Things to know about your company and its profits

Sally Preston

Understanding trusts in business structures
Many Australian businesses have a company in their structure. It may be the entity running the business, it may be as the trustee of a trust, it may even act as the partner in a partnership.
In many cases, this company will be a “private” company. That is, it is not listed on a stock exchange.
If this is you, do you have a good understanding of tax on company profits and the key tax issues you need to be aware of?
This article will explore some of these topics just to check on your understanding and hopefully provide you with some valuable information.

Company basics

There are several different types of companies and the two main ones you would probably be aware of are Proprietary Limited (“Pty Ltd”) companies – these are usually privately owned; and Limited companies - which are often listed on a stock exchange.

This article will be focusing on private companies – those that are not listed on a stock exchange.

One thing to be aware of is that a company is a separate legal and tax entity. This means it is separate from you and should be treated this way. 

Company - advantages

  • Companies offer limited liability where the shareholder’s liability is generally limited to the ‘paid up’ value of the shares.

  • Generally, shareholders and directors are not exposed to business risks unless they have provided personal guarantees.

  • If shares are owned by a discretionary trust, there may be flexibility to distribute dividends to different beneficiaries.

  • A company structure allows a full or partial change in ownership of the entity.

  • A company can reinvest profits back into the company without the fear of anti-avoidance or shareholder loan tax laws.

Company - disadvantages

  • Companies may not be taxed as favourably on capital assets that appreciate in value. The main reason is that a company cannot access the 50% general CGT discount on capital gains.

  • There may be taxation issues for shareholders when profits are paid out of the company without paying it as a dividend.

  • Tax losses will be trapped in the company.

  • If a shareholder dies, the company's assets and liabilities will not form part of the estate. Note though, that if the shares are held by the deceased individual, they will form part of the estate.

Key roles in a company

Two key roles to be aware of are:

Director - As a director, you are responsible for overseeing the affairs of the company. You must comply with your legal obligations as a director under the Corporations Act 2001. This is the case even if you appoint an agent to look after your company's affairs. It is also important that you remain up to date on what your company is doing, including its financial position. You should regularly speak with managers and staff about the affairs of the business and take an active part in directors’ meetings.

Shareholder - A shareholder is a person, company, or institution that owns at least one share of a company – they are the owners of the company.

Company profits and shareholders

There are some tax issues you need to be aware of with your company the relate to company profits and any payments, loans or dividends you receive from your company.  In particular these relate to:

  • Company tax rates

  • Dividends

  • Imputation (and franking accounts)

  • Division 7A

Company tax rates

Companies pay a flat rate of tax without a tax-free threshold – which is currently 30%. A company that qualifies as a base rate entity is taxed at a lower rate – currently 25%.

A company is a base rate entity for an income year if:

  • the company’s aggregated turnover for that income year is less than the aggregated turnover threshold for that income year – currently $50m, and

  • it has 80% or less of its assessable income in that income year that is base rate entity passive income.

Base rate entity passive income includes:

  • corporate distributions and franking credits on these distributions

  • royalties and rent

  • interest income (some exceptions apply)

  • gains on qualifying securities

  • a net capital gain

  • an amount included in the assessable income of a partner in a partnership or a beneficiary of a trust, to the extent it is traceable (either directly or indirectly) to an amount that is otherwise base rate entity passive income

So what this means is that if your company is used substantially for generating passive income, it may be subject to the 30% tax rate.

Things you need to know

  • Changing tax rates and dividends

If a company changes tax rates from one year to the next – due to becoming a base rate entity or no longer being a base rate entity, you need to be careful when franking dividends.

The company tax rate that can be applied when franking a dividend is worked out based on the current year tax rate applying the turnover, passive income, and assessable income of the prior year. So, if a company is no longer a base rate entity in a year, if it was in the prior year, the lower tax rate will be applied to the dividend (not the current year rate).

  • Dividends paid to a parent company

Dividends and any attached franking credits paid to a parent company by a subsidiary (whether out of passive or non-passive income) are disregarded for purposes of determining the parent company's eligibility for the lower rate.

Dividends

A dividend is the payment of the profits to the company shareholders.

Under the Corporations Law 2001, a company must not pay a dividend unless:

  • the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and

  • the payment of the dividend is fair and reasonable to the company's shareholders as a whole; and

  • the payment of the dividend does not materially prejudice the company's ability to pay its creditors.

Things you need to know

  • When a dividend is included as assessable income - For tax purposes, a shareholder is assessable on a dividend it is “paid”.  The term “paid” includes “credited” or “distributed”. The declaration of a dividend creates a debt owing to the shareholders and the payment, crediting, or distribution of the dividend discharges that debt. Therefore, even though you may not have received a dividend you may be assessable on it.

The imputation system (and franking accounts)

The basis of the imputation system of company taxation is that shareholders who receive assessable dividends from a company are entitled to a tax offset for the tax paid by the company on its income. It is called an imputation system because the payment of company tax is imputed to shareholders. Dividends paid to shareholders may effectively become tax-free to varying extents.

A company can choose the franking percentage for frankable distributions.

For the recipient shareholder, an amount equal to the franking credits attached to franked distributions is included in their assessable income. The shareholder is then entitled to a tax offset equal to the amount included in their income. This is referred to as grossing up the dividend and tax offset.

A franking account is maintained by a company as a record of its franking credits and franking debits, which broadly represent the amount of tax paid by a company or the tax refunded to it or used by it to pay franked dividends. A credit to the company franking account arises when the company pays income tax or receives a franked dividend from another company. A debit arises when the entity franks a dividend or receives a tax refund.

Things you need to know

  • Refund of excess franking credits - As a general rule, where an individual receives a dividend (whether directly from the company or through a trust) once they have applied the franking credits to offset any income tax liability, any excess credits will be refunded. If the recipient of the dividend is a company, they will not be eligible for a refund of excess franking credits. The excess is converted into tax losses.

  • The benchmark rule - Once a franked dividend has been paid in a year, any further dividends must be franked to the same extent. So, if more than one dividend is paid in a year, it is important to look at prior dividend payments, to make sure it has the same franking percentage. Don’t also forget to monitor the franking account balance in case, adhering to this rule then causes a shortfall.

  • Holding period rule – Taxpayers must hold shares at risk for more than 45 days (or 90 days for preference shares) to qualify for a franking benefit. Where this applies, there is no gross-up of income for franking credits, and any tax offset received. Instead, the entity includes the dividend as is in its assessable income.

  • Franking deficits tax - Where a company has a franking account deficit at the end of a year, it is required to pay franking deficit tax shortly after the end of the year to make good this deficit.

Division 7A

Division 7A is an anti-avoidance measure designed to prevent private companies from making tax-free distributions of profits to shareholders or to their associates in the form of payments, loans or debts that are forgiven.

If Div 7A applies, amounts paid, lent, or forgiven by a private company to a shareholder or their associate are treated as dividends, unless they come within certain exclusions. The problem with this is that the deemed dividend is unfrankable, which means the recipient will be required to pay their marginal tax rate on the dividend.

For Division 7A purposes, whether an entity is an “associate” of a shareholder depends on the type of entity the shareholder is.

Broadly, for an individual shareholder, an associate will include relatives. It will also include other entities that the shareholder or their relatives has control over, an interest in, or can benefit from. For a company shareholder, it would include an entity it controls or is controlled by, or an entity (like a trust) that it can benefit from. For a trust, any entity that can benefit under the trust.

The following payments and other benefits are not treated as Division 7A dividends:

  • loans and other payments repaid before company's lodgment day for the year in which the payment or loan occurred

  • amounts that are treated as assessable income or excluded from being assessable income under another provision of the income tax law

  • payments that discharge an obligation of the private company to pay money that are consistent with the two parties dealing at arm’s length

  • complying loans for the purpose of Division 7A

  • payments that are converted to complying loans for the purpose of Division 7A before the private company's lodgment day

  • loans made by the private company in the ordinary course of its business on the usual terms it makes similar loans to parties at arm's length

  • payments (but not loans or debts forgiven) to shareholders or their associates in their capacity as an employee – Fringe benefits tax (FBT) may apply instead of Division 7A

  • loans solely for the purpose of enabling the shareholder or their associate to acquire certain shares or rights in the company under an employee share scheme

  • payments or loans to shareholders or their associates that are companies except where the company shareholder or associate is trustee of a trust

  • certain retirement exemption payments

  • a distribution by a liquidator in the course of winding-up a company

  • minor use of a company asset – where the value of the use is under $300

  • otherwise deductible usage – that is, had the shareholder or their associate paid for the use of the asset they could have claimed the cost as an income tax deduction

  • the use of certain residences.

Things you need to know

  • Division 7A can apply to:

o   An amount the company pays to another entity but it is on behalf of a shareholder or associate

o   a transfer of property to a shareholder or its associate.

o   The use of an asset of the company

o   Forgiveness of debts the shareholder or associate owes the company.

  •  Fringe benefits -If the provision of an asset for use by an entity constitutes a fringe benefit, the FBT rules, not the Div 7A rules, will be relevant.

  • Intermingling funds - Division 7A dividends may inadvertently arise as a consequence of a failure to keep private expenses separate from company expenses.

 

Typical examples

  • A loan made by the company to the shareholder which is undocumented.

  • A payment of $5,000 made by the company to the shareholder's spouse (not the shareholder).

  • A payment of an amount to a trust – which is an associate of the shareholder – for the trust acquiring a property.

  • The use of a car that is owned by the company by the shareholder's son.