Company Tax

Company losses cannot be distributed to shareholders. The losses must be carried forward in the company and offset against assessable income in subsequent years.

Two major tests determine whether such losses can be carried forward. They are the continuity of ownership test (COT) and the same business test (SBT) which are discussed below. A company must satisfy one of these tests to carry forward its revenue tax losses – s 165-10 Income Tax Assessment Act 1997 (ITAA 97) and 165-93 ITAA 97.

The same rules apply to company carry forward capital losses. Subdivision 165-CA ITAA 97 makes the ability of a company to set off a net capital loss of an earlier income year against capital gains in a later year subject to the same conditions that it must satisfy to deduct a tax loss of an earlier income year (i.e. a company cannot apply a net capital loss of an earlier year unless):

• it has the same majority ownership and control throughout the loss year and the income year (continuity of ownership test); or
• it carried on the same business and did not enter into new kinds of business or transactions (same business test).

Foreign deductions and losses are treated in the same way as other deductions and losses.

Generally, losses can be carried forward indefinitely. However, they must be utilised on a first in first out basis (i.e. earlier-year losses must be utilised before later-year losses).

Companies can choose the number of losses they wish to deduct in a later year of income. This means they need not have those losses wasted by being offset against tax-free income (e.g. against franked dividend income). It also means a company can choose not to utilise prior-year losses in a particular year to pay sufficient tax to enable it to distribute franked dividends.

Continuity of ownership test

The continuity of ownership test (contained in section 165-12 ITAA 97) requires that shares carrying more than 50% of all voting, dividend and capital rights be beneficially owned at all times during the ownership test period by the same people and in the same proportions.

The ownership test period is the period commencing from the beginning of the year in which the loss was incurred until the end of the year in which the loss is recouped.

Example
A company incurs a tax loss in the 2022-23 income year. In the 2023-24 income year the company generated assessable income against which it wishes to claim a tax deduction for the 2022-23 tax loss.

The ownership test period commences on 1 July 2022 (the start of the loss year) and ends on 30 June 2024 (the end of the income year).

The COT must be satisfied throughout the ownership test period.

The shares can be held either directly or indirectly by an individual. The company is required to trace back to the individuals who have indirect interests in the company. This can create problems where the shares are held by a discretionary trust and this is discussed later below.

The ownership of companies does not have to be traced through a complying superannuation fund, a superannuation fund that is established in a foreign country and is regulated under foreign law, a complying approved deposit fund, a special company, or a managed investment scheme.

Same share, same interest rule

Section 165-165 ITAA 97 provides for determining whether the COT test is passed, the only shares in the company that can be considered are the same shares that are held by the same persons throughout the relevant period.

Example
ABC Pty Ltd incurred a tax loss in the 2021 income year. Annie, Mary and Barry owned shares in ABC Pty Ltd as shown in the table below.

SHAREHOLDER	SHAREHOLDING FROM 1 JULY 2020 TO 17 AUGUST 2021	SHAREHOLDING FROM 18 AUGUST 2021 TO 30 JUNE 2023	PERCENTAGE COUNTED TOWARDS COT
Annie	40%	10%	10%
Mary	40%	10%	10%
Barry	20%	80%	20%
Total	100%	100%	100%

On 18 August 2021, both Annie and Mary sold 75% of their shareholding in ABC Pty Ltd to Barry.

ABC Pty Ltd is seeking to deduct a tax loss in the 2023 income year. Will ABC Pty Ltd satisfy the continuity of ownership test?

No, ABC Pty Ltd will not satisfy the continuity of ownership test as only 40% of the shares have been held by the shareholders in the same way during the ownership test period.

Companies majority owned by discretionary trusts

Where companies in losses are 50% or more owned by discretionary trusts, it is very difficult for them to utilise the losses unless the discretionary trusts have made family trust elections.

This is because the continuity of ownership test (COT) provides that a company needs to show that the same persons have the right to exercise >50% of the voting power, the right to receive >50% of any dividend and >50% of any distribution of capital at all times, from the start of the loss year to the end of the income year.

However, if one or more non-fixed trusts own a company, it is not possible to show which persons have the voting power or the right to receive dividends and distributions of capital.

The same business test cannot be relied on in this situation to carry forward the losses.

However, there is a solution. Section 165-207 ITAA 97 provides that if a trust elects to be a family trust the trustee of the family trust is taken to be an individual shareholder for the loss recoupment tests and the COT may then be met. Alternatively, the SBT may be relied on.

Example from Interpretative Decision ID 2006/157
Company A has a tax loss available to it from an earlier income year.

The trustees of trusts B and C collectively own shares that carry more than 50% of the voting power in company A, and rights to more than 50% of the dividends and capital distributions of Company A, during the whole (or the relevant part) of the loss year and the whole of the income year.

Both trust B and C have made family trust elections (FTEs) which are in force for all relevant income years.

The ID states the company meets the conditions of the continuity of ownership test (COT) as the two trusts will be taken to be persons that meet the requirements for the COT.

There is an alternative solution, but it is not at all practical. If a family trust election is not made, subdivision 165-F ITAA 1997 contains special provisions to enable the COT to be passed.

Section 165-215 provides that a company that does not meet the conditions in the COT in respect of a loss is nevertheless taken to satisfy the COT if it meets all the relevant conditions contained in that section. They are that:

at all times during the ownership test period, the company has non-fixed trusts and other owners; and the non-fixed trusts have 50% or more of the fixed entitlements

the other owners hold their entitlements throughout the ownership test period

throughout the ownership test period, the non-fixed trusts adopt the position that they have also incurred the company loss and can carry it forward under the trust loss rules (i.e. this requires that every non-fixed trust shareholder that hasn’t made a family trust election is notionally able to satisfy the trust loss rules in respect of the loss made by the company).

Control test where there is a change in control of voting power

Even if a company passes the continuity of ownership test, section 165-15 ITAA 97 can prevent the loss from being carried forward wherein during the ownership test period, a person became able to control the voting power in the company to get some income tax benefit or advantage.

The section applies where:

• for some (or all) of the ownership test period that started at the end of the loss year, a person controlled or was able to control the voting power in the company; and
• for some (or all) of the loss year that person did not control and was not able to control that voting power; and
• that person began to control or become able to control, that voting power to gain a tax advantage or benefit, either for that person or for someone else.

Where these conditions are present, the company must satisfy the same business test to recoup its losses.

Example
A Pty Ltd incurred a tax loss in the income year 2022-23 and is seeking a deduction for that loss in the 2023-24 income year. The shares carry equal voting, dividend and capital distribution rights.

The register of shareholders is:

SHAREHOLDER	2022-23	2023-24
Bill	40%	60%
John	40%	30%
Charles	20%	10%

The company will be subject to the control test even though it satisfies the COT. Accordingly, it will not be able to deduct the tax loss if Bill began to control (or became able to control) the voting power in A Pty Ltd to get some taxation benefit or advantage for himself or others. However, A Pty Ltd would be able to deduct the tax loss in these circumstances if it satisfied the same business test.

Same business test

If the company cannot meet the continuity of ownership test, it must satisfy the same business test in section 165-210 ITAA 97 to carry forward its losses.

This test requires that at all times in the year in which it is desired to claim the deduction for the prior year’s loss:

• the company must carry on the same business (meaning the business of the company as an entirety) as it carried on immediately before the change in ownership (same business test); and
• the company must not derive income from a business (meaning a particular undertaking or enterprise) of a kind that it did not carry on before the change in ownership (new business test); and
• the company must not derive income from a transaction of a kind that it had not entered into during its business operations before the change in ownership (new transactions test), and
• the company must not enter into a scheme to get around the above tests (i.e. enter into a new business or new transactions before the change in ownership, so that the same business test would be satisfied after the change in ownership).

Taxation Ruling TR 1999/9 states that the Taxation Office will strictly apply these tests with potentially dire consequences for companies whose new owners have pruned the company’s businesses, introduced new profitable activities, restructured or made any other changes.

Example
A company owns and operates a very expensive Japanese restaurant. The restaurant makes losses and changes hands. The new owners change the restaurant to an Italian restaurant that serves cheap pasta meals. In TR 1999/9, the ruling stated this would fail the new business test and the losses could not be carried forward.

Similar business test

The similiar business tests are collectively known as the business continuity test.  As with the same business test, the business continuity test applies to the deductibility of tax losses, capital losses, and bad debts. It also is relevant to whether a company joining a consolidated group can transfer its losses to the head company of the consolidated group.

The similar business test looks at all the commercial operations and activities of the former business and compares them with all the commercial operations and activities of the current business to work out if the businesses are “similar”.

The negative limbs of the same business test (the new business test and the new transaction test) are not replicated in the similar business test, allowing companies to legitimately enter into new lines of business without losing access to tax losses.

As with the same business test, the focus of the similar business test is on the identity of the business. It is not sufficient for the current business to be of a similar ‘kind’ or ‘type’ to the former business. For example, it is not enough to say that the former business was in the hospitality industry and the current business is in the hospitality industry. Instead, the test looks at all the commercial operations and activities of the former business and compares them with all the commercial operations and activities of the current business to work out if the businesses are similar.

In working out whether the current business is similar to the former business, regard must be had to the following four factors, which are not exhaustive:

• the extent to which the assets (including goodwill) used in the current business to generate assessable income were also used in the company’s former business to generate assessable income;
• the extent to which the activities and operations from which the current business generates assessable income were also the activities and operations from which the former business generated assessable income;
• the identity of the current business and the identity of the former business; and
• the extent to which any changes to the former business resulted from the development or commercialisation of assets, products, processes, services, or marketing or organisational methods, of the former business.

Example from the Explanatory Memorandum to the legislation

Furnish Art Pty Ltd is a start-up online retail company that sells various household furniture items from established brands. In its first year, Furnish Art made a tax loss.

Through conducting this business, Furnish Art discovered that there was a market for affordable, high-quality mattresses.

While it continues selling furniture from established brands, Furnish Art decided to expand the mattress component of its business. To acquire the funds necessary to make this change, Furnish Art gained a new equity investor, causing it to fail the continuity of ownership test.

Furnish Art researched and developed its mattresses (and applied them to register its patents, trademarks and designs with IP Australia) and it outsourced the manufacturing of the mattresses to a local factory.

Furnish Art commenced selling its new mattresses through its website and under its established ‘Furnish Art’ brand name, alongside the other furniture products. Approximately 15 per cent of Furnish Art’s sales are from its specialised mattresses.

Furnish Art then became profitable and sought to recoup the tax losses incurred before the ownership change.

Furnish Art would satisfy a similar business test.

About the first factor, the current business is generating income from the same assets as the former business in so far as it continues to generate income from its brand name, website and goodwill. However, it is also generating income from new assets, namely, the various intellectual property rights connected to the range of new mattresses.

About the second factor, the current business is generating income from the same activities and operations to the extent that it is generated from the online reselling of furniture items from established brands. However, income is also being generated from the sale of the specialised mattresses that Furnish Art has developed.

About the third factor, there is a change in Furnish Art’s business from reselling established products to both reselling established products and selling mattresses it has developed itself.

However, the change supplements the former business’s identity as a subsidiary or ancillary business activity, rather than replacing the former business. This indicates that the current identity of the Furnish Art business is sufficiently similar to the identity of the former business.

About the fourth factor, the change to the business reflects the ongoing development of the former business’s assets and processes. The current business makes use of many of the assets, processes and methods of the former business, including the business website, marketing strategies and organisational methods.

The above analysis of the factors leads to the conclusion that the former business and the current business are sufficiently similar to satisfy the test. The identity of the Furnish Art business has been maintained, and although the business has changed and derived income from new assets, these new assets and activities do not outweigh the similarities between the former and current business and the current business’s reliance on the development of the former business’s assets.

This conclusion would likely be different if Furnish Art ceased to sell other furniture products and instead became exclusively an online retailer of mattresses which it developed itself.

Current year losses

The current year loss rules in Subdiv 165-B ITAA 97 require an income year to be split into two periods (pre and post-change of control) to restrict a tax loss incurred in one part of an income year from being recouped against taxable income attributable to the other part of the same income year.

The current year loss rules apply if, during an income year, a company:

• changes majority underlying ownership or control of voting power, and
• fails the SBT for the remainder of the year, and
• has incurred a ‘notional loss’ in a period of the income year, whether before or after the change in ownership.

The notional loss of one period cannot be offset against the notional taxable income of another period.

The notional loss can however be carried forward and offset against net assessable income in a future income year, provided it then satisfies the COT and control test or, failing that, the SBT.

The extent to which Australia imposes tax on a company (or any entity for that matter) is dependent on the residency of that company.

For example, the basic rule regarding the assessable income is that a company which is an Australian tax resident will be taxed on all income (ordinary or statutory income) regardless of whether the source of the income is in Australia or outside of Australia.

If a company is not an Australian tax resident, the basic rule is that a corporate entity will only be taxed on income (ordinary or statutory income) which is sourced in Australia.

The residency status of the company will also have an impact on the application of capital gains tax. The CGT regime will only impose tax on CGT events happening to CGT assets where the CGT asset is classified as Taxable Australian Property as that is defined under Division 855 of the ITAA 1997.

The residency status of a company may also have a bearing on the rights available to that entity under the application of any tax treaty that Australia has entered into with another nation.

Company tax resident definition

The definition of a company resident and the effective criteria for determining whether a company is a resident of Australia for taxation purposes is set out in section 6(1) of the ITAA 1936.

Note that the definition of resident in respect of a company is different from the definition of resident that applies to individuals, or trusts or partnerships.

The term resident for a company is defined as follows:

“A company which is incorporated in Australia, or which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.” 

You will see that there are two key avenues for a company to be classified as a resident that flow from this definition.

• That the company is incorporated in Australia.
• That the company carries on business in Australia and has central management and control in Australia or its voting power is controlled by resident shareholders.

These tests will be addressed in turn under the below headings.

The company is incorporated in Australia

The incorporation of a company in Australia refers to the process of a company coming into existence by being registered with the Australian Securities & Investments Commission.

Keep in mind that it is possible for a business to exist prior to incorporation. For example, where a business operates through a sole trader, trust or partnership structure and is re structured to operate through a company.

Also keep in mind that it is possible for an Australian originated business to have been incorporated in a foreign jurisdiction.

Carries on a business in Australia

The term business is defined in the tax legislation as ‘any profession, trade, employment, vocation or calling, but does not include occupation as an employee’.

There is no specific definition of carrying on a business. However, the prevailing view is that this involves the carrying on of trading or investment operations in Australia.

The ATO in Taxation Ruling 2019/1 sets out the circumstances where it considers a company is carrying on a business.

This includes by making an assessment of the following key factors:

• Whether the person intends to carry on a business
• The nature of the activities, particularly whether they have a profit making purpose.
• Whether the activities are repeated and regular and organised in a business like manner, including the keeping of books, records and the use of a system.
• The size and scale of a company’s activities including the amount of capital employed in them, and
• Whether the activity is better described as a hobby, or recreation.

Interestingly, there is a view expressed in case law and by the ATO in Taxation Ruling 2018/5 that it is possible for a company to be carrying on a business where there is no direct trading or investment operation in Australia, but where the central management and control of the company is based in Australia. This is because the central management and control of the company is considered to be inherently inseparable from the operation of the business. The logic being that the exercise of management and control is a key activity of the business in and of itself. In this way, the central management and control test essentially makes the carrying on a business test obsolete.

Central management and control

The term central management and control is undefined in the tax legislation. However, the prevailing view is that it refers to the location at which high level decisions are made.

High level decisions versus lower level decisions

High level decisions refer to decisions of gravity for the company. Taxation Ruling 2018/1 specifies examples which include:

• Setting investment and operational policy, including setting the policy on disposal of trading stock, and/or the use and development of capital assets and deciding to buy and sell significant assets of the company.
• Appointing company officers and agents and granting them power to carry on the company’s business (and the revocation of such appointments and power)
• Overseeing and controlling those appointed to carry out the day to day business of the company, and
• Matters of finance, including determining how profits are used and the declaration of dividends.

These high level decisions should be distinguished from lower level decisions concerning the day to day activities and operations of the company. The location of the exercise of lower level decision should not be taken into account in determining the location of the exercise of central management and control. Taxation Ruling 2018/1 provides a number of examples of lower level decisions:

• Keeping a company’s share register, including registering transfers of shares.
• Keeping and adopting a company’s accounts
• Where a company pays dividends, and
• The minimum acts necessary to maintain a company’s registration.

The classification of a decision as a high level decision or lower level decisions will obviously vary according to the nature of the company’s specific activities and business.

Determining who exercises central management and control

The determination of who is a decision maker that exercises central management and control is a matter of fact and substance. All the relevant facts and circumstances must be considered.

Ordinarily, the power to make high level decisions rests with directors. Ordinarily, the power to make high level decisions does not rest with shareholders (notwithstanding that the shareholders have power to appoint directors).

However, the central management and control will not rest with a director (or another person) with a mere status or title of authority where that position is awarded only as a formality without that person having any practical decision making ability. That is, the person must practically have the right to consider what decisions to make in the interests of company and then have the right to exercise power to make such decision. If a director (or another person with a title of authority) mechanically implements or rubberstamps company decisions that have already made, they are not a real decision maker who exercises central management and control.

Where high level decision making is found to rest with a person without a formal decision making position within the company, that person will be a decision maker who exercises central management and control.

In a similar way, a person who has genuine power to control and direct decision making but refrains from doing will not be considered a decision maker who exercises central management and control.

A case in point was Bywater Investments Ltd. The case involved a number of taxpayer companies which were incorporated overseas. The companies collectively argued that they were not resident companies for taxation purposes on the basis that the central management and control test was not satisfied because decisions were formalised outside of Australia at board meetings. The court rejected that argument and held that central management control is determined by reference to where decision making actually occurs, not where decisions are formally made or rubber stamped to reflect decisions already made.

The Bywater case established a couple of key indicators to use when considering whether directors exercise control.

Firstly, whether the directors could and would refuse to follow advice or directions from outsiders that is improper or bad advice. If so, it is more likely than not that the directors are the real decision makers. If not, it is more likely that an outsider is exercising central management and control.

Secondly, what is the director’s knowledge of the business? The greater the inside knowledge of the business, the more likely that they are exercising control.

Note that a person may be considered to control and direct a company without actively intervening in the company’s affairs on an ongoing basis. This is provided they:

Have appointed agents or managers whom they tacitly control to conduct the company’s day to day business.
Tacitly control and regularly exercise oversight of the affairs of the company, including monitoring the company’s performance, and
Do not need to actively intervene because the company’s affairs are running smoothly and in the manner they desire.

A further question to answer is whether a person is merely influential over decision making as opposed to genuinely exercising central management and control. The ATO view in Taxation Ruling 2018/1 is that a person who merely influences decision (even if the influence is strong), will not be a relevant decision maker. The person must actually dictate and control decisions of the company.

The location of central management and control being exercised

Keep in mind that the location at which the central management and control is exercised is the location at which the high level decisions are made by those making such decisions. Put another way, it the place where decisions are made that is determinative of the location of central management and control. It is not the residency of the person making the decision or the place where that person lives.

For example, assume the directors of a company (who have power to exercise control) travel to a particular country in order to formulate, contemplate and execute high level decisions on behalf of the company. In this case, the relevant central management and control takes place in that country. However, if the directors of that company instead formulate, contemplate and decide on high level decisions from a local workplace or from home, that location will be the relevant place in which central management and control is taking place. Any meeting overseas to merely formalise a decision already considered and made will not cause that location to be where central management and control is exercised.

It is possible that control and direction may be undertaken in multiple places. In this case, central management and control may be divided between several places. However, control will only be viewed as exercised in a location if the control is exercised to a substantial degree that makes it sufficient to conclude that the company is really carrying on business at that location.

The factors that may be taken into account to determine the location of the exercise of central management and control include.

• Where those who exercise central management and control do so, rather than where they live.
• Where the governing body of the company meets.
• Where the company declares and pays dividends.
• The nature of the business and whether it dictates where control and management decisions are made in practice.
• Minutes or other documents recording where high level decisions are made.
• Where those who control and direct the company’s operations live.
• Where the company’s books are kept.
• Where its registered office is located.
• Where the company’s register of shareholders is kept.
• Where the shareholder’s meetings are held.
• Where its shareholders reside.

Note that the nature of a company’s business activities may dictate where high level decision making must occur as a practical matter. Refer to the case of North Australian Pastoral and Waterloo Pastoral.

Keep in mind that the ATO is cautious about contrived circumstances intended to affect the location of central management and control. A previous Practical Compliance Guidance (no longer in force as at 1 July 2023), sheds light on the ATO approach when it comes to anti avoidance type behaviours.

Risky anti avoidance type behaviours include:

• where there is an arrangement whereby decision makers travel to an overseas location (particularly one in which the company does not have a business operations) in order to make high level decisions to avoid central management and control being located in Australia.
• where a majority of the high level decision makers spend a majority of their time in Australia but make decisions overseas.

The anti avoidance rules enable the cancellation of tax benefits achieved under a scheme and the imposition of further penalties.

Complications presented by the central management and control test

There are many complications presented by the corporate residency rule, at least partly due to how subjective the rule is. These present challenges for businesses in determining residency status. Common examples of complications include:

• What is the borderline between influencing decisions (which falls short of the exercise of central management and control) and the exercise of control?
• What is the borderline between a high level and low level decision?
• What happens where a few high level decisions are made in Australia but the majority are made elsewhere?
• At what point in time does decision making occur (e.g. at the time the thought of a decision is first communicated, or when the decision is first agreed to, or where the decision is finalised formally)? Theoretically, certain aspects of the decision making process could occur in different locations. Note that the ATO considers that decision making occurs at the time when a person (or group of persons) actively consider and decided to do, or not do something.

Voting power controlled by resident shareholders

The company should assess the residency of shareholders and determine whether more than 50% of total voting power is held by resident shareholders.

Dual Resident Companies

A prescribed dual resident is essentially a company that is a tax resident of Australia and another country.

A prescribed dual resident can lose out on certain tax advantages available to ordinary resident companies. For example:

• a prescribed dual resident is not entitled to certain forms of CGT roll over relief on the transfer of certain assets.
• a prescribed dual resident is treated as a non resident under the thin capitalisation rules and under the anti avoidance provisions.
• a prescribed dual resident may be prevented from joining a tax consolidated group with its parent company.

A prescribed dual resident is defined in section 6(1) of the ITAA 1936 as a company that satisfies either of the following conditions:

First condition:

• The company is a resident of Australia within the meaning of subsection 6(1); and
• There is an agreement (within the meaning of the International Tax Agreements Act 1953) in force in respect of a foreign country; and
• The agreement contains a provision that is expressed to apply where, apart from the provision, the company would, for the purpose of the agreement, be both a resident of Australia and a resident of the foreign country; and
• That provision has the effect that the company is, for the purposes of the agreement, a resident solely of the foreign country.

Essentially, this means that a company is treated (pursuant to a tax treaty) as a resident solely in a foreign country (not Australia).

Alternative condition:

• The company is a resident of Australia within the meaning of subsection 6(1) for no other reason than it carries on business in Australia and has its central management and control in Australia; and
• The company is also a resident of another country; and
• The company has its central management and control is in another country.

Essentially, this applies where a company is a resident of Australia but where there is a division in central management and control between Australian and another country.

What happens if a foreign company is reclassified as a resident company?

If circumstances change, a non resident company can become a resident company for taxation purposes. For example, where central management and control of the business shifts to Australia, or where a majority of the company shares are purchased by Australian resident shareholders.

There are a number of tax implications for a foreign company that becomes a resident company. For example:

• The rules for the assessment of income of an Australian resident will apply. That is, all ordinary and statutory income will be assessable to the company, regardless of the source of that income. As a result, foreign sourced income derived by the company will be assessable.
• The CGT rules may apply to capture capital gains on CGT assets which are not Taxable Australian Property.
• The company may not be entitled to receive protection from double taxation outcomes. Such protection is usually otherwise available under a relevant double tax agreement.
• The participation exemptions in Subdivision 768-A and 768-G of the ITAA 1997 may not be available in relation to share disposals and distributions.

The payment of dividends or other profit distributions from a company to shareholders will be assessable income to the recipient shareholders. The assessable dividend will need to be grossed-up for the value of franking credits. Thereafter, the taxpayer will be entitled to a tax offset for the tax already paid by the company on the profits which support the dividend payment. For an individual shareholder, the offset can result in a cash refund. For a corporate shareholder, the offset will be non-refundable. That is, the franking credits may reduce the company tax liability but cannot result in a cash refund.

The impact of franking credits on tax outcomes for the shareholder can be summarised with an example:

Abbie is a shareholder of Abbie Pty Ltd. On 1 August 2023, she is paid a dividend of $100,000. The dividend is partially franked with 20,000 franking credits attached. Abbie has no other assessable income or deductions. Therefore, in her tax return of 2023-2024, her assessable income will be $120,000. As she has no deductions, her taxable income will also be $120,000. The tax on her taxable income is $29,467 (excluding medicare levy) less the franking tax offset. Abbie’s tax payable for 2023-2024 is $9,467.

The ‘power’ of franking credits to produce beneficial tax outcomes for shareholders is particularly on display where personal tax rates are less than corporate rates. In fact, a taxpayer can theoretically achieve a refund position despite the dividend receipts.

Example:
On this occasion, Abbie is paid a $70,000 dividend with 30,000 franking credits attached. Her assessable income is grossed-up to $100,000 and as she has no allowable deductions her taxable income is also $100,000. The tax on her taxable income is $22,967 payable (excluding Medicare levy). This is offset by $30,000 being the value of franking credits attached to the dividend. Abbie receives a cash refund from the ATO of $7,033 despite having received a $70,000 dividend!

The impact of franking credits on tax outcomes for the company making the distribution can be summarised as follows:

• The dividend payment is not deductible (with exception for non-equity shares).
• The company franking account is debited (reduced) for the value of the franking credits attached to the dividends.

Note that the amount of dividend and franking credits can generally be determined by referring to distribution statements issued by a company to a shareholder.

Note also that the dividends will be assessable to the taxpayer even where those dividends are not ‘received’ per se and are instead re-invested under a dividend reinvestment plan.

What is a dividend?

A dividend is defined broadly to include:

• Any distribution made by a company to any shareholders, whether in money or property.
• Any amount credited by a company to any shareholders as shareholders.

Note in particular that a dividend can include property which is distributed in-specie to a shareholder. The dividend amount will be equal to the market value of the property transferred.

Monies paid or credited to a shareholder which are sourced from the company share capital account will not be a dividend but instead a return of capital. The share capital account essentially represents the amount shareholders invested (‘paid up’) into the company to obtain their shareholdings. It is illogical for a return of capital to be taxed as a dividend in the same way as it would be illogical for someone to deposit $100 into a bank account and then withdraw the full $100 only for that amount withdrawn to be taxed as though the withdrawn funds were a form of profit.

When is a dividend assessable?

For a ‘dividend’ (per the above definition) to be assessable, it must be paid ‘out of profits’. This will generally be the case as the tax law provides that a dividend paid out of an amount other than profits is taken to be paid out of profits. This includes dividends sourced from revenue profits, capital profits, gifts received by the company and potentially unrealised profits, noting the general consensus that unrealised profit must have a degree of permanence before a payment sourced therein would constitute a payment out of profits.

The disadvantages of the imputation system

The dividend imputation system means tax-preferred amounts (e.g. discounted capital gains) within the company do not retain their tax-advantaged character when they are distributed to a shareholder. This is different from the situation in respect of trusts and partnerships, where tax-preferred amounts can retain their tax-advantaged status at the beneficiary or partner level. For example, if a corporate beneficiary is streamed a discounted capital gain from a trust, the company is unable to distribute the discounted capital gain to the shareholder such that the benefit of the discount is available for use by the shareholder. Rather, the entire tax-free or tax-discounted amount will effectively be an assessable (undiscounted) dividend in the hands of the recipient shareholder.

Another disadvantage of the imputation system is that foreign shareholders are not entitled to utilise franking credits as a tax offset. There is some consolation for the company and foreign shareholders in that there is no withholding tax obligation imposed in respect of fully franked dividend. Unfranked dividends to foreign shareholders are generally otherwise subject to a dividend withholding tax at a rate of either 15% or 30%.

Anti-streaming rules and anti-manipulation rules

There are a number integrity measures including the anti-streaming and anti-manipulation rules which are designed to deter taxpayer arrangements which exploit weaknesses in the imputation system.

Probably the most commonly encountered integrity measure is the ‘qualified person rule’, also known as the ‘45 day rule’. The rule is designed to ensure that those who benefit from franking credits are those that bear the risk of the underlying shares, including the risk that those shares could change in value.

Specifically, shares must be held for a continuous period of 45 days during the ‘qualification period’ in order for the shareholder to utilise the franking credits. It is preferrable to view this as 47 days, as the day of the acquisition and disposal of the shares is not included in the 45 day test period. The qualification period begins the day after the shares are acquired and ends 45 days after the ex-dividend date. The ex-dividend date being the last day on which acquisition of a share will entitle a shareholder to receive an impending dividend payment.

Note that if the taxpayer satisfies the small shareholder exemption, essentially by being entitled to 5,000 or less in franking credits for the income year, that person is considered a ‘qualified person’ even if they fail the 45 day rule.

Without the qualified person rule it is easy to imagine the imputation system being exploited by shareholders entering into schemes which involve purchasing shares just prior to the ex-dividend date, receiving a dividend and the associated benefit of attached franking credits and immediately thereafter selling the shares.

What is a franking account?

A franking account is a running balance of the income tax flowing in and out of a company. The balance of the franking account represents the amount of tax paid by the company that can be passed on to shareholders via franking credits attached to dividends.

The balance of the account rolls forward from year to year and is not reset. The account is credited (for tax paid) and debited (for tax received or refunded). In essence, where the credits exceed the debits, the franking account will have a positive balance and where the debits exceed the credits, there will be a negative balance.

A company should generally avoid a negative balance at year end as this can result in liability for franking deficit tax. It is important to understand what tax events will cause a debit or credit to arise and also the rules concerning the timing of recognition of these debits and credits.

Examples of credits

Payment of a PAYG instalment. The credit is equal to the amount paid and is recognised at the date of payment provided an actual liability for the instalment exists at that time. A company may generally not recognise a credit until there is a liability for the payment of the instalment. A voluntary payment will not provide a credit.

Payment of year end income tax. The credit is equal to the amount paid and is recognised at the date of payment. The liability for the payment generally arises on the date of lodgement of the tax return.

The company incurs a liability to pay franking deficit tax (FDT). The credit is the amount of the FDT and is recognised as a credit on 30 June of the income year in which there is a deficit.

Examples of debits

The company franks a dividend. The debit is equal to the franking credits attached to dividends and is recognised at the date of distribution.

The company receives a refund of income tax. The debit is equal to the refunded amount and is generally recognised on the date received.

Other debits may include where a company under-franks a distribution; is involved in certain linked distributions; is involved in distribution streaming; or is involved in an on-market share buy-back.

How does a company frank a dividend?

A company must satisfy the following in order to be eligible to frank a dividend:

• The company must be a tax resident at the time of distribution;
• The franked distribution must a ‘frankable distribution’; and
• The company must allocate franking credits to the distribution and disclose this to the shareholder by issuing a distribution statement.

The following are examples of distributions which are not frankable distributions:

• A distribution in respect of a non-equity share.
• A distribution sourced from the company share capital account.
• A distribution which is a deemed dividend by operation of Part III Division 7A of the Income Tax Assessment Act 1936.
• A distribution of profit to a shareholder out of certain exempt CGT gains.

To what extent can the distribution be franked?

The extent of franking attached to a distribution is largely at the discretion of the company. However, there are certain restrictive rules to consider.

The first rule is that franking credit on a distribution may not exceed the ‘maximum franking credit’ amount.

The maximum franking credit amount = the amount of the frankable distribution x [1 / the applicable gross-up rate].

In this instance, the ‘applicable gross-up rate’ = [1 – corporate tax rate of company expressed as decimal] / corporate tax rate of company expressed as decimal.

As an example, ABC Pty Ltd makes a distribution of $10,000 to its single shareholder. It is not a base rate entity and therefore pays tax at a corporate rate of 30%. The maximum franking credit amount is calculated as follows:

Applicable gross-up rate = [1 – 0.3] / 0.3 = 2.3333.
Maximum franking credit = $10,000 x [1 / 2.3333] = 4,285.

If the maximum franking credit is exceeded, the company must only recognise a debit to the franking account equivalent to the maximum franking credit. Similarly, the shareholder may only include the maximum franking credit in their assessable income and will only obtain a tax offset for the maximum franking credit amount.

The second rule is the benchmark franking percentage rule which provides that all dividends paid during the franking period (i.e. income year in most instances) are required to have the same franking percentage. Note that certain public companies may have two or more franking periods within an income year. The purpose of this rule is to prevent tax avoidance in instances where certain shareholders are distributed lower franked dividends and other shareholders receive highly franked dividends to take advantage of shareholder tax circumstances.

If the benchmark franking percentage rule is not complied with there will either be an over-franking situation or an under-franking situation. The consequences attached to either circumstance can be quite disadvantageous for the company and shareholders. The company should therefore seek to avoid either situation occurring.

Over franking and under franking

Over franking

Where the franking percentage for a distribution exceeds the benchmark percentage, the excess triggers over-franking tax. The tax is calculated as follows:

Amount of the frankable distribution x [franking percentage differential / applicable gross-up rate].

‘Franking differential percentage’ = the difference between the franking percentage for the relevant distribution and the benchmark franking percentage for the relevant franking period.

For example, ABC Pty Ltd makes a distribution to a sole shareholder of $7,000 to which 1,200 in franking credits are attached. The benchmark percentage for the remainder of the franking period is therefore set at 40% (i.e. franking credits of 1,200 / maximum franking credits of 3,000).

ABC Pty Ltd later in the same income year makes another distribution to the shareholder of $7,000 and attaches 2,100 in franking credits. The maximum franking credit is 3,000 (i.e. $7,000 x [1 / 2.3333]). The franking percentage is therefore 70% (2,100 being the franking credits attached to the distribution / 3,000 as the maximum franking credit).

Over-franking tax = $7,000 amount of frankable distribution x [30% franking percentage differential / 2.3333 as the applicable gross-up rate ]= $900.

In this instance, despite the company exceeding the benchmark percentage, the entirety of the franking credit attached to the over-franked distribution is valid for the shareholder and the over-franked amount will still be recognised as debit to the franking account. However, the $900 over-franking tax will be payable by the company within one month after income year end (i.e. 31 July). The tax payment will not be credited to the franking account. The tax is also not an offset that can be applied against the company income tax liability, nor is it deductible.

Under franking

Where the franking percentage for a distribution is less than the benchmark percentage the shortfall will result in an under-franking debit to the franking account. Essentially, this results in ‘wasted’ franking credits rather than a separate penalty tax to be paid. To calculate the under-franking debit refer to the formula used to calculate the over-franking tax.

There are some limited circumstances where the ATO may waive the above-listed penalties related to a departure from the benchmark percentage. For further detail, refer to Section 203-55 of the Income Tax Assessment Act 1997.

Franking Deficit Tax

Where the franking account is in a deficit balance (i.e. the opening balance less debits plus credits produces a negative amount) at the end of the income year, franking deficit tax will apply. (Note that a company is taken receive a refund of income tax in a particular year where the refund is paid within 3-months of year-end. This may prevent application of franking deficit tax in certain situations.)

The consequences of franking deficit tax include the following:

1. The company is liable for payment of the tax within one-month of the end of the income year (i.e. 31 July).
2. The company will obtain a credit at midnight on 30 June to ensure the franking account is brought to nil for the start of the next income year.
3. The franking deficit tax amount will be a non-refundable tax offset for the company. However, the offset entitlement will be reduced by 30% if the amount of the FDT exceeds 10% of total franking credits.

For example, in FY 2023-24 XYZ Pty Ltd has total franking credits of 100,000. The franking account balance was in a debit deficit of $5,000 at 30 June. The tax offset penalty reduction of 30% does not apply here as the deficit is only 5% (5,000 deficit / 100,000 franking credits) of the total franking credits that arose during the financial year.

If, on the other hand, the deficit was $15,000 at year end, the tax offset reduction of 30% would apply as the deficit is 15% (in excess of the 10% threshold). In this second example, the amount of franking deficit tax that could be utilised by the company as a tax offset is reduced by 30% to $10,500 (i.e. $15,000 (deficit) less 4,500 (30% of deficit)). In this scenario, the company is effectively penalised by losing entitlement to a tax offset of $4,500.

Franking deficit tax concessions

There is a special rule which prevents the 30% reduction where there is a franking account deficit due to the company being in its first year of operation. This is because a company will generally not have paid any PAYG instalments in its first year of operation and will therefore not have any credits built-up which may be attached to distributions. The conditions required for the special rule to apply include the following:

• The company is a private company.
• The company will have a tax liability.
• The company has not incurred at tax liability in a previous income year.
• The liability for income tax is greater than 90% of the franking account deficit.

The ATO also retains discretion not to enforce penalties where the 10% tolerance threshold is exceeded due to circumstances outside the control of the company. Relevant circumstances for consideration include:

• The company having a franking account debit that was unexpected and outside the control of the company.
• A franked distribution was not received at the usual time expected.
• The company has a sudden downturn in business leading to reduced PAYG instalments after the company had already distributed franked dividends.