Senate

Revised Explanatory Memorandum

(Circulated by authority of the Minister for Revenue and Financial Services, Minister for Women and Minister Assisting the Prime Minister for the Public Service, the Hon Kelly O'Dwyer MP)

Chapter 1 Enterprise tax plan base rate entities

Outline of chapter

1.1 Schedule 1 to this Bill amends the Rates Act to ensure that a corporate tax entity will not qualify for the lower corporate tax rate if more than 80 per cent of its assessable income is income of a passive nature.

Context of amendments

1.2 As part of the Government's Enterprise Tax Plan, the corporate tax rate for small corporate tax entities has been cut to 27.5 per cent. From the 2017-18 income year, this lower corporate tax rate applies to a corporate tax entity that is a base rate entity. Currently, a base rate entity is a corporate tax entity that carries on a business and:

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for the 2017-18 income year - has an aggregated turnover of less than $25 million; and

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for the 2018-19 income year - has an aggregated turnover of less than $50 million.

1.3 Under the second phase of the Enterprise Tax Plan, the aggregated turnover that applies for corporate tax entity to qualify for the lower corporate tax rate is increased annually until it reaches $1 billion in the 2022-23 income year. In the 2023-24 income year, the corporate tax rate will be 27.5 per cent all corporate tax entities. The corporate tax rate will then be progressively lowered in stages until it reaches 25 per cent for the 2026-27 income year and for subsequent income years.

1.4 These amendments will modify the requirements that must be satisfied for a corporate tax entity to qualify as a base rate entity by replacing the carrying on a business test with a passive income test. Under the passive income test, companies that are generating predominantly passive income will not be eligible for the lower corporate tax rate.

Summary of new law

1.5 This Bill amends the Rates Act to ensure that, from the 2017-18 income year, a corporate tax entity will qualify for the lower corporate tax rate for an income year if:

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no more than 80 per cent of the corporate tax entity's assessable income for that income year is base rate entity passive income; and

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the aggregated turnover of the corporate tax entity for the income year is less than the aggregated turnover threshold for that income year.

Comparison of key features of new law and current law

Detailed explanation of new law

1.6 Under subsection 23(2) of the Rates Act, from the 2017-18 income year, a corporate tax entity will qualify for the 27.5 per cent corporate tax rate for an income year if it is a base rate entity for that income year.

1.7 A corporate tax entity is a base rate entity for an income year only if:

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no more than 80 per cent of the corporate tax entity's assessable income for that income year is base rate entity passive income; and

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the aggregated turnover of the corporate tax entity for the income year is less than:

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for the 2017-18 income year - $25 million;

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for the 2018-19 income year - $50 million.

[Schedules 1, item 2, section 23AA of the Rates Act]

1.8 Under the second phase of the Enterprise Tax Plan, the aggregated turnover that applies for corporate tax entity to qualify as a base rate entity is increased annually until it reaches $1 billion in the 2022-23 income year.

1.9 An amount of assessable income is base rate entity passive income if it is:

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a distribution (as defined in section 960-120 of the ITAA 1997) by a corporate tax entity, other than a non-portfolio dividend (within the meaning of section 317 of the ITAA 1936);

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franking credits attached to such a distribution;

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a non-share dividend (as defined in section 974-115 of the ITAA 1997) made by a company;

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interest (or a payment in the nature of interest);

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a royalty;

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rent;

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a gain on a qualifying security (as defined in Division 16E of Part III of the ITAA 1936);

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a net capital gain (as defined in subsection 995-1(1) of the ITAA 1997);

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an amount that is included in the assessable income of a partner in a partnership or a beneficiary of a trust estate (under Division 5 or Division 6 of Part III of the ITAA 1936) to the extent that the amount is referable (either directly or indirectly through one or more interposed partnerships or trust estates) to another amount that is base rate entity passive income.

[Schedule 1, items 1 and 2, definition of 'base rate entity passive income' in subsection 3(1) and subsection 23AB(1) of the Rates Act]

1.10 In relation to paragraph 23AB(1)(a), a distribution made by a corporate tax entity includes dividends, and amounts that are taken to be dividends under the income tax law, made by a company (item 1 of the table in subsection 960-120(1) of the ITAA 1997).

1.11 However, a dividend that is a non-portfolio dividend (within the meaning of section 317 of the ITAA 1936) is not base rate entity passive income. A non-portfolio dividend is, broadly, a dividend paid to a company where that company has a voting interest amounting to at least 10 per cent of the voting power in the company paying that dividend. Consequently, dividends derived, for example, by a holding company which are made by a wholly-owned subsidiary company will not be base rate entity passive income of the holding company.

1.12 In relation to paragraph 23AB(1)(d), interest (or a payment in the nature of interest) does not include an amount derived by:

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an entity that is a financial institution (as defined in section 202A of the ITAA 1936) - a financial institution is defined in section 202A to include a bank (such as an authorised deposit-taking institution) and a co-operative housing society;

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an entity that is a registered entity within the meaning of the Financial Sector (Collection of Data) Act 2001 that carries on a general business of providing finance (within the meaning of that Act) on a commercial basis;

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an entity that holds an Australian credit licence (within the meaning of the National Consumer Credit Protection Act 2009) or is a credit representative (within the meaning of that Act) of another entity that holds an Australian credit licence;

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an entity that is a financial services licensee (within the meaning of the Corporations Act 2001) whose licence covers dealings in financial products mentioned in paragraph 764A(1A)(a) of that Act, or is an authorised representative (within the meaning of section 761A of that Act) of such a financial services licensee - paragraph 764A(1A)(a) covers financial products that are securities; or

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an entity that is of a kind mentioned in a legislative instrument made by the Minister under subsection 23AB(3).

[Schedule 1, item 2, paragraph 23AB(2)(a) of the Rates Act]

1.13 In addition, interest (or a payment in the nature of interest) does not include an amount derived by an entity that is a return on an equity interest in a company. [Schedule 1, item 2, paragraph 23AB(2)(b) of the Rates Act]

1.14 The Minister may make a legislative instrument to specify one or more kinds of entities for the purposes of subparagraph 23AB(2)(a)(v). [Schedule 1, item 2, subsection 23AB(3) of the Rates Act]

1.15 A legislative instrument made by the Minister under subsection 23AB(3) is a disallowable instrument. This legislative instrument making power will allow the scope of paragraph 23AB(2)(a) to be expanded so that it covers other entities that are actively carrying on commercial money lending business if necessary.

1.16 In relation to paragraph 23AB(1)(g), an amount that flows through a trust to a corporate tax entity (that is, directly from the trust to the corporate tax entity) will retain its character for the purposes of determining whether or not the amount is base rate entity passive income of the corporate tax entity. That is:

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if an amount derived by a trust is, for example, a dividend (other than a non-portfolio dividend) which passes directly from the trust to a beneficiary that is a corporate tax entity, then the amount will be base rate entity passive income of the corporate tax entity because the trust distribution is directly referable to the dividend of the trust;

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if an amount derived by a trust is, for example, trading income which passes directly from the trust to a beneficiary that is a corporate tax entity, then the amount will not be base rate entity passive income of the corporate tax entity because the trust distribution is directly referable to the trading income of the trust.

1.17 Similarly, an amount that flows through a chain of trusts to a corporate tax entity (that is, indirectly through one or more interposed trusts to the corporate tax entity) will also retain its character as it passes through each trust for the purposes of determining whether or not the amount is base rate entity passive income of the corporate tax entity. That is:

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if an amount derived by a trust is, for example, a dividend (other than a non-portfolio dividend) which passes from the trust through one or more interposed trusts to a beneficiary that is a corporate tax entity, then the amount will be base rate entity passive income of the corporate tax entity because the trust distribution is indirectly referable to the dividend of the original trust;

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if an amount derived by a trust is, for example, trading income which passes from the trust through one or more interposed trusts to a beneficiary that is a corporate tax entity, then the amount will not be base rate entity passive income of the corporate tax entity because the trust distribution is indirectly referable to the trading income of the original trust.

Example 1.1

Terrace House Pty Ltd is the sole beneficiary of the Mountain Trust. The Mountain Trust is the sole beneficiary of the Apples Trust.

The Apples Trust owns and operates a large orchard in the Victorian Alps. In the 2017-18 income year the Apples Trust produced $1 million in trading income and distributes all of its income to the Mountain Trust. The Mountain Trust then distributes all of its income to Terrace House Pty Ltd.

The trust distributions retain their character as trading income as they flow through the Apples Trust and the Mountain Trust.

Therefore, the trust distributions from the Mountain Trust to Terrace House Pty Ltd are not base rate entity passive income because they are indirectly referable to the trading income of the Apples Trust.

Example 1.2

Super Retail Pty Ltd is the sole beneficiary of the Beta Trust. The Beta Trust is the sole beneficiary of the Ace Property Trust which, in turn, is the sole beneficiary of the Central Rental Trust.

The Central Rental Trust owns a small suburban strip of shops which it rents to local businesses. In the 2017-18 income year, the Central Rental Trust receives $1 million of rental income and distributes all of its income to the Ace Property Trust.

The Ace Property Trust distributes all of its income to the Beta Trust. The Beta Trust then distributes all of its income to Super Retail Pty Ltd.

The trust distributions retain their character as rental income as they flow through the Central Rental Trust, the Ace Property Trust and the Beta Trust.

Therefore, the trust distributions from the Beta Trust to Super Retail Pty Ltd are base rate entity passive income because they are indirectly referable to the rental income of the Central Rental Trust.

1.18 The following examples illustrate the operation of the base rate entity passive income test.

Example 1.3

Jane and Dave Smith are the sole shareholders and directors of Smith Pty Ltd. Smith Pty Ltd holds a diversified portfolio of shares from which it earns dividend income as well as several term deposits from which it earns interest. It is also the beneficiary of a trust which owns a commercial investment property. All rental income earned by the trust is distributed to Smith Pty Ltd.

Smith Pty Ltd also earns a small amount of fee for service income. This is derived from the consulting services Jane Smith, a retired business woman, provides to a number of independent businesses year.

In the 2017-18 income year, Smith Pty Ltd had an aggregated turnover that is under the $25 million aggregated turnover threshold. The amount of its assessable income was $900,000, comprising:

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dividends, rent and interest income of $620,000;

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net capital gains of $180,000; and

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consulting income of $100,000.

Smith Pty Ltd is a passive investment company as 89 per cent of its assessable income is base rate entity passive income.

Consequently, for the 2017-18 income year, Smith Pty Ltd's corporate tax rate is 30 per cent.

Example 1.4

Best Equity Ltd is a listed investment company which invests in small cap Australian shares.

In the 2017-18 income year, Best Equity Pty Ltd had an aggregated turnover that is under the $25 million aggregated turnover threshold. The amount of its assessable income was $5 million, comprising:

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interest income of $1 million; and

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dividends of $4 million.

Best Equity Ltd is a passive investment company as 100 per cent of its assessable income is base rate entity passive income.

Consequently, for the 2017-18 income year, Best Equity Ltd's corporate tax rate is 30 per cent.

Example 1.5

Happy Feet Pty Ltd is a small business that has just started selling socks online. Its owner, Winston Chan, wants to expand the business into running shoes as well. The capital he needs to expand the business is put into a term deposit while he negotiates with suppliers. In the 2017-18 income year, Happy Feet Pty Ltd had an aggregated turnover that is under the $25 million aggregated turnover threshold. The amount of its assessable income was $104,000, comprising:

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trading income of $100,000; and

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interest income of $4,000.

Happy Feet Pty Ltd is not a passive investment company as only 3.8 per cent of its assessable income is base rate entity passive income.

Consequently, for the 2017-18 income year, Happy Feet Pty Ltd's corporate tax rate is 27.5 per cent.

Example 1.6

Coffee and Cake Pty Ltd is the owner of a small cafe. Coffee and Cake Pty Ltd is also the beneficiary of a trust which owns the premises from which the cafe operates and the premises next door. Above the cafe, there is a large studio space which the trust rents out to a very successful yoga school. Next door is rented to high end retail store. All rental income earned by the trust is distributed to Coffee and Cake Pty Ltd.

In the 2017-18 income year, Coffee and Cake Pty Ltd had an aggregated turnover that is under the $25 million aggregated turnover threshold. The amount of its assessable income was $700,000, comprising:

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trading income of $500,000; and

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rental income attributable to the trust distribution of $200,000.

Coffee and Cake Pty Ltd is not a passive investment company as only 28.6 per cent of its assessable income is base rate entity passive income.

Consequently, for the 2017-18 income year, Coffee and Cake Pty Ltd's corporate tax rate is 27.5 per cent.

Consequential amendments

Consequential amendments to the ITAA 1997

Operation of the imputation system

1.19 Under the company imputation system, when an Australian corporate tax entity distributes profits to its members, the entity has the option of passing to those members credit for income tax paid by the entity on the profits. This is done by franking the distribution.

1.20 The amount of franking credits that can be attached to a distribution cannot exceed the maximum franking credit for the distribution (section 202-60 of the ITAA 1997). The maximum franking credit is worked out by reference to the corporate tax gross-up rate, which is defined in subsection 995-1(1) by reference to the corporate tax rate for imputation purposes.

1.21 Corporate tax entities usually pay distributions to members for an income year during that income year. However, a corporate tax entity will not know its aggregated turnover, the amount of its base rate entity passive income, or the amount of its assessable income for an income year until after the end of that income year. Therefore, generally, for the purposes of working out its corporate tax rate for imputation purposes for an income year, a corporate tax entity must assume that:

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its aggregated turnover for the income year is equal to its aggregated turnover for the previous income year;

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its base rate entity passive income for the income year is equal to its base rate entity passive income for the previous income year; and

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its assessable income for the income year is equal to its assessable income for the previous income year.

[Schedule 2, item 1, paragraph (a) of the definition of 'corporate tax rate for imputation purposes' in subsection 995-1(1) of the ITAA 1997]

1.22 However, if the corporate tax entity did not exist in the previous income year, its corporate tax rate for imputation purposes for an income year will be the lower corporate tax rate of 27.5 per cent. [Schedule 2, item 1, paragraph (b) of the definition of 'corporate tax rate for imputation purposes' in subsection 995-1(1) of the ITAA 1997]

Example 1.7

In the 2017-18 income year, Bear Co has:

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aggregated turnover of $8 million;

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base rate entity passive income of $7.5 million; and

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assessable income of $8 million.

Therefore, for the 2017-18 income year, 92.59 per cent of Bear Co's assessable income is base rate entity passive income. Consequently, for that income year, Bear Co's corporate tax rate is 30 per cent (even though its aggregated turnover is only $8 million).

Bear Co proposes to pay a dividend to its shareholders in the 2018-19 income year. For the purpose of working out its corporate tax rate for imputation purposes for the 2018-19 income year, Bear Co must assume that its aggregated turnover, base rate entity passive income and assessable income are the same as for the 2017-18 income year.

As 92.59 per cent of its assessable income was base rate entity passive income for the 2017-18 income year, Bear Co's corporate tax rate for imputation purposes is 30 per cent. Therefore, Bear Co's corporate tax gross-up rate for that income year will be 2.33 (that is, (100% - 30%)/30%).

Bear Co makes a fully franked distribution of $100 per share in the 2018-19 income year. The maximum franking credit that can be attached to that distribution is $42.91 (that is, $100/2.33). Bear Co makes the dividend payment on 31 March 2019.

Amy holds 50 shares in Bear Co and receives a dividend of $5,000. Franking credits of $2,145 are attached to the dividend. For the 2018-19 income year, Amy includes $7,145 in her assessable income in relation to the dividend she has received from Bear Co - that is:

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the amount of the dividend ($5,000); plus

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the amount of franking credits ($2,145).

Amy is entitled to a refundable tax offset equal to the amount of the franking credits. Amy's total assessable income for the 2018-19 income year is $30,000 (so that her marginal tax rate is 19 per cent). Therefore, (ignoring Medicare levy) the tax payable by Amy on the franked dividend is $1,357.55. The excess franking credits ($787.45) will be:

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applied to reduce Amy's other tax liabilities; or

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if she has no other tax liabilities, refunded to Amy.

Emma also holds 50 shares in Bear Co and receives a dividend of $5,000. Franking credits of $2,145 are attached to the dividend. For the 2018-19 income year, Emma includes $7,145 in her assessable income in relation to the dividend she has received from Bear Co - that is:

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the amount of the dividend ($5,000); plus

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the amount of franking credits ($2,145).

Emma is entitled to a refundable tax offset equal to the amount of the franking credits. Emma's total assessable income for the 2018-19 income year is $120,000 (so that her marginal tax rate is 37 per cent). Therefore, (ignoring Medicare levy) the tax payable by Emma on the franked dividend is $2,643.65. Consequently, Emma will need to pay additional tax of $498.65 on the franked dividend that she has received from Bear Co.

Example 1.8

Investment Co is a passive investment company that has income consisting solely of franked dividends. As the whole of its income is base rate entity passive income, Investment Co's corporate tax rate is 30 per cent.

Investment Co is wholly-owned by Mountain Gear Co. In the 2017-18 income year, Investment Co pays a fully franked dividend (that is, a dividend of $70,000 and franking credits of $30,000) to Mountain Gear Co.

In the 2017-18 income year, Mountain Gear Co has an aggregated turnover and assessable income of $15 million. None of Mountain Gear Co's assessable income is base rate entity passive income. In this regard, the dividend paid by Investment Co to Mountain Gear Co is a non-portfolio dividend and therefore is not base rate entity passive income. Consequently, for that income year, Mountain Gear Co is a base rate entity that has a corporate tax rate of 27.5 per cent.

Mountain Gear Co's pays no tax in the 2017-18 income year because it has a taxable income of nil (due to its assessable income being reduced by deductions, including prior year tax losses).

Therefore, the only credit made to Mountain Gear Co's franking account in relation to the 2017-18 income year is in respect of the franking credits attached to the dividend paid by Investment Co - that is, $30,000.

Mountain Gear Co proposes to pay dividends to its shareholders in the 2018-19 income year. The total amount of the dividends it pays is $70,000, effectively passing on the dividend that it received from Investment Co to its shareholders.

For the purpose of working out its corporate tax rate for imputation purposes for the 2018-19 income year, Mountain Gear Co must assume that its aggregated turnover, base rate entity passive income and assessable income are the same as for the 2017-18 income year.

As 0 per cent of its assessable income was base rate entity passive income for the 2017-18 income year, Mountain Gear Co's corporate tax rate for imputation purposes is 27.5 per cent. Therefore, Mountain Gear Co's corporate tax gross-up rate for that income year will be 2.63 (that is, (100% - 27.5%)/27.5%).

Therefore, the maximum franking credit that Mountain Gear Co can attach to the dividends paid to its shareholders is $26,615.97 (that is, $70,000/2.63). Therefore, Mountain Gear Co will have a debit to its franking account of $26,615.97.

Consequential amendments to the Rates Act

1.23 Under the second phase of the Enterprise Tax Plan, in the 2023-24 income year, the corporate tax rate will be 27.5 per cent for all corporate tax entities, with the consequence that there will no longer be a need to identify an entity that is a base rate entity.

1.24 Consequently, if the Treasury Laws Amendment (Enterprise Tax Plan No. 2) Act 2017 comes into force and commences, the definition of base rate entity passive income will be repealed with effect from the 2023-24 income year. [Item 5 of the table in subsection 2(1); Schedule 2, items 3 to 5]

Application and transitional provisions

1.25 The amendments apply to the 2017-18 income year and later years of income and commence on 1 July 2017. [Subsection 2(1); Schedule 1, item 3; Schedule 2, item 2]

1.26 These amendments have been sought by stakeholders and will clarify the circumstances when a corporate tax entity is eligible for the lower corporate tax rate. This will make it easier for all corporate tax entities to self-assess their eligibility for the lower corporate tax rate.