In Australia, the general corporate tax rate is 30%. To assist smaller businesses in becoming more competitive with larger corporations, the Australian Government introduced various law changes (with only some passing into law) over the last few years to allow small and medium Australian companies to access a lower corporate tax rate. These changes have led to a multitude of new concepts, different tax rates & turnover thresholds and additional eligibility requirements that need to be analysed and understood by corporate taxpayers and their advisors.

More recently, the new definition of a “base rate entity” (BRE) has now become law with effect from 1 July 2017. This new BRE definition effectively replaces the previous definition of a small business entity (SBE) for the purposes of accessing the lower corporate tax rate from the 2017/18 income year.

As the changes have caused significant confusion and uncertainty, we have attempted to provide a clear and concise summary of the latest position on accessing the lower corporate tax rate and potential flow on tax implications to consider.

The following table provides a snapshot of the eligibility criteria for the relevant income years impacted by the changes. All references to monetary amounts are denominated in Australian dollars. The standard income year in Australia ends on 30 June.

Income Year Classification Test 1:
SBE / BRE
Test 2:
Aggregated Turnover Threshold (C)
Lower corporate tax rate General corporate tax rate
2015/16 Small business entity (SBE) Carrying on a business test (A) $2 million 28.5% 30%
2016/17 Small business entity (SBE) Carrying on a business test (A) $10 million 27.5% 30%
2017/18 Base rate entity (BRE) Base rate entity passive income test (B) $25 million 27.5% 30%
2018/19 Base rate entity (BRE) Base rate entity passive income test (B) $50 million 27.5% 30%

 

Broadly, if a company passes the following two tests then it should be able to access the lower corporate tax rate:

  • the carrying on a business test or new BRE passive income test (whichever applies for the relevant income year); and
  • its aggregated turnover is under the threshold for the relevant income year.

These two tests are explored in more detail below

A. The “carrying on a business” test

Traditionally, a company is carrying on a business if it carries on activities/operations in a business-like manner and derives ‘active’ business income as opposed to ‘passive’ investment income. However, in October 2017, the Australian Taxation Office (ATO) issued draft Taxation Ruling TR 2017/D7 which sets out the Commissioner’s views on when a company is “carrying on a business” for the purposes of accessing the lower corporate tax rate.

According to some of the examples included in TR 2017/D7, a company simply deriving dividend income or rental income could be considered carrying on a business. In the draft ruling, the ATO states that some key indicators of when a company is considered to be carrying on a business are that it carries on “repeated and regular” activities that are for “profit making purposes” and are organised in a “systematic and business” like manner.

We note that the ATO’s views in TR 2017/D7 on companies deriving mainly passive income appear to be inconsistent with historical approaches taken by the ATO albeit for different tax purposes (for example, for the purposes of accessing tax concessions for small businesses). However, at the time of writing this ruling is still in draft and so there is still a possibility that it may change in its final form.

In July 2018, the ATO issued a draft Practice Compliance Guideline: PCG 2018/D5 which sets out a practical administrative approach to assist taxpayers in complying with the small business company tax rate changes. In particular, the ATO will not conduct specific reviews of the corporate tax rate adopted for 2015/16 and 2016/17 unless the ATO becomes aware that the taxpayer’s assessment of whether they were carrying on a business in those income years was plainly unreasonable (or steps were taken to enter into any sort of tax avoidance arrangement to access the lower corporate tax rate). As PCG 2018/D5 is still in draft form at the time of writing it may be subject to change.

Further, with the new BRE definition applying from 1 July 2017 we note that this carrying on a business test is only relevant for the 2015/16 and 2016/17 income years.

B. The new “base rate entity passive income” test

The new BRE definition replaces the abovementioned “carrying on a business” test with a “BRE passive income test” from 1 July 2017 (i.e. the 2017/18 income year onwards). Broadly, if less than 80% of a company’s assessable income is BRE passive income then this test is satisfied.

Some examples of BRE passive income include:

  • Dividends from listed companies.
  • Distributions from public trusts.
  • Interest.
  • Royalties.
  • Rent.
  • Net capital gains.

There are also exceptions from BRE passive income for certain dividends from private companies and distributions from private trusts. Further analysis is required to determine whether these types of income are BRE passive income or not.

C. The relevant aggregated turnover thresholds

To calculate the aggregated turnover for a particular income year you need to also include the annual turnovers of connected entities and affiliates. We note that the definitions of connected entities and affiliates have not changed for many years and therefore we have not considered this aspect in this paper. However, in light of the ATO’s view in TR 2017/D7 mentioned above, consideration now also needs to be given to whether the turnovers of entities previously considered ‘passive investment vehicles’ deriving mainly passive income should be included in the calculation of aggregated turnover.

Example 1: Determining the applicable corporate tax rate in 2017/18

For illustration purposes, a simple example of how the BRE passive income test is worked out is included below.

For the 2017/18 income year, a company’s:

  • Aggregated turnover is $26m.
  • Total assessable income is $24m.
  • BRE passive income $19m (i.e. 79.2% passive income).

Although the company’s BRE passive income is below 80%, its aggregated turnover is above the $25m threshold applicable for the 2017/18 income year. Therefore, the company in this example would not be eligible for the lower corporate tax rate for 2017/18 and its applicable corporate tax rate would be 30%.

D. Impact on dividend imputation and franking credits

Australia has a dividend imputation system in which some or all of the tax paid by a company may be attributed (or imputed) to shareholders by way of a tax credit (or franking credit) to reduce the income tax payable on a distribution. For the purposes of working out the corporate tax rate for dividend imputation purposes, the company must assume that its aggregated turnover, assessable income, and BRE passive income will be the same as the previous income year and compare this to the current year’s aggregated turnover threshold.

Because of the way that the franking percentage is worked out based on previous year figures and the changes to the corporate tax rate for some companies, a franking issue potentially arises whereby it can only frank dividends at the lower corporate tax rate (i.e. 27.5%) on profits from previous years which have been taxed at the higher 30%. The result of this is that the 2.5% (30% – 27.5%) tax differential for historical franking credits taxed at 30% are effectively “trapped” in the company.

Example 2: Determining the applicable franking percentage in 2018/19

To illustrate this potential franking issue, we assume the same information as in example 1 above for the 2018/19 income year. That is, for the 2018/19 income year the company’s:

  • Aggregated turnover is $26m.
  • Total assessable income is $24m.
  • BRE passive income $19m (i.e. 79.2% passive income).

As the company’s BRE passive income is below 80% and aggregated turnover is below the 2018/19 threshold (i.e. $50m), it would be eligible for the lower corporate tax rate of 27.5% in 2018/19. However, because of the company’s prior (2017/18) income year results, it would only be able to frank dividends it pays in the 2018/19 year at 27.5% despite the fact that it would have paid corporate tax at 30% in 2017/18.

E. Existing income tax concessions available for small businesses in Australia

For completeness, we note that the turnover thresholds for the existing small business entity income tax and capital gains tax (CGT) concessions remain unchanged for now.

From the 2017/18 income year, there are now three types of small business entities which can qualify for different tax concessions, with each having their own separate tests and requirements. The three types of small business and their key tax attributes are summarised in the table below:

Types of small business entities Aggregated turnover threshold Tax concessions Examples of tax concessions
Base rate entity (BRE) 2017/18 – $25m
2018/19 – $50m
Lower corporate tax rate Corporate tax rate of 27.5%
Small business entity (SBE) $10m Small business income tax concessions Immediate asset write off, simplified prepayment and depreciation rules
CGT Small business entity (CGT SBE) $2m Small business CGT concessions 15 year exemption, 50% active asset reduction and small business retirement exemption

More questions

As you can see from the above, the new rules are complex and require a more detailed analysis each year to determine whether a small to medium company is eligible for the lower corporate tax rate. Please contact your Hill Rogers advisor for more information.

Disclaimer.

This material is general commentary only. None of the material is, or should be regarded as, personal or financial product advice. Accordingly, no person should rely on any of the contents of this publication without first obtaining specific advice from Hill Rogers. Every effort has been made to ensure that the content is accurate, however it is not intended to be a complete description of the matters described. Hill Rogers, its Principals and agents accept no responsibility to any person who acts or relies in any way on any of the material without first obtaining such specific advice.