The Australian Government has shown its commitment to the 2016-17 budget and secured a deal to reduce the corporate tax rate from 28.5% to 27.5% for small business companies and also increase the annual turnover threshold to qualify as a small business to $50 million (previous threshold was $2 million). The tax rate reduction will apply to companies progressively, starting with companies at the $10 million annual turnover in 2016-17, increasing to $25 million annual turnover in 2017-18 and then to those with $50 million annual turnover in 2018-19 and later years.
The increase in the small business entity turnover threshold to $50 million will expand the number of entities eligible for the reduced corporate tax rate. Companies previously outside the realm of concessions available to small businesses may very well soon be inside. It is important to note that the threshold is determined on an ‘aggregated turnover’ basis. Accordingly, the annual turnover of connected and affiliated entities are also captured within a small business entity’s annual turnover.
At first look, the tax cut will increase the cash flow of eligible corporates. However, corresponding amendments to the imputation system operate such that resident individual shareholders will ultimately bear additional tax on the increased dividend at their marginal tax rate. As a result, any distribution of the additional cash (caused by the corporate rate cut) will, generally, be of no net benefit to Australian resident individuals.
Under the new rules, the maximum franking credit attached to a franked dividend will be based on the corporate entity’s tax rate. Accordingly, for companies within the realm of the new turnover threshold, the maximum allowable franking credit will be determined using the reduced 27.5% rate. In effect, whilst the cash dividend received by shareholders may be greater following the reduction in the corporate tax rate, the maximum franking credit that can be attached to that dividend will also be reduced. Accordingly, the overall impact from the corporate rate tax cut for resident shareholders is nil (depending on their marginal tax rate).
The corporate tax cuts however may benefit non-resident shareholders who receive fully franked dividends. In circumstances where the dividend has been franked up to the maximum allowable percentage for that entity, the dividend will be taken to be “fully franked” and no further withholding tax will be payable on distributions to non-resident shareholders. Accordingly, foreign shareholders will therefore receive the benefit of the corporate tax cut through an increased net dividend following the change.
As alluded to, a downside of the corporate rate cut is that dividends can only be franked by reference to that entity’s corporate tax rate. This means that a company that had previously paid tax at 30% and retains franking credits arising from that tax but is now a small business, will only be able to franked by reference to its reduced corporate tax rate of 27.5%.
The legislative amendments introduce the concept of ‘corporate tax rate for imputation purposes’ which is not to be confused with the entity’s applicable ‘corporate tax rate.’ For imputation purposes, the rate for the current year is determined by reference to the entity’s aggregated turnover for the previous income year. For income tax purposes, the corporate tax rate is calculable by reference to the aggregated turnover for the current year. These two concepts can result in a discrepancy for imputation and corporate tax purposes.
For example, consider an entity with a $20 million turnover in the 2016-17 year. For that year, the entity is not a small business entity (above $10 million threshold). If that entity turnover’s is $26 million in the 2017-18 year, it will still not be regarded as a small business (above the $25 million threshold). The corporate tax rate therefore remains at 30%. However, the corporate tax rate for imputation purposes is referrable to the $20 million turnover in 2016-17 year, which is below the $25 million threshold for the 2017-18 year. Therefore, the entity pays 30% corporate tax but may only attach 27.5% franking credits to each dividend.
Additionally, from 2018-19 onwards franking credits will be based on the 30% corporate tax rate where the annual turnover for a corporate is greater than $50 million. However, once the annual turnover is less than $50 million, a company can only attach franking credits based on the 27.5% corporate tax rate. Effectively, franking credits can be trapped in the corporate entity.
It is important that companies not previously eligible for tax concessions available to small business entities carefully consider how to manage their capital going forward. In particular, these companies are at risk of losing the ability to fully distribute existing franking credits and should consider how this may impact their shareholders.