ACCG924 Taxation Law

Lecture Notes Week 11 2018

 Lecture Eleven

Readings from Australian Taxation Law 2018 OUP for this week’s lecture

Taxation of companies and shareholders

Overview -- W18-000; W2-130
Companies -- W18-010; W 32-445
Carry forward of company losses and bad debts -- W19-000 to 19-030;
W19-090; W19-140 to 19-150
Company distributions W18-200 to 18-210
Imputation system W18-100 to 18-130; W18-389 to 18-394
Franking issues for companies W18-330 to 18-350
Franking accounts W18-370 to 18-389

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 Overview
A company is a separate legal entity (unlike a partnership or trust).

A company is a taxpaying entity – generally pays tax on its taxable income at

flat rate of 30%
-- from 2016/17, a tax rate of 27.5% applies to companies that are
qualifying companies and have an aggregated turnover of less than $10m
for 2016/17 and $25m for 2017/18.
-- From 2017/18 the concessional corporate tax rate will only be available
for ‘base rate entities’. Being entities with no more than 80% of its
income being ‘base rate entity passive income’

Section 44(1) ITAA36: a resident shareholder who is paid a dividend out of a

company’s profits includes the dividend in their assessable income
-- non-resident shareholder only includes dividends in their assessable
income to the extent that they are paid out of profits derived by the company
from sources in Australia. W18-205: discussion of s 44.

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 Overview

The imputation system provides for a resident shareholder to receive a

credit (a franking credit) for tax paid by a resident company on the
profits out of which a dividend is paid.

The company paying the dividend must be a resident for imputation to

apply.
“Resident” company is defined in s 6(1) ITAA36 as a company:
(1) incorporated in Australia, or
(2) not incorporated in Australia, and
(i) carries on business in Australia and central management
and control is in Australia, or
(ii) carries on business in Australia and voting is controlled by
resident shareholders.
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 Companies

Tax law refers to “corporate tax entities” and their “members” – these
are most commonly “companies” and “shareholders”

The decision makers with respect to a company are the directors of that
company, and the “central management and control” is generally
where the directors meet

W18-010: discussion of companies

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 Companies
Every company must appoint a public officer (s 252 ITAA36) who must ensure
that all requirements of the tax legislation are met:
– the public officer is liable for all penalties if the company is in breach of its
obligations, eg fails to pay tax on time or lodge returns
– but is not personally liable for the company’s income tax

Directors of the company may be personally liable if the company breaches its
obligations, eg:
-- for failure to pay the company’s income tax or superannuation
contributions for employees, or
-- for failure to remit to the ATO tax that has been withheld from employees’
wages. W32-445

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 Companies – public or private?

Tax law distinguishes between public and private companies – is different from
the Corporations Act distinction
Under s 103A(1) ITAA36, a company is a private company in relation to a year
of income if it is not a public company.
A company is stated in s 103A(2) to be a public company in relation to a year of
income in various circumstances – most importantly, where shares in the
company are listed on the stock exchange in Australia or elsewhere on the
last day of the income year.
Commissioner has a discretion to treat a company as a public company where
he considers it would be reasonable to do so.

Importance of the distinction -- includes:

-- loans or payments by private companies to associated persons may be
treated as dividends
-- different periods within which a “distribution statement” must be issued
-- different “franking periods” for the purposes of the “benchmark franking rule”

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 Carry forward of company losses and bad
debts
Restrictions on a company’s ability to carry forward revenue losses are
contained in Subdiv 165-A ITAA97
Key section is s 165-10: a company cannot deduct a tax loss from a previous
year unless:
-- the company satisfies the continuity of ownership test in s 165-12, which
generally requires the company to have the same majority ownership from
the year the loss was incurred to the year the deduction is being claimed, or
-- the company satisfies the same business test in s 165-13, which requires
the company to carry on the same business in the year of the deduction
claim as it carried on immediately before its ownership changed
“Same business” means identical business, not just similar business: Avondale
Motors 1971.
Company can’t pass the same business test if, in the year of the deduction
claim, it derives assessable income of a new kind or from a new type of
transaction: s 165-210.
Subdiv 165-CA sets the same tests for the carry forward of a company’s capital
losses, and Subdiv 165-C for the carry forward of a company’s bad debts.
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Classical system of taxing company profits:
pre-1 July 1987
Under the classical, pre-imputation, system of taxing company profits, (a) the
company paid tax on its profits, and (b) the shareholder paid tax on
dividends paid from the profits with no relief for the tax paid by the
company.

Example (assumes a 30% company tax rate and a 47% rate for an individual
shareholder) –
Company taxable income $100
Tax at 30% 30
After-tax profits $70 – paid to shareholder as a dividend
Shareholder
Dividend $70
Tax at 47% 33
Total tax paid: $30 by the company + $33 by the shareholder = $63
Effective tax rate on the company income: 63%

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 Imputation system

From 1 July 1987, shareholder may get credit for the tax paid by the company –
the company tax is “imputed” to the shareholder
Example:
Company taxable income $100
Tax at 30% 30
After-tax profits $70 – paid to shareholder as a dividend
Shareholder
Dividend $70
Franking credit 30
Taxable income $100
Tax at 47% 47
Minus offset for franking credit 30
Net tax payable $17
Total tax paid: $30 by the company + $17 by the shareholder = $47
Effective tax rate on the company income: 47%.

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 Imputation system

Example where the shareholder tax rate is below the 30% company tax rate

Taxation of a $70 dividend assuming the individual taxpayer’s marginal tax rate
is 19% (taxable income between $18,200 and $37,000)
Dividend $70
Franking credit 30
$100
Tax at 19% 19
Minus offset for franking credit 30
Excess offset $11

Refund of excess offset: s 67-25

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 Imputation

Purpose of the imputation system

The purpose of the imputation system is to allow certain corporate tax entities
to pass to their members the benefit of having paid income tax on the profits
underlying certain distributions: s 201-1(1) ITAA97.
The imputation system is designed so that:
(a)  the benefit of income tax paid by a company is only passed to members
who have a sufficient economic interest in the entity (generally means they
must have owned the shares for at least 45 days), and
(b)  some members cannot be preferred over others when this benefit is passed
on: s 201-1(2).

Division 200 ITAA97 (s 200-1 to 200-45) provides an overview of the imputation

system.

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 Imputation system

For the benefits of imputation to be passed on, at the time of the distribution:
-- the corporate tax entity (the company) must be resident -- otherwise, it
cannot attach franking credits to (“frank”) the distribution, and
-- the member (the shareholder) must be resident

The franking credit attaches to the frankable distribution, eg dividend, that the
company decides to frank – all distributions are frankable distributions
unless are “unfrankable” (s 202-40, 202-45), eg certain loans from private
companies that are deemed to be dividends

Companies are required to keep a franking account -- this records the extent
to which franking credits can be passed to shareholders

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 Imputation system

Direct distributions: Subdiv 207-A (s 207-10 to 207-20)

Resident shareholders who receive a franked dividend:
–  include the dividend in their assessable income (s 44(1) ITAA36) plus
the franking credit attached to the dividend (the dividend is “grossed
up”) and are taxed at their ordinary rates, and
–  are entitled to a tax offset equal to the franking credit: W18-390.
Individuals and complying superannuation funds are entitled to a refund of
excess franking credits: s 67-25 ITAA97
– no refund for companies, but can convert excess franking credits into a
loss for deduction in a later year: s 36-55 ITAA97. W19-260
Resident shareholders who receive an unfranked dividend include the
dividend in their assessable income, with no franking credit to reduce their
tax liability.
W18-390

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 Imputation system

Direct distributions received by non-resident shareholders

Non-resident shareholders who receive a dividend from a resident company:

-- are generally subject to withholding tax (s 128B ITAA36) if the dividend is
unfranked – tax is withheld from the dividend and sent to the ATO, the
remainder of the dividend is sent to the shareholder and they have no
further tax liability on the dividend
-- withholding tax rates are discussed at W24-605 (not examinable)
-- to the extent the dividend is franked, it is exempt from withholding tax and
the shareholder has no tax liability – this is because the company has
already paid tax on the profits out of which the dividend is paid
Example at W24-620.
Company paying the dividend has obligation to withhold if appropriate; is liable
to penalty if does not withhold and possible payment of the amount that
should have been withheld (s 12-210 and 16-25 Taxation Administration Act
1953).
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 Imputation system

Indirect distributions: Subdiv 207-B (s 207-25 to 207-59)

Taxpayer receives the benefit of the dividend indirectly through a partnership or
trust, as a partner or beneficiary: s 207-50.
The dividend as well as the franking credit is included in the assessable income
of the partnership or trust
The share of net trust income or net partnership income assessable to the
beneficiary under s 97 ITAA36 or partner under s 92 ITAA36 includes a
share of the franking credit -- the beneficiary or partner is entitled to a tax
offset for their share of the franking credit, but only if they are residents.
Where the trustee of a trust pays tax on behalf of a beneficiary under s 98
ITAA36 or is assessed under s 99 or 99A ITAA36 on income accumulated
in the trust, the trustee is also entitled to a tax offset for a share of the
franking credit.
W18-394
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 Imputation system

Simple example of franked dividend received by an individual

indirectly through a partnership

Partnership income in 2017/18 is $15,000 – made up of fees from clients ($14,000) and
franked dividend ($700) with franking credit ($300) attached
Assume two partners, each with 50% interest in the partnership
Assume also that the income of Partner A, who is a resident, is made up of $20,000 from
investments and $7,500 share of the net partnership income
Tax on $27,500: $1,767
Reduction for offsets:
(1) low income offset : $445
(2) share of franking credit: $150
Income tax: $1,767 - $445 - $150 = $1,172
Partner A would not benefit from the franking credit if he was a non-resident.
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 Franking issues for companies

Franking a distribution

To pass on franking credits to shareholders, s 202-5 requires that:

–  the company is a franking entity (s 202-15) that satisfies the residency
requirements (s 202-20) when the distribution is made
–  the distribution is a frankable distribution (s 202-40 and 202-45) , and
–  the company franks the distribution -- allocates a franking credit.

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 Franking issues for companies

Distribution statements

A distribution statement must be provided by a company in relation to each

distribution: s 202-75(1).

Distribution statements must be given:

-- by public companies, when the distribution is made
-- by private companies, by four months after the year ends

Distribution statement must contain the information set out in s 202-80, eg the
amount of the dividend, the amount of the franking credit and the franking
percentage.

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 Franking issues for companies

Amount of franking credit on a distribution

Franking credit is the amount stated on the distribution statement unless that
amount exceeds the maximum franking credit for the distribution (s
202-60(1)
If the amount stated exceeds the maximum franking credit, the amount of the
franking credit is taken to be the maximum franking credit for the distribution
(s 202-65)

Maximum franking credit for a distribution is the maximum amount of income

tax that the entity making the distribution could have paid, at the standard
corporate tax rate, on the profits out of which the distribution is paid (s
202-55)
“Standard corporate tax rate” is 30%

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 Franking issues for companies

Maximum franking credit for a distribution is calculated using the following

formula in s 202-60(2):
1
amount of the frankable distribution x -----------------------------------------
corporate tax gross-up rate

100% - standard corporate tax rate 70

“Corporate tax gross-up rate” (defined in s 995-1(1)) = --------------------------------------------- = ---
standard corporate tax rate 30

Maximum franking credit calculation is the same for all companies -- whether
they pay tax at the 30% rate or the 27.5% rate
In all cases, the maximum franking credit is:
amount of the frankable distribution x 30/70)
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 Franking issues for companies

Example

If a company pays a $700 dividend, the maximum franking credit that

can be attached is calculated as: $700 x 30/70 = $300.

Company can choose to make the $700 dividend:

(i) fully franked -- $300 franking credit – franking percentage 100%,

(ii) partly franked – franking credit is more than $0 but less than $300 –
franking percentage more than 0%, less than 100%, or

(iii) unfranked – no franking credit – franking percentage 0%

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 Franking issues for companies

Benchmark rule -- a company must frank all frankable distributions made

within a particular period at a franking percentage set as the benchmark
percentage for that period (s 203-5).
-- so that one shareholder is not preferred over another when the company
franks dividends (s 203-15)

All frankable distributions made by a company during a franking period must be

franked to the same extent (the benchmark franking percentage): s 203-25.

Benchmark rule does not apply to companies where the share ownership
makes it difficult to stream benefits to one shareholder over another, eg a
listed public company with a single class of membership interest at all times
during the franking period: s 203-20.
Commissioner may permit departure from the benchmark rule in unusual
cases.
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 Franking issues for companies

Franking period is 12 months for private company; six months for public
company (s 203-40 and 203-45)

Benchmark rule means that the franking percentage for the first distribution in a
franking period must be continued throughout the period (s 203-30)

Franking percentage (s 203-35) is calculated as:

franking credit allocated to the distribution

-------------------------------------------------------- x 100
maximum franking credit for the distribution

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 Franking issues for companies

Consequences of breach of benchmark rule -- penalty for the company based

on the difference between benchmark franking percentage and the franking
percentage for the distribution: s 203-50
Over-franking tax is payable if the franking percentage exceeds the benchmark
franking percentage (tax = the excess amount)
– no credit in franking account for this tax
– shareholder gets franking credits allocated on the statement
-- debit in the franking account for all the franking credits passed on
Franking debit in franking account if the franking percentage is less than the
benchmark percentage – franking debit for the franking credits it passes to
shareholders and also for those it should have passed to shareholders
-- shareholders only get amount of franking credits passed on
– unused credits are wasted because are cancelled in the franking account
by the franking debit and not passed to shareholders
Commissioner can allow departure from benchmark rule: sec 203-55
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 Franking issues for companies

Example of application of benchmark rule

Assume a private company pays a dividend on 1 July 2017 which is franked 60% -- 60%
becomes the benchmark franking percentage for the 12-month franking period -- if
the company wants, for example, to pay a dividend of $100 franked at the benchmark
percentage, it should attach $26 franking credits ($100 x 30/70 x 60% = $26).
Over-franking: on 1 September 2017, the company pays a dividend of $100 which has
$30 franking credits attached – this means it is franked 70%, the company has over-
franked by 10% and has passed on $4 too much franking credits
Consequences: (1) company is liable to $4 over-franking tax with no credit in the franking
account for the $4 tax, (2) shareholder gets $30 franking credit, (3) debit in franking
account of $30.
Under-franking: if instead the company pays a dividend of $100 on 1 September 2017
which has $17 franking credits attached – this means it is franked 40%, the company
has under-franked by 20% and has failed to pass on $9 of franking credits that it
should have passed on.
Consequences: (1) company debits its franking account the $17 and also the $9 that it
should have passed on, (2) shareholder gets $17 franking credit, (3) $9 of franking
credits are lost.
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 Franking Accounts

Each company has a franking account which it must maintain: s 205-10

Is a running account that identifies: (a) the company’s franking credits and
franking debits, and (b) when there is a franking surplus or deficit in the
account
Company must satisfy residency requirements before a franking credit or
franking debit arises in the franking account
Company may have a surplus carried forward from previous year as opening
credit, but a deficit is never carried forward
Franking account indicates the extent to which a company can pass franking
credits to its shareholders at a particular time.

Section 205-5: summary about franking accounts, franking deficit tax liabilities
and the related tax offset

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 Franking Accounts

Possible franking credit entries (s 205-15) -- most important:

-- company makes PAYG instalments of income tax or pays income tax
from tax return liability – franking credit is the amount of tax paid
-- company receives a franked dividend – franking credit is the amount of
franking credits attached to the dividend it receives
-- payment of franking deficits tax
W18-380
Possible franking debit entries (s 205-30) – most important:
-- company receives income tax refund -- debit is the amount of the refund
-- company pays franked dividend – debit is the amount of franking credits
attached to the dividend it pays
-- company breaches the benchmark rule by under-franking dividends –
debit is the amount of under-franking
W18-385
Example of movements in a franking account in W18-387
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 Franking Accounts

Franking deficits tax (s 205-45)

Company is liable to franking deficit tax if the franking account is in deficit

(because the franking debits exceed the franking credits) at the end of the
income year

Franking deficits tax is equal to the amount of the deficit

Company obtains a credit for the tax in its franking account: s 205-15(1) item 5
-- because the franking deficits tax is treated as a pre-payment of tax

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 Franking Accounts

Entitlement to tax offset (s 205-70)

Company is entitled to a tax offset for franking deficits tax it is required to pay at
the end of an income year -- offset reduces the company’s income tax
liability for the year (generally when the company lodges its annual tax
return about 9 months later)

Where the company’s franking deficit tax liability is greater than 10% of the total
franking credits that arose in the franking account for the year, the tax offset
is reduced by 30% -- this operates as a penalty to prevent substantial over-
franking.

Offset is not reduced by 30% if the Commissioner is satisfied the deficit was
caused by circumstances outside the company’s control, eg the company
had expected there would be more PAYG instalments and therefore more
franking credits, but had been a downturn in the company’s business.
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