An outcome of the 2014-15 Budget, and other tax rate changes, will see the difference in the effective rate of tax paid by a top marginal rate taxpayer on a fully franked dividend versus a discount capital gain blow out from 0.32% to 4.75%.

As with recent years, the release of this year’s Federal Budget did not yield many surprises as far as taxation matters go, with most measures having been previously announced.

The single most important item for many of our clients will be the proposed introduction of the temporary 2% Deficit Repair Levy for individual taxpayers with taxable incomes in excess of $180,000. The levy is proposed to commence from 1 July 2014 and cease applying from 1 July 2017; so it will cover three tax years.

Other proposed changes include:

  • the reduction in the company tax rate from 30% to 28.5%; and
  • the introduction of the 1.5% Paid Parental Leave Levy for companies with taxable incomes in excess of $5 million

both commencing from 1 July 2015.

We also need to remember the Medicare levy will be increasing from 1.5% to 2% from 1 July 2014 to help fund the NDIS.

The combined effect of these measures will see the gap between total tax rates for top marginal rate individuals and companies fluctuate significantly from year to year. The following table illustrates the variations.

Click here to view table.

*This figure will need to be adjusted up to 30% for companies required to pay the Paid Parental Leave levy of 1.5%

Immediately it can be seen that there will be attraction in earning income in a company structure rather than in the hands of a top marginal rate individual. We assume this won’t go unnoticed by the ATO who will no doubt look at applying the PSI rules, Part IVA and Div 7A, where appropriate, to guard against it.

Planning point:

Consider establishing new businesses in company structures or transferring existing businesses into companies using available CGT roll-overs or small business CGT concessions.

While this will provide the up-front benefit of accessing the company tax rate, it must be weighed against the loss of access to the 50% CGT discount on a future sale of business. However, a share sale (rather than an asset sale) could permit access to the 50% CGT discount.

If the business profits are needed to fund lifestyle and private assets, the Div 7A consequences of loaning funds out of the company need to be factored in.

And another point to factor in is that tax losses will reside in the company, which may make them more difficult to offset against related party profits.

It’s not just the gap between the rates that is worth noting. It is also interesting to look at the effects on a top marginal tax rate individual receiving fully franked dividends. The following table illustrates this.

Click here to view table.

Action point:

Where a complying Div 7A loan is being managed through the payment of annual dividends, modelling should be done to check whether it will be preferable to declare and off-set a larger than required dividend prior to 30 June 2014. This will have the effect of reducing the loan balance and future years’ repayments. It may be preferable to bring forward a larger tax bill and reduce the future years’ dividends (and top-up tax).

A final comparison worth noting is that between the effective rate of tax payable by a top marginal rate individual on a fully franked dividend versus a discount capital gain.

Click here to view table.

Under the existing tax rates, individual taxpayers on the top marginal rate have been largely indifferent between receiving a fully franked dividend or a discount capital gain.

However, the comparisons show the effective tax rate differential is about to blow out, favouring discount capital gains.

Planning point:

When exiting an individual shareholder from a private company, a selective share buy-back is sometimes considered as an alternative to a sale of shares to the on-going shareholders.

Generally, under a buy-back the difference between the buy-back proceeds and the amount debited against the company’s share capital account is deemed to be a frankable dividend for income tax purposes. The capital proceeds for CGT purposes are reduced by this deemed dividend.

Until now, a top marginal rate individual would be largely indifferent between receiving a fully franked deemed dividend under a share buy-back or a capital gain from a share sale.

This is about to change. From 1 July 2014 the buy-back option will be significantly less attractive when compared with a share sale; a rate difference of 2.64%. The difference in the years ending 30 June 2016 and 2017 will blow out to 4.75%!