DONE WEEK 10 - Summary Business Taxation PDF

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WEEK 10 – COMPANIES 10.1. The company as a tax entity Legislation: ITAA97 s995(1) ‘definitions of "company" and “corporate tax entity”’; s104-230; s165-10; s165-12, to s165-13; s26-35 ITAA36 s103A; s109, s65, Division 7A.

UTL: Paragraphs 12.15 to 12.17; 12.26 to 12.33

What is a company?  Salomon v Salomon & Co Ltd [1897] AC 22  Company is separate legal entity distinct from members  May enter into contracts, sue and be sued, own property, continue as the same entity despite changes in shareholders  Liability of shareholders limited to amount (if any) unpaid on their shares What is a company? (Tax)  ITAA97 s995-1: definition of persons includes a company  Companies are taxpayers  Company defined in ITAA97 s995-1: o Body corporate o Unincorporated association or body of persons o Does not include a partnership & not a non-entity joint venture  Examples: o Bodies incorporated under Corporations Law o Unincorporated nonprofit associations and clubs Public vs. Private companies  ITAA36 s103A o The characterization of a company as private of public is made annually

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o o

If not a public company then a private company s103A (1). Public company includes (see legislation for full list):

o

 Listed company: Non-preference shares listed on stock market on the last day of year of income s103A(2)(a)  Subsidiaries of public companies s103A(2)(d)(v) Listed company will not be a public company if they fail the 75%/20 person test: s103A(3)

Significance of Public – Private distinction Why draw this distinction? o ‘Same owners’ test for loss carry forward and bad debts differs between private and public companies o Deemed dividend provisions (ITAA36 s 109 and Div 7A) only apply to private companies o o

Franking period differs for purposes of the benchmark franking rule Certain aspects of CGT (not studied in this course) differ between public and private companies

10.2. Distinctive features of companies for tax purposes Taxation of companies  Payment Of Tax By Companies o Flat tax rate: 30% (regardless of residency) o Lodge return – deemed assessment s166A o Payment of tax under PAYG system: 

UTL: Paragraphs 12.18 to 12.24

Usually quarterly installments on income for that quarter Quarter ends Payment due 30 September 28 October 31 December 28 February 31 March 28 April 30 June 28 July

10.3. Carry forward tax losses (brief discussion carry-back losses) Legislation: s165-10, s165-12, s165-13, s165-15, s165-210 UTL: Paragraphs 12.89 to 12.102

Carry Forward Losses  For individuals, a tax loss in one year can be used as a deduction in following years. Losses are ‘carried forward’ until they are used (or until death)  Companies may also claim a prior year loss as a tax deduction, but must pass one of the following tests: (s165-10) o Continuity of ownership test: s165-12 (COT) 

o Same business test: s165-13 (SBT) You have to pass either COT or SBT – you do not have to pass both.

Continuity of ownership test COT  s165-12: In broad terms, there must be persons who had: o more than 50% of the voting power; and o o o

rights to more than 50% of dividends; and rights to more than 50% of capital distributions At all times during the ownership test period.

Ownership test period: start of loss year to end of income year when company trying to claim loss. Same share same interest rule: ownership rights attaching to a shareholder's share in a company are only taken into account if the shareholder owns exactly the same share throughout the ownership test period. Example  Based on example from ATO website  Peter Pty Ltd incurs a tax loss during the 2005 income year. Shares owned by Annie (40%), Mary (40%) and Susan (20%)  On 18 August 2005, Annie and Mary both sell 75% of their shareholding to Susan.  New ownership is: Annie (10%), Mary (10%), Susan (80%)  Peter Pty Ltd is seeking to deduct the tax loss in the 2007 income year.  Will Peter Pty Ltd pass the continuity of ownership test? Shareholder Shareholding from 1 July Shareholding from 18 August Percentage counted 2004 to 17 August 2005 2005 to 30 June 2007 towards COT Annie 40% 10% 10% Mary 40% 10% 10% Susan 20% 80% 20% Total 100% 100% 40%  The same amount of shares that’s been carried through, so the 10% of Annie and Mary are the ones that’s continually owned throughout and the 20% of Susan is continually held, not the 60% addition that’s been transferred.  Private vs. public company: s165-165: o Private company must actually pass. o Public company passes COT if it is reasonable to assume that the test is satisfied.  

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o Listed public company: special rules in Div 166. Primary vs. alternative test: o Primary test: company in question directly owned by individuals o

Alternative test: used if company in question is owned by other companies. In such a case you need to trace through interposed companies to natural persons. See Diagram 12.3 in text

Same business test  S165-13 – applies the same business test in a way which treats the income year as the same business test period. o If fail COT – must carry on same business in income year as it carried on between loss year and when same owners test was failed s165-210(1)  The same business test encompasses ‘sub-tests’ o New business test s165-210(2)(a) o New transaction test s165-210(2)(b)  (Ie. You will fail the SBT if you carry on new business or new transactions). 10.4. Types of corporate tax systems Should companies be taxed?

UTL: Paragraphs 12.8 to 12.14

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Companies are separate legal entities and as such are separate tax entities Therefore, companies taxed on their taxable income But are they really a legal fiction? That is, the “real” taxpayers are the shareholders of the company. Shareholders are normally taxed when they receive a dividend.

How should companies be taxed?  Why tax companies? o If company is not taxed and shareholders not taxed unless income is distributed, a company could defer tax indefinitely by retaining income  But, if both company and shareholder are taxed on the same profits (classical system), this is double taxation Classical system example Taxable income of company $100 Tax @ 30% ($30) Distribution to shareholder $70 Tax @ 46.5% ($32.55) Cash remaining after tax $37.45 Effective tax rate 62.55% Dividend imputation systems  Company pays tax on taxable income  Shareholder receives dividend and is told how much tax the company has paid  Dividend ‘grossed-up’ by amount of tax the company has paid  Shareholder taxed on ‘grossed-up’ amount at marginal rate  Receives credit for the ‘gross-up’ amount (i.e. amount of tax actually paid)

Taxable income of company Less: Tax @ 30% Distribution to shareholder Gross-up Tax @ 46.5% Less gross-up credit Tax paid by shareholder Company tax Classical $30 Imputation $30

Classical Dividend imputation $100 $100 $30 $30 $70 $70 0 $30 $32.55 $46.5 (70 * 46.5%) (100 * 46.5%) 0 $30 S/holder $32.55 tax Total tax $16.50Effective tax rate $32.55 $62.55 62.55% $16.50 $46.50 46.5%

Profits of company Tax ($50,000 * 30%) Distribution to shareholder Gross-up amount (i.e. Tax actually paid) Shareholder taxed on Tax (@ 46.5%) Less: credit of gross-up amount Tax paid by shareholder “Cash remaining”

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$100,000 ($15,000) $85,000 $15,000 $100,000 $46,500 ($15,000) $31,500 $53,500 (85,000 – 31,500)

Dividend imputation another example  Example where “profits” are greater than taxable income o Company has taxable income of $50,000

In this example, the shareholder has received (cash) $85,000. Of this: o $35,000 is a franked dividend o $50,000 is an unfranked dividend (profits where no tax has been paid)

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Also has a gain made on sale of property purchased in 1984 (not purchased/held with the intention of profit) of $50,000 $50,000 not taxed as not ordinary income and exempt from capital gains

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The shareholder will include in their tax return: o The franked dividend, the unfranked dividend, and franking credit (tax the company has paid)

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The shareholder will receive a tax offset for the franking credit.

10.5. Franking accounts Legislation: ITAA97 s205-15; s205-25, s205-30, s205-40, s205-45 UTL: Paragraphs 12.34 to 12.50 Franking accounts  As we saw in the past example, a company’s taxable income does not necessarily equal distributable profits o Therefore, we can’t assume that a company has always paid 30% tax on the profit distributed to a shareholder  Australian dividend imputation system – limits the amount of gross-up and credit to tax actually paid by company  Company must keep franking account to keep track of tax paid Imputation: company level  Obligation to maintain a franking account  Some major franking credits o Payment of PAYG installment s205-15 (Item 1)

o

 Cr = amount of payment Payment of tax s205-15 (Item 2)  Cr = amount of payment Receipt of a franked dividend s205-15 (Item 3)

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 Cr = franking credit on distribution Payment of franking deficit tax s205-15 (Item 5)

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 Cr = amount of franking deficit tax liability Some Major Franking Debits o Refund of company tax s205-30 (Item 2)  Debit = amount refunded o Payment of a franked dividend s205-30(Item 1) 

Debit = franked amount of dividend

10.6. Franking A Dividend Legislation: ITAA36 s202-30; s202-35; 202-40; s202-45; s202-55; s202-60; s202-65; s203-40; s203-45; s203-50(1)(a); s203-50(2); s205-45; s207-50; s203-50(1)(b); s203-50(2)

UTL: Paragraphs 12.51 to 12.62

Australian dividend imputation system  Franking account - keeps track of tax paid (refer to example on Moodle)  When dividend distributed to shareholder: o Franked amount: income distributed on which tax has been paid (in example - $35,000) o Unfranked amount: income distributed on which tax has not been paid (in example - $50,000) o

Franking credit: essentially the tax already paid by the company (in example - $15,000)

Imputation: Company Level  Franking A Dividend o Who may frank s202-15 and s202-20 o 

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 Company must be a resident @ time of distribution What may be franked

 s202-40 frankable unless unfrankable Maximum credit for a distribution s202-60 o Amount of distribution x c/1-c o Distribution statement required ss202-75 to s202-85 Maximum franking credit: amount of distribution x c/1-c (i.e. 30/70) o This is based on the fact that this is the maximum amount of tax the company will have paid (i.e. has paid 30% tax on the amount the company is distributing). o As we saw earlier, a company may have “profits” that have not been subject to tax. In this case, the franking account will not have sufficient “credits” to pay the maximum franking credit.

o

If the company then ‘franked’ the distribution to the maximum amount, they would have a deficit in their franking account

Franking Deficit Tax  If franking account has deficit at year end, entity liable to pay franking deficit tax: s205-45.  Amount of tax is equal to the amount of the deficit, which will result in a credit to the franking account (e.g. pay $500 of FDT, $500 credit, bringing franking account back to nil)  FDT due 31 July  FDT can be offset against company tax liability o FDT offset reduced by 30% if FDT > 10% of total fr credits  Refer to example 12.15 in text and s205-70 10.7. Taxation of shareholders Legislation: ITAA36 s6(1) ‘definitions of “dividend” “paid”’; s44(1)(a); s44(1A); s44(1B); s128B(1); s128B(3)(ga) ITAA97 s995-1 ‘definition of “dividend”’; s67-30; s67-35; s207-20(1); s207-20(2); s207-70; s207-75

UTL: Paragraphs 13.2 to 13.56; paragraph 12.25; paragraphs 18.36 to 18.37

Imputation: Shareholder level  Overview – assume resident natural person shareholder o ITAA36 s44(1) inclusion of dividend paid out of profits in shareholder’s assessable income o o 

o Tax offset = amount of franking cr s207-20(2) ITAA36 s6(1) definition of ‘dividend’ on shares o Any distribution made by the company to shareholders

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Gross up for franking credit s207-20(1) Calculation of tax at shareholder’s marginal rate

 Includes non cash distributions C of T (NSW) v Stevenson (1937) 59 CLR 80  Includes informal appropriations of company’s assets C of T (NSW) v Stevenson; FCT v Blakely (1951) 82 CLR 388  Does not include forgiveness of a debt owing to the company FCT v Black (1990) 21 ATR 701 Any amount credited to shareholders as shareholders

 Must be in capacity as a shareholder – not as a debtor FCT v Black (1990) 21 ATR 701 “Out of profits” Resident natural person shareholder o Whole of dividend included in assessable income s44(1) o Inclusion of franking credit in assessable income s207-20(1) o o

Calculation of tax at marginal rates + Medicare Tax offset allowed = amount of franking credit s207-20(2)

o

Refund of excess rebates ITAA97 ss67-30 and 67-35

Example  Shelly is a resident Australian individual. She received a dividend of $5,000 in the year ended 30 June 2012. She has no other income (and no deductions). The dividend is fully franked.  Dividend: $5,000  Franking credit: $2,142 ($5,000 * 30/70)  Taxable income: $7,142  Tax liability: nil ($6,000 tax free threshold, low-income earner tax offset)  Shelly will receive a refund of the $2,142  Resident company shareholder  Similar treatment: include dividend + gross-up in taxable income, receive ‘offset’ of franking credit  However, franking credits are not refundable.

Example of excess franking credits  Company 1 (company paying dividend): o Taxable income/profit: $100,000 o Tax (@ 30%): ($30,000)

o

Distribution:

$70,000

o If fully franked, franking credit $30,000 Resident Company Shareholder – Example of excess franking credits  Company 2 (company receiving dividend): o Dividend: $70,000 o o

Gross-up: Assessable income:

$30,000 $100,000

o

Deductions:

($90,000)

o o

Taxable income: Tax payable (30%):

$10,000 $3,000

o o

Tax offset: Excess tax offset:

$30,000 $27,000

o o o

No refund of offset. Section 36-55(2) converts excess tax offset to tax loss by dividing it by the corporate tax rate of 30%. Loss carried forward: $27,000 / 30% = $90,000 Why – because the company would have had to earn an extra $90,000 of income to make use of the entire tax offset.

Imputation: Non-resident shareholders  Non-residents are subject to withholding tax on dividends  This means that the company is required to ‘withhold’ an amount of tax and send it to the ATO.  ITAA36 s128D – if subject to withholding tax, then not subject to tax on assessment basis (i.e. taxpayer not separately taxed on the amount) Withholding tax – dividends  Dividend withholding tax: ITAA36 s128B(1) and s128B(4)  Rates o Absence of double tax agreement: 30% (Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 – s 7(a)) o If double tax agreement: refer to DTA. (You will be told the relevant rate if there is a DTA). 

Exceptions: o s128B(3)(ga) franked portion of dividend exempt from withholding tax o

However, non-resident taxpayers do not get a tax offset for franking credits

Dividends example – AU vs. overseas resident 

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AusCo Ltd pays a dividend of $1,000 to four different shareholders: 1) Australian resident (assume 45% tax rate / ignore Medicare for simplicity) 2) Australian resident (assume nil tax rate) 3) UK resident 4) Hong Kong resident Advise on tax treatment if dividend is: A) Fully franked B) Franked to 50% C) Unfranked See Moodle for answers...