Greater certainty on company tax rates for small business entities

As part of the Government’s Enterprise Tax Plan, the corporate tax rate for small business entities (aggregated turnover of less than $10m) has been;

  • cut to 27.5% for the 2017 income year, 

with the turnover threshold for small business entities;

  • increasing to $25m for the 2018 income year, and
  • again increasing to $50m for the 2019 to 2024 income year.  

The rate will then progressively decrease over a number of years with a company tax rate of 25% by the 2027 income year.  It should be noted that whilst the Government has proposed extending the lower tax rate to all companies regardless of turnover however this has not been legislated.

Recently there has been significant uncertainty in relation to whether companies receiving primarily passive income (including corporate beneficiaries) constitute small business entities and therefore qualify for the lower corporate tax rate.
 
As a consequence, the Government is attempting to clarify the position by introducing a “bright line” test in the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (the Bill) to prevent companies from qualifying for the lower corporate tax rate if more than 80% of their assessable income comprises passive income.
 
Importantly, these amendments apply to the 2018 and later income years, meaning some uncertainty remains for the 2017 income year.

The Bill defines “passive income” to be:

  • ​distributions by corporate tax entities, other than non portfolio dividends*, including the attached franking credits;
  • non share dividends by companies;
  • interest income, royalties and rent;
  • gains on qualifying securities;
  • net capital gains; or
  • trust or partnership distributions, to the extent that they are attributable to passive income under a preceding paragraph of this definition.

  What this means for the 2018 income year and later income years

  • Dividends paid by a subsidiary company to its parent/holding company with a 10% or greater interest and the attached franking credit will not be passive income. Therefore, investment companies who hold larger interests in their investments will be subject to the lower tax rate.
  • Trust or partnership distributions paid to companies will be considered passive income to the extent that the distribution relates to passive income in the hands of the trust or partnership.  On the other hand, a distribution of trust or partnership income that relates to business operations will not constitute passive income. Where a trust or partnership conducts both active and passive activities, consideration will need to be given to the allocation of expenses to determine the extent of passive income.
  • If a company is over the 80% passive income threshold, it will be subject to the higher 30% tax rate, but it will also be able to pay franked dividends to its shareholders based on the 30% tax rate. 
  • The tax rate is dependent on the 80% test and as the amount of active versus passive income can change each year, companies may find their tax rate changes on an annual basis. This may be relevant where a company disposes of a significant asset and the net capital gain is included as passive income.
  • For the purposes of determining a company’s tax rate for paying franked dividends, the company’s passive income for the previous income year is used instead of the current year passive income. If a company was only incorporated during the current income year, then it will only be able to pay franked dividends based on the lower corporate tax rate.

For example, assume a company receives $90,000 of rent and $10,000 of trading income during the 2016 income year, and $50,000 of rent and $50,000 of trading income during the 2017 income year. The company’s 2017 income will be subject to the 27.5% tax rate but it will be able to pay franked dividends in 2017 income year based on the 30% tax rate.

  What this means for the 2017 income year

As the changes proposed by the Bill only apply for the 2018 and later income years, a company will only be eligible for the lower company tax rate in the 2017 income year where it is carrying on a business and its turnover is below the $10m threshold.

The ATO has released draft taxation ruling TR 2017/D7 which discusses when a company carries on a business for the purposes of determining whether the lower income tax rate applies.

According to the draft ruling, a head company which owns shares in a subsidiary which carries on a trading business, and manages the company group would be considered to be carrying on a business. An investment company which invests in shares for the purpose of earning income from dividends is also considered to be carrying on a business.

As the determination of whether a company is carrying on a business is a question of fact, there may still be situations in the 2017 income year where the appropriate company tax rate is uncertain.

* A non-portfolio dividend is one where the shareholder owns at least 10% of the issued shares.
Please note information provided is current as at 20 October 2017.