The effect of passive income on a company’s entitlement to a 27.5% tax rate

Legislative changes passed by the government in May 2017 reduced the corporate tax rate to 27.5% from 1 July 2016 for companies with aggregated turnover of less than $10 million (the threshold is set to increase to $25 million in the 2018 financial year and $50 million in the 2019 financial year).

However, following the decision in the Bywater case a recent draft ATO Interpretative Decision has been releaed that included the following comment by the Commissioner:

 “This ruling is not concerned with what amounts to carrying on business. However, generally, where a company is established or maintained to make profit or gain for its shareholders it is likely to carry on business. This is so even if the company only holds passive investments, and its activities consist of receiving rents or returns on its investments and distributing them to shareholders.”

Much discussion followed as to whether companies holding passive investments would be eligible for the lower 27.5% tax rate provided their aggregated turnover was less than the relevant threshold. However, the government was quick to state that this was not an intended outcome of the policy and, albeit some months later, the Parliament has now moved to determine through legislation the circumstances where passive income earning companies will be entitled to the lower tax rate. 

Base rate passive income

Parliament seeks to tax corporate entities at the full 30% tax rate where more than 80% of the company’s income for the year is base rate passive income, which includes the following:

  • Interest, royalties and rent derived;
  • Dividends and franking credits received from companies (unless the company holds more than 10% of the interests in the dividend paying company);
  • Non-share dividends from companies;
  • Gains on certain qualifying securities;
  • Net capital gains; and
  • Amounts of partnership or trust income that is base rate passive income as previously defined.  

The proposed legislation is intended to take effect from 1 July 2017. This is a step back from the retrospective application of the legislation with effect from 1 July 2016 previously being considered, and will avoid the potential issues of companies having to re-visit 2017 dividend statements that may already have been issued.

Impacts of the change

Companies may find the 80% passive income threshold quite generous given there is also a carve-out of non-portfolio dividends (intended to assist holding companies to gain access to the lower rate on dividends from subsidiaries). However, they will need to analyse their income streams to determine whether they qualify for the 27.5% rate. This also effectively imposes a requirement on trusts and partnerships to identify clearly the nature of the income they distribute to the partners and beneficiaries in order to track the character for recipient companies.

 Potential for the rate changing from year-to-year

Companies must apply the base rate passive income test each year and some may find their tax rate varies between 27.5% and 30% from year to year, particularly companies that straddle the 80% passive income line. Those companies may find that they alternate between tax rates as a result, for example, from deriving larger capital gains from the sale of an investment.  Therefore, companies with predominantly passive incomes or trading companies that are selling capital assets may need to manage their net capital gain position in order to access the lower tax rate.

The impact on franked dividends

The legislation allows companies to assume their aggregated turnover and base rate passive income is the same as the prior year for the purposes of franking dividends. Although there may be a delay between year-end and the completion of the necessary statements, it will be obvious to many companies whether they are likely to fall within the 27.5% or 30% taxation categories for the purposes of franking dividends, therefore providing a much-needed degree of certainty.

As the base rate passive income percentage effectively carries forward for franking purposes, companies may wish consider the timing of paying dividends to shareholders, as dividends paid in the years where the higher franking rate applies will utilise more of the franking credits that have built up during a 30% tax period.

Companies with aggregated turnover of less than $25 million in the 2018 financial year may find that they are restricted to franking their dividends at the 27.5% rate, thereby trapping in the company franking credits that had built up at the higher 30% tax rate. Companies with aggregated turnover between $25 million and $50 million might consider reviewing their dividend strategy during the 2018 year in order to ensure that dividends are franked at that higher rate of 30%.

 Suggested action

With almost six months of the 2018 financial year gone, companies expecting to generate significant amounts of base rate passive income should consider carefully whether they qualify for the reduced corporate tax rate.

Please get in touch with your Walker Wayland NSW contact if you would like to discuss the impacts of the new legislation on your business..