Investment companies miss out on tax relief

* Updated 20 October 2017: Please note this bill was introduced to the Parliament of Australia on the 19 October 2017 and as a consequence elements of this article are no longer correct. Please refer to our update 'Greater certainty on company tax rates for small business entities' by clicking here.

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% from FY17,
with the turnover threshold for small business entities;
 
  • increasing to $25m in FY18
  • increasing to $50m in FY19. 
However, 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. Recent commentary amongst practitioners has certainly supported the possibility.
 
As a consequence the Government has released draft legislation for public comment that seeks to prevent companies from qualifying for the lower corporate tax rate if more than 80% of their assessable income comprises passive income.
 
Passive income has been defined as:
(a)    distributions by corporate tax entities, other than non‑portfolio dividends;
(b)    non‑share dividends by companies;
(c)    interest income, royalties and rent;
(d)    gains on qualifying securities;
(e)    capital gains; or
(f)     trust or partnership distributions, to the extent that they are attributable to passive income under a preceding paragraph of this definition.
 
 What this means
 
  • Dividends paid by a subsidiary company to its parent/holding company with a 10% or greater interest will be exempt.
  • 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.

    On the other hand, a distribution of trust or partnership income that relates to business operations will not constitute passive income.
  • If a company is over the 80% passive income threshold, then 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. 
  • 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 FY16, and $50,000 of rent and $50,000 of trading income during FY17. The company’s FY17 income will be subject to the 27.5% tax rate but it will be able to pay franked dividends in FY17 based on the 30% tax rate.
 
 
How these changes will affect investment companies
 
To an extent the changes will reduce the attractiveness of holding shares in an investment company, this said the 30% corporate tax rate continues to be more attractive than the highest marginal tax rate for individuals (45% excluding Medicare levy).
 
Some companies, such as those with significant existing franking account balances and those receiving mainly franked dividend income (franked based on 30% tax rate) may benefit from the 30% tax rate as they will be able to pass on a greater amount of franking credits to shareholders than would be the case if eligible for the lower rate of tax.
 
For example, assume a passive investment company has income of $100,000, all of which relates to listed company dividends that are fully franked based on the 30% tax rate. If the investment company was subject to the 27.5% tax rate and paid out all of its income for the year to its own shareholders through fully franked dividends, then the maximum franking credit that it could pass on to its shareholders would be $37,931, even though it received $42,857 of franking credits from the listed company dividends. In this case, $4,926 of franking credits have effectively been trapped inside the investment company.
 
Based on the draft legislation, the changes will apply to FY17 and later income years. It should also be noted that, as the Government is proposing to extend the lower corporate tax rate to all companies (regardless of turnover) by FY24, companies primarily receiving passive income may eventually be eligible for the lower corporate tax rate in accordance with the table below.
 
Income year Turnover threshold Company tax rate for entities under the threshold Company tax rate for entities over the threshold
2015–16 $2m 28.5% 30.0%
2016–17 $10m 27.5% 30.0%
2017–18 $25m 27.5% 30.0%
2018–19 to 2023–24 $50m 27.5% 30.0%
2024–25 $50m 27.0% 30.0%
2025–26 $50m 26.0% 30.0%
2026–27 $50m 25.0% 30.0%