New company tax rate — beware of franking implications

TaxJarInsideThe recent cut to the tax rate for small incorporated businesses, while generally very welcome, can bring with it some important considerations when it comes to making franked distributions.

The rate change to 28.5% means that small businesses could easily frank dividends in excess of the underlying taxes paid on their profits and “overdraw” on their franking account.  While the rate has decreased, small companies are still entitled to frank dividends at a maximum 30% rate. The arbitrage between the new tax rate and maximum franking rate may trip up the unwary.

Consider the following example:

  • ABC Co Pty Ltd derives $100 of taxable income for the income year.  Assume that the tax is paid before year end.
  • The company’s after-tax income is paid as a fully franked divided to Dexter, a sole shareholder of the company.  Assume that the dividend was paid before year end.
  • Dexter is taxed at the current top marginal rate (ie. 47% plus 2% Medicare Levy).
Previous tax rate (30%) New tax rate (28.5%)
Company level – ABC Co Pty Ltd
Taxable income $100 $100
Tax on taxable income $30 $28.50
Profit after tax available for distribution $70 $71.50
Shareholder level – Dexter
Dividend $70 $71.50
Add: Franking credit gross-up $30 $30.64*
Taxable income $100 $102.14
Tax on taxable income
(at 47% plus 2% Medicare levy)
$49 $50.05
Less: Franking offset $30 $30.64
Net tax payable $19 $19.41

*$71.50 x 30/70

Theoretically, assuming that there is a nil balance in the franking account at the start of the year, ABC Co’s franking account could look as follows on the basis that tax is paid at 28.5%:

DR CR Balance
Tax paid $28.50 $28.50 CR
Franked distribution $30.64 $2.14 DR

What does a franking debit at year end mean?
In the above scenario, there is a franking debit at year-end of $2.14.

In simple terms, this means that the company has franked more dividends to its shareholders than the tax that it has paid.  This is referred to as “over-franking”.  Consequently, it will be liable to pay franking deficit tax (FDT) of $2.14.

Generally, a tax offset for any FDT that has been incurred is available. Use of the “FDT offset” however indicates that the FDT is merely a prepayment of income tax rather than a penalty payment.

Be aware however that this FDT offset is applied against the company’s tax liability after all other tax offsets have been applied, such as foreign income tax offsets.  Any excess unused FDT offsets may also be carried forward and applied against a future tax liability of the company.

It is important to note that an FDT penalty may apply where there is excessive “over-franking” – referred to as over-franking tax.  Broadly speaking, this occurs in cases where the FDT exceeds 10% of the total franking credits arising in the income year (see how this is worked out here).  This is commonly referred to as the “10% rule”.

Where this happens, the FDT offset is reduced by 30% as a penalty.  Put another way, the tax offset is 70% of the FDT amount and the remaining 30% is never set against the income tax liability as a tax offset. In the above example, the available offset would be limited to $1.50 (ie. $2.14 x 70%).

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