CHAPTER 1 Chapter 21 Companies and shareholders  2020 Thomson Reuters (Professional) Australia Ltd. All Rights Reserved. Kerrie Sadiq, Queensland University of Technology 1 Overview The key issues in...

CHAPTER 1 Chapter 21 Companies and shareholders  2020 Thomson Reuters (Professional) Australia Ltd. All Rights Reserved. Kerrie Sadiq, Queensland University of Technology 1 Overview The key issues in this topic are grouped as follows: Companies are subject to income tax at a flat rate of 30% Small business entities are subject to income tax at a flat rate of 27.5%, now legislated to be lowered progressively to 25% by 2021-22. PoTL 2020 paragraph [21.10] Taxation of companies and shareholders Taxation of dividends Imputation system Treatment of losses Consolidation Definition Section 995-1 ITAA97 defines “company” as: A body corporate; or any other unincorporated association or body of person Does not include a partnership or a non-entity joint venture. Separate legal entity Companies may be public and private Public companies are generally listed on the stock exchange: s 103A(2) ITAA36 A private company is not a public company: s 103A(1). PoTL 2020 paragraph [21.20] Public officer Every company carrying on business or deriving property income in Australia must appoint a public officer: s 252 ITAA36 Public officer must be a resident, a natural person aged at least 18 years For income tax law, the public officer is responsible for: Documents served on them Answerable for all obligations imposed on the company The same penalties if the company defaults. PoTL 2020 paragraph [21.30] Taxation of dividends Taxing provision in s 44 ITAA36 stipulates that the assessable income of a resident shareholder in a company includes: Dividends paid to the shareholder by the company out of profits derived by it from any source; and All non-share dividends paid to the shareholder by the company. PoTL 2020 paragraph [21.40] Deemed dividends for private companies Consider the two mutually independent scenarios: Scenario 1: Scenario 2: Lower corporate tax rate is an incentive for taxpayers to accumulate profits in the company. Assessable gain Income tax treatment Assessed in the individual’s hands at their marginal rate of up to 45% + Medicare levy Assessable gain Income tax treatment Assessed in the company at the rate of 30% PoTL 2020 paragraph [21.110] Individual taxpayer Company taxpayer Deemed dividends for private companies Avoidance issue: Schemes used by private companies to pass benefits (ie, use of profits) to shareholders while avoiding the payment of “dividends” include: Paying excessive salaries or fees paid to shareholders Making payments and loans to shareholders. PoTL 2020 paragraph [21.110] Deemed dividends for private companies Excessive salaries or fees paid to shareholders (s 109(1)) To the extent that salaries or fees for services provided by a shareholder (or associate) is excessive, that portion: Is deemed to be a dividend to the shareholder; and Is not deductible to the company. Pays excessive salaries / fees Services Provided PoTL 2020 paragraph [21.130] Private Company Shareholder Deemed dividends for private companies: Division 7A Provisions that deem certain kinds of amounts paid by a private company to a shareholder (or associate) as dividends: Payments (s 109C) Loans (s 109D) Debt forgiveness (s 109F). Total amount of Division 7A deemed dividends capped at the “distributable surplus” of the private company: s 109Y. PoTL 2020 paragraph [21.130] Deemed dividends for private companies: Division 7A Payments to shareholders (s 109C) Payments made to shareholders (or associates) are treated as deemed dividends. “Payment” is widely defined: any payment or credit to, on behalf of, or for the benefit of, the shareholder and includes the transfer of property or the provision of an asset. Exclusions include: Payment to discharge an arm’s length debt: s 109J. Payment to corporate shareholders: s 109K. PoTL 2020 paragraph [21.130] Deemed dividends for private companies: Division 7A Loans to shareholders (s 109D) Loans made to shareholders (or associates) that are not repaid by the “lodgement date” constitutes a deemed dividend. Exclusions include: Loans made to a corporate shareholder: s 109K. Loans meeting minimum criteria: (i) written loan agreement; (ii) commercial interest rate; and (iii) term of loan: s 109N. PoTL 2020 paragraph [21.130] Deemed dividends for private companies: Division 7A Forgiven debts to shareholders (s 109F) Debts owed by shareholders of private companies that are forgiven constitute a deemed dividend. Exclusions include: Debts that were owed by another company. Debts forgiven due to bankruptcy of the shareholder. PoTL 2020 paragraph [21.130] Imputation system Income tax systems treats a company as a separate taxpayer from its shareholders. Issue of double taxation under the classical system arises when the same economic income flows from company to shareholder: Example: classical system - double taxation issue Company level$ Taxable income100 Less: income tax payable (30%)30 = Net profit available for distribution70 Shareholder level Dividend70 Income tax payable on dividend (assume 47%)33 PoTL 2020 paragraph [21.150] Total tax paid $63 Imputation system Imputation system addresses “double taxation” issue by use of “imputation credits” and “gross up and offset” mechanism: Example: basic operation of the imputation system Company level$ Taxable income100 Less: income tax payable (30%)30 = Net profit available for distribution70 Shareholder level Dividend70 Gross Up: imputation / franking credit30 = Taxable income100 Shareholder’s tax payable Tax on taxable income (assume 47% rate)47 Less: tax offset(30) Income tax payable17 PoTL 2020 paragraph [21.150] Total tax paid $47 Imputation system: Franking credits attached to dividends Franking credits are “attached” to dividends. Company’s decision to attach a franking credit. Should represent income tax already paid on profits. The maximum franking credits that can be attached to a distribution is determined by the formula in s 202-60(2): Example: franking credits attached to a dividend A company (not a small business entity) pays a cash dividend of $70 and decides to frank it to $80%. The franking credit attached to the dividend is:   PoTL 2020 paragraphs [21.160] – [21.170] Frankable Distribution x Corporate Tax Rate 1 - Corporate Tax Rate Imputation system: Franking accounts Franking accounts keep track of the amount available franking credits to attach (ie, frank) its distributions. Corporate tax entities must keep a franking account: s 205-10. Franking deficit tax payable if the franking account is in deficit at the end of the income year: s 205-45(1). PoTL 2020 paragraphs [21.180] – [21.190] Franking Debits (s 205-30) Franking a distribution Violating the benchmark rule due to under-franking. Franking Credits (s 205-15) Paying income tax or PAYG Receiving a franked distribution directly or indirectly through a partnership or trust Receiving an income tax refund Incurring a liability to pay franking deficit tax. Entries include the entity: Entries include the entity: Imputation system: Implications on shareholders In general, if a shareholder receives a franked distribution: It has to “gross up” its assessable income by the amount of the franking credit: s 207-20(1); and It is entitled to claim a tax offset by the same “gross up” amount: s 207-20(2). A component of taxable income being “assessable income” is grossed up (ie, increased) by franking credit 2. Claim tax offset by the same “gross up” amount PoTL 2020 paragraphs [21.200] Income Tax Payable Taxable Income Rate Tax Offsets Imputation system: Implications on shareholders Resident individuals Franking credit tax offset is refundable if it exceeds the resident individual’s income tax payable. Example: refundable franking credit tax offset Company distributes a fully franked dividend to a resident individual. Taxpayer has no other taxable income. Shareholder Dividend70 1. Gross up: franking credit30 Taxable income100 Income tax payable (within tax-free threshold)0 2. Less: franking credit tax offset(30) Income tax refundable30 PoTL 2020 paragraph [21.210] Imputation system: Implications on shareholders PoTL 2020 paragraphs [21.220] – [21.240] Resident corporate shareholders Franking credit tax offset is generally not refundable for shareholders who are corporate tax entities Excess franking offsets can be converted into a tax loss which can be carried forward to future income years: Excess franking offset Corporate tax rate (ie, 30%) = Tax loss Imputation system: Implications on shareholders Resident partnerships and trusts as shareholders Generally, franked distributions are traced through so that partners and trust beneficiaries receive their share of the distribution and franking credits. Non-resident shareholders “Gross up and offset” mechanism not available to non-resident shareholders: s 207-20. Treated generally as non-assessable non-exempt income in the hands of the non-resident shareholder: s 128D ITAA36. Withholding tax applies to unfranked dividends. PoTL 2020 paragraphs [21.250] – [21.260] Imputation system: Integrity measures Benchmark rule Purpose: counteracts streaming arrangements Ensures that one member of a corporate tax entity is not preferred over another when the entity franks distributions. Rule: all distributions in a “franking period” must be franked to the same “benchmark franking percentage”: s 203-25. Over-franking: liable to pay over-franking tax (s 203-50(1)). Under-franking: debit in the franking account (s 203-50(1)(b)). Commissioner may permit deviation from the benchmark rule in extraordinary circumstances: s 203-55. PoTL 2020 paragraph [21.270] Imputation system: Integrity measures “Benchmark franking percentage”: franking percentage of the first frankable distribution in the franking period (s 203-30). “Franking period”: Private company: Public company: One franking period: 1/7 to 30/6 Two franking periods: 1/7 to 31/12; 1/1 to 30/6 30 December X1 / 1 January X2 PoTL 2020 paragraph [21.270] 1 July X1 30 June X2 1 July X1 30 June X2 Imputation system: Integrity measures Diagram showing a breach of the benchmark rule: distributions under-franked and over-franked over one franking period. Under-franked Over-franked Benchmark franking % PoTL 2020 paragraph [21.270] Imputation system: Integrity measures Qualified person Use of the “gross up and tax offset” mechanism is denied if the distribution is made to a person that is not a “qualified person”. “Qualified person” is, among other things, a shareholder that holds the shares at least 45 days (90 days for preference shares). PoTL 2020 paragraphs [21.280] – [21.290] Company losses A tax loss arises under s 36-10 when: Tax losses are generally carried forward indefinitely to offset future taxable income of the taxpayer Issue of “loss trafficking” activities through trading companies with tax losses. Anti-avoidance provisions. PoTL 2020 paragraph [21.310] Deductions Assessable income and net exempt income Difference is the amount of the tax loss Company losses: Carry forward realised losses Carried forward revenue losses cannot be deducted unless company satisfies either the: Continuity of ownership test (CoT); or Business continuity test (SBT): s 165-10 ITAA97. Above tests also apply to a revenue loss in the current year: Subdiv 165-B. Similar rules apply to net capital losses, current year net capital losses and bad debts: Subdivs 165-CA, 165-CB and 165-C. PoTL 2020 paragraph [21.320] Company losses: Carry forward realised losses Continuity of ownership test (CoT): s 165-12 A company has to maintain the same majority owners during the “ownership test period”, that is, the same persons holding: Focus on application of the test is on beneficial ownership Tracing to ultimate individual owners required when there are corporate shareholders. PoTL 2020 paragraph [21.330] 1 More than 50% of the voting power in the company 2 Rights to more than 50% of the company’s dividends; and 3 Rights to more than 50% of the company’s capital distributions Definition of a partnership General law partnership Contractual relationship between two or more people who wish to conduct a business in common with a view to profit. State based statutory law and the general law See, for example, s 5 of the Partnership Act 1958 (Vic) and Ruling TR 94/8. Not a separate legal entity. PoTL 2021 paragraph [19.20] Definition of a partnership Tax law partnership A partnership at tax law as defined