Company Tax Cuts – don’t let the good story turn into a franking nightmare
It has been well over a year since the debate about company tax cuts came to an end.

The bad news is that Australia seems to be stuck with a 2-tier company tax system for the foreseeable future – a lower tax rate for companies under $50M turnover (and have at least 20% of their turnover in the form of non-passive turnover) and the higher 30% tax rate for all other companies (e.g., those above $50M turnover and those with more than 80% passive turnover, regardless of amount).

The good news is that the tax cuts are coming much faster – this year (FY20) is the last year of the 27.5% lower tax rate.  We then move to 26% in FY21 and 25% in FY22 and beyond.  This is literally around the corner and will benefit most SME business companies in Australia.

So is the good news entirely good?  Well, that depends, because Australia operates a franking system whereby tax paid at the company level is effectively a prepayment of the final tax ultimately paid by the individual shareholders. And while the thresholds at which the higher individual tax rates apply are gradually increasing (to combat “bracket creep”), the top marginal rate is still 45% (plus 2% Medicare Levy) and that is not proposed to change or reduce.

Assume, for example, that a company makes a $1M profit and pays tax at the lower rate of 27.5% or $275,000.  It then pays its entire after-tax profit of $725,000 as a fully franked dividend and the individual shareholder/s. Assuming they are on the top marginal tax rate, they pay top-up tax of $195,000. The net cash position after company and individual tax is $530,000.

The same company, had it been on the tax rate of 30%, would pay tax of $300,000, then pay an after-tax dividend of $700,000. The individual shareholder/s would have to pay top-up tax of $170,000. Again, the net cash position after company and individual tax is $530,000.

In other words, to the extent companies pay out dividends regularly and their shareholders are taxpayers on the top marginal rate of tax, the company tax cuts are not all that useful – they merely “shift” more of the overall tax burden to the shareholders rather than the company, but the overall position is still the same.

The company tax cuts, however, can be useful where:

  • Companies retain a significant portion of their after-tax profits for investment, working capital, growth funding, debt reduction, etc. Where this is the case, the company tax cuts drop straight to the bottom line, at least until dividends are paid out.
  • Companies do pay dividends regularly, but can distribute to a range of shareholders, some or all of whom are on lower marginal tax rates than the company. This is often achieved if the shareholder is a trust that can distribute to lower-income beneficiaries, entities with losses, etc. In these circumstances, some shareholders may even be entitled to a tax refund of excess franking credits.
Another hidden trap in a falling company tax rate environment is the rate at which dividends can be franked.

While the provisions are complex, it is not uncommon that companies that have paid tax at the 30% tax rate will not be able to frank at that rate if they annually pay dividends in later years where they are subject to a lower tax rate (e.g. 27.5%, 26% or 25%). This can unfortunately create a franking credit "trap" where, in extreme circumstances, tax paid by the company can be lost forever and never used by the shareholders.

It is therefore important to carefully monitor your company's turnover trajectory, its active v passive income and other factors that determine the company tax rate and franking rate, as well as the shareholder' immediate, medium-term and long-term need for dividends.

In this era of falling tax rates, you need to make sure that the benefits obtained by the company are not eroded or eliminated at the shareholder level.

Your Prosperity Team will discuss this with you as part of your year-end planning.

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