Company tax cuts: clarification made complex

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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.