26 Nov Franking rules and company tax rates
While the recent passing of a Bill to accelerate the reduction of the corporate tax rate for qualifying small to medium business may provide welcome relief for many in the years to come, there may be some unintended and perhaps adverse consequences in terms of the franking rules. Put simply, the issue arises when a company pays tax at a certain rate on the income year, franking debits accrue in that year, but any dividends are usually paid in the next income year, and those dividends can only be franked at the company tax rate when the payment is made. Therefore, if the company tax rate has dropped from one year to the next, the lower tax rate must be used when determining the franking amount. This has the effect of locking any tax paid at the higher company tax rate in the franking account which may be lost to shareholders forever.
ABC Pty Ltd has a taxable income of $20,000 in the 2017-18 income year which it paid tax of $6,000 at a rate of 30%. It had no other tax payments or distributions. Its franking account balance stood at $6,000 on 30 June 2018. On 1 July 2018, ABC Pty Limited declared a dividend of $14,000. At this point, having regard to its turnover for 2017-18, ABC Pty Limited determined that it qualified as a base rate entity with a tax rate of 27.5%. The maximum franking credit the company can attach to this distribution is calculated as follows: $14,000 × 1/ [(100 -27.5) / 27.5] = $5,310 In this case, although the company paid tax of $6,000, because of the reduction in the corporate tax rate, its ability to frank the dividend is $5,310. Effectively, the benefit of some of the tax paid is lost to the shareholder. As you can see, around $690 worth of benefit is lost to the shareholder due to the lower tax rate when the dividend was declared in the 2018-19 income year.
As the newly implemented corporate tax rate for qualifying small to medium businesses are on a sliding scale (ie 27.5% in 2018-19 reducing to 26% in 2020-21, before being cut to 25% for the 2021-22 and later income years), this poses an ongoing issue to ensure that there is no wastage of tax benefits when paying out franked dividends. So now you know what the issue is, how do you deal with it? Since the amount of dividend is usually determined by the after-tax profits generated by the business and in some respects the free cash flow, if your business has the capacity, you should be choosing to pay 100% franked dividends at every opportunity. This will ensure that the company is not restricted by the benchmark rule for other dividends paid during the franking period.