Free kick? It depends on the company you keep
The election promise by Tony Abbott to reduce company income tax by 1.5 per cent has prompted much debate about its benefits and costs. Unfortunately, whenever income tax promises are made there will always be winners and losers.
Inevitably the debate is often based on half truths and confused expert opinion. One criticism is the massive free kick the wealthy will get. When you look at the income tax laws, there are several reasons why operating through a company does not provide any tax benefit.
There are other benefits, such as limiting the legal liability of the owners. But when it comes to income tax a company, at best, delays the paying of tax by the owners. Where a person chooses to earn what is really employment income through a company, in the belief that they will benefit from the lower company tax rate, there is a section of the tax act that effectively negates them receiving any benefit. This is the alienation of personal-services income section.
Someone classed as being in a personal-services income business must pay income tax paid on profits made by the company at their applicable marginal tax rate. This tax must also be paid on at least a quarterly basis. There are severe penalties when a person running a personal-services business through a company does not regularly pay income tax on profits made to the ATO at their tax rate.
Even if the alienation of personal-services income section did not apply, operating through a company does not really provide a tax break for the owners.
After a company makes a profit and pays tax at the company tax rate, it must be taken as dividends that are then taxed at the owner's tax rate. If any after-tax profits are taken by the shareholders other than as dividends, they are shareholders that take accumulated profits from a company - not as dividends - and end up with a loan owing to their company.
Unless these loans are treated properly, having interest charged on the loan at a high statutory rate that must be repaid within seven years, they are treated as an unfranked dividend, and the owner pays tax at their applicable marginal rate on the profits taken.
This means no real tax benefit is received when an individual earns income through a company, no matter what the company tax rate is, unless they are prepared to leave the cash and profits in the company. Even if someone is prepared to do this, there is a major disincentive and tax penalty if a company is used to buy investments that will increase in value.
This is because companies do not receive the 50 per cent general discount that individuals do when capital gains are made.
Someone on the top tax rate pays 23.25 per cent on a capital gain as long as the investment has been owned for at least 12 months.
Because a company does not get the 50 per cent general discount it will pay tax at 28.5 per cent on all capital gains.
The main losers from a drop in the company tax rate will be those that depend on fully franked dividends for their income.
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