In light of the recent Bill to clarify which companies are eligible for the lower corporate tax rate for small companies (27.5% in the 2017 and 2018 income years), it is worth taking stock on how the imputation system applies in the context of two-tiered corporate tax rates.  

This requires working our way through several definitions.

By way of refresher, pursuant to Subdivision 202-D of the Income Tax Assessment Act 1997, the maximum franking credit on a distribution is equal to:

The ‘applicable gross up rate’ is the ‘corporate tax gross-up rate’ of the entity making the distribution for the income year in which the distribution is made.

Section 995-1 defines the ‘corporate tax gross-up rate’ as the amount worked out using the following formula:

That ‘corporate tax rate for imputation purposes’ is the tax rate that applies for the income year:

• assuming the entity’s aggregate turnover for the income year is the same as for the previous income year; or
• if the entity did not exist in the previous income year, the ‘default’ corporate tax rate of 30%.

The Bill amends the definition of ‘corporate tax rate for imputation purposes’ but only so far as to assuming that the entity’s aggregate turnover, passive income, and assessable income (as those terms are used in determining eligibility for the lower corporate tax rate) are the same as in the previous year.

The effect is that if a company:

• was on a 30% tax rate in the 2017 income year, the maximum franking credit on dividends in the 2018 income year will be 30% unless the company’s turn over in 2017 was less than the 2018 turnover threshold of $25 million (and the company does not have more than 80% of passive income), in which case the maximum franking credit on dividends in the 2018 income year will be 27.5%
• was on a 27.5% tax rate in the 2017 income year, the maximum franking credit on dividends in the 2018 income year will be 27.5% unless more than 80% of the company’s 2017 assessable income was base rate entity passive income in which case the maximum franking credit on dividends in the 2018 income year will be 27.5%
  
  And now some examples. The examples assume that the Bill is passed in its current form and in all examples the company had taxable income of $1 million.  

Example one: 30% tax rate in 2017, 30% franking rate in 2018

A company had turnover of $12 million comprising solely passive income in the 2017 income year and so the company was on a corporate tax rate of 30% for 2017 (as the company's turnover was more than $10 million).

The ‘corporate tax rate for imputation purposes’ assumes the company’s turnover (and composition) for 2018 was the same as in 2017 (that is, $12 million of passive income). Therefore, the ‘corporate tax rate for imputation purposes’ in 2018 is 30%.

If the company pays a cash dividend of $700,000 during the 2018 income year ($1,000,000 of taxable income less 30% tax), the ‘corporate tax gross-up rate’ will be 2.3333 (that is, (100% - 30%)/30%). The maximum franking credit that can be attached to the dividend is $300,000 (that is, $700,000 / 2.3333).

For a shareholder on a marginal tax rate of 45% (ignoring the Medicare levy), the grossed-up dividend will be $1,000,000 ($700,000 + $300,000), tax on the grossed-up dividend will be $450,000, and the shareholder will have a franking credit offset of $300,000 and top-up tax to pay of $150,000. (Top-up tax of 15% on the grossed-up dividend).

Example two: 27.5% tax rate in 2017, 27.5% franking rate in 2018

A company had turnover of $8 million of active income in the 2017 income year and so was on a corporate tax rate of 27.5% for 2017.

The ‘corporate tax rate for imputation purposes’ assumes the company’s turnover (and composition) for 2018 was the same as in 2017 (that is, $8 million of active income). Therefore, the ‘corporate tax rate for imputation purposes’ in 2018 is 27.5%. (This would be the case even if the company’s actual turnover in 2018 increased to (say) $100 million).

If the company pays a cash dividend of $725,000 during the 2018 income year ($1,000,000 of taxable income less 27.5% tax), the ‘corporate tax gross-up rate’ will be 2.6364 (that is, (100% - 27.5%)/27.5%). The maximum franking credit that can be attached to the dividend is $275,000 (that is, $725,000 / 2.6364).

For a shareholder on a marginal tax rate of 45% (ignoring the Medicare levy), the grossed-up dividend will be $1,000,000 ($725,000 + $275,000), tax on the grossed-up dividend will be $450,000, the shareholder will have a franking credit offset of $275,000 and top-up tax to pay of $175,000. (Top-up tax of 17.5% on the grossed-up dividend compared with 15% if the dividend was franked to 30%).

Example three: 30% tax rate in 2017, 27.5% franking rate in 2018

A company had turnover of $15 million of active income in the 2017 income year and so was on a corporate tax rate of 30% for that income year. For the 2018 income year the turnover threshold for the lower 27.5% corporate tax rate increases to $25 million.

The ‘corporate tax rate for imputation purposes’ assumes the company’s turnover (and composition) for 2018 was the same as in 2017 (that is, $15 million of active income). Therefore, the ‘corporate tax rate for imputation purposes’ in 2018 is 27.5% as the $15 million turnover is less than the $25 million threshold. The 27.5% rate for imputation purposes is despite the company paying tax in the 2017 income year at 30%.

If the company pays a cash dividend of $700,000 during the 2018 income year ($1,000,000 of taxable income less the 30% tax for 2017), the ‘corporate tax gross-up rate’ will be 2.6364 (that is, (100% - 27.5%)/27.5%). The maximum franking credit that can be attached to the dividend is $265,517 (that is, $700,000 / 2.6364).

For a shareholder on a marginal tax rate of 45% (ignoring the Medicare levy), the grossed-up dividend will be $965,517 ($700,000 + $265,517), tax on the grossed-up dividend will be $434,483, the shareholder will have a franking credit offset of $265,517 and top-up tax to pay of $168,966. The company will also have a balance in its franking account of $34,483. (Perhaps the company could have borrowed to pay a larger dividend?)

The following table summarises the numbers.

The examples illustrate that in an imputation system of corporate and shareholder taxation, lowering corporate tax rates has no effect on the tax burden for Australian resident shareholders – the higher top-up tax offsets the lower corporate tax. However, lower corporate tax rates can have positive economic effect for foreign resident shareholders depending on the tax treatment in their country of residence due to fully franked dividends paid to foreign residents being exempt from further Australian tax.

For further information or advice, please contact:

Neil Brydges
Special Counsel
T: 03 9611 0176
E: nbrydges@sladen.com.au

Rob Jeremiah
Principal
T: 03 9611 0103
E: rjeremiah@sladen.com.au

Daniel Smedley
Principal
T: 03 9611 0105
E: dsmedley@sladen.com.au