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Tutorial Solutions – Chapter 24

Foundations of Taxation Law 2019

Chapter 24 COMPANIES SOLUTIONS TO STUDY QUESTIONS

QUESTION 1* A company is a ‘private company’ if it is not a ‘public company’ for the relevant income year (s 103A (1) ITAA36). Therefore, it is the term ‘public company’ that is defined in s 103A(2) ITAA36 (which operates subject to s 103A(3)–(7)). Generally, a ‘public company’ will be one that is listed on the stock exchange on the last day of the income year. In general, for tax purposes, companies are treated the same whether public or private. However, the distinction is still relevant because some different rules may apply in relation to losses, dividends, franking accounts and superannuation depending on whether the entity is a private company or a public company. Foundations of Taxation Law 2019 ¶24.2 QUESTION 2 For the 2018/19 income year, the tax rate for companies that are ‘base rate entities’ is 27.5%. For all other companies, the tax rate is 30% of taxable income. A ‘base rate entity’ is a company that carries on business and has ‘aggregated turnover’ for the income year below the prescribed threshold, which for 2018/19 is $50m. Foundations of Taxation Law 2019 ¶24.2

QUESTION 3* The return of $7 per share (capital) by X Co to Tony amounts to a reduction in share capital (assuming no part was a dividend). Where a reduction in share capital does not result in the shareholder’s shares being cancelled, as is the case with Tony, CGT event G1 will apply as per s 104-135(1) ITAA97. Since the amount returned ($7) is not more than the cost base of the shares ($10), the share’s cost base is reduced by such amount (s 104-135(4)). Therefore, the cost base of the shares will now be $3. When the shares are sold in February, CGT Event A1 will arise as Tony has disposed of property. Under s 104-10(4) ITAA97, Tony will make a capital gain equivalent to $17,000 (capital proceeds of $20,000 less the new cost base of $3,000). The CGT 1|Page

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Tutorial Solutions – Chapter 24

discount in Div 115 ITAA97 will be likely to apply to reduce the assessable gain to $8,500 as Tony is an individual and the shares have been held for more than 12 months. If X Co had returned $13 per share to Tony in January, this would mean that the amount returned was more than the share’s cost base. In this case, the share’s cost base would be reduced to nil and the excess amount would be treated as a capital gain under s 104-135(3) ITAA97. Therefore, Tony would have a capital gain of $3 per share in January. Additionally, when the shares are sold in February, Tony will make a capital gain of $20 per share (ie $20 – nil cost base). If the shares were cancelled in January when the company returned $7 per share, then CGT Event C2 would apply and Tony would make a capital loss of $3 per share or $3,000 (as the amount returned is less than the reduced cost base of the shares). Foundations of Taxation Law 2019 ¶24.9

QUESTION 4 The definition of a ‘dividend’ in s 6(1) ITAA36 includes ‘any distribution from the company to any of its shareholders, whether in money or other property, and any amount credited by a company to any of its shareholders’. Additionally, the definition states that a dividend is not ‘an amount debited against the company’s ‘share capital account’. Therefore, in determining whether an amount is a dividend, it is important to distinguish between distributions of profit and returns of share capital. It is important to note that when a company makes capital gains that form a part of profit, this will still generally be a distribution of profit. Foundations of Taxation Law 2019 ¶24.5

QUESTION 5* Division 7A of Pt III ITAA36 will deem a private company to have paid a dividend where they make certain types of payments, make loans, or forgive a debt owing to shareholders (or their associates) that are not fully repaid by the time the company lodges its tax return for the year (s 109D ITAA36). From 1 July 2009, a payment also includes the provision of an asset for use by a shareholder or their associate. This Division prevents private companies from making loans to shareholders (which would not be assessable income of the shareholder) in lieu of distributing profits as dividends (which would be assessable income of the shareholder). 2|Page

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Tutorial Solutions – Chapter 24

Not all loans made to shareholders will be deemed to be dividends under Div 7A. If a loan meets certain requirements (minimum interest rates, maximum loan terms and written agreement) then it will not be subject to Div 7A and will continue to be treated as a loan in the hand of the shareholder. Foundations of Taxation Law 2019 ¶24.4 QUESTION 6 Residents and non-residents are treated in the following ways in respect of dividends paid by companies. Residents Resident shareholders are assessed under s 44(1)(a) ITAA36 on the amount of dividends paid to them out of a company’s profits, irrespective of whether the company paying the dividend is a resident or non-resident. Where the shareholder has paid foreign tax in respect of a dividend, the dividend is grossed up by the foreign tax and the shareholder is usually entitled to a foreign tax credit for the tax already paid. The shareholder is also entitled to gross up any franked dividend received by a resident company and obtain a tax credit for the tax already paid by the corporate entity. Non-residents Non-residents are also required to include any ‘dividends’ received in their assessable income under s 44(1)(b) ITAA36, but only to the extent that those dividends are paid out of profits from an Australian company. However, to overcome the administrative difficulty of collecting this tax, dividends paid out of profits of an Australian resident company, to a non-resident shareholder are generally subject to withholding tax (or if not, would be franked dividends) as per s 128B(1) and s 128B(3)(ga) ITAA36. Dividends that are subject to withholding tax, or which are exempt from withholding tax because they are franked, are non-assessable nonexempt income and therefore are not assessable under s 44(1)(b) as per s 128D ITAA36. Foundations of Taxation Law 2019 ¶24.5

QUESTION 7* In accordance with IT 2285, Sandy will still be assessed as receiving a $100 dividend regardless of whether she participates in the dividend re-investment plan. Foundations of Taxation Law 2019 ¶24.5 QUESTION 8 The imputation system aims to alleviate double taxation of corporate profits. It replaced the former ‘classical system’ of corporate taxation, where a company was 3|Page

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Foundations of Taxation Law 2019

taxed on its profits and its shareholders were taxed on dividends received without any relief for the tax already paid by the company. With an imputation system, double taxation is overcome by giving the shareholder a credit for the tax (if any) paid by the company on the profits when including dividends in assessable income. This is done by the company attaching franking credits where available. The shareholder receives a tax offset to the amount of the franking credits attached. It should be noted that the benefits of the imputation system are only available where the shareholder is a resident at the time the franked distribution is paid and is not exempt from tax. Foundations of Taxation Law 2019 ¶24.6 QUESTION 9* No, the imputation system will only apply where the distribution is made by a ‘franking entity’ that satisfies the ‘residency requirement’. The residency requirement provides that the company must be an Australian resident at the time of the distribution (s 202-20 (a) and (b) ITAA97). Special rules may apply to a non-resident entity that carries on business in Australia through a permanent establishment. Foundations of Taxation Law 2019 ¶24.6

QUESTION 10 The fundamental role of a franking account is to indicate to a corporate tax entity the extent to which it is able to pass on franking credits to its members for the tax it has paid. This account operates as a running balance of the franking credits available. An entity makes franking credit entry when: • the entity pays a PAYG instalment • the entity pays income tax • a franked distribution is made to the entity • a franked distribution flows indirectly to the entity through a partnership or trust, and • the entity incurs a liability to pay ‘franking deficit tax’. An entity makes franking debit entry when: • the entity franks a distribution • the entity receives a refund of income tax • the entity under-franks a distribution, and

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Foundations of Taxation Law 2019

•

the entity transfers amounts to their share capital account from certain other accounts.

Assuming the entity has a corporate tax rate of 30%, the relevant franking credit or franking debit entries are: •

A company pays income tax of $300. Credit $300

•

A company pays a PAYG instalment of $600. Credit $600

•

A company pays GST of $100. None – only income tax amounts are relevant in the franking account.

•

A company pays FBT of $500. None – only income tax amounts are relevant in the franking account

•

A company receives a dividend of $700 which has a $100 of franking credits attached. Credit $100

•

Receipt of a unit trust distribution of $100 which includes a dividend of $70 which has a franking credits attached of $30 Credit $30 Foundations of Taxation Law 2019 ¶24.7

QUESTION 11* The benchmark rule provides that a corporate tax entity must not make a frankable distribution if its ‘franking percentage’ differs from its ‘benchmark franking percentage’ for the ‘franking period’ in which the distribution occurs (s 203-25 ITAA97). The ‘benchmark franking percentage’ is set by the franking percentage for the first frankable distribution that the corporate tax entity makes during the relevant franking period. For all other frankable distributions in the same franking period, the frankable percentage must be the same. Taxpayers must use the formula in s 203-35 ITAA97 to calculate the franking percentage. Franking percentage = Franking credit allocated to the frankable distribution × 100 Maximum franking credit for the distribution The benchmark rule aims to prevent ‘streaming’ of franking credits to members of the corporate entity who can benefit most from receiving franked distributions. The 5|Page

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Foundations of Taxation Law 2019

Commissioner is able to identify streaming because a corporate tax entity must notify the Commissioner if its benchmark franking percentage ‘differs significantly’ from the benchmark franking percentage for the last franking period in which a frankable distribution was made (s 204-75 ITAA97). There are limited exceptions for listed public companies (s 203-20 ITAA97), whereby the Commissioner may exercise his discretion to allow an entity to frank a distribution at a different franking percentage (s 203-55 ITAA97). If a corporate entity breaches the benchmark rule, either by over-franking or underfranking during the ‘franking period’, it will be penalised by an amount calculated according to the formula in s 203-50(2) ITAA97. Amount of the frankable distribution × Franking % differential Applicable gross-up rate This penalty will either be an ‘over-franking tax’ payable amount (for over-franking) or a ‘penalty franking debit’ (for under-franking). Foundations of Taxation Law 2019 ¶24.7

QUESTION 12 The maximum amount of franking credits that can be allocated to the dividend is worked out according to the formula in s 202-60 ITAA97, which sets out the ‘maximum franking credit’ for a distribution as: Maximum franking credit = Amount of the frankable distribution × 1 Applicable gross-up rate = 100,000 × 1/2.636363 = $37,931 If the company’s corporate tax rate was 30%, the maximum franking credit would be $42,857. Foundations of Taxation Law 2019 ¶24.7

QUESTION 13* A resident private company with an applicable tax rate of 30% pays a $7,000 fully franked dividend to each of its five shareholders. Note that the tax rates used in these calculations are those applying in the 2019 income year. • •

Tom is a resident who has a salary income of $60,000. Teresa is a resident who has no other income. 6|Page

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Foundations of Taxation Law 2019

• • •

R Co is a resident private company that has a tax loss of $1,000 (assume R Co has a corporate tax rate of 27.5%). Super Co is trustee of a complying superannuation fund that has no other income. F Co is a company that is resident in the United Kingdom and has no other income.

The following table outlines how each shareholder is taxed.

Other income Franked dividend s 44(1) ITAA36 Gross-up s 207-20(1) ITAA97 Tax losses Taxable income Basic Income Tax (+2% Medicare) Less Franking offset s 207-20(2) ITAA97 Net tax payable (refund)

Tom $ 60,000 7,000

0 7,000

Super Co $ 0 0 7,000 7,000

3,000

3,000

3,000

70,000

10,000

(1,000) 9,000

10,000

15,697

Nil

2,475

1,500

3,000

3,000

3,000

3,000

$12,697 Tax payable

$(3,000) Refund*

(0) No refund*

$(1,500) Refund*

3,000

Teresa $

R Co $

F Co $ 0 0

0

Nil ITAA36 s128D*

Note – The ‘refundable tax offset rule’ in s 67-25(1) ITAA97 allows resident individuals and complying superannuation entities refunds for any excess franking credits that are not offset against their income tax liabilities for a particular year. However, companies (see R Co above) are generally not entitled to refunds for excess franking credits as per s 67-25(1C) ITAA97. See also the solution to Question 17 below. Note – The dividend received by F Co, is wholly non-assessable non-exempt income under s 128D ITAA36 because the receiving company is a non-resident and the dividend is fully franked. Foundations of Taxation Law 2019 ¶24.5, ¶24.8

QUESTION 14 As stated in the question, both Bit Co and Bot Co have corporate tax rates of 30%.

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Foundations of Taxation Law 2019

Bit Co Franking Account Receipt of partially franked dividend:

Credit $12,000

Bot Co Franking Account Payment of partially franked dividend: Debit $12,000 Tax Payable by Bit Co Other income Franked dividend (s 44(1) ITAA36) Gross up (s 207-20 ITAA97) Deductions Taxable income

nil $70,000 $12,000 nil $82,000

Basic Income Tax @ 30% less tax offsets (franking credit) (s 207-20 ITAA97) Net tax payable

$24,600 (12,000) $12,600

If Bit Co was a base-rate entity, then the calculations would be: Bit Co Franking Account Receipt of partially franked dividend: Bot Co Franking Account Payment of partially franked dividend: tax rate)

Credit $12,000 (same as above)

Debit $12,000 (same as above as 30%

Tax Payable by Bit Co Other income Franked dividend (s 44(1) ITAA36) Gross up (s 207-20 ITAA97) Deductions Taxable income

nil $70,000 $12,000 nil $82,000

Basic Income Tax @ 27.5% less tax offsets (franking credit) (s 207-20 ITAA97) Net tax payable

$22,550 (12,000) $10,550

If Bit Co were a non-resident, to the extent that the dividend is unfranked, withholding tax would apply as per s 128B(1) ITAA36. Therefore, as per s 128D ITAA36, the dividend received by Bit Co (if it were a non-resident) would be nonassessable non-exempt income and therefore Bit Co would not be liable for tax and would not be entitled to any franking credits. Foundations of Taxation Law 2019 ¶24.5–¶24.8, ¶37.2

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QUESTION 15* Consequences for P Co P Co has made two frankable distributions as neither of the dividends would be unfrankable under s202-45. The maximum franking credits attached to the first dividend of $2.4m paid to A Co would be: $2.4m × 1/2.333 (30% corporate tax rate) = $1,028,718 Since the dividend is franked to 20%, the debit entry in the franking account would be $205,743. Similarly, the maximum franking credits attached to the second dividend of $1.2m paid to F Co would be: $1.2m × 1/2.333 (30% corporate tax rate) = $514,359 Since the dividend is also franked to 20%, the debit entry in the franking account would be $102,871. A Co is a non-resident shareholder, therefore, the unfranked portion of the dividend paid, $960,000 will have withholding tax applied. P Co is liable to pay the withholding tax to the ATO under s 128B(1). The rate of withholding tax will depend on a range of factors relating to the ownership and nature of A Co. As both dividends paid are franked to 20%, there is no breach of the benchmark rule. Consequences for A Co Section 44(1)(a) provides that the assessable income of a resident shareholder includes dividends paid to the shareholder out of a company’s profits, irrespective of whether the company paying the dividend is a resident or non-resident and irrespective of the source of those profits. This means the $2.4m dividend paid to A Co will be assessable income. The franking credits associated with the dividend would be: 2.4m × 1/2.333 × 20% = $205,743.64 This means that A Co will have taxable income of $2,605,743 before considering its carried forward loss. Tax payable at 30% would be $781,722 (without considering franking credits). In accordance with s36-17(5)(a)&(b), A Co is only able to deduct so much of the tax 9|Page

Foundations of Taxation Law 2019

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loss as to ensure it does not have excess franking credits for the year. A taxable income of $685,812 would result in primary tax payable of $205,743.64 and therefore full use of the franking credits. A Co should then choose to deduct $1,919,931 of its $3m carried forward loss. Consequences for F Co In relation to the dividend franked to 20% paid by P Co, the unfranked part of the dividend is subject to withholding tax under s 128B(1) as described above. The franked part of the dividend is exempt from withholding tax under s 128B(3)(ga). However, as a result of the application of the dividend-withholding provisions, both the franked and unfranked parts of the dividend are non-assessable non-exempt income under s 128D and are therefore not assessable to F Co under s 44(1)(b). Foundations of Taxation Law 2019 ¶24.5 – ¶24.8, ¶37.2 QUESTION 16 Unlike individuals and complying superannuation funds, companies are not entitled to refunds for excess franking credits that are not offset against their income tax liabilities for a particular year (s 67-25(1)). However, companies are able to convert their ‘excess franking offsets’ into equivalent tax loss amounts under the special rule in s 36-55 ITAA97. Converting an ‘excess franking offset’ amount into an equivalent tax loss amount means that the amount is grossed up. For example, an excess franking offset amount of $6,000 would be equivalent to a tax loss amount of $20,000 (6,000/30%) if the corporate tax rate was 30%. These equivalent tax loss amounts may only be offset if the company satisfies the relevant carry forward loss requirements (see Chapter 29). Foundations of Taxation Law 2019 ¶24.8

QUESTION 17* ‘Share buy-backs’ are one way companies can return amounts of income or capital to shareholders. Companies can fund share buy-backs using either or both their sh...