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The ATO has an eye on every 2017 work-related expense claim

As soon as Tax Time 2017 began, the ATO activated its version of a warning system via the Australian media to caution individual taxpayers and their advisers against over-claiming work-related expenses.

While the ATO will certainly be looking at unusually high claims for work-related expenses (WRE) of all types, car expenses and clothing and laundry expenses are the two categories which will receive the most scrutiny for 2016–17.

Another year … another ATO crackdown on WRE deductions

Following ATO audits and reviews of 2015 individual tax returns, which resulted in revenue adjustments of over $1.1 billion in income tax, the ATO has flagged its concerns about inappropriate deductions.

In a bid to reduce the magnitude of incorrect claims, in June 2017 — just prior to year end — Assistant Commissioner Kath Anderson issued a media release aimed at educating taxpayers on WRE deductions before they lodge their 2017 returns.

This Tax Time, tax practitioners must be alert for clients who may misunderstand their entitlement to WRE deductions to prevent ATO attention on dubious claims.

While the ATO will look at all risk areas in lodged 2017 tax returns, it will pay special attention to deductions in two categories: car expenses and clothing and laundry expenses.

The ATO’s ‘golden rules’ of WRE deductibility

The media release contains the ATO’s oft-repeated ‘three golden rules’ for deductibility of a WRE under the general deduction rules. These rules are paraphrased and expanded below.

Airing the dirty laundry about clothing-related claims

Why is the ATO concerned about clothing-related claims?

In 2015–16, over 6.3 million taxpayers claimed almost $1.8 billion in clothing and laundry WRE. Interpreting these statistics at an individual taxpayer level, this means that almost half of Australia’s 13 million individuals who lodged 2016 returns had spent money on eligible items, and that each individual claimed a mean average of $285. Claims in this category have also increased by around 20 per cent over the past five years. These figures have caused the ATO concern that deductions are being erroneously claimed.

Consequently, Ms Anderson issued another media release in July 2017 warning taxpayers about incorrectly claiming clothing and laundry expenses.

Three tips for correctly claiming clothing and laundry expenses

Employer dress code does not mean costs of clothing are deductible

TR 97/12 states that expenditure on ‘conventional’ clothing is unlikely to be deductible — even if the taxpayer’s employer requires or expects the taxpayer to wear a particular type of conventional clothing, or where that clothing is perceived as being important to success in the profession. A business suit, or black attire required to be worn by staff working at a restaurant or a department store, are common examples.

Fundamentally, expenditure on clothing and footwear is properly characterised as a personal or living expense. However, the expenditure will be considered work-related — and therefore deductible — if there is a sufficient nexus to the taxpayer’s income-earning activities.

In the ATO’s view, for the requisite nexus to exist, the clothing must distinctively identify the wearer as a person associated with a particular profession, trade, vocation, occupation or calling — i.e. occupation specific clothing. ATO examples include a barrister’s robes, a nurse’s traditional uniform, a cleric’s ceremonial robes and a chef’s chequered pants.

The ruling emphasises that clothing which could be worn in a number of occupations is not occupation specific clothing. A business suit (the same one of which could be worn by, for example, an accountant, a real estate agent and a retail store manager) would fall into this category, even if the taxpayer has no choice about wearing one to work under their workplace dress code.

There is no ‘standard deduction’ of $150 for laundry expenses

There is a statutory substantiation exception for deductions for washing, drying and ironing (laundry) expenses if the amount of the laundry expense claim does not exceed $150.

However, this does not provide taxpayers with a ‘standard deduction’ of $150. The taxpayer must still be able to verify that they actually incurred the expenditure — i.e. that a certain number of loads of eligible clothing were washed, dried and/or ironed.

To make the record-keeping easier, the ATO provides standard rates which can be used for a total laundry claim that does not exceed $150:

• $1 per load — if the load only comprises work-related clothing; and
• $0.50 per load — if the load includes private clothing as well as work-related clothing.

It is not compulsory to use these rates but the taxpayer will need to be able to explain any other basis of calculation. TR 98/5 provides practical guidance on calculating laundry deductions.

Note:

• A deduction for laundry expenses — and the substantiation exception — is only available where the clothing or footwear is used for income-producing purposes and the expense is occasioned by the performance of those duties.
• Laundry expenses that are eligible for the substantiation exception do not include dry cleaning expenses (which may nevertheless be claimed as a WRE subject to the usual substantiation rules).

Not all ‘protective’ items are deductible ‘protective clothing’

Expenditure on work-related ‘protective clothing’ is deductible. Whether an item is ‘protective’ is determined by reference to tax law and ATO criteria; it is not tested by reference to common social norms.

Under the tax law, protective clothing must protect the taxpayer or someone else from risk of death, disease, injury, damage to clothing, or damage to an artificial limb or medical aid. Specific examples include goggles, hard hats and safety boots worn on a work site. Less clear-cut are items used in everyday life such as sunglasses, closed-toe shoes or boots, waterproof clothing and sunscreen.

The ATO’s criteria for determining whether items worn at work are work-related protective clothing are set out in TR 2003/16 and include whether:

• the work environment could be harmful if adequate safety precautions are not taken (e.g. extreme weather conditions);
• the use of the item in the work place makes it unsuitable for private use (e.g. the protective clothing becomes too soiled for private use);
• the expenditure is in addition to the taxpayer’s normal private expenditure on such items (e.g. the taxpayer acquires additional protective clothing to guard against unsafe conditions);
• the item is qualitatively different to comparable items used privately (e.g. the item can cope with more rigorous work conditions);
• the item is used principally for income-producing activities (i.e. private use is no more than incidental);
• the taxpayer is required to use the item by the employer, safety laws or an industrial agreement (e.g. an industrial award provides for an allowance to purchase the item);
• the use of the item adds to workplace productivity (e.g. the wearer can work for longer periods); and
• any other feature indicates a work-related character.

Australians are taught from childhood to ‘slip, slop, slap’ to protect themselves from sun damage. Based on the examples in TR 2003/16, expenditure on sunglasses, sunscreen and sun hats are likely to be deductible to an outdoor worker in a horticulture business, but not to an office worker taking a short walk from the office or car park to a client.

Over-claiming car expenses — from ‘go’ to ‘no’

Why is the ATO concerned about car expense claims?

Ms Anderson issued another WRE media release in August 2017, this time focusing on car expenses.

In 2015–16, over 3 million taxpayers claimed a total of approximately $8.5 billion in car expenses. This equates to a mean average of $2,833 per claimant.

The ATO is particularly concerned by a pattern in their 2016 tax return data: a ‘significant proportion’ of those 3 million claims were ‘right at the limit that does not required detailed records’. Under the law, deductions using the cents per kilometre method do not require written evidence if no more than 5,000 kilometres are claimed.

In a simplistic exercise, dividing the $2,833 mean average deduction by the cents per kilometre rate of $0.66 — and disregarding the logbook method — equates to 4,292 kilometres per average claim.

Three tips for correctly claiming car expenses

There is no ‘standard deduction’ for 5,000 kilometres

There is a legislated substantiation exception for claims made under the cents per kilometre method — capped at 5,000 kilometres. However, this does not represent a ‘standard deduction’. The taxpayer is entitled to a deduction only for kilometres actually travelled in the course of producing assessable income and which is not private in nature.

The substantiation exception means that there is no requirement to keep detailed records in a logbook or similar. However, the taxpayer must still be able to verify that they undertook the purported trips for a work purpose, and that the kilometres claimed reflect the distances actually travelled by car during those trips.

Deductions may be available for using someone else’s car

The tax law clearly states that a taxpayer is entitled to a car expense deduction in relation to a car only if the taxpayer making the claim owned or leased the car.

Therefore, a taxpayer is generally not eligible for deductions relating to a work trip taken in a car borrowed from a colleague, relative or friend.

However, the ATO will in practice allow a taxpayer to claim car expenses in relation to a car registered in the name of another individual if the taxpayer contributes financially to the purchase or lease costs. This is most common in family arrangements where a car is registered in the name of one individual, but their spouse/partner also drives it and paid for some or all of the acquisition cost.

A private ruling confirms that the ATO will consider a taxpayer to ‘own or lease’ a car for the purposes of car expense deductions if they can demonstrate their financial contribution to any of the following:

• the initial purchase of the car;
• lease payments;
• hire purchase agreements; or
• loan payments relating to the car.

Note: merely contributing to ongoing running costs of the car is insufficient to prove ownership.

No deductions for a salary packaged car

An employee is prevented from claiming car expenses in relation to a car provided by the employer under a salary packaged novated lease arrangement — for two reasons. It does not matter whether those expenses otherwise meet the general deductibility criteria. It also does not matter whether the employee pays the costs from pre-tax or post-tax income.

Firstly, the tax law specifically provides that car expenses are non-deductible to an employee where:

• the car is provided for the employee’s exclusive use; and
• any time during the income year, the employee or a relative is entitled to use the car for private purposes (note: entitlement to private use is sufficient — actual private use is not necessary).

The law ensures that any contribution by the employee is used solely to reduce the employer’s FBT liability and that the employee cannot double dip by also claiming a personal deduction for the expenditure.

Secondly, the ATO considers that an employee does not ‘own or lease’ a car under a novated lease arrangement. The car expense deductibility rules require the taxpayer to own or lease the car.

ATO guidance and compliance activities

Specific ATO guidance on WREs

In the 1990s, the ATO issued a suite of taxation rulings for employees working in specific industries and occupations, including real estate industry workers; building workers; itinerant workers; truck drivers; nurses; teachers; and lawyers.

For a general summary of the guidance in all rulings for specific industries and occupations, see this ATO webpage.

The following guidance is also available:

• TR 98/9 — relating to self-education expenses;
• PS LA 2005/7 — which sets out the ATO approach to substantiation of WREs; and
• TR 93/30 — which differentiates between a home office and ‘working from home’.

Further, the ATO is currently updating its technical guidance on employee travel expenses: TR 2017/D6.

The impact of technology on WRE deductions

Recent years have seen marked advancements in ATO technology. Three key developments may impact how practitioners and their clients approach WRE claims in 2017 tax returns:

Tax return preparation — ATO app: myDeductions tool

The myDeductions tool in the ATO app can help individual taxpayers to keep accurate records, including photos of receipts, during the income year. For example, a taxpayer can enter the details of expenses incurred during a work-related trip in real-time while they are travelling, without the need to keep track of paper receipts for months before tax return preparation. A tax agent can request a client to send them the data directly from the app. The practitioner can then review the data and the photo evidence, and adjust the amounts if necessary before lodging.

Before lodgment — Real-time checks of WRE deductions

The ATO first introduced real-time checks of deductions for 2016 tax returns. If the taxpayer’s WRE claims were ‘substantially higher’ than others in similar occupations with similar incomes, a message appeared asking for the claims to be checked prior to lodgment.

The ATO has taken this a step further for 2017 tax returns. A new message in the Tax Agent Portal
pre-filling report displays if the taxpayer’s 2015–16 WRE deductions were high in comparison to other taxpayers in similar occupations with similar incomes. The ATO intends to deliver this information through the practitioner lodgment service (PLS) in future years.

A warning message is an indicator that the taxpayer may be brought into the ATO’s compliance activity net by virtue of the size of their WRE deduction. It should also serve as a pre-lodgment reminder to check that the taxpayer can verify all their WRE deductions.

After lodgment — Detection of non-compliance

In recent years, the ATO has used increasingly sophisticated tools and data analytics to scrutinise every tax return that has been lodged. It is increasingly easy for the ATO to automatically select higher-than-average deductions for review. Tax agents and their clients need to be able to produce conclusive evidence that the amount has been incurred.

Final observation …

Perhaps the taxpayer has misunderstood the operation of the substantiation exception … perhaps the taxpayer was able to ‘get away’ with exaggerated claims for WRE deductions in the past … perhaps the ATO’s compliance activities and data analytics many years ago were not as sophisticated as they are now …

But the mindset — that ‘Everyone cheats a bit, so I can too’; ‘My mates claim it’; ‘I’ll just claim a little bit extra and no one will notice’; ‘There’s a standard deduction, so I can automatically claim $150 of laundry, or $300 of WRE, or 5,000 kilometres of car expenses without receipts’ — is one that the ATO will not tolerate. WRE claims are, according to the Commissioner of Taxation who spoke at the National Press Club on 5 July 2017, ‘truly in our sights and we will be lifting our education, our support, our attention, our scrutiny and enforcement in this area’.

If every single person paid the correct amount of tax they are supposed to under the law and no one claimed anything they are not entitled to, revenue collections would unquestionably be higher and the rate of tax payable could be lower for everyone.

Click to see infographic: Category breakdown of work-related expense claims 2014–15:

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

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The ‘foreign resident’ capital gains withholding rules apply to Australian residents too

The misnamed ‘foreign resident capital gains withholding’ (FRCGW) regime not only affects Australian residents but requires them to comply with legal obligations, and can impose heavy penalties for non-compliance. Recent legislative changes extended the rules to many more taxpayers, so it has never been more critical for resident taxpayers to be aware of their tax obligations if they are planning on buying or selling Australian property.

Note: ‘foreign resident’ means a non-resident for Australian tax purposes.

What are the FRCGW rules?

The FRCGW rules, which commenced on 1 July 2016, impose a payment obligation on purchasers of certain taxable Australian property from foreign resident vendors. Broadly, the purchaser is required to withhold 12.5 per cent (note this rate has recently changed; the rate was previously 10 per cent) of the purchase price and send this to the ATO; the vendor then claims a credit for the withheld amount.

All types of Australian property are subject to the rules, but there is a carve-out for real property with a market value below the specified threshold (see below), including for residential, commercial and agricultural property, as well as vacant land. This threshold does not apply to certain other types of indirect Australian property interests.

How did the FRCGW rules change on 1 July 2017?

The Treasury Laws Amendment (Foreign Resident Capital Gains Withholding Payments) Act 2017 received Royal Assent on 22 June 2017 and implements two changes which were announced by the Government on 9 May 2017 as part of the 2017–18 Federal Budget:

1. A reduction in the threshold for real property and company title interests from $2 million to $750,000
   Previously, the former $2 million threshold (which applied only to contracts entered into from 1 July 2016 to 30 June 2017) ensured most family home sales were not affected by the FRCGW rules. However, the reduced threshold of $750,000 is below the current median house price in Sydney and Melbourne — and only just above the median price in Canberra: see our Australian house prices infographic. As ABS data reveals, a collective 9,706,059 million people lived in Sydney, Canberra and Melbourne on Census Night 2016. This means many more Australian families are now affected by these rules when they move house.
2. An increase in the withholding rate from 10 per cent to 12.5 per cent
   The higher withholding rate of 12.5 per cent means purchasers are liable for a larger payment than was previously the case — and this means larger penalties can be imposed if the purchaser does not comply with their tax obligations.

These two changes affect contracts entered into on or after 1 July 2017 and make the FRCGW rules more relevant to Australian taxpayers and their advisers than ever before.

Why are Australian residents affected by the FRCGW rules?

Where the value of the property transferred is $750,000 or more, the purchaser (whether or not a resident) is obliged to withhold 12.5 per cent of the purchase price and pay this to the ATO by settlement, unless the vendor is an Australian resident or an exception applies.

Crucially, the legislation provides that all vendors of eligible taxable Australian property will be considered foreign residents for this purpose unless:

• in relation to real property and company title interests — the vendor obtains a valid clearance certificate from the ATO and provides it to the purchaser by settlement; or
• in relation to indirect Australian real property interests (i.e. certain shares and units in entities that hold the majority of their assets in Australian real property, and certain rights and options) — the vendor makes a vendor declaration and provides it to the purchaser by settlement. There is no minimum dollar threshold for sales of these assets.

A vendor who is a genuine non-resident will not be able to obtain a clearance certificate from the ATO, or make a vendor declaration that they are a resident, so the purchaser will need to withhold from payments made to these vendors.

However, the rules also extend to Australian resident vendors who fail to obtain a clearance certificate and give it to the purchaser by settlement, by treating them as if they also are a foreign resident for this purpose.

What are the benefits of a resident vendor supplying a clearance certificate?

• The purchaser has no obligation to withhold an amount from the purchase price and pay this to the ATO, which also relieves them of the obligation to complete and lodge with the ATO a purchaser payment notification form.
• This means the vendor can receive their settlement proceeds in full, so there is no impact on the vendor’s cash flow.

What are the penalties for non-compliance?

Impact on the vendor

The FRCGW rules do not impose a tax obligation on the vendor, so there is no penalty on the vendor for failing to obtain a clearance certificate from the ATO or for failing to provide it to the purchaser by settlement. However, if the purchaser is required to withhold 12.5 per cent of the sale proceeds because the vendor failed to provide the purchaser with a clearance certificate, the vendor will have a cash flow issue because they will only receive 87.5 per cent of their sale proceeds, and they will need to wait until they lodge their income tax return to claim a credit back for the withheld amount.

The amount required to be withheld on the sale of an $800,000 property is $100,000. An unnecessary withholding of this amount could significantly affect the vendor’s capacity to settle on their new home or apply the substantial sum to other uses. The vendor is unable to claim a credit for the $100,000 that is withheld until they lodge their income tax return for the income year in which the CGT event occurred. If the settlement occurs early in an income year, there could be a delay of over a year before the vendor could claim the withheld amount against any tax liability payable, or receive a refund in the event that there is no tax to pay on the sale (for example, if the main residence exemption applies or the withheld amount exceeds the tax payable on the sale of the property).

Impact on the purchaser

If the purchaser fails to withhold from the purchase price when they were obliged to, the ATO can impose a penalty of $2,100 for failing to remit the withheld amount, as well as — and much more significantly — a penalty equal to the amount they failed to withhold … plus the general interest charge (GIC). This penalty is on top of the withholding amount that has not been remitted. In the above example of the $800,000 property, the ATO could impose a total penalty on the purchaser of $202,100 plus GIC!

In practice, it will be very difficult — if not impossible — for the purchaser to recover an amount representing the original $100,000 withholding liability from the vendor post-settlement. And the purchaser would certainly have to fund the $100,000 penalty amount themselves. From another, non-pecuniary, perspective, the purchaser’s failure to withhold may be a black mark against their otherwise-unblemished ATO compliance history.

What actions should be taken going forward?

What should vendors do?

A resident vendor of a property that is sold for $750,000 or more should obtain a clearance certificate from the ATO as soon as they have entered into a sale contract. They can even apply for the clearance certificate when they are considering listing their property for sale. This can be easily done online via the ATO website. However the vendor should not simply file it away with their other tax records; for it to be effective in avoiding withholding, they must provide it to the purchaser before the date of settlement. Clearance certificates are valid for 12 months so they should be sought well ahead of settlement, and they cover all properties sold by the vendor in that 12-month period. ATO policy is not to issue retrospective clearance certificates to vendors.

What should purchasers do?

A purchaser should request a clearance certificate from the vendor well before settlement date. If the purchaser is required to withhold — because the vendor does not supply the purchaser with a clearance certificate — the purchaser needs to register with the ATO (using the purchaser payment notification form) and prepare their documentation in time for withholding and remittance to the ATO by settlement.

The conveyancers and real estate agents involved in the sale should play a significant role in ensuring sale contracts reflect a potential withholding and in ensuring their clients, both vendors and purchasers, are aware of these rules. However, the liability for withholding and responsibility for payment of the withheld amount to the ATO falls solely on the purchaser — the tax law imposes this statutory obligation on the purchaser not the conveyancer.

Tax agents can play an important role in ensuring their clients — whether vendor or purchaser — consider and comply with these rules by encouraging their clients to advise them of any intention to buy or sell Australian property before entering into a contract. Forewarned is forearmed.

The devil is in the detail

Recognising that a resident client buying or selling Australian property may be subject to the FRCGW rules is only the first step. Next, you need to decide whether a specific exemption applies; whether the rules apply in a special way; and/or whether the withholding rate could/should be less than 12.5 per cent. Practical issues addressed by the legislation and the ATO include:

• multiple vendors, multiple purchasers and/or multiple properties covered by a single contract;
• when vendors or third parties may apply to vary the withholding rate;
• settlement adjustments;
• the sale of a property on revenue account;
• the impact of GST on the $750,000 threshold and the withholding calculation;
• how the purchaser pays the withholding obligation to the ATO;
• how the vendor claims a credit for a withheld amount;
• exceptions — including marriage breakdown, deceased estates and income tax exempt entities; and
• how the rules apply to indirect Australian real property interests (i.e. certain shares, units, rights and options).

ATO guide: Capital gains withholding: Impacts on foreign and Australian residents

Click to see infographic: Median house prices for Australian capital cities June 2017:

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

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The misleadingly-named Foreign Resident Capital Gains Withholding rules now apply to transfers of Australian real property valued at $750,000 or more. This reduced threshold took effect on 1 July 2017 (previously it was $2 million). Who do these rules affect?

Going by the figures in our infographic, many Australian families unwittingly buying or selling their family home, people who are not even foreign residents, are unaware that the typical sale or purchase of a property is subject to these rules. As at June 2017, the median house price in Australia was $818,416 — well above the $750,000 threshold. The median prices in Sydney and Melbourne also exceed the threshold, and Canberra is not far behind.

Read our Foreign Resident Capital Gains Withholding article to understand how these withholding rules apply to both residents and foreign residents who are buying or selling property.

Click to enlarge

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UPDATE: On 18 October 2017, the Government tabled in Parliament draft legislation to introduce an 80 per cent passive income eligibility test for the lower corporate tax rate from 2017–18.

The Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 differs significantly from the exposure draft discussed in the article below.

Read our current article ‘Proposed changes to eligibility for company tax cut’ for an explanation of the Bill, including how it will impact corporate beneficiaries.

The Treasury has just released exposure draft legislation to clarify that a company will not qualify for the lower corporate tax rate of 27.5 per cent from 1 July 2016 if 80 per cent or more of its assessable income is income of a passive nature. For more than two months, the tax community has been awaiting Government guidance on eligibility for the tax cut … elucidation finally arrived on 18 September 2017 but the attempt at clarification has further muddied the legislative waters.

The proposed amendments, should they be enacted in their current form, will have two significant effects: (1) preventing ‘passive investment companies’ from accessing the tax cuts; and (2) bringing forward the commencement of the ‘base rate entity’ concept by 12 months to 1 July 2016.

A recap of the current law

The corporate tax cuts and new method of calculating maximum franking credits when making a distribution became law on 19 May 2017 but took effect from 1 July 2016. The following discussion briefly summarises the enacted rules. Refer to our previous article The new franking conundrum for more detail.

The enacted tax cuts

The enacted legislation — in the form of the Treasury Laws Amendment (Enterprise Tax Plan) Act 2017 — 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 concessional 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 taxed at 25 per cent — permanently.

Eligibility for the tax cuts

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

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

The BRE concept came into effect on 1 July 2017. A company is a BRE for an income year if:

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

Critical Point

The BRE definition tests only the current year’s aggregated turnover; the previous year’s turnover is not relevant. This contrasts with the SBE definition which allows an examination of either the current year’s or previous year’s turnover in determining whether the turnover test is satisfied.

The new maximum franking credit calculation

From 1 July 2016, the maximum franking credit is calculated by reference to a new concept — the company’s corporate tax rate for imputation purposes (CTRFIP).

This differs from the company’s corporate tax rate which is the rate of tax payable on the company’s taxable income; the corporate tax rate is determined by whether the company is an SBE or a BRE.

The CTRFIP calculates the maximum franking credit that the company can attach to a franked 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 … and the ATO and Government responses

The legislation introducing the tax cuts and changes to franking credit calculations were enacted a mere six weeks before year end for 2016–17. The rushed timing and the inherent complexity of the legislation resulted in many questions from tax professionals seeking certainty on how to apply the new rules to their corporate clients’ 2017 tax calculations and profit distributions.

What is ‘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 concessional 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 be carrying on a business is not new — the SBE definition has applied for small business concession purposes since 2007–08 — the need for clarity and guidance on specific circumstances has never been more important.

Specifically, the tax community has questioned whether the 27.5 per cent concessional 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’.

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

ATO guidance

On 15 March 2017, the ATO issued draft ruling TR 2017/D2, which considers the ‘central management and control limb’ of the statutory definition in s. 6(1) of the ITAA 1936 about whether a company is an Australian tax resident. Footnote 3 to the draft ruling states that:

where a company is established or maintained to make profit or gain for its shareholders it is likely to carry on business … even if the company only holds passive investments, and its activities consist of receiving rents or returns on its investments and distributing them to shareholders. [emphasis added]

On 4 July 2017, the ATO published website guidance Reducing the corporate tax rate (QC 48880). The guidance essentially restates the position taken in footnote 3 to TR 2017/D2, 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]

Government response

On the same day that the ATO published Reducing the corporate tax rate — i.e. 4 July 2017 — the media reported that, based on the ATO’s statements in TR 2017/D2 and QC 48880, it can be concluded that a passive investment company can access the concessional tax rate of 27.5 per cent.

This elicited an adamant response by the Minister for Revenue and Financial Services, Kelly O’Dwyer, who issued a media release on 4 July 2017 stating the Government’s position — that is, that the tax cut ‘was not meant to apply to passive investment companies’.

Exposure draft released

There was media speculation in August that the Government would introduce clarifying legislation to ensure that passive investment companies could not access the tax cuts. On 18 September 2017, the Treasury released exposure draft legislation (the ED) and accompanying draft explanatory material to clarify that a company will not qualify for the lower corporate tax rate if most of its income is of a passive nature.

The new 80% passive income test

It was expected that the proposed amendments would define, limit or clarify the term ‘carrying on a business’. Disappointingly, the proposed amendments do not address this key condition of qualifying for the lower tax rate. Rather, they propose to introduce a third, additional passive income threshold test to restrict eligibility for the tax cuts.

A revised definition of ‘base rate entity’

The ED proposes an additional condition for a company to qualify as a BRE and be eligible for the concessional tax rate. It is proposed that a company is a BRE if:

1. it carries on a business in the income year [existing condition];
2. it has an aggregated turnover less than the turnover threshold for the income year [existing condition]; and
3. less than 80 per cent of its assessable income is base rate entity passive income (BREPI) [new proposed condition].

What is ‘base rate entity passive income’?

The following types of income are BREPI:

1. company dividends — other than non-portfolio dividends;
2. non-share dividends;
3. interest income, royalties and rent;
4. gains on qualifying securities;
5. capital gains (i.e. the gross capital gain worked out in the way described in each CGT event, before any discounts, concessions or application of capital losses); and
6. partnership and trust distributions to the extent that they are attributable to an amount that is passive income (i.e. BREPI in the hands of the partnership or trust under any of the preceding paragraphs).

Implications of the proposed BREPI test

Assessable income vs aggregated turnover

The proposed BREPI 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 BREPI test is one of the three mandatory eligibility requirements for the concessional tax rates. 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) 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 corporate shareholder holds at least 10 per cent of the voting power in the company. Therefore distributions that holding companies receive from their subsidiaries are not BREPI.

At first glance, this may appear as though holding companies can access the 27.5 per cent tax rate provided its aggregated turnover is less than the turnover threshold. But is this the outcome of the proposed amendments? Remember that the BREPI test is proposed to be a third condition to qualify for the tax cuts; the first condition — i.e. whether the company is carrying on a business — still needs to be satisfied.

The two scenarios below assume that the company satisfies the aggregated turnover test.

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

However, where the corporate beneficiary is not carrying on a business, it will be taxed at 30 per cent as it does not satisfy the first eligibility condition. As with holding companies, it is ultimately a question of fact as to whether a corporate beneficiary is carrying on a business.

It is desirable that the Government or the ATO provide further clarification on the tax rate applicable to corporate beneficiaries.

Additional assumptions for maximum franking rate calculation

The ED also proposes to amend the CTRFIP rules so that it is also assumed that the passive income proportion for the current year is equal to that of the previous year in determining the maximum franking rate.

Specifically, the ED proposes that a company’s CTRFIP for an income year is equal to its corporate tax rate for that income year with the following assumptions:

1. its aggregated turnover for the income year equals its previous year’s aggregated turnover [existing condition];
2. its BREPI for the income year equals its previous year’s BREPI [new proposed condition]; and
3. 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. 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:

BRE concept to commence 1 July 2016

The ED also contains an unwelcome surprise — if the legislation is enacted as drafted, the BRE concept would commence on 1 July 2016 which is 12 months earlier than the currently legislated 1 July 2017.

Practically, companies would need to determine their eligibility for the 27.5 per cent rate in 2016–17 based on the BRE test rather than the SBE test. Recall that the BRE concept uses only current year turnover whereas the SBE concept uses either current year or previous year turnover.

Accordingly, if the proposed amendments become law, a company with a turnover of at least $10 million in 2016–17 but less than $10 million in 2015–16 would no longer be able to rely on its 2015–16 turnover to access the 27.5 per cent rate in 2016–17; it would instead be taxed at 30 per cent. Such a company may have already lodged its 2017 tax return, which would necessitate:

• a subsequent amendment to the tax return; and
• the payment of 2.5 per cent additional tax.

The proposed amendments will not be introduced into Parliament at the earliest until its next sitting on 16–19 October 2017. Then the Parliamentary process begins … it may not clear Parliament for many weeks, or even months, beyond that … it may be amended by Parliament or it may not be passed at all.

This situation creates uncertainty for two key groups of corporate taxpayers:

1. Companies with aggregated turnovers of at least $10 million in 2016–17 which are relying on their 2015–16 turnovers below $10 million to access the 27.5 per cent rate. They are now unsure whether they will now be taxed at 30 per cent based solely on their 2016–17 turnover. Many affected companies will have already lodged returns and prepared accounts on the basis of the 27.5 per cent tax rate, or are in the process of finalising such. The changes may result in a tax shortfall and it may be necessary to revise cash flow budgets to account for a 30 per cent tax rate.
2. Companies that derive substantial amounts of BREPI. A company may be carrying on a business but fails the BREPI test due to low levels of business turnover relative to passive income in 2016–17; perhaps due to a large capital gain arising from the sale of business property, poor business decisions or a natural disaster. These companies which are eligible for the 27.5 per cent rate under current law may be ineligible under the proposed law.

Guidance for lodging tax returns

So what happens with lodgment of 2017 tax returns? Should you hold off lodging your company returns? If you lodge now based on the existing law, what happens if the law is amended? Do you have to amend your tax return? Would penalties apply?

The ATO published website guidance Administrative treatment of retrospective legislation (QC 43477) states that:

The announcement of proposed retrospective legislation poses a dilemma for affected taxpayers. Should they follow the existing law or anticipate the proposed change?

The ATO published website guidance Lodgment and payment obligations and related interest and penalties (QC 43478) explains that:

1. if you lodge and self-assess in line with the existing law, and the amendments:

• reduce your liability — the ATO will pay appropriate interest on any overpayment;
• increase your liability — no tax shortfall penalties will apply, any interest attributable to the shortfall will be remitted to nil up to the date of enactment of the law change, and any interest accruing after the date of enactment will be remitted if you actively sought to amend your assessments within a reasonable time after the enactment of the law change (a reasonable time to be determined on a case-by-case basis);

2. if you self-assess by anticipating an announced law change, and the amendments:

• are as anticipated — your self-assessment will not be affected;
• are not as anticipated — you’ll need to make an amendment. The same rules about amendments as outlined at 1. above would apply; and

3. if the announced law change is not enacted:

• affected taxpayers would need to seek amendments to their assessments as necessary and make any consequential tax payments; and
• if an amendment is necessary, the interest and penalty consequences will be as outlined at 1. above, depending on whether you self-assessed by anticipating the announced change or not.

Final thoughts …

It is indeed a strange predicament companies find themselves in where a question as fundamental as ‘What rate of tax does my company pay?’ cannot currently be answered with certainty.

Taxbanter will be making a submission to The Treasury on, and will monitor the progress of, the proposed amendments. We keenly await the resolution of these issues and will advise of any developments in a future post.

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This infographic shows how the company tax and dividend imputation systems have evolved over the decades. Change is ongoing, and in mid-May 2017 — a mere six weeks before the end of 2016–17 — company tax cuts and changes to the calculation of maximum franking credits became law … and took effect on 1 July 2016. Read our article The new franking conundrum to understand these changes.

The Government has recently released draft legislation proposing further amendments to the company tax rate and franking rules. See our post ‘Proposed changes to eligibility for company tax cut‘ for an analysis of these proposals.

Click to enlarge

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</p><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /> <p><strong>Please include attribution to https://taxbanter.com.au with this graphic.</strong></p><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /> <p><a href=’https://taxbanter.com.au/company-tax-cuts-infographic/’><img src=’https://taxbanter.com.au/wp-content/uploads/2022/11/Company-tax-facts-and-figures-web-large.jpeg’ alt=’Company Tax Cuts – Infographic by Taxbanter’ width=’800px’ border=’0′ /></a></p><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /><br /> <p>

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Corporate clients are in the midst of finalising their 2016–17 financial statements, calculating tax liabilities and deciding how much of the year’s profits to pay out as dividends. This same process occurs each year … but it will not be business as usual this time!

The new suite of tax cuts and fundamental changes to how franking credits are calculated took effect on 1 July 2016 — but became law a mere six weeks before year end. Since the changes were enacted in May 2017, tax practitioners nationally have been seeking elusive guidance as to how these rules affect their clients.

How do the tax cuts apply to your clients?

An historical note — and to the future

From the 2001–02 to the 2014–15 income years, the tax rate for all companies in Australia (other than not-for-profits and life insurance companies) was 30 per cent.

The simplicity of a single-tier, flat rate system for the vast majority of corporate taxpayers did not last. As part of the Government’s package of initiatives to stimulate the small business sector, a concessional tax rate of 28.5 per cent for companies that were ‘small business entities’ (SBEs) — i.e. companies that carried on a business and whose aggregated turnover was less than $2 million — was implemented for the 2015–16 income year. This created a two-tier corporate tax system; non-SBE companies remained subject to the standard 30 per cent rate.

The concessional tax rate of 28.5 per cent lasted only one year. On 31 March 2017, after nearly a year of political debate, the Senate finally agreed to pass an amended version of that part of the Government’s proposed 10-year tax relief package (known as the Enterprise Tax Plan) which sought to reduce the corporate tax rate. The amended legislation received Royal Assent on 19 May 2017, but left the big end of town without a reduction in their corporate tax rate.

A second bill containing the remaining part of the corporate tax cuts for the big end of town (i.e. those companies with a turnover of $50 million or more) remains before Parliament.

The enacted legislation implements a series of 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 concessional 27.5 per cent tax rate. This includes SBE companies that enjoyed the 28.5 per cent rate in 2015–16.

By 2026–27, all companies that carry on a business and have an aggregated turnover of less than $50 million will be taxed at 25 per cent — permanently.

So, for now, not only does Australia have a two-tier corporaten tax system, it will not be a static system: the parameters (i.e. the threshold and the concessional tax rate) will change many times over the next 10 years.

Concessional tax rate: which companies are ‘in’ and which are ‘out’?

The first step in helping your clients is to work out which companies can access the concessional tax rate and which ones cannot … being mindful that this needs to be done every year, as a company may qualify for the lower tax rate for one income year but not for the next.

A company is eligible for the 27.5 per cent rate in 2016–17 where:

• it carried on a business in 2016–17; and
• its aggregated turnover in either or both of 2015–16 and 2016–17 was less than $10 million.

From 2017–18, a company is eligible for the concessional tax rate for a particular income year where:

• it carries on a business in that year; and
• its aggregated turnover in that year is less than the turnover threshold for that year.

Now that the standard 30 per cent rate does not automatically apply to all companies, we must carefully consider the following questions for every corporate client:

What is the income year in question?

For the 2017–18 to the 2026–27 income years, this is the first question to be considered. Establishing the specific year is crucial as the tax rates and thresholds will regularly change over the next 10 years.

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Is the company ‘carrying on a business’ during that year?

One component of the SBE/BRE test is that the company must have ‘carried on a business’ during the relevant year.

This is easy to satisfy where the company is actively trading. However, there is much conjecture as to whether a company ‘carries on a business’ for tax purposes if all or most of its income is derived from what would normally be characterised as ‘passive’ investment activities: interest, rent, dividends and trust distributions.

Recent developments have further muddied the waters for passive investment companies, such as holding companies and corporate beneficiaries of discretionary trusts.

On 15 March 2017, the ATO issued TR 2017/D2 which sets out the Commissioner’s preliminary views in relation to the central management and control limb of the corporate residency test for foreign incorporated companies. Footnote 3 to the draft ruling indicates that the ATO accepts that a passive investment company is likely to be ‘carrying on business’ for those purposes. Some commentators (making a quantum leap) have joined the dots and concluded that a passive investment company can access the concessional 27.5 per cent tax rate based on a broad interpretation of that footnote.

By early July 2017, the media had picked up the story, prompting the Government to counter-respond on 4 July 2017 with a media release adamantly declaring that the tax cuts were not meant to apply to passive investment companies. There has even been conjecture that the Government will implement a legislative amendment to tighten the meaning of what constitutes ‘carrying on a business’.

Unfortunately, this rumoured amendment did not transpire during the recent Parliamentary sittings. The ATO has also not yet clarified its position; so — for now — holding companies and corporate beneficiaries will have to continue to wait for much-needed clarification on which tax rate applies to them.

What is the current year aggregated turnover?

From 2017–18, the current year aggregated turnover is the other component of the BRE test. For that income year, a company that carries on business must also have an aggregated turnover of less than $25 million. The threshold increases to $50 million from 2018–19.

For 2016–17, the current year aggregated turnover is also used in the SBE test. However, for SBE purposes only, if the company’s 2016–17 turnover is not below $10 million, the turnover of the prior income year (i.e. 2015–16) is tested.

Remember that ‘aggregated turnover’:

• is a defined term and includes the turnover of the company’s affiliates and any entities ‘connected with’ the company;
• includes only ordinary income, which excludes statutory income (such as net capital gains) and certain types of income such as related party dealings and sales of retail fuel.

What is the prior year aggregated turnover — and is it relevant?

Let’s deal with the second part of the question first. The prior year aggregated turnover may be relevant — if the income year in question is 2016–17 and access to the lower company tax rate of 27.5 per cent is determined by the company’s status as an SBE. This would be most of the corporate tax returns and accounts that are currently being prepared. A company (that carried on a business in 2016–17) is a SBE if either:

• its prior year aggregated turnover is less than $10 million; or
• its current year aggregated turnover is likely to be less than $10 million.

Therefore a company’s 2015–16 aggregated turnover is relevant in determining whether the company is eligible for the 27.5 per cent rate in 2016–17 — which will be the case if its 2016–17 turnover is, or is likely to be, at least $10 million.

Prior year aggregated turnover is not relevant for the 2017–18 and later income years. This is because the meaning of BRE has regard only to current year turnover.

Using the right tax rate — and can a company ‘choose’ its tax rate?

Since the corporate tax cuts became law in May 2017, TaxBanter trainers have regularly been asked: Can I choose to pay tax at the higher rate (of 30 per cent) so that I can continue to frank my dividends at 30 per cent (rather than 27.5 per cent)?

The answer is a decisive No. Where the company satisfies all of the eligibility criteria for the concessional tax rate, it will be assessed at that rate. An eligible company cannot ‘choose’ to apply the lower rate in the same way that it can choose to utilise many of the small business concessions in Div 328.

For 2017 tax returns that are now being prepared, the ATO has offered administrative guidance in recognition of the confusion caused by the changes in the law late in the income year.

In any case, the premise of the question — while well-intentioned — is off-base: the rate at which profits of one income year are taxed does not guarantee the rate at which dividends paid out of those profits are franked in a later income year. The following section discusses this change in the fundamental mechanics of the imputation system.

What franking rate should the client use?

Don’t franking credits represent company tax paid? So what is all the fuss about?

Before 1 July 2016, the franking credits that could be attached to dividends represented the corporate tax paid on the underlying profits.

From 2016–17, the operation of the imputation system 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.

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 permanently remaining in their franking accounts, because they cannot be passed out at more than the concessional 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.

From an administrative perspective, the new franking rules have complicated what should be a routine dividend payment process.

What is the client’s franking rate?

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

Calculating the corporate tax rate for imputation purposes that applies to a particular dividend payment involves a two-step process:

The rate that results from Step 2 is the company’s corporate tax rate for imputation purposes for the year of the dividend payment.

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What are the implications of the new franking rules?

Aside from the administrative complexity, the new franking rules will result in the following two general trends over the longer term:

• excess franking credits will be trapped in franking accounts and will not be available for distribution to shareholders; and
• shareholders will pay more top-up tax or receive lower refunds of excess franking credits.

What if the company has already franked a 2016–17 dividend at 30%?

Given that the legislative changes were not enacted until 19 May 2017, many companies that should have franked dividends in 2016–17 at 27.5 per cent had franked them at 30 per cent. Companies are not permitted to frank their dividends at 30 per cent where they should be franked at the 27.5 per cent rate, so on 22 May 2017 the ATO issued draft administrative guidelines to assist taxpayers to correct their franking with no penalty.

Unfortunately, this corrective action will impact on shareholders who relied on the 30 per cent franking credit previously advised by affected companies, and they may in fact have already lodged their 2017 returns which will necessitate amendment of their tax return in order to claim the correct franking credit.

The domino effect is an inevitability of which tax practitioners will have to be mindful.

Final thought …

All this trouble, all this fuss, all this complexity, all this confusion … for what should have been a simple reduction in the corporate tax rate for small business.

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