Tax and Credits

Company tax rate cut decreases value of franking credits

Recent media coverage has been devoted not only to whether or not passive investment companies are eligible for the reduced company tax rate of 27.5%, but also to the consequent loss in value (2.5%) of franking credits by the shareholders of small incorporated businesses that qualify for the tax rate reduction.

The legislation that reduced the corporate tax rate to 27.5% for small businesses became law on 19 May 2017, and applies retrospectively from 1 July 2016. To qualify for this concessional tax rate a company must have an aggregated turnover of below $10 million.

This is in stark contrast to the prior rules that introduced the former 28.5% rate for small businesses for the 2015-2016 income year, but allowed companies to keep franking dividends up to 30%, ie, the standard corporate tax rate, instead of at the applicable rate of 28.5%.

Given that the tax return process for 2016-2017 is now in full swing, it is important that both businesses and shareholders are aware of the impact of this tax rate change on the franking credit distribution.

How does the reduction of 2.5% in franking credits emerge?

It appears that obtaining the new tax rate reduction could be a pyrrhic victory for some small and medium-sized companies as the benefit of the company tax cut (from 30% to 27.5%) would not be passed on to shareholders if distribution of dividends is fully franked. Instead, shareholders will receive reduced franking credits based on a 27.5% tax rate in lieu of 30%, so essentially a 2.5% reduction in the value of franking credits.

What do reduced franking credits mean for you?

Under the Australian imputation system, when a company distributes its profits to its shareholders, the company can pass to the shareholders credits for income tax paid by the company on the profits. This is achieved by franking the distribution and those credits given to the shareholders are called “franking credits”.

Franking credits help to reduce the shareholder’s personal tax bill so the higher they are the better for the shareholder.

Basically, the idea of the franking credits is to prevent double taxation of a company’s profits, first in the hands of the company and then in the hands of the shareholders.

While companies pay taxes on the current year turnover, franking credits are calculated based on turnover for the previous year. The result could be, for example, that while tax is paid at 30% (or even 28.5% if you are a small business with a turnover below $2 million for 2015-2016 income year), credits can only be franked at 27.5%; hence the disparity.

This change will have greatest effect on corporate tax entities that paid a fully franked (or close to fully franked) distribution at the 30% rate between 1 July 2016 and 18 May 2017, but that distribution was over-franked due to their tax rate being reduced to 27.5%.

“During the 2016-2017 income year, “Company A” paid a franked dividend based on profits of a previous year (2015-2016 income year) where the company’s tax rate was higher (30%) than the year in which it paid the dividend (27.5% for 2016-2017 income year). This means that the shareholders of Company A will receive franking credits at 27.5% instead of 30%, resulting in a loss of 2.5% in franking credits that cannot be offset against the tax paid by the shareholder.”

As a consequence of these changes, the ATO has released the Practical Compliance Guideline PCG 2017/D7. It notes that if a small business entity fully franked a 2016-2017 distribution prior to 19 May 2017 (before the legislation that reduced the company tax rate to 27.5% was enacted), the amount of the franking credit on members’ distribution statements may be incorrect if it was based on the 30% corporate tax rate.

The draft guideline recommends that affected companies advise shareholders in writing of their correct franking credit for the 2016-2017 income year, without re-issuing the distribution statement. By doing this, such companies will avoid the imposition of penalties.

Are you still in doubt?

Essentially, the change in tax rate will represent a higher cost to shareholders (who will see a reduction to the franking credits they can claim), which perhaps defeats the purpose of the company tax reduction. If you are in doubt about the implications and consequences of the franking credits please contact us.

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Renting out your holiday home

A holiday home is a common investment for many Australians. Often the holiday home is rented out for part of the year to help finance the cost of owing the property or just to provide an additional source of income. The rent received must be declared in the owner’s tax return as income against which related expenses can be claimed as tax deductions. In this article we cover some of the essentials in claiming holiday home rental expenses.

What can be claimed as a tax deduction?

As with traditional rental properties most expenses incurred in running a holiday home may be deductible. These include:

  • Advertising costs

  • Agents fees and commissions

  • Body corporate fees

  • Council rates

  • Depreciation on assets and buildings

  • Insurance – building/landlord

  • Interest on funds borrowed to acquire the property

  • Land tax

  • Repairs and maintenance

  • Water rates

  • And more

When are these expenses deductible?

The most common mistake when accounting for holiday homes in a tax return is claiming expenses for the entire year.

Expenses are only deductible where the property is rented out or when it is genuinely available for rent even if it is not rented at that time. Therefore, expenses incurred when the property is used for private purposes or while it is not genuinely available for rent are not claimable.

Private purposes include periods where it is used by the owners or the owners’ family or friends for free. Genuinely available for rent means the owner is making a bona fide attempt to rent the property and that it has a realistic chance of being rented. Factors that suggest it is not genuinely available for rent include:

  • Only using advertising that has limited exposure (such as word of mouth)

  • Only making the property available at low demand times (i.e. when it is unlikely to be rented)

  • Poor property condition

  • Poor location and accessibility that make rental unlikely

  • Placing unreasonable conditions on renting the property

  • Asking for an unrealistic rental amount

How to calculate deductions correctly

Where a holiday home is used to genuinely produce rental income during a year, but is also used for private purposes or has periods where it is not genuinely available for rent, expenses must be apportioned. Generally, this is done on a time basis. For instance, where a holiday home is rented for 3 months and not available for rent for the other 9 months, 25% of expenses, representing 3 months out of the entire year, will be deductible.

Expenses that relate directly to rental income such as advertising and agents commission do not need to be apportioned.

Where the holiday home is rented at below market rates to a related party, the deductions for that period are limited to the rental income received in that period.

Is the sale of a holiday home subject to capital gains tax?

In most cases, a holiday home will be subject to capital gains tax. This is because generally the owners will claim the main residence exemption on another property (such as their home). However, in addition to purchase, selling and capital costs, expenses incurred in holding the property that could not be claimed as tax deductions will also reduce any capital gain. These include rates, land taxes, insurance and repairs while the holiday home is not rented or available for rent. For this reason, it is important to keep records for all holiday home expenses for the entire period of ownership.

For more information on this topic, or for assistance with correctly declaring your holiday home, contact our team at Private Wealth Accountants.