Lower Company Tax Rate Reduction and ATO Ruling: Certainty or Confusion?

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Lance Cunningham

Lance Cunningham BDO Australia

Lance Cunningham is National Tax Director at BDO Australia

Small- to medium-sized companies in Australia will have to deal with three different sets of rules to determine their eligibility for the lower company tax rate and the rate of franking for dividends over the 2015–16, 2016–17 and 2017–18 income years. This is a result of the introduction of tax legislation changing the rules for the 27.5 percent tax rate from July 1, 2017 and the Australian Taxation Office (“ATO”) simultaneously releasing a draft ruling on when a company is considered to be carrying on a business.

The Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (“new law”) was introduced into the House of Representatives on October 18, 2017 and will amend the current tax law to ensure that from July 1, 2017 a company will not qualify for the lower company tax rate of 27.5 percent if more than 80 percent of its assessable income is passive income (such as interest, dividends or royalties). This “bright line” test will replace the current requirement that a company be “carrying on a business”. On the same day the ATO released draft taxation ruling TR 2017/D7 on when a company “carries on a business”, which expands on the commonly held view of when companies are carrying on business.

This means there will be some companies that were previously entitled to the lower tax rates for the 2015–16 and/or the 2016–17 income years but will now not be entitled to the lower tax rates for the 2017–18 year where they qualify as carrying on business but don't qualify under the new passive income test. It may also go the other way for some companies that are not carrying on business but qualify under the passive income test so they become entitled to the lower company tax rates for 2017–18 but not for the earlier years.

New “Base Rate Entity Passive Income” Definition

The amendments to ensure a corporate tax entity will not qualify for the lower company tax rate if more than 80 percent of its assessable income is of a specifically defined “passive” nature. This new concept of “base rate entity passive income” (passive income) includes, among other things, portfolio dividends (dividends on shares with less than 10 percent voting interest), franking credits attached to portfolio dividends, net capital gains, rent, interest, royalties, and certain amounts that flow through a partnership or a trust (to the extent that it is attributable to an amount of passive income).

Non-portfolio Dividends

The definition of “base rate passive income” includes dividends from a company other than non-portfolio dividends (within the meaning of section 317 of the ITAA 1936), which is a dividend paid to a company where the company has at least 10 percent of the voting power in the company paying the dividend. However, there is no tracing through to the type of income received by the dividend paying company so that all non-portfolio dividends will not be treated as passive income even if they are paid out of passive income of the dividend paying company. Therefore, where a dividend is received by a trust and then distributed to a company it appears that dividend will not be able to be a “non-portfolio dividend” even if the trustee holds 10 percent or more of the voting power. This is because the definition requires the dividend to be paid to a company by the dividend paying company. It is not clear whether this is the intention of Parliament because there are comments in the explanatory memorandum to the new law that indicates that a trust can receive a non-portfolio dividend.

Rent and Royalties

The definition of passive income in the new law includes interest income, royalties and rent. There are existing provisions that ensure that interest derived by an entity that is from the “active conduct of a business” or banking business or money lending business will not be treated as passive income. However, it appears that the same exclusion does not apply to rent or royalties that come from the active conduct of a business. Therefore, under the changes in the new law, rent and royalties will constitute passive income irrespective of the extent of activities that would otherwise point to an active business i.e. companies which are in the business of actively deriving rent and royalties will be considered passive investment companies.

Aggregate Turnover Hurdle

In determining whether a company is entitled to the 27.5 percent tax rate, its “aggregate turnover” must be less than the “annual aggregate turnover threshold” (AU$10 million for 2016–17) which includes the annual turnover of the company and its connected entities. Following the release of the draft ruling on companies carrying on business, many companies and their connected entities will now have to recalculate their aggregate turnover to include “passive income” in their business income, which may result in them being over the aggregate turnover threshold. This is an issue for entitlement to the lower company tax rates for all of 2015–16 and 2016–17, 2017–18 and future years. These companies may also have to reconsider their entitlement to the other small business entity concessions (including the small business CGT concessions and the under AU$20,000 asset write off, etc.) for previous, current and future years.

Prospective Amendment Going Forward

The amendments introducing the passive income test for the 27.5 percent tax rate will apply prospectively from the 2017/18 income year; whereas for the 2015–16 and 2016–17 income years the carrying on a business test is still the relevant test to qualify for the 27.5 percent tax rate (in addition to the relevant aggregate turnover test for the year). Given the ATO's view on companies carrying on business, there may be some that have lodged their 2015–16 and/or 2016–17 income tax returns that did not lodge as a small business entity because it was considered not to be carrying on business but can now ask for amended assessments to be assessed at the lower tax rates for those years. Where companies have not yet lodged their 2016–17 tax return they can now confidently lodge tax returns as small business entities.

ATO Draft Ruling TR 2017/D7 on “Carrying on a Business”

On October 18, 2017 the ATO released draft taxation ruling TR 2017/D7 (“draft ruling”) on when a company “carries on a business” in relation to section 23 of the Income Tax Rates Act 1986 and sections 328-110 of the ITAA 1997. However, The ATO has issued a comment that when the ruling is finalized it will apply more generally to companies that are small business entities.

The draft ruling indicates that companies that are established and maintained to make profits for its shareholders will generally be carrying on business even if the company's activities primarily consist of passive receiving rent or returns on its investments and distributing them to its shareholders. This would appear to cover most companies including most passive investment companies.

While the draft ruling makes reference to various indicia which have been considered by courts in determining whether a business is being carried on, it also includes references to various court cases that indicate that, for companies, these rules are not so restrictive so that as long as the company is actively making decisions on how to profitably invest the company's funds for the benefit of its shareholders it will generally be considered to be carrying on business.

The draft ruling also includes several examples. The examples of companies not carrying on a business include:

  •  (i) a dormant company with retained profits and bank account, on which it derives small amounts of interest that only covers its holding costs (e.g. ASIC fees);
  •  (ii) a company engaged solely in the preliminary activity of investigating the viability of carrying on a particular business;
  •  (iii) a family company's only income is trust distributions from a discretionary family trust, which it distributes part in cash to its shareholders and the balance is held in a non-interest bearing bank account pending distribution to shareholders. The company has no other assets; and
  •  (iv) a family company with an unpaid present entitlement (“UPE”) from a family trust and has not demanded payment from the trust and nor has it entered any arrangement with the trust to receive any profit from the UPE.

The examples of companies that are carrying on business include a family company that has a UPE from a family trust but, in distinction to the example (iv) above, it has entered into an agreement with the family trust to loan the UPE funds to the trust in return for a commercial rate of interest secured against the assets of the trust. This example is not exactly in line with the usual situations in relation to such UPEs that are either compliant with Division 7A loan agreement or Sub-trust arrangements as per PS LA 2010/4, which do not always require the loans to be secured. However, it appears from the other comments in the draft ruling that as long as the Division 7A loan or sub trust arrangement was seen as a profitable way of investing the company's assets it should result in the company carrying on a business. This is also supported by a number of other examples where the company is investing its assets to receive passive income where it is concluded that the company is carrying on business. However, as the ATO says in the draft ruling, the answer ultimately turns on an overall impression of the company's activities, having regard to the indicia of carrying on a business. BDO will be lodging a submission on these and other issues ahead of the deadline of December 1, 2017.

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Lance Cunningham is National Tax Director at BDO Australia.

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