If the coalition manages to pass its legislation to drop the company tax rate from 30 per cent to 25 per cent, most advisers understand that this would effectively result in increased tax paid by investors in companies.
What is not as well understood is the effect that the decrease in the company tax rate for small businesses from 30 per cent down to 28.5 per cent in 2016, and then down to 27.5 per cent for the 2017 year, will not only result in more tax being paid on dividends distributed to small business shareholders, but potentially also results in the loss of accumulated imputation franking credits.
Previously when there was a decrease in the company tax rate, companies were required to identify two types of imputation franking credits, with one type attracting a high imputation credit that related to the previously higher company tax rate, and with the second type being a lower imputation credit that related to the lower company tax rate.
With the reductions in the small business company tax rates no such provision has been built into the legislation. Worried about how my small business clients could be affected after I contacted the ATO and asked what the franking credit would be for a small business that made a $10,000 taxable profit in each of the 2015, 2016 and 2017 financial years, and then paid a dividend from after-tax profits in 2018.
“The dividend it pays on the 2018 income can only be franked to a maximum of 27.5 per cent because this is the corporate rate that applies to it in that year,” a spokesperson for the ATO told me. Having clients that had been operating for many years and paying company tax at 30 per cent and that could potentially lose the benefit of imputation credits, I looked for ways of preserving the imputation franking credits.
My first thought was to ask the ATO if, as is the case with most other small business tax concessions, owners had a choice with regard to accessing the concessions. “Companies must apply the rate that is specifically applicable to them,” a spokesperson said. “This means that unlike some of the other small business concessions, a company that is eligible for 27.5 per cent must apply that rate. It cannot choose to apply the 30 per cent rate.”
To put things into perspective, let’s look at the example of a small business that had been operating for the past 17 years, which had accumulated after-tax profits of $140,000 at June 30, 2015, and which had made a profit during the 2016 year that resulted in after-tax profits of a further $40,000. For that company, the imputation franking account would total $75,944.
If the owners sold their small business during the 2017 financial year, at a time when the imputation franking account rate dropped to 27.5 per cent, and they received a fully franked dividend of $180,000, the imputation franking credit would only be $68,276 resulting in the potential loss of $7668 of imputation franking credits to the owners.
This prospect for my small business clients left me racking my brain for a strategy that could be used to make sure that the benefit from the accumulated 30 per cent imputation franking credits would not be lost.
Attending one of the sessions at the recent Australian Investors Association 2017 annual conference I had an epiphany, complements of one of the presenters who was detailing the benefits of the imputation system. This prompted me to send another question to the ATO about how unused imputation franking credits could be attached to what would normally be classed as unfranked income.
To find out how the answer from the ATO means there are several strategies available, those advisers with clients in the same situation should look for my column in a fortnight’s time.