As part of the Australian Government’s Enterprise Tax Plan, the corporate tax rate has been reduced to 27.5 per cent for entities that satisfy the annual turnover threshold requirement, which applies progressively from $10 million in the 2016-17 income year to $50 million in the 2018-19 income year.
The Government released for consultation on 18 September 2017 exposure draft legislation aimed at excluding entities with predominantly passive income from access to the lower 27.5 per cent rate. That is, entities with ‘base rate entity passive income’ that is 80 per cent or more of their assessable income in an income year would continue to pay corporate tax at 30 per cent despite being under the annual turnover threshold. This proposal, once legislated, will apply retrospectively to restrict the application of the rate reduction from the 2016-17 income year.
The usual items such as dividends, interests, royalties, rent (including a flow through of these items through trusts and partnerships) will be included in the proposed definition of ‘base rate entity passive income’. The proposed definition will also take into account capital gains as defined by the Act. However, this fails to reflect that:
- gains on the disposal of assets such as trading stock and other assets held on revenue account prima facie give rise to capital gains, as defined, but for CGT purposes are then subsequently disregarded to prevent double counting of the gain;
- capital gains on the disposal of assets in an income year are reduced by capital losses made during that year, as well as carried forward capital losses; and
- most importantly, capital gains are often realised on the disposal of active assets that are used to carry on a business (for example goodwill).
The current drafting would often result in genuine active business income being incorrectly classified as passive. We expect this is a drafting error, and not the intended policy behind this proposed amendment. However, this will need to be confirmed through the consultation process.
It is surprising that the exposure draft did not mirror other provisions in the Act that identify net gains on passive assets, such as the controlled foreign company rules in Part X of the 1936 Act or the active foreign business asset rules in Subdivision 768-G of the 1997 Act.
This may not be all bad news. Where an entity has predominantly Australian resident shareholders and routinely distributes all of its profits to shareholders, consistently having passive income of 80 per cent or more may enable them to avoid complexities and simply continue to pay tax at 30 per cent and frank their distributions at 30 per cent. This could be a more favourable outcome when compared to an entity that from year to year is just under 80 per cent and then just over 80 per cent, resulting in different tax and franking rates from one year to the next.
These issues relating to the current exposure draft are in addition to the franking credit issues previously identified in relation to the corporate tax rate reduction measure in general, as listed below.
- The reduction in corporate tax rate will increase cash flow to shareholders. However, the lower corporate tax rate also means that less franking credits will be available to shareholders. This may result in more tax being paid at the shareholder level where the shareholder is an Australian resident individual; and
- The potential mismatch between an entity’s applicable ‘corporate tax rate’, which is determined based on the aggregated turnover and passive income amount for the current year, and ‘corporate tax rate for imputation purposes’, which is calculated by reference to an entity’s aggregated turnover and passive income for the previous income year. This can result in a discrepancy for imputation and corporate tax purposes and the potential for franking credits to be trapped in a corporate entity where the entity moves from 30% to a lower tax rate.
Our previous post explains these franking credit issues in greater detail.