Two tax steps that don't add up

Summary: The Government’s cut to the company tax rate has implications for franking credits, while the Opposition's tax plans for family trusts will affect small business owners most.

Key take-out: The 27.5 per cent lower tax rate may result in shareholders not getting the full benefit of accumulated franking credits, but there is a way to claim them by attaching them to untaxed income.

The Federal Government reduced the company tax rate to 27.5 per cent for businesses with a turnover of less than $10 million for the 2017 financial year.

This decrease in the company tax rate for small businesses is the second instalment of so-called assistance to small business. The first was a reduction in the company tax rate from 30 per cent down to 28.5 per cent for the 2016 financial year.

Lowering the company tax rate does not help shareholder owners of a small business; it only helps shareholders that want to grow their business by retaining more after-tax profits. This is because, when after-tax profits are paid as dividends, tax is paid at the individual shareholders’ marginal tax rates.

The tax challenge for businesses

The tax cut to 27.5 per cent could result in shareholders not getting the full benefit of accumulated franking tax credits in their company. Previously, when there have been reductions in tax rates, companies could pay dividends with different levels of franking or tax credits attached. By having differing levels of franking, shareholders were protected.

In relation to these latest reductions in the company tax rate for small businesses, this will not be the case. An example of how this will work is a company that made $10,000 taxable profit in 2015, 2016, and 2017, and then decided to pay a dividend of all after-tax profits in 2018.

The profit made by the company would have been taxed at 30 per cent for the 2015 year, 28.5 per cent for the 2016 year, and at 27.5 per cent for the 2017 year. For shareholders not to be disadvantaged there would have needed to be three different franking rates that corresponded to the actual income tax paid, or that allowed companies to convert the value of tax paid at the higher rates to an amount had tax been paid at the 27.5 per cent rate.

The reality is small business shareholders, with accumulated profits where tax has been paid at higher than the 27.5 per cent tax rate, can only apply a 27.5 per cent franking account tax credit to all dividends paid.

A company that made a profit of $10,000 a year for the three years, and paid tax at the three different rates, would then pay a dividend of all of its after-tax accumulated profits of $21,400 in 2018.

Shareholders of that company could miss out on the benefit of $483 of taxes paid at the higher company tax rates. Thankfully, there is a way that the accumulated and possibly lost franking credits can be used.

This is done by attaching the unused franking credits to untaxed income that would normally be distributed as unfranked dividends.

An example of how this would benefit a shareholder with a small business operated through a company is when a business is sold. Under normal circumstances there is no benefit received by shareholders of a company claiming the 50 per cent active assets discount when a business is sold. This is because the discount claimed results in untaxed income and an unfranked dividend.

A company with unused franking credits, due to the reduction in the company tax rate, can claim the 50 per cent active assets discount up to an amount resulting in a dividend that uses what would have been lost franking credits.

Family trusts under the tax microscope

The proposed new tax on family trust income put forward by the Labor Party has been done under the guise of making, “the tax system fairer by making it harder for wealthy individuals to minimise the tax through income splitting”.

The way that the proposed tax would be levied on beneficiaries is similar to the way that non-residents are taxed. Someone who is classed as a non-resident for Australian income tax purposes pays tax on all income earned at 32.5 per cent up to $80,000, and then on the excess at the relevant marginal tax rates.            

Under the new tax, beneficiaries of family trusts will pay a minimum tax rate of 30 per cent on income distributed to them. This means an individual that receives only trust income will not get the benefit of the $18,200 tax-free threshold or the lower 19 per cent marginal tax rate. Instead they will pay 30 per cent on all trust distributions up to $37,000. Income above this level will be taxed at normal marginal tax rates.

Where a family trust has been used purely for investment purposes, with the investment income distributed amongst family members, this will mean tax of $11,100 would be paid on $37,000 distributed to an individual, rather than the $3572 that is currently payable.

To justify this new tax rate the Labor party states that, “discretionary trusts are predominately used by wealthier Australians”. The reality of this new tax rate payable by beneficiaries of family trusts is that it will affect small business owners more than “wealthy individuals”.

Small businesses the biggest trust users

An analysis of the 2015 Australian Tax Office statistics reveals that out of the 340,965 trusts which had assessable income and made profits in the 2015 year, 94 per cent had an income turnover of less than $2 million. This is the old lower income threshold that defined a small business.

When asked if the Labor Party was considering exempting small business trusts from this new tax, the answer was that it was difficult if not impossible to differentiate discretionary trusts used by small businesses and those used by high-income professionals.

This answer clearly demonstrates that the new policy is more about increasing the general tax take rather clamping down on so-called tax avoidance buy high income earners. In fact, the ATO can easily identify trusts that operate a small business as there is a section of the annual tax return that requires an amount to be entered if the beneficiary is entitled to receive the small business tax offset.

Any subscribers that operate a small business through a family trust, and thus could be affected by this proposed new tax, should seek advice from a tax professional who specialises in small business as there will be ways to minimise the adverse effect of this tax.