an altcoin from a Japanese exchange.

Some Bitcoin loyalists are adamant that if Bitcoin holders can ride out its current fickleness, they will be abundantly rewarded by financial gains. Others are dubious of its viability and predict that the ‘bubble’ will inevitably burst. In online commentary, there have been parallels drawn with the dotcom bubble of the early 2000s, the Wall Street crash of 1929 and even the Tulipmania of the 1630s.

A bit about Bitcoin …

What is ‘blockchain’?

Bitcoin — and other cryptocurrency — is created using blockchain technology.

Blockchain is a decentralised, real-time ledger which simultaneously records transactions on a large number of computers in a network. Blockchain creates permanent and secure records and promises to reduce the scope for fraud — mainly due to fact that, as a decentralised system, there is no single IT system to hack. Instead, information is securely stored in separate, decentralised records (i.e. ‘blocks’), which cannot be removed or changed.

The use of blockchain technology is not limited to cryptocurrencies. Commentators have suggested that, in the future, blockchain might be used for these varied purposes:

• to automatically create contracts or execute financial transactions;
• for land registry and deed management;
• to process insurance claims;
• storage of personal identification;
• security of electronic voting systems.

How is Bitcoin acquired?

This summary relates only to Bitcoin. It may reflect the processes relating to other cryptocurrencies to varying degrees.

Bitcoins are created by the process of ‘mining’. Mining Bitcoin involves using a computer program to solve mathematical problems to verify various transactions. Bitcoin miners are paid a certain number of Bitcoins for solving those problems.

Other than through mining, Bitcoins can be purchased on a Bitcoin exchange or acquired as a means of payment for goods and services.

Bitcoin transactions

A user of Bitcoin has a personal Bitcoin electronic ‘wallet’ which can be downloaded from a number of websites and mobile apps. The wallet is not used for storing Bitcoins per se — as they are not actually stored anywhere. Instead, records of Bitcoin transactions are stored in the blockchain which acts as a public ledger.

The wallet stores the user’s private ‘keys’, which are strings of letters and numbers formed from an encryption algorithm and are used to authorise transactions. The user also receives a Bitcoin address for sending and receiving Bitcoin.

With a wallet, the user can buy and sell Bitcoin through numerous online Bitcoin exchanges — including over a dozen which service users in Australia. These exchanges are not regulated by government. They operate differently, but generally, exchanges enable Bitcoin to be purchased with regular currency using traditional payment methods such as bank transfers, credit cards and debit cards, and allow it to be sold to other users. A Bitcoin exchange generally charges transaction fees. Broadly, transacting on a Bitcoin exchange is somewhat akin to buying and selling shares using an online account.

It is also possible to trade Bitcoin directly with someone else. There are even Bitcoin (and altcoin) ATMs located worldwide which can be used to buy and sell Bitcoin.

It is possible to transact a part of one Bitcoin. One Bitcoin — denoted as BTC — has eight decimal places. One mBTC is one 1,000^th of one Bitcoin. The smallest recognised unit of Bitcoin is Satoshi, of which there are 100 million in one Bitcoin.

Out of government hands … for now

A defining characteristic of cryptocurrency has historically been its independence from government control. However, in the past couple of years, governments all around the world have attempted to become involved to varying degrees:

• Central banks: The central banks of China, Japan, Sweden, Estonia, the United Kingdom, Uruguay, Kazakhstan and the United States are all looking into creating their own cryptocurrency.
• China: In recent years, Chinese Bitcoin exchanges had accounted for more than 90 per cent of all Bitcoin trades; but in September 2017, regulators shut down all exchanges in mainland China and banned cryptocurrency trading.
• Europe: The United Kingdom and other European Union governments plan to bring cryptocurrency within anti-money laundering and counter-terrorist financing regulations.
• South Korea: The government has banned cryptocurrency trading from anonymous accounts and plans to implement a tax.
• Venezuela: The government intends to create and issue 100 million ‘petros’, which will be backed by Venezuela’s oil and mineral reserves.
• Australia: The Australian Government has granted $8.6 million to Power Ledger, the first Australian company to be listed on digital currency exchanges which, in October, made Australia’s first initial coin offering through the Ethereum cryptocurrency network.

Further, the Anti-Money Laundering and Counter-Terrorism Financing Amendment Act 2017 — which received Royal Assent on 13 December 2017 — will extend the scope of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 to include regulation of digital currency exchange providers. Digital currency exchange providers will be required to:

• register with the Australian Transaction Reports and Analysis Centre (AUSTRAC);
• implement a program to mitigate and manage money laundering and terrorism financing risks;
• identify and verify the identities of their customers;
• report suspicious matters and transactions involving $10,000 or more (or foreign equivalent) to AUSTRAC; and
• keep relevant records for seven years.

It will be a watershed moment if (and when) a government adopts — or creates — and regulates a cryptocurrency as legal tender.

However — at least in Australia — the absence of official recognition or regulation doesn’t prevent Australia’s taxation laws applying to transactions involving cryptocurrency. The challenge for taxpayers and the ATO is that the taxation legislation has not been updated to adequately deal with these real-world developments (save for some recent amendments to the GST legislation — see below).

The cryptocurrency taxation dilemma is not unprecedented. In recent years, the ATO has published its interpretations of how the established principles in the income tax and GST law should apply to the growing population of online sellers, the sharing economy juggernaut and the ubiquitous Uber network of contractor-drivers in the absence of modernised statute to provide certainty.

Taxing cryptocurrency transactions in Australia

As noted above, Bitcoin is the original and predominant cryptocurrency. The Australian Government and the ATO have mainly focused on Bitcoin in their quest to clarify how the taxation law should apply. The general principles in the guidance (discussed below) may also apply to other forms of cryptocurrency but care must be taken to account for any distinguishing features from Bitcoin.

Income tax treatment of Bitcoin — ATO views (no legislation)

In a suite of taxation rulings issued in 2014, the ATO set out its views in relation to the income tax implications of transactions involving Bitcoin.

Central to the ATO views expressed in its binding guidance is its conclusion that Bitcoin is not money — and is not ‘foreign currency’ — but is instead ‘property’ for tax purposes.

This position is in direct contrast to the recent legislative development (discussed below) which — while it stops short of defining cryptocurrency as a form of money — enables digital currency to be treated in the same manner as money for GST purposes. Despite these changes, the ATO has not withdrawn its income tax guidance nor altered its premise that Bitcoin is not money for income tax purposes.

The Government has not announced any further plans to amend the income tax legislation in relation to the treatment of Bitcoin or other forms of cryptocurrency. Similarly, the ATO has not indicated whether it is reconsidering its income tax position in light of the GST amendments. Currently, taxpayers and their advisers can only rely on the binding interpretation of the ATO.

Aside from the suite of rulings, the ATO has more recently — in late 2017 — released non-binding general website guidance titled Tax treatment of crypto-currencies in Australia — specifically bitcoin (QC 42159).

In the meantime, taxpayers seeking certainty can apply to the ATO for a private binding ruling. As at the time of writing, there are over 20 publicly available edited private rulings relating to Bitcoin.

Non-business use: so is it a revenue, investment or personal use asset?

The income tax treatment of Bitcoin depends — based on the same principles which apply to most other intangible and tangible items — on the purposes for which it is held and the manner in which is it used.

When is Bitcoin subject to the CGT rules?

TD 2014/26 sets out the Commissioner’s view that Bitcoin is a CGT asset, and that:

• CGT event A1 happens if a taxpayer disposes of a Bitcoin;
• a capital gain will arise if the capital proceeds on the disposal of the Bitcoin exceed its cost base; and
• Bitcoin that is kept or used mainly to make purchases for personal use will ordinarily be a personal use asset (see below). In this case, any capital gain arising from a transaction involving Bitcoin will be disregarded (if the first element of the cost base is $10,000 or less), and a capital loss will be disregarded.

In the ATO’s view, Bitcoin will generally be a personal use asset if it is kept or used mainly to make purchases of items for personal use or consumption. For example, if an individual purchased Bitcoin from an exchange and used it to make online purchases for personal use — such as clothing or music — the Bitcoin would be a personal use asset.

Bitcoin would not be a personal use asset where:

• it is used for purchasing income producing investments; or
• the taxpayer keeps the Bitcoin for a number of years with the intention of selling it at an opportune time based on favourable values.

When is profit from sale of Bitcoin taxed as ordinary income from an isolated transaction?

TD 2014/26 states that a gain arising on the disposal of Bitcoin will generally be ordinary income where the taxpayer’s intention or purpose of entering into a commercial transaction was to make a profit or gain. Accordingly, a taxpayer who acquires Bitcoin under a commercial transaction for the purpose of profit or gain will be assessed under s. 6-5 of the ITAA 1997 on the gain arising on disposal, but any capital gain arising under CGT event A1 will be correspondingly reduced under the anti-overlap provision.

In an example given in the determination, where a taxpayer mines a small amount of Bitcoin as a hobby and after two years sells it for a small profit in order to purchase another investment asset, the gain will be assessed under the CGT rules and not as ordinary income. The Bitcoin is not a personal use asset as it was used to purchase an investment. Therefore, the capital gain is not disregarded.

Using Bitcoin for business

Akin to barter transactions

It has recently been reported that over 100,000 merchants worldwide — including global tech giant Microsoft — accept Bitcoin as payment for their goods and services.

In  the ATO’s view, Bitcoin received for goods or services provided in a business should be treated in the same way as non-cash consideration received as part of a barter transaction.

The business’s ordinary income will include the value of the Bitcoin received, expressed in Australian dollars. Under the ATO’s barter transactions rules, the value of the Bitcoin needs to be either its money value or its arm’s length value. The ATO will accept the fair market value — which for example could be obtained from a Bitcoin exchange — as a proxy for the money value or arm’s length value.

Deductions for expenditure paid in Bitcoin will be calculated based on the arm’s length value of what was acquired.

Bitcoin can be trading stock

TD 2014/27 sets out the Commissioner’s view that Bitcoin held for the purpose of sale or exchange in the ordinary course of business is trading stock for income tax purposes.

Bitcoin will be considered trading stock where:

• the Bitcoin is held by a taxpayer in carrying on a business of mining and selling Bitcoin;
• the taxpayer is carrying on a Bitcoin exchange business; or
• it is received as a method of payment by a business that sells goods where it is held for the purposes of sale or exchange in the ordinary course of the business.

Paying salaries and wages in Bitcoin

The ATO has contemplated the possibility of Australian employers offering cryptocurrency as employee remuneration. At the end of 2017, a large Japanese internet company announced its plans to do just that.

In TD 2014/28, the ATO confirms that the provision of Bitcoin by an employer to an employee in respect of their employment is a property fringe benefit — comprising intangible property — for FBT purposes. The determination specifically notes that Bitcoin is excluded from PAYG withholding — and therefore cannot be salary or wages — because it satisfies the definition of a ‘non-cash benefit’.

In practical terms, this means that:

• the employer is liable to pay FBT on the taxable value of the property fringe benefit — unless the value is less than $300 and it is provided a minor benefit (i.e. provided on an infrequent and irregular basis); and
• the Bitcoin is not assessable to the employee.

Interestingly, the position taken in the determination appears to conflict with the more recently released Tax treatment of crypto-currencies in Australia — specifically bitcoin webpage guidance which states that the payment of Bitcoin is a fringe benefit only where the employee has a valid salary sacrifice arrangement with their employer to receive Bitcoin as remuneration. In the absence of a valid salary sacrifice agreement, the guidance states that the remuneration should be treated as normal salary or wages and the employer is subject to PAYG withholding obligations.

It can be inferred that — at least in the context of employee remuneration — the ATO now takes the view that Bitcoin is equivalent to money rather than property. However, TD 2014/28 clearly intends for all Bitcoin provided in relation to employment to be treated as a fringe benefit, as it contains no carve-out for Bitcoin which is not salary sacrificed.

It has become necessary for the Government and the ATO to set out their views on how the recent GST amendments (discussed below) will impact on the income tax and FBT treatment of Bitcoin. A flow-on impact is not without precedent; in 2017, the ATO commenced a consultation on how a Federal Court ruling that an Uber driver provided ‘taxi’ services for GST purposes should affect the FBT treatment of Uber rides.

In the meantime, any affected employer or employee may seek a private ruling for tax certainty — preferably prior to entering into an agreement to exchange services for cryptocurrency (whether or not salary sacrificed).

Bitcoin miners

Some taxpayers may be carrying on a business of mining Bitcoin. Any income derived from the transfer of mined Bitcoin to a third party is included in assessable income. Expenses incurred in respect of the mining activity (which, for example, may include depreciation for computer equipment or home office expenses) may be allowable deductions.

The ATO considers that Bitcoin held by a taxpayer carrying on a business of mining and selling Bitcoin is trading stock. The tax treatment of this Bitcoin is in accordance with the normal trading stock rules, including the simplified rules for small business entities.

Record-keeping for tax purposes

The general record-keeping rules apply to cryptocurrency transactions. The ATO has provided some tailored guidance that the following information should be retained:

• the date of the transaction;
• the amount in Australian dollars;
• what the transaction was for; and
• the other party to the transaction (this may be no more than their Bitcoin address).

The onus is always on the taxpayer to maintain adequate information records for the purposes of the substantiation rules. Depending on the data that is readily available from the taxpayer’s cryptocurrency wallet and/or online exchange account, this could necessitate keeping a secondary record (e.g. a spreadsheet) which sets out the transaction information in a readable and understandable format.

If the taxpayer sells some of their cryptocurrency holding, they will need to determine:

• the appropriate cost base and/or deductible expenses referable to the acquisition, and the sale proceeds on disposal, to correctly calculate the gain or loss;
• whether that gain or loss is on revenue or capital account.

They will also need to ensure that these figures can be substantiated.

Correctly determining the cost of a cryptocurrency holding that is subsequently disposed of presents a practical challenge to taxpayers due to the anonymity, encryption, lack of regulation, and the different ways that exchanges and digital wallets operate. Currently, there is no guidance as to whether the disposal of a parcel of cryptocurrency holding should be determined on a FIFO (first-in first-out) basis, or whether the taxpayer can freely determine which parcel they are disposing of.

GST and ‘digital currency’

Recent GST amendments — ‘digital currency’ as a means of payment

On 30 October 2017, the Treasury Laws Amendment (2017 Measures No. 6) Act 2017 received Royal Assent. The Act amends the GST Act with effect from 1 July 2017 to ensure payments of ‘digital currency’ — including Bitcoin — by consumers are equivalent to payments of money by ensuring that:

• a supply does not include a supply of digital currency unless the digital currency is provided as consideration for a supply that is a supply of digital currency or money — new s. 9-10(4) of the GST Act; and
• an acquisition does not include an acquisition of digital currency unless the digital currency is provided as consideration for a supply that is a supply of digital currency or money — new s. 11-10(3) of the GST Act.

The GST Act now contains a definition of ‘digital currency’. This ATO webpage sets out the characteristics of digital currency in the definition, and things that are not digital currency.

Prior to these amendments, consumers who used digital currencies as payment could effectively bear GST twice:

• once on the purchase of the digital currency; and
• again on its use in exchange for other supplies which are subject to GST.

Now, consumers will not have any GST consequences in relation to buying or selling digital currency, or using it to pay for goods or services.

GST consequences for a business

A business may now use digital currency to pay for goods and services without GST consequences in the same way that it would use money.

Sales of digital currency are input taxed sales of financial supplies. That means if a business only makes sales of digital currency, it will not be required to register for GST even if its annual turnover is $75,000 or more. For a registered business, input tax credits generally cannot be claimed on acquisitions relating to the making of digital currency sales, except to the extent that the financial acquisition reduced credit rules apply.

If a registered business receives Bitcoin or another digital currency as payment, the normal GST rules apply. For example, if Bitcoin is received as consideration for a taxable supply, the business is required to remit ¹/₁₁^th of the amount as GST.

The amount of GST must be reported on the activity statement as an amount of money in Australian currency.

ATO guidance on converting amounts of digital currency into Australian currency

In mid-January 2018, the ATO released draft determination DCC 2018/D1 which sets out the ATO’s proposed method for converting amounts of consideration that are expressed in digital currency into Australian currency for the purposes of working out the value of a taxable supply. The formula is:

Amount of digital currency × your particular exchange rate on the conversion day

where:

1. your particular exchange rate is the taxpayer’s choice of a digital currency exchange rate that is:
   • obtained from a digital currency exchange;
   • obtained from a digital currency website; or
   • an agreed rate between the supplier and the recipient.

If the exchange rate is quoted in:

1. • Australian currency — use that rate; or
   • foreign currency — convert that foreign currency rate into Australian currency following the GST Foreign Currency Conversion Determination (No. 1) 2017.
2. conversion day is the date that the digital currency is converted into Australian currency. The conversion day differs depending on whether the business accounts for GST on a cash basis or an accruals basis.

When the determination is finalised, it will apply retrospectively from 1 July 2017, in line with the amendments to the GST law.

SMSF trustees: Invest in cryptocurrency with caution

An increasing number of SMSF trustees have included, or are contemplating including, cryptocurrency as part of their investment strategies. These trustees must proceed with care, and only invest after doing their due diligence.

There is no law that prohibits SMSF trustees from investing in cryptocurrency. But planning to include these assets in an investment portfolio gives rise to numerous issues stemming from well-established SMSF investment principles.

‘Read the trust deed’ …

The trustee must ensure that the trust deed allows the proposed investment. In this regard, investing in cryptocurrency is no different to investing in any other asset class.

The investment must meet the sole purpose test

An SMSF must be maintained for the sole purpose of providing retirement benefits to its members. The fund will breach the sole purpose test if the trustee or anyone else, directly or indirectly, obtains a financial benefit as a result of investment decisions.

Given the notorious difficulties in tracing and proving ownership of cryptocurrency, the trustee must be diligent in ensuring that the online wallets and exchange accounts — and gains and losses — are clearly attributable to them in their capacity as trustee for the SMSF, for example, with trustee resolutions that make it clear that the asset is held in the name of the trustee (see below).

Cryptocurrency cannot be acquired from related parties

A member of an SMSF may be contemplating making an in specie contribution of some of their personal Bitcoin to the fund. However, an SMSF cannot acquire this type of asset from a related party. Under s. 66 of the Superannuation Industry (Supervision) Act 1993 (SIS Act), an SMSF can only acquire specific types of assets from related parties.

The trustee is able to acquire cryptocurrency only from a third party.

Investment strategy must consider risk and diversity

Section 52B(f) of the SIS Act requires the investment strategy to have regard to ‘the whole of the circumstances of the fund’, relevantly including:

• the risk and likely return from investments; and
• the composition of the fund’s investments including the diversity of the investments,

It is indisputable that all forms of cryptocurrency fall into the ‘risky’ basket of investments. There are regular news items in the media about individuals who have chosen to go ‘all in’ with their savings (i.e. by investing 100 per cent of the fund’s assets in cryptocurrency) and come out on top with windfall gains. This approach may work for individuals with high risk profiles, but it is not compatible with the requirements of s. 52B(f).

Unlike real property and shares, cryptocurrency as an investment class does not have ‘low risk’ or ‘less risk’ options with which to diversify within the same asset class. A trustee wishing to incorporate cryptocurrency into an SMSF investment strategy must consider how much extra risk the investment portfolio should bear.

How can title to the cryptocurrency be proven?

The trustee will need to consider whether the SMSF’s auditor will be able to verify that the trustee — in their capacity as trustee of the SMSF — is indeed the legal ‘owner’ of the cryptocurrency.

The relative anonymity of the cryptocurrency system is touted as one of its great benefits — but an SMSF trustee cannot be anonymous or otherwise not transparent in their dealings on behalf of the fund.

Online digital currency exchanges and wallets are not regulated. Before proceeding with a purchase, the trustee should undertake due diligence on the different providers, understand the new client procedures in place, and confirm the information trail that would be readily available to the trustee, the SMSF auditor, other advisers, and the ATO. The trustee’s own records about cryptocurrency holdings and transactions will not be sufficient for regulatory purposes and must be backed up by records sourced from third parties. The information must also be understandable to the reader and, for example, cannot be lengthy computer code which requires power computer equipment to decipher.

Bitcoin: Another catalyst for tax law modernisation

Is Bitcoin — and any of the altcoins — a bubble doomed to burst, or a sure bet in the sport of wealth generation? History will tell …

Bitcoin — irrespective of its future success — has followed the charge led by online selling (eBay, Gumtree), Uber, and the sharing economy (Airtasker, AirBnb). In some respects, the tax treatment of Bitcoin and other cryptocurrencies is no different to traditional means of payment or exchanging goods and services. But what is clear is that Australia’s tax laws need to be updated and must be robust to accommodate the rapid shift to online, borderless transactions and non-traditional means of exchanging goods and services so that taxpayers have certainty in relation to their technologically-progressive dealings.

There are significant changes to the rate at which a company franks its distributions from 1 July 2016 … do you know the rate at which a dormant company should be franking its distributions?

A company may be dormant because it previously carried on a business and sold, or ceased to carry on, that business. Or it may have previously received a distribution from a trust (in its capacity as a corporate beneficiary) in one or more income years. In any case, the company is no longer active but has retained earnings on which tax has been paid, yet to be paid to the shareholders in the form of a franked distribution.

The new suite of tax cuts and fundamental changes to how franking credits are calculated took effect on 1 July 2016, and further changes are proposed from 1 July 2017. What do these changes mean for dormant companies that make a franked distribution in 2016–17 or 2017–18?

What franking rate should a company use?

Historical note

Prior to 1 July 2016, the franking credits that could be attached to dividends represented the corporate tax paid on the underlying profits. Since 2002, this rate has been a flat 30 per cent.

The amount of franking credits that can be attached to a distribution cannot exceed the maximum franking credit for the distribution (s. 202-60 of the ITAA 1997). The maximum franking credit is worked out by reference to the corporate tax gross-up rate, which is defined in s. 995-1(1).

Enacted changes — for distributions made from 2016–17

From 2016–17, a company’s maximum franking rate is based on the company’s corporate tax rate for the year in which the dividend is paid, worked out having regard to the company’s turnover for the previous income year.

The changes are contained in Schedule 4 to the Treasury Laws Amendment (Enterprise Tax Plan) Act 2017 which was enacted on 19 May 2017 with effect from 1 July 2016.

What is the company’s maximum franking rate?

Under the new franking rules, the maximum franking rate is known as the ‘corporate tax rate for imputation purposes’.

Calculating the corporate tax rate for imputation purposes that applies to a dividend payment involves a two-step process:
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The rate that results from Step 2 is the company’s corporate tax rate for imputation purposes for the year of the dividend payment.

This change has led to much consternation as company representatives and their tax advisers realise the impact of franking dividends at the lower rate of 27.5 per cent where the franking credits arose from tax paid at the higher rate of 30 per cent.

Many companies will end up with inaccessible franking credits remaining permanently in their franking accounts, because they cannot be passed out at more than the lower rate for that year. As the corporate tax rate continues to decrease, so will the rate at which those franking credits can be passed out.

Proposed changes — for distributions made from 2017–18

Schedule 1 to the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 — which was introduced into Parliament on 18 October 2017 — proposes that from 1 July 2017, a company will be eligible for the lower tax rate for an income year only if it is a base rate entity, which means it:

• satisfies the aggregated turnover test for that income year; and
• is not a passive investment company — determined on the basis of a new 80 per cent passive income test.

The proposed passive income test will be satisfied if the company’s base rate entity passive income (BREPI) is not more than 80 per cent of the company’s assessable income. A company’s BREPI is defined in proposed s. 23AB of the Income Tax Rates Act 1986 and has been examined in detail in a previous article on the Banter Blog: Proposed changes to eligibility for company tax cut.

Schedule 2 to the Bill proposes to make a consequential change to the assumptions a company must make when working out its corporate tax rate for imputation purposes for an income year. In addition to assuming that its aggregated turnover for the income year is equal to its aggregated turnover for the previous income year, a company must also assume that:

• its BREPI for the income year is equal to its BREPI for the previous income year; and
• its assessable income for the income year is equal to its assessable income for the previous income year.

This is because a company will not know its aggregated turnover, the amount of its BREPI, or the amount of its assessable income for an income year until after the end of that income year.

Impact of proposed changes on franking distributions made by passive investment companies

The proposed changes, if enacted in their current form, will mean that a company that has:

• an aggregated turnover of less than $25 million in 2016–17; and
• BREPI that is not greater than 80 per cent of its assessable income in 2016–17,

will not be able to frank a distribution it makes in 2017–18 at a rate exceeding 27.5 per cent, irrespective of the rate at which it paid tax in previous income years.

Note that the maximum franking rate for a distribution made by a company in 2017–18 is not based on whether it is a base rate entity in 2017–18, or even its 2017–18 tax rate — the 2017–18 maximum franking rate is worked out by reference to its aggregated turnover, BREPI and assessable income for 2016–17.

Impact on dormant companies

So we know that the proposed amendments from 1 July 2017 are intended to clarify that a passive investment company is not eligible for the lower tax rate. What if the company is dormant, and has no taxable income but has retained profits? How does it determine its franking rate when it doesn’t have a corporate tax rate? Does the franking rate automatically default to 30 per cent, because surely the company is considered passive since it’s not active?

In the discussion below, assume the dormant company has received no income for many years, has retained profits and pays a dividend in 2017–18. What is the maximum franking rate?

Anecdotally, common opinion suggests it should be 30 per cent. However, let’s work our way through the proposed measures …

To recap, it is proposed that a company will frank a distribution it makes in 2017–18 at the rate of 27.5 per cent if its:

• aggregated turnover in 2016–17 was less than $25 million; and
• 2016–17 BREPI is not more than 80 per cent of its assessable income for 2016–17,

otherwise its maximum franking rate is 30 per cent.

Analysis

This discussion is not about the dormant company’s tax rate for 2017–18 — it has no taxable income, and no income tax liability, so the company tax rate is not relevant … but we need to determine the dormant company’s corporate tax rate for imputation purposes.

Aggregated turnover condition

A dormant company with zero income in the previous income year does not have an aggregated turnover of $25 million or more (being the turnover threshold for 2017–18). Zero is less than $25 million, so the dormant company satisfies this first condition.

Passive income condition

It is tempting to view the passive income test as a mathematical fraction, that is, the passive income test is satisfied if:

However, when the company has been inactive for many years, it has neither BREPI nor assessable income in the previous income year. This would produce 0/0 in the above fraction, which is a mathematically impossible outcome.

It is preferable to think of the passive income test as a mathematical multiplication, that is, the passive income test is satisfied if:

BREPI ≤ [Assessable income × 80%]

This would produce the following outcome: 0 ≤ [0 × 80%]

So, does this mean the test is passed, failed, or does not apply?

A dormant company does not have BREPI in the previous income year that is more than 80 per cent of its assessable income in the previous income year, so the dormant company also satisfies the second condition.

Conclusion

As the dormant company meets both conditions (based on its previous year’s amounts), its maximum franking rate for a distribution made in 2017–18 is 27.5 per cent. This may be a surprising outcome, given that the dormant company is certainly ‘passive’ from a commercial perspective.

Over time, this will result in franking credits being trapped in the franking account. This is because the franking credits were generated by tax paid in previous years at the rate of 30 per cent, but under the new franking rules, the company will only be able to frank distributions at the rate of 27.5 per cent.

Prefer to frank at the 30% rate?

The dormant company may prefer to frank distributions paid from its retained profits at the higher rate of 30 per cent so that it can pass on those otherwise trapped franking credits to its shareholders.

To frank a distribution made in 2017–18 at 30 per cent, the company would need to have:

• aggregated turnover in 2016–17 of $25 million or more; and/or
• 2016–17 BREPI that is more than 80 per cent of its assessable income for 2016–17.

Since the company has no income, it won’t be able to satisfy the first condition. But, if the company derived just $1 of BREPI (e.g. interest received) in the previous income year, the company’s BREPI would be 100 per cent of its assessable income. This would result in the company being able to frank its 2017–18 distribution at the rate of 30 per cent.

This could easily be achieved by the company either:

• continuing to operate a bank account from which it earns passive interest in the previous income year (that is the income year prior to the year in which it intends to make a distribution) following the sale or cessation of a business in an earlier income year; or
• opening a bank account on which it earns passive interest — but note that this had to be done during 2016–17 so that the company could earn passive income in 2016–17. Any interest income derived by the company in 2017–18 is not relevant in determining the 2017–18 maximum franking rate.

Any interest income received in 2017–18 (which could also be distributed from a trust and retain its character as it flows to the company) would be BREPI that is taken into account in determining the company’s maximum franking rate for a distribution to be made in 2018–19.

Example — how the rules are proposed to change in 2017–18

Facts

Jingle Pty Ltd (Jingle) is a corporate beneficiary which has never carried on a business. As at 30 June 2016, it had around $14,000 in a bank account which bore interest at a low rate.

The bank account balance represented retained profits derived from $20,000 pre-tax trust distributions received in previous income years, on which Jingle had paid tax at a rate of 30 per cent.

In June 2016, the directors of Jingle decided to pay $7,000 in each of 2016–17 and 2017–18 as franked distributions to its shareholders.

In 2016–17, the trust distributes $5,000 to Jingle. The distribution solely comprises the trust’s trading income. The distribution was assessable to Jingle in 2016–17 but the money will not be paid until 2017–18.

Jingle also derived $200 in bank interest in 2016–17.

Question

What is the maximum franking credit which can be attached to each $7,000 distribution by Jingle?

Answer

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Analysis

The 2016–17 distribution

In 2016–17, Jingle’s maximum franking rate is equal to the corporate tax rate that would apply in 2016–17, using its 2015–16 aggregated turnover as a proxy for the 2016–17 turnover.

Jingle was not an SBE in 2016–17 because it did not carry on a business in that income year. The directors made this conclusion based on the Commissioner’s preliminary views on the meaning of ‘carrying on a business’ in draft ruling TR 2017/D7 (Example 1 in particular). The directors are aware that the Commissioner intends for the ruling, once finalised, to apply for SBE purposes.

As Jingle was not an SBE in 2016–17, its ‘corporate tax rate’ for that income year cannot be anything other than 30 per cent, regardless of its aggregated turnover. Accordingly, its corporate tax rate for imputation purposes in 2016–17 cannot be any rate other than 30 per cent.

The passive income test is not proposed to apply to 2016–17 distributions and therefore the components of Jingle’s assessable income for 2015–16 are irrelevant.

The 2017–18 distribution

From 2017–18, it is proposed that the ‘carrying on a business’ condition be repealed from the definition of ‘base rate entity’. Accordingly, whether a company carries on a business will not be relevant in determining a company’s maximum franking rate. Instead, the directors will need to consider whether the company satisfies the aggregated turnover condition and the passive income condition.

Aggregated turnover condition: Jingle’s stand-alone turnover for 2016–17 was approximately $200. However, for the purposes of the aggregated turnover test, annual turnover includes only ordinary income derived in the ordinary course of carrying on a business. As Jingle did not carry on a business in 2016–17, the interest income of $200 is excluded from the calculation. Assuming that any entities connected with Jingle, and Jingle’s affiliates, did not collectively derive annual turnovers of $10 million or more, Jingle’s aggregated turnover for 2016–17 will be below the $10 million threshold.

Passive income condition: In 2016–17, Jingle’s BREPI is $200 (bank interest) and its assessable income is $5,200 (bank interest and trust distribution representing trading income). Jingle’s BREPI is 3.4 per cent of its assessable income. Accordingly, Jingle’s BREPI is no more than 80 per cent of Jingle’s assessable income in 2016–17.

Based on the outcomes of the two tests, Jingle’s maximum franking rate for its 2017–18 distribution is 27.5 per cent.

Had Jingle not received the trust distribution in 2016–17, its bank interest of $200 would have been 100 per cent of its assessable income. In that case, Jingle’s BREPI would have exceeded 80 per cent its assessable income, so it would be able to frank the distribution at 30 per cent.

Final thought …

The changes to the company tax rate, and the associated franking implications, have created enormous confusion … the further you look, the more you stumble across related issues; the deeper you dig, the more you find. Can it get any more confusing?

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The highly anticipated measures that will prevent passive investment companies from accessing the lower corporate tax rate from 2017–18 were introduced into Parliament on 18 October 2017. The Bill proposes to improve the current law by setting a ‘bright line’ test to determine which companies are eligible for the tax cut. Clarity has finally trumped confusion.

New corporate tax regime: the story so far

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The recently enacted tax cuts and franking credit rules

A series of corporate tax cuts, and a new method of calculating maximum franking credits which can be attached to a distribution, were legislated on 19 May 2017 although the measures have retrospective effect from 1 July 2016.

These new rules are briefly summarised below. Refer to our previous article The new franking conundrum for more detail.

The tax cuts

The enacted legislation implements a series of corporate tax cuts from the 2016–17 to the 2026–27 income years. In the first stage of the plan, companies that carry on a business and have an aggregated turnover of less than $10 million for 2016–17 are entitled to the lower tax rate of 27.5 per cent. By 2026–27, all companies that carry on a business and have an aggregated turnover of less than $50 million will be permanently taxed at 25 per cent.

A company is eligible for the lower tax rate for an income year if it is:

• for the 2016–17 income year — a small business entity (SBE); and
• from the 2017–18 income year — a base rate entity (BRE).

A company is an SBE for the 2016–17 income year if:

• it carries on a business in that income year; and
• either its previous year or current year aggregated turnover is less than $10 million.

Under the current law, from the 2017–18 income year, a company is a BRE for an income year if:

• it carries on a business in that income year; and
• its current year aggregated turnover is less than $25 million ($50 million from 2018–19).

Note

The Government proposed the tax cuts in the 2016–17 Federal Budget. In the original 10-year Enterprise Tax Plan, tax cuts were to be progressively made available to all companies — regardless of turnover — and a flat 25 per cent corporate tax rate would apply permanently from 2026–27. However, the legislated tax cuts apply only to companies with an aggregated turnover of less than $50 million. On 11 May 2017, the Government tabled a Bill in Parliament which proposes to reduce the tax rate to 25 per cent by 2026–27 for all companies — i.e. to give full effect to the original proposal. At time of writing, the Bill was before the House of Representatives.

The new maximum franking credit calculation

From 1 July 2016, the maximum franking credit is calculated by reference to its corporate tax rate for imputation purposes (CTRFIP). This may or may not be the same as its corporate tax rate.

The CTRFIP — a new concept that did not exist prior to 2016–17 — calculates the maximum franking rate that the company can frank a distribution that it makes to its shareholders. Broadly, a company’s CTRFIP is its corporate tax rate, using its previous year’s turnover as a proxy for the current year’s turnover. This addresses the dilemma where a company wants to make a franked distribution during an income year but is unable to determine its turnover — and therefore its corporate tax rate — until after the end of that income year.

Ensuing confusion: When is a company ‘carrying on a business’?

A recurring question which underpins access to the tax cuts is: What is carrying on a business for the purposes of these rules?

To be an SBE or a BRE, and so qualify for the lower tax rates, a company must be carrying on a business for the relevant income year. That term is not defined in the tax law. While the requirement for an SBE to carry on a business is not new (the SBE definition has applied for small business concession purposes since 2007–08), the enactment of the tax cuts intensified demands for clarity and guidance on specific circumstances.

Specifically, the tax community has questioned whether the 27.5 per cent tax rate applies to holding companies, corporate beneficiaries and other ‘passive’ investment companies; in other words, whether any or all of these types of companies can be said to be ‘carrying on a business’.

In response, both the Government and the ATO made preliminary — and somewhat conflicting — comments in relation to this issue.

On 4 July 2017, the ATO published website guidance Reducing the corporate tax rate (QC 48880). The guidance states that:

… where a company is established and maintained to make profit for its shareholders, and invests its assets in gainful activities that have a prospect of profit, then it is likely to be carrying on business. This is so even if the company’s activities are relatively passive, and its activities consist of receiving rents or returns on its investments and distributing them to shareholders. [emphasis added]
(This guidance essentially replicates the position that the ATO previously — on 15 March 2017 — took in footnote 3 of draft ruling TR 2017/D2, which is concerned with the ‘central management and control’ limb of the statutory tax residency test for companies.)

The comments in Reducing the corporate tax rate, and the consequential widespread conclusion that a passive investment company can access the 27.5 per cent tax rate, elicited an adamant response by the Minister for Revenue and Financial Services, Kelly O’Dwyer. On the same day — 4 July 2017 — the Minister issued a media release clearly stating the Government’s policy intent that the tax cut ‘was not meant to apply to passive investment companies’.

Exposure draft released

On 18 September 2017, the Treasury released exposure draft legislation (the ED) to clarify that a company will not qualify for the lower corporate tax rate if most (at least 80 per cent) of its income is of a passive nature. The ED was met with widespread disapproval by the tax community. In addition to numerous technical deficiencies, the ED was heavily criticised for completely side-stepping the uncertainty surrounding the ‘carrying on a business’ requirement with no clarification in that respect. Further, the proposed retrospective application date of 1 July 2016 was particularly unwelcome as it would have resulted, in some cases, in amendments to lodged tax returns and payment of additional tax.

The Bill which was subsequently tabled in Parliament on 18 October 2017 (see below) thankfully differs significantly from the ED. While it retains the core passive income test that appeared in the ED, the technical redesign of the proposed measures has overcome a number of the identified deficiencies of the ED and overall provides some much-needed clarity on which companies will qualify for the lower tax rate from 2017–18.

What proposals are now before Parliament?

The core purpose of the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (the Bill) is to ensure that ‘passive investment companies’ will not be able to access the lower tax rate in a given income year; instead, they will be taxed at 30 per cent. As a fair corollary, these companies can frank distributions made in the following year at 30 per cent.

The Government’s term ‘passive investment company’ does not appear in the Bill but the concept is represented by a ‘bright line’ test. This test will deem a company to be ‘passive’ for a particular income year if more than 80 per cent of its assessable income comprises specific types of ‘passive’ income. The ‘bright line’ test has no regard for actual activity, intention, assets or profitability. Further, the Commissioner of Taxation has no discretion to grant an exception.

These amendments, if enacted in their current form, will have retrospective effect from 1 July 2017 (or the first day of a company’s 2017–18 income year if the company is a substituted accounting period taxpayer).

A revised definition of ‘base rate entity’

The ‘carrying on a business’ test — out of sight, out of mind

The Treasury heeded the tax community’s concern over the inherent uncertainty of the ‘carrying on a business’ requirement — in both the current law and the ED — to access the lower tax rate. In response, the Bill completely removes that uncertainty — by repealing the requirement in its entirety from the definition of a BRE.

It is proposed that the ‘carrying on a business’ test be replaced with a passive income test.

A revised definition of ‘base rate entity’

The Bill proposes that a company is a BRE if it satisfies two requirements:

• it carries on a business in the income year [repeal of existing condition];
• no more than 80 per cent of its assessable income is ‘base rate entity passive income’ (BREPI) [new proposed condition]; and
• its aggregated turnover is less than the turnover threshold for the income year [existing condition].

What is ‘base rate entity passive income’?

The following types of income are BREPI:

1. a company dividend — other than a non-portfolio dividend (which is a dividend paid to a company where that company has a voting interest of at least 10 per cent in the company paying the dividend);
2. a franking credit attached to a dividend covered by (a);
3. a non-share dividend;
4. interest income, royalties and rent;
5. a gain on qualifying securities;
6. a net capital gain; and
7. assessable partnership and trust distributions to the extent that they are referable (either directly or indirectly through one or more interposed partnerships or trust estates) to an amount that is BREPI under any of paras. (a) to (f).

Implications of the proposed passive income (BREPI) test

Assessable income vs aggregated turnover

The proposed passive income test requires a comparison of the company’s total BREPI for the income year to its assessable income for the income year. In contrast, the existing turnover test uses the company’s aggregated turnover.

Note the following key differences in relation to the income figures used in the two tests:

Deriving both business income and passive income

The proposed passive income test is one of the two mandatory eligibility requirements for the lower tax rate. The company’s entire taxable income will be taxed at one rate, whether that be 27.5 per cent or 30 per cent. A company will never have its BREPI taxed at 30 per cent and its business income taxed at 27.5 per cent.

All rental income is taken to be BREPI. There is no carve-out for companies that derive rental income in the course of carrying on a business of renting properties. This is similar to the active asset test in s. 152-40(4)(e) of the ITAA 1997 which prevents assets whose main use is to derive rent from being an active asset.

Holding companies

Non-portfolio dividends are specifically excluded from being BREPI. A distribution is a non-portfolio dividend where the holding company holds at least 10 per cent of the voting power in the subsidiary. Therefore, distributions that holding companies receive from their subsidiaries are not BREPI.

As a general rule, from 2017–18, a holding company will be eligible for the 27.5 per cent tax rate if its aggregated turnover is less than the turnover threshold. Whether the holding company’s activities constitute ‘carrying on a business’ will no longer be a relevant consideration (although it remains relevant for 2016–17).

Where the holding company also holds assets from which BREPI is derived — most commonly interest-bearing deposits, rental properties and portfolio shares — care must be taken to ensure that its BREPI does not exceed 80 per cent of its assessable income (which includes the non-BREPI dividends received from its subsidiaries).

Corporate beneficiaries

Under the proposed BREPI test, a trust distribution received by a corporate beneficiary must be dissected into its:

• BREPI component (i.e. that part of the distribution which is attributable to the trust’s passive income such as rental income); and
• non-BREPI component (i.e. that part of the distribution which is attributable to the trust’s trading or business income).

The Bill explicitly clarifies that income will retain its BREPI/non-BREPI character when it flows through a chain of trusts, for example:

In this illustration, the corporate beneficiary is taxed at the lower 27.5 per cent tax rate for 2017–18 as it satisfies both of the eligibility criteria to be a base rate entity:

Implications

In relation to trust distributions, the tax law only recognises the streaming of net capital gains and franked distributions to beneficiaries. Other classes of income cannot be separated and distributed to different beneficiaries. However, the manner in which capital gains and franked distributions are distributed to beneficiaries may affect whether a corporate beneficiary satisfies the proposed passive income test.

Further, the corporate beneficiary will need to trace up through a chain of one or more interposed partnerships or trust estates to determine the extent to which the distribution is attributable or not to BREPI. Perhaps new labels which identify the amount of BREPI included in a partnership or trust distribution will appear in the 2018 tax returns so that the ultimate corporate beneficiary can calculate its BREPI as a proportion of its total assessable income for an income year.

Additional assumptions for maximum franking rate calculation

The Bill proposes to amend the CTRFIP rules so that it is assumed that the passive income proportion for the current year is equal to that of the previous year in determining the maximum franking rate.From 2017–18, a company’s CTRFIP for an income year will be equal to its corporate tax rate for that income year with the following assumptions:

• its aggregated turnover for the income year equals its previous year’s aggregated turnover [existing condition];
• its BREPI for the income year equals its previous year’s BREPI [new proposed condition]; and
• its assessable income for the income year equals its previous year’s assessable income [new proposed condition].

If the previous year’s BREPI was at least 80 per cent of the company’s previous year’s assessable income, the company’s maximum franking rate for the current year is 30 per cent — regardless of its aggregated turnover or whether it is carrying on a business. Incidentally, the corporate tax rate for the previous year would also have been 30 per cent.

The following table summarises the different corporate tax rates and maximum franking rates that apply under the Bill:

Carrying on a business? The question is still relevant

The headline proposal in the Bill is the repeal of the ‘carrying on a business’ condition to access the lower tax rate from 2017–18.

On 18 October 2017 — the same day on which the Bill was introduced into Parliament — the ATO issued draft taxation ruling TR 2017/D7 which sets out the Commissioner’s preliminary views in relation to when a company carries on a business for the purposes of the definition of a BRE. The draft ruling states that:

… where a … company is established and maintained to make a profit for its shareholders, and invests its assets in gainful activities that have both a purpose and prospect of profit, it is likely to be carrying on a business in a general sense and therefore to be carrying on a business within the meaning of [a BRE] … This is so even if the company’s activities are relatively limited, and its activities primarily consist of passively receiving rent or returns on its investments and distributing them to its shareholders.

This position reflects the broad view expressed in the initial guidance provided on 4 July 2017 (see above). The draft ruling provides eight practical examples, including scenarios involving corporate beneficiaries with unpaid present entitlements (UPEs) and holding companies.

Example 5 sets out various scenarios in relation to whether corporate beneficiaries that have UPEs to a share of trust income are considered to be carrying on a business. Remarkably, the Commissioner’s preliminary view in one of the scenarios is that because the activities of a corporate beneficiary that reinvests its UPE consist of investing its assets in a business like way with both a purpose and prospect of profit, the Commissioner concludes that the company is carrying on a business. Notably, this draft ruling applies only for the purpose of the BRE definition and therefore only from 1 July 2017. But this has led some practitioners to conclude that there will be corporate beneficiaries that have lodged their 2016 and/or 2017 tax returns — on the basis that they were not eligible for the lower tax rate, and so determined that their tax rate was 30 per cent — that may seek an amendment on the basis they are eligible for the lower tax rate and claim a refund of overpaid tax.

If the Bill is enacted in its current form, we expect that this draft ruling would not be finalised or could even be withdrawn as the ‘carrying on a business’ requirement will be removed from the definition of a BRE.

The amendments proposed in the Bill do not affect the definition of an SBE. Therefore the ‘carrying on a business’ condition is still relevant for 2016–17 for companies determining whether they are an SBE and therefore eligible for the 27.5 per cent rate in that income year.

Critical Point

The scope of the draft ruling is limited to what constitutes carrying on a business for the purposes of satisfying the definition of a BRE, which takes effect from 2017–18. The scope of the draft ruling does not extend to any other provision in the tax law. Relevantly, it is not intended to apply to the ‘carrying on a business’ requirement in the definition of an SBE. Therefore, taxpayers and advisers cannot rely on this draft ruling to determine whether a company is eligible for the 27.5 per cent tax rate in 2016–17.

Comment

The BRE definition was based on the SBE definition, and the requirement that a company carry on a business is common to both concepts (under the current law). Accordingly, it is intriguing that the Commissioner’s preliminary view on whether a company is carrying on a business is confined to BRE purposes and does not also apply for SBE purposes. It is difficult to see how the term ‘carries on a business’ could mean one thing for BRE purposes but another for SBE purposes. Practically, despite the Commissioner’s clear statement that the draft ruling applies only for BRE purposes, it is foreseeable that many practitioners will nonetheless also apply the Commissioner’s preliminary views for SBE purposes.

Clarity will be sweet relief … if enacted

We keenly await whether the Bill will be enacted in its current form. The proposed amendments, if legislated, will bring much needed clarity around eligibility for the tax cuts from 2017–18. A law that is simpler to understand will also improve taxpayer compliance rates and reduce inadvertent errors.

The ‘carrying on a business’ confusion still exists in relation to 2016–17, so we are not out of the woods yet. We are hopeful for some definitive guidance on this front from the ATO for corporate taxpayers and their tax agents currently completing 2017 tax returns — perhaps the ATO will alter the draft ruling and extend its application to also cover the meaning of an SBE.

If the enacted and proposed amendments to the corporate tax rate and the franking implications are extended to those companies with a turnover of $50 million or more, then the issues that are currently tying the SME sector up in knots as it works through the complicated changes will also become the domain of the large corporate sector.

Click to see infographic: The history of Australia’s company tax and dividend imputation systems:

Contact Taxbanter to discuss your 2018 tax training needs: 03 9660 3500  |  enquiries@taxbanter.com.au

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An ATO crackdown on work-related expense claims has been a regular feature of Tax Time for the past few years. For 2017 tax returns, the ATO will be focusing on clothing-related expenses and car expenses. Our article, The ATO has an eye on every 2017 work-related expense claim, explains the common traps in claiming these two categories of deductions.

This infographic shows the breakdown, by category, of the work-related expense claims made by individual taxpayers in 2014–15.

Click to enlarge