Revised Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello MP)Chapter 1 - Simplified imputation system
Outline of chapter
1.1 Schedule 1 to this Bill amends the simplified imputation system to ensure that, in certain situations, private companies that pay franked distributions will not have their franking deficit tax offset reduced in respect of the income year in which they first incur an income tax liability.
Context of amendments
1.2 Generally, a company does not pay income tax until after the end of the first income year during which it derives taxable income. Consequently, the company does not generate franking credits during that income year to attach to distributions made in that year. The company will first generate franking credits after the end of the relevant income year when the company pays its income tax liability for that year.
1.3 The inability of a company to generate franking credits does not restrict it from paying franked distributions during that year. However, a company that makes franked distributions in these circumstances is required to pay franking deficit tax at the end of the income year because the balance in its franking account will be in deficit at that time.
1.4 The payment of franking deficit tax allows a company to claim an offset equal to the amount of franking deficit tax paid when calculating its income tax liability for that income year. The franking deficit tax offset can also be carried forward to later income years to reduce the company's future income tax liability.
1.5 A company is deterred from paying franked distributions in excess of the franking credits generated in an income year as its franking deficit tax offset is reduced by 30 per cent. This reduction occurs where the company's franking deficit at the end of the income year exceeds the franking credits in its franking account at that time by more than 10 per cent.
1.6 This deterrent causes a problem for private companies as they are unable to pay franked distributions in their first profitable income year without incurring a franking deficit tax penalty.
Summary of new law
1.7 The amendments will provide greater flexibility to private companies by allowing them, in certain situations, to pay franked distributions during the income year in which they first incur an income tax liability without incurring the penalty that reduces their franking deficit tax offset by 30 per cent for that year.
Comparison of key features of new law and current law
| New law | Current law |
|---|---|
| Private companies, subject to certain conditions being met, will not have their franking deficit tax offset reduced by 30 per cent in the year of income in which they first incur income tax liability. | Private companies that have a franking deficit tax liability at the end of the year have their franking deficit tax offset reduced by 30 per cent where their franking deficit exceeds the franking credits by more than 10 per cent. |
Detailed explanation of new law
1.8 A company is entitled to a franking deficit tax offset in an income year if, broadly, it has incurred a liability to pay franking deficit tax in that income year (subsection 205-70(1) of the Income Tax Assessment Act 1997 ).
1.9 The amount of the tax offset is worked out by applying the method statement in subsection 205-70(2). If the company's franking deficit at the end of the income year exceeds the franking credits in its franking account by more than 10 per cent, the amount of the tax offset is reduced by 30 per cent (steps 1 and 2 of the method statement). This 30 per cent reduction will not apply to a private company that meets certain conditions. [Schedule 1, item 1, steps 1 and 2 in the method statement in subsection 207-70(2)]
1.10 The conditions are that:
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- the private company must (assuming that it did not have the franking deficits tax offset) be liable to pay income tax for the income year that is sufficient to generate franking credits equal to at least 90 per cent of the deficit in the company's franking account at the end of that income year - this 90 per cent rule ensures that there is a close alignment between the amount of franking credits the company has paid out during the income year and the company's income tax liability for that income year, and
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- the private company must not have had an income tax liability for any earlier income year - that is, it must be the private company's first income year.
[Schedule 1, item 2, subsection 207-70(5)]
Example 1.1
Andrew is the sole member of Top Speed Pty Ltd, a private company that specialises in installing turbo chargers. The company was established on 1 July 2002 but did not generate taxable income (or become liable for income tax) for the 2002-03 income year. Top Speed's franking account balance as at 1 July 2003 is zero.
Top Speed makes a pre-tax profit of $10,000 for the 2003-04 income year and expects to pay income tax for that income year of $3,000 ($10,000 * 30%). Top Speed makes a franked distribution to Andrew of $7,000.
Top Speed attaches $3,000 in franking credits to the distribution. The deficit in its franking account at the end of the income year is $3,000. Top Speed is liable to pay $3,000 in franking deficit tax. Top Speed pays the franking deficit tax and therefore is entitled to a franking deficit tax offset.
As the 2003-04 income year is the first income year in which Top Speed derives taxable income and it satisfies the other conditions in subsection 205-70(5), Top Speed's franking deficit tax offset will not be reduced by 30 per cent. Therefore, Top Speed will be entitled to a franking deficit tax offset of $3,000.
Application and transitional provisions
1.11 These amendments apply in relation to the income year in which this Bill receives Royal Assent and to later income years. [Schedule 1, item 3]