Companies EXAM Notes PDF

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Summary of the topic Companies for exam...

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Companies  Companies are separate legal entities and are required to calculate their taxable income (or loss) for an income year, are liable to pay tax on their taxable income and are entitled to carry forward tax losses. Assessable income- allowable deductions.  Shareholders are liable to pay tax on dividends, but are entitled to tax offsets (“franking credits”) to the extent that dividends are paid out of after-tax profits.  The full corporate tax rate, which applies to larger companies, is currently 30%. Before changes were implemented a few years ago, this was the standard corporate tax rate for all companies. ◦ Since 1 July 2015, companies that are ‘small business entities’ have been subject to a lower tax rate. This was initially 28.5% (in 2015/2016) and has been 27.5% since 2016/2017. An entity is a small business entity if its annual turnover is less than $10 million (previously the threshold was $2m). For CGT purposes, it is still 2 million. ◦ From 2017/2018, the reduced rate of 27.5% also applies to companies with an annual turnover of less than $25 million, provided any passive income is no more than 80% of assessable income. Eg. Rental income/dividend income essentially a company that is carrying on a business ◦ In the 2016/2017 Budget, the Government announced that it intended to (i) progressively enlarge the corporate entities eligible for the lower rate, and (ii) further reduce the rate – eventually to 25%. It is intended that all corporate entities would be taxed at 25% by 2027.

Profit Distributions  Corporate profits may be: ◦ retained within the company (“retained earnings”); or ◦ distributed to shareholders as dividends. The decision to pay a dividend and the amount of the dividend is at the discretion of the Board of Directors.

Dividends  Shareholders are liable to pay tax on dividends but are entitled to tax offsets (“franking credits”) to the extent that dividends are paid out of after-tax profits.  Companies cannot claim a deduction for the payment of dividends; dividends are ascertained after profit has been worked out, and as such are not a loss or expense incurred in earning income: Macquarie Finance Ltd v FCT 2004 ATC 4866.  Section s6(1) ITAA36 provides that a dividend excludes ◦ amounts debited against the company’s share capital account. (But, an account will not be treated as a share capital account if it is “tainted”: s975300(3) ITAA97. A share capital account is tainted if amounts from other accounts have been transferred to it: subdivision 197-A ITAA97. IT is not tainted if it has amounts of capital in it. If it has a mixture, it is tainted and not considered a return of capital, it is a dividend.) And includes ◦ A distribution made by a company to its shareholders, whether in money or other property, ( Distributions out of the share capital account are treated as a return of capital to the shareholders (and are not treated as dividends). A payment to shareholders from a company’s share capital account triggers CGT Event G1 under s104-135 ITAA97. ◦ Under s104-135(3), there is a capital gain at the time of the distribution only if the amount of the payment (from the share capital account) exceeds the shareholder’s

cost base. In this event, the share’s cost base and reduced cost are reduced to nil. It is not possible to make a capital loss as a result of CGT Event G1: s104-135(3), Note 1. ie. Company is making payment to shareholders that is more than shareholder’s investment. If it exceeds cost base, there will be a capital gain, and cost base will be nil and whole amount is capital gain. ◦ However, if the payment (from the share capital account) is not more than the shareholder’s cost base (or reduced cost base), the cost base (and reduced cost base) are decreased by the amount of the payment: s104-135(4). This is relevant to future transactions. This would be the more usual outcome where a company makes a payment from its share capital account. Pg 644  Example – Alpha Co makes a payment of $100 to its shareholders. One quarter of the payment ($25 per shareholder) is debited against its share capital account, and the balance ($75 per shareholder) is from accumulated profits.  Assuming only amounts of capital are transferred to the share capital account (i.e. the account is not tainted), only $75 of the payment is treated as a dividend, and the balance $25 is treated as a return of capital. IF you do have a payment from share capital account, there is a CGT event G1 (104-137) ◦ And Any amount credited by a company to its shareholders as shareholders. (ie if company is a shareholder?)

Deemed Dividends under s109 ITAA36: remuneration to associated persons  Under Section 109(1) ITAA36, to the extent that remuneration and retiring allowances paid or credited by private companies to associated persons are regarded as excessive by the Commissioner, the “excessive” portion will be: ◦ non-deductible to the private company; and ◦ deemed a dividend in the hands of the recipient. ◦ Ie. Payment is deemed a dividend. For company it is not deductible. Consequences of being a dividend.  Under s109(2)(a) ITAA36, a transfer of property is deemed to be a payment of an amount equal to the value of the property.  S109(2)(b) provides that an “associated person” is a current or former shareholder or director of the company, or an associate of theirs within the meaning of s318 ITAA36.  The definition of associate in s318 is very wide, extending to spouses and relatives of current and former shareholders/directors, and also companies and trusts under the influence of either the current or former shareholder/director or their associates.  So much of the amount which exceeds what the Commissioner regards as reasonable is treated as a deemed dividend. Taxation Ruling IT 2621 lists some of the factors that the Commissioner would consider in determining whether a payment is reasonable, including: - the terms of the taxpayer’s employment, the length of their service, - the level of remuneration received during the period of service, - market and normal commercial practice. Example:

 Beta Co Pty Ltd paid a fee of $10,000 to Tom for legal fees in connection with the purchase of a block of land. Tom is the husband of Sally, who is one of the directors of Beta.  The land was of a high value ($1.5M), but the work done by Tom was fairly routine (following standard conveyancing practice) and no special legal advice was necessary in relation to the transaction.  Research into industry practice reveals the following: although a premium is charged for conveyancing in relation to high value land, the upper limit of fees charged in relation to similar transactions is $5,000.  How would s109 ITAA36 apply to the above facts?  Is not a normal commercial practice, although premium is charged, upper limit is 5000 dollars. Do we have a deemed dividend situation here? Because there is an excess: partly. The other 5000 is an unreasonable amount: it will be a deemed dividend. It is beyond a reasonable fee, treated as distribution of profits.  Company can deduct the first 5000 because it is reasonable. (consistent with market practice)

Deemed dividends under Div 7A, Part III ITAA36:  a private company is also deemed to have paid a dividend where it: ◦ Pays an amount to a shareholder or their associate (s109C); Scope of people it applies to is narrower (does not apply to directors or former shareholders) ◦ Makes a loan during the income year to a shareholder or their associate and it is not fully repaid by the due date for lodgment of the company’s tax return (s109D); ◦ Forgives a debt owed by a shareholder or their associate (s109F).  As with s109 ITAA36, the rationale of this Division is to capture as dividends what are in substance profit distributions.  There are a number of exceptions to the operation of Div 7A: ◦ Payments of genuine debts (s109J); ◦ Payments and loans to other companies (s109K); ◦ Payments that are otherwise assessable income (s109L); ◦ Loans made in the ordinary course of business on ordinary commercial terms (s109M).  Note section 109N which provides that a loan will not be deemed a dividend if it is in writing and meets specified minimum interest rate and maximum term requirements. ◦ The minimum interest rate is the indicator lending rate for bank variable housing loans last published by the Reserve Bank of Australia before the start of the income year – for 2017/2018 this is 5.30% (TD 2017/17). ◦ The loan cannot exceed the maximum term, which is:  25 years if the loan is secured by a registered mortgage over real property (i.e. land), provided the value of the property is at least 110% of the loan amount( if land is offered security); or  7 years in all other cases.

Taxation of Dividends  Section 44(1) requires shareholders to include dividends that are paid out of a company’s profits in their assessable income. Dividends are statutory income.  A person is a “shareholder” in a company if they appear on the company’s register as a shareholder or are entitled to be registered; it is legal, rather than beneficial ownership that matters here  Eg. If B holds shares in Alpha Ltd on trust for C, it is B that is the shareholder in Alpha (legal ownership, taxed)

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The term “paid” is defined in s6(1) ITAA36 to include “credited” or “distributed”. The term paid is wide enough to cover distributions of benefits other than money: Commissioner of Taxation (Vic) v Nicholas (1938) 59 CLR 230;

 Note: intermin dividends are not “paid” - In Brookton Co-operative Society Ltd v FCT 81 ATC 4346 the High Court held that an interim dividend which the directors had the power to revoke had not been paid or credited to the company’s shareholder. ◦ Dividends not actually received by shareholders but which are re-invested in exchange for new shares under dividend reinvestment plans are treated by the ATO as having been paid to the shareholder: IT 2285. ◦ Note: can be property not necessarily cash. Eg. Gold. S44(1A) ITAA36: Dividend (deemed paid out of profits rule)  It used to be the case that companies could only pay dividends out of profits. Now, companies can pay a dividend if:  Assets> liabilities by an amount sufficient to cover dividend AND  the payment of the dividend does not prejudice the company’s creditors.  Given it is now possible for companies to pay dividends even when they don’t have profits, the tax law was also amended to provide that payment of a dividend from a source other than profits is taken to be a dividend paid out of profits: s44(1A) ITAA36.

How do franking credits (imputation credits)work?  Dividends are paid out of profits which have already been subject to Australian company tax which is currently 30%. This means that shareholders receive a rebate for the tax paid by the company on profits distributed as dividends.  These dividends are described as being 'franked'. Franked dividends have a franking credit attached to them which represents the amount of tax the company has already paid.  You are entitled to receive a credit for any tax the company has paid. If your top tax rate is less than the company's tax rate, the Australian Tax Office (ATO) will refund you the difference.

Imputation system  Formerly (before 30 June 1987) double taxation applied in relation to dividends paid out of after-tax profits; the taxpayer received no tax offset/rebate for tax already paid by the company.  Franking credit rebate/offset: Where a resident company pays dividends to its resident shareholders, the shareholder is entitled to an offset for tax paid by the company.  Franking credits are a form of wealth and a refundable offset.  s200-15(1) ITAA97. Companies maintain “franking accounts”, which keep track of income tax paid, so that they can pass on credits for tax paid to their shareholders when a distribution is made: Franking Credits  s200-15(3) ITAA97. Typically franking credits arise when companies pay tax in Australia; franking credits also arise where a company receives franked distributions (Dividends are frankable distributions. Note that deemed dividends under s109 and Div 7A Part III ITAA36 are not frankable distributions: s202-45 ITAA97.)  Resident companies are able to allocate franking credits to “frankable distributions”: s202-5 ITAA97

 The maximum franking credit a company can allocate is calculated as follows (under s202-60 ITAA97):  Amount of Frankable distribution * (Corp tax rate/1-corp tax rate).  i.e. currently: amount of frankable distribution * 30/70 (for larger companies but make sure corporate tax rate is 30% otherwise different)  A dividend is “fully franked” where the maximum franking credit as defined above is allocated to it.  Example: A company pays a fully-franked dividend of $1,000. This means that the franking credit attached to the dividend is: 1000*30/70=$428.57= franking credit.  Dividend statement will tell you amount of the franking credit.  Where a shareholder receives a franked dividend, the amount of the franking credit is included in the shareholder’s assessable income: s207-20(1) ITAA97 (this is the “gross up” amount). The $1000 goes into bank account+ the franking credit goes into assessable income then there is offset. By doing that you are “grossing up” the dividend. What oges in is pre tax amount of dividend. Then you will pay tax at marginal rates at  But the franking credit is also a tax offset for the shareholder: s207-20(2) ITAA97. (it goes into assessable income during grossing up), then after basic liability, you can claim offset.  The net effect is that the shareholder pays tax on the dividend at their marginal rate. Franking Debits  Franking debits typically arise where a company pays a franked distribution, and when it receives a refund of tax: s200-15(4) ITAA97. (used to pay off franking credits) Refunding of excess imputation credits  The refund applies when your total imputation credits that are attached to your franked dividends paid exceeds your basic income tax liability for the year.  A cash amount can be refunded to you reflecting the amount of excess imputation credits, after applying them and any other tax offsets to which you are entitled to. This will in turn reduce your basic income tax liability to zero.  If you are required to lodge an income tax return, you can use it to claim a refund of excess imputation credits. If you are not required to lodge a tax return, the refund is available on application.

Case study: James receives a tax refund  James owns shares in a company. The company pays him a fully franked dividend of $700. His dividend statement says there is a franking credit of $300. This represents the tax the company has already paid. This means the dividend, before company tax was deducted, would have been $1,000 ($700 + $300).  Come tax time, James must declare $1,000 (the $700 dividend plus the $300 franking credit) in his taxable income. If his marginal tax rate was 15%, he would have paid $150 tax on the dividend. Because the company has already paid $300 in tax, James will receive a refund of the difference, which is $150.  If James was in a higher tax bracket he may not have been entitled to a refund of any of the franking credit, he may even have to pay additional tax. However, if he is a low income earner, it is possible to be refunded the full amount of the franking credit. Case Study: franked distributions  XYZ Ltd pays a fully-franked dividend of $7000 to each of it two resident shareholders, Stacey and Steve. ◦ Stacey’s taxable income (apart from the dividend) is $50,000, i.e. Stacey’s marginal rate of tax is 32.5%.

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Steve’s taxable income (apart from the dividend) is $200,000, i.e. Steve’s marginal rate of tax is 45%. Assume Steve has private health insurance. Consider (to be discussed in lectures):  What is the franking credit allocated to each distribution? Amount of Frankable distribution * (Corp tax rate/1-corp tax rate): 50 000 divided by marginal tax rate = 7000 x (32.5%/1-32.5%) What is the income tax position of Steve and Stacey? Stacey

Steve

Dividend s44(1)(a) ITAA36

$7,000

$7,000

Gross up for franking credit s207-20(1) ITAA97

$3,000

$3,000

(Other) Taxable Income

$50,000

$200,000

Total Taxable Income

$60,000

$210,000

Basic tax liability

$11,047

$67,732

Plus Medicare Levy

$1,200

$4,200

Less franking credit offset s207-20(2) ITAA97 Less partial low income earner rebate

($3,000) ($100)

($3,000)

Final Tax Liability

$9,147

$68,932

Partially Franked dividends  It is possible that a dividend is only partially franked.  The franked part of a dividend is worked out as follows under s976-1 ITAA97:  Franking credit on distribution * (1-corp tax rate/corp tax rate) i.e. currently: franking credit on distribution * 70/30  A company pays a dividend of $70 and allocates $15 of franking credits to the dividend.  The franked part of the dividend is $35 ($15*70/30).  The “franking percentage” is defined in s203-35(1)ITAA97 as:  Franking credit allocated to the frankable distribution /Maximum franking credit for the distribution * 100  What is the franking percentage in the above example?  15%. 

Consolidation for income tax purposes  Since 1 July 2002, an Australian resident head company of a corporate group is able to make an irrevocable decision to form a consolidated group for income tax purposes  The consolidated regime is in Part 3-90 ITAA97  Only wholly owned subsidiaries (who are Australian residents) can be included in the consolidated group  The consolidated group is treated as a single entity for income tax purposes  Consequences for the group: ◦ Lodges a single annual tax return and pays consolidated income tax instalments;

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Maintains a single franking account; Pools losses, franking credits and foreign income tax offsets; Intra-group transactions (e.g. dividends, loans, transfers of assets) between members of a consolidated group are ignored for income tax purposes.

Question 1 QUESTION 1 - COMPANIES Bella Pty Ltd sells women’s fashion accessories. Greta and Lily are the directors and shareholders of Bella Pty Ltd (each has a 50% interest in the business). Assume that the accounts of Bella Pty Ltd for 2017/2018 show the following: Sales $2,500,000 Cost of goods sold $1,300,000 Rent for the year $400,000 Salaries and administrative expenses $300,000 A consultancy fee of $7,000 was paid to Greta’s brother, Robert. Robert provides advisory services to small to medium sized businesses. In this instance the work involved advising Bella Pty Ltd in relation to whether it would be profitable to establish a second store. Fees charged were based on Robert’s usual hourly rate. Cash proceeds of $10,000 were received on 1 May 2018 from the sale of chairs in Bella’s store. Bella Pty Ltd had purchased the chairs online for $1,000 on 1 June 2012, with the purpose of enhancing the ambience of the store. In the previous income year Bella Pty Ltd made a tax loss of $50,000. Greta and Lily decide that any profits made by Bella Pty Ltd in 2017/2018 will be retained within the business, and would be used to help finance the planned second store. Based on the above information, calculate Bella Pty Ltd’s tax liability for 2017/2018.

Assessable Income Sales – ordinary income under s6-5(1) ITAA97 Net capital gain on chairs Section 102-5 ITAA97 requires taxpayer to include any net capital gains in AY; The sale of the chairs involves a CGT event A1: subdivision 104A ITAA97. Under s104-10(4), a capital gain has arisen because capital proceeds $10,000 (s116 -20 ITAA97) are greater than the asset’s cost base of $1,000 (only element 1, acquisition cost is relevant under s110-25 ITAA97). Companies in general are not entitled to the CGT discount (subdivision 115-A only refers to individuals, trusts and super funds as being eligible). CGT small bus...