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 In any case, the company is no longer active but has retained earnings on which tax has been paid, yet to be paid to the shareholders in the form of a franked distribution.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:
[fusion_table]

Step 1 What was the aggregated turnover for the previous income year?
Step 2 What is the tax rate that would apply in the current income year to the Step 1 turnover — based on the threshold for the current income year?

[/fusion_table]

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:

BREPI ≤ 80%
Assessable income

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

[fusion_table]

Year of distribution by Jingle Maximum franking rate Franking credit on $7,000 distribution
2016-17 30% $3,000
2017-18 27.5% $2,665

[/fusion_table]

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?