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New company tax franking implications

The recent cut to the tax rate for small incorporated businesses, while generally welcomed, can bring with it some important  considerations when it comes to distributing franked dividends.

The rate change to 28.5%, which applies from July 1, 2015, 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 and means that you’re using up franking credits faster than you normally would expect. Consider the example below.

 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 at year end could look as follows on the basis that tax is paid at 28.5%:

 DRCRBalance
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 (referred to as “over-franking”). Consequently, it will be liable to pay franking deficit tax (FDT) of $2.14.

The FDT represents a prepayment of income tax rather than a penalty payment. A tax offset for any FDT that has been incurred is generally available to the company.

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.

Is there penalty taxes if a company over-franks?

Yes. A 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. This is sometimes 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 (that is, $2.14 x 70%).

The calculations and implications can be complicated, so please contact TNR if you need assistance.