With the start of the new tax year, eligibility for the lower company tax rate of 27.5 per cent extends to companies with annual turnover up to $25 million – up from $10 million in the 2016/17 year.
When the 28.5 per cent company tax rate was introduced in 2015/16 for small businesses that met the $2 million turnover test, dividends could still be franked at 30 per cent.
However, accompanying the increase in the turnover test to $10 million and the drop in the company tax rate to 27.5 per cent for the 2016/17 year was a change to the imputation rules.
Robert Deutsch, senior tax counsel at the Tax Institute, explains: “The change to the imputation rules means a small business will have to frank dividends at the rate of 27.5 per cent. This could have the effect of ‘trapping’ franking credits in the company and lead to the real possibility that much excess credit will be wasted.
“While we support the reduction of the company tax rate for small business, we do not support the wastage of franking credits. This is an unfair burden to place on small business.”
What all this means is that a company paying franked dividends will only be able to frank that dividend at the corporate tax rate applicable to that company in the prior year.
While this appears reasonable on a go-forward basis, it does mean that any company with historical franking credits as a result of tax payments historically paid at a 30 per cent rate will effectively have some of their historical tax payments wasted, as the franking which have been paid by the company at 30 per cent can only be passed through to shareholders at the lower corporate tax rate that applies in the year the dividend is paid – 27.5 per cent.
Tax commentators like Deutsch says this is an unfair outcome for companies that have a balance of retained earnings and franking credits.
The Tax Institute has called on the Government to reconsider its position on the issue and, at the very least, allow small businesses a transition period to allow them to use up any unused franking credits before reverting to the lower rate.
In a note to clients on the issue, chartered accountants Lowe Lippmann says: “While a reduction in the tax rate will clearly benefit companies, consider that the profits earned by the company will eventually be paid to shareholders in the form of dividends and it is necessary to consider the taxation of these dividends when determining the total tax paid on company profits.
“These changes will be important for small companies that have a small number of shareholders. A reduced franking credit rate may lead to a higher personal income tax liability.”
Iain Spittal, tax partner at PKF, says: “For small business owners focused on the returns to individual shareholders, these tax cuts are no more than a deferral of tax due.”
When a dividend is paid to shareholders, those shareholders will pay tax at their marginal rate of tax (which is unchanged) and so, when profits are returned to shareholders, the same amount of tax will be paid as under the previous regime.
Under the new regime, companies paying a 27.5 per cent tax rate will be able to pay out more after-tax earnings to shareholders. However, because the franking credit rate falls in line with the change in the company tax rate, shareholders will have to pay additional tax on those dividends.
The after-tax dividend received by shareholders ends up being the same.