Bills Digest No. 166 2001-02
New Business Tax System (Over-Franking Tax) Bill 2002
WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced
and does not canvass subsequent amendments. This Digest does not have
any official legal status. Other sources should be consulted to determine
the subsequent official status of the Bill.
CONTENTS
Passage History
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer & Copyright Details
Passage History
New Business
Tax System (Imputation) Bill 2002
New Business
Tax System (Over-Franking Tax) Bill 2002
New Business
Tax System (Franking Deficit Tax) Bill 2002
Date Introduced:
30 May 2002
House:
House of Representatives
Portfolio:
Treasury
Commencement:
On the day the Acts receives Royal Assent.
The measures take effect from 1 July 2002.
Purpose:
The package of Bills comprising the New
Business Tax System (Imputation) Bill 2002 (the Imputation Bill),
the New
Business Tax System (Over-Franking Tax) Bill 2002 (the Over-Franking
Tax Bill) and the New
Business Tax System (Franking Deficit Tax) Bill 2002 (the Franking
Deficit Tax Bill) introduce a new simplified imputation system.
The Imputation Bill includes proposed measures in three
Schedules.
- Schedule 1 inserts proposed Part 3-6 – The imputation system
into the Income Tax Assessment Act 1997 (ITAA 1997) which
applies to events that occur on or after 1 July 2002 under proposed
section 201-5.
- Schedule 2 has consequential amendments to the Dictionary of
the ITAA 1997 and takes effect under section 2 of the Imputation Bill
when it receives Royal Assent.
- Schedule 3 includes transitional provisions and provides for
Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936)
which deals with the current imputation system to cease to apply to
events that occur on or after 1 July 2002.
The Over-franking Bill provides a mechanism that ensures
that companies frank distributions in accordance with the benchmark rule.
The Franking Deficit Bill ensures that a company makes
good the over-imputation of franking credits that it makes to its shareholders
when making franked dividends to them.
In the words of the joint Explanatory
Memorandum to the three Bills (paragraph 1.18) the changes are mainly
to the mechanics of the imputation system and not to its outcome:
Whilst the new imputation system changes the mechanics
of the current system, the new imputation provisions will generally
provide the same outcome as the current imputation system.(1)
The Explanatory Memorandum also states that new imputation system will
have no revenue impact.(2)
The imputation system is the mechanism in taxation
law which enables income tax paid by a corporate tax entity to be passed
on to its members. It was first inserted into tax law in 1987.(3)
It is through this system that members of a corporate tax entity obtain
a credit for the underlying company tax paid on the company profits that
have been distributed to them. This credit, called an imputation credit,
gives rise to a franking rebate. Members use this franking rebate to reduce
their income tax liability. The imputation system prevents the
double taxation of income earned and distributed by corporate tax entities.
Without the imputation system, income tax would be levied when income
is earned by the entity and then again in the hands of the members when
it is distributed to them.
The way in which the corporate tax entity passes the
income tax paid by it to its members is by franking (in the sense of stamping
or marking) the distribution. Only frankable distributions may be franked.
In order to frank (that is, allocate franking credits to a distribution),
a corporate tax entity is required to maintain a franking account.
The tax credits that can be imputed to members are recorded
in the entity’s franking account as franking credits. Franking credits
generally reflect income tax paid by the entity, or underlying tax paid
through other corporate entities that is imputed to it.
Subject to anti-avoidance rules, resident individuals,
superannuation entities, registered charities and deductible gift organisations
are eligible for refunds of excess imputation credits to the extent that
imputation credits exceed tax payable by these entities.
The rules around franking a distribution and franking
accounts, and some of the anti-streaming rules, apply to corporate tax
entities only. Corporate tax entities are companies, corporate limited
partnerships, corporate unit trusts and public trading trusts. These entities
are taxed separately from their members and are taxed at the company tax
rate.
The rules on the tax effects of receiving a franked distribution
apply to all entities, including individuals, corporate tax entities and
superannuation entities.
It will be noted that corporate tax entities do not include
partnerships and trusts (which are not corporate unit trusts and public
trading trusts).
A key proposal in the
Tax Reform: not a new tax a new tax system (4)
(the ANTS package) issued by the Government in August 1998 to ensure fairness
and integrity in the tax system with the introduction of the goods and
services tax (GST) was the implementation of a unified entity regime (UER).
This reform has been referred to by various names, including "entity
taxation", "tax entity regime" "unified entity regime"
and "consistent entity regime". The simplified imputation system,
a significant component of the UER, was to apply to all entity distributions
including trust and partnership distributions so that the tax paid by
the entity was attributed to the recipients of the distributions.
The consequences of the differential treatment of entities
and the inconsistent treatment of distributions and the need for reform
was stated in the ANTS package as follows:
Taxation of business entities is inconsistent
The taxation of business entities requires reform
across three key problem areas: inconsistent entity treatment; inappropriate
taxation of company groups; and inconsistent treatment of distributions.
Different treatment of entities produces unfair outcomes
Under current law, vastly different treatment is
accorded to investment income channelled through different entities.
The treatment is different both between the various entities and at
the individual investor (eg shareholder) level.
Companies, fixed trusts, and discretionary trusts
all offer investors the prospect of limited liability – shielding
them from full personal liability for making good the entities’ financial
liabilities. And yet there is very different treatment across these
entities of distributions out of profits freed from taxation by tax
preferences (‘tax-preferred’ income). Such distributions by companies
(ie franked dividends) are taxed in the hands of individual resident
shareholders. In the case of fixed trusts these distributions
are generally taxed with a delay when the interests in the trust are
sold. With discretionary trusts the distributions are not taxed
at all. The beneficiaries of discretionary trusts enjoy ‘the best
of both worlds’, benefiting from both limited liability and the flow-through
of tax preferences.
Sole traders and partners in partnerships are able
to access tax-preferred income but they bear liability for losses
of their businesses (unless in limited partnerships); that is, they
do not have limited liability arising from the entity.
Some co-operatives are taxed differently again
from companies under complex arrangements that can result in different
outcomes depending on the timing of distributions.
The treatment of life insurance investments are unlikely
to be taxed at the policyholder’s marginal tax rate. different tax
rates apply to life insurers depending on the type of institution
offering the policy, the nature of the policy and the investor.(5)
The A
Tax System Redesigned (6)which was a report by a committee
chaired by Mr John Ralph following a review of business taxation in Australia
(Ralph Review) recommended the implementation of the UER. In the context
of the UER the Ralph Review recommended a broad definition of distribution
to enhance the integrity of the tax system. In its Overview it stated:
A broad definition of distribution is the simplest
and most equitable means of taxing benefits provided by entities to
members. Such a definition adds integrity to the tax system as it
restricts the situations in which value can be shifted from an entity
to a member without being subject to tax. The recommended definition
will apply to the provision of loans, or goods and services, at less
than fair value.(7)
In a Press
Release of 21 September 1999 the Treasurer, the Hon. Peter
Costello, indicated in
Attachment K that the implementation of the entity tax regime (which
was a key recommendation in the Review of Business Taxation) will provide
for a more consistent taxation of business entities and their members,
while being fairer, simpler and having greater integrity. However, in
the light of other pressures on business, the commencement of this measure
was deferred to 1 July 2001.
The need for a change to the UER including a simplified
imputation system was to remove inconsistencies in the current arrangements
which did not contribute to the equity of the tax system. Further, the
non taxation of certain benefits paid by companies and trusts presented
an opportunity for tax avoidance. This was stated by the Treasurer in
Attachment K of his Press Release of 21 September 1999 as follows.
The recommendation of the Review to adopt a comprehensive
definition of distribution from entities will improve the fairness
of the tax system by ensuring, among other things, that benefits provided
by companies to shareholders and by trusts to beneficiaries are subject
to tax.
… … …
The current arrangements are characterised by an
inconsistent treatment of entity distributions, no coherent approach
for dealing with groups of wholly owned entities, and a lack of integrity
in the treatment of inter-entity distributions. A New Tax System
proposed reforms to address these problems, with implementation
from the 2000-01 income year.
In a Press
Release of 11 November 1999, the Treasurer reiterated that the unified
entity tax regime will commence on 1 July 2001.
On 11 October 2000 the Treasurer issued an exposure
draft of the New Business Tax System (Entity Taxation) Bill 2000 for
implementing the UER and the simplified imputation rules. In Press
Release No 095 of the same date titled – Taxing Trusts Like Companies
and Simplified Imputation rules – it was emphasised that the proposed
legislation will introduce greater consistency into the taxation of entities
and achieve the objectives outlined in the ANTS package.
This legislation will implement the Government’s
policy, which was announced in A New Tax System, of introducing
greater consistency in the taxation of entities.
There has been extensive consultation in the development
of this legislation. The exposure draft will provide further opportunity
for comment on the operation of the new arrangements. The exposure
draft legislation also covers the simplified imputation system and
franking credits for foreign dividend withholding tax, and an accompanying
explanatory statement.
The proposed legislation for taxing trusts like companies
achieves the objective of greater consistency in the taxation of entities
while minimising compliance and restructuring costs. Under this approach,
non fixed trusts will be taxed like companies. Broadly, companies,
fixed trusts, limited partnerships and co-operatives will retain their
current tax treatment. This approach removes the requirement for the
introduction of a collective investment vehicle regime.
On 27
February 2001, the Government withdrew the exposure draft of the New
Business Tax System (Entity Taxation) Bill 2000 conceding that it was
"not workable" and that the Government would look at alternative
approaches.
However, announcing a revised timetable of Business Tax
Reform in a Press
Release of 22 March 2001, the Treasurer stated that the Government
will not be proceeding with draft legislation on entity taxation. It would
therefore appear from the revised timetable that Government has no intention
to resurrect the entity tax regime in the life of this Parliament. Referring
to the simplified imputation system from 1 July 2002 he stated:
The exposure draft legislation on entity taxation
also contained provisions for simplifying the imputation system, including
imputation credits for foreign dividend withholding tax. The consultation
process has raised several issues and options which could reduce compliance
costs. In giving close consideration to these, the Government recognises
that sufficient advance notice and certainty of the detail of the
final arrangements is necessary for taxpayers and accordingly will
defer their commencement.
The ANTS package envisaged a full franking system where
all distributions to members of an entity would be subject to tax at the
company rate. In the case of distributions out of taxable income the entity
would have paid tax at the company tax rate and this tax would be imputed
to the members. Where the distribution is out of profits which has not
been subject to tax at the entity level such distributions would also
be taxed at the entity level at the company tax rate and be called the
‘deferred company tax’. Thus the entity tax paid on taxable income as
well as the deferred company tax paid on distributions out of non-taxable
income would be imputed to members of the entity. Under the simplified
imputation system the entity tax so paid would be creditable to individual
shareholders, beneficiaries, members of co-operatives or policy holders.
The case for a full franking system was made in the ANTS
package as follows:
There is considerable complexity in the present system
caused by dividends being either franked or unfranked depending on
whether they are paid out of taxable income or not. Virtually all
company profits are taxed. But only taxable income is subject to company
tax (with distributions of these taxed profits being franked). Other
tax-preferred profits are taxed in the hands of individual shareholders
as unfranked dividends when distributed.
Under a full franking system, taxable income would,
as now for companies, be subject to company tax. In contrast to current
arrangements, however, distributions of other profits, would be taxed
(at the company tax rate) at the entity level, rather than at the
shareholder level. This deferred company tax would subject distributed
tax-preferred income to tax at the entity level so that all distributions
of profit would then be franked.(8)
The proposal for a deferred company tax on distributions
other than from taxable profits was dropped following the Ralph Review
which recommended against it This was mainly on the grounds that it would
impact adversely on after-tax profits of Australian companies and consequently
adversely affect share prices and the ability of companies to raise capital.(9)
The imputation system introduced by the three Bills would
continue the complexities that flow from the existence of franked and
unfranked dividends which the ANTS proposal sought to eliminate.
On
24 May 2002, the Minister for Revenue and Assistant Treasurer announced
in Press Release No. C57/02, the Government’s program for delivering the
next stage of business tax reform measures. In that press release, the
Minister confirmed that the simplified imputation system will commence
on 1 July 2002.
This
section of the Digest highlights the more significant provisions which
bring about changes to the current imputation system. To appreciate the
changes it is necessary to know what additional objects the simplified
imputation system is to serve over and above those served by the current
imputation system
The Explanatory Memorandum in paragraph 1.20 states that
the new imputation system introduced by the three Bills have the additional
objectives of ensuring that:
- the imputation system is not used to give the benefit of income tax
paid by a corporate tax entity to members who do not have a sufficient
economic interest in the entity
- the imputation system is not used to prefer some members over others
when passing on the benefits of having paid income tax, and
- the membership of the corporate tax entity is not manipulated to create
either of the above outcomes.
The Explanatory Memorandum sets out succinctly explanations
of the main provisions of the three Bills and the reader is invited to
refer to the EM for greater details.
The simplified imputation system will apply to a corporate
tax entity defined in section 960-115 of the ITAA 1997.
A corporate tax entity is:
- a company
- a corporate limited partnership in relation to the income year
- a corporate unit trust in relation to the income year, or
- a public trading trust in relation to the income year.
The following entities are not corporate tax entities:
- a non-fixed trust
- a fixed trust (other than a corporate unit trust or a public trading
trust)
- a complying superannuation fund
- a complying approved deposit fund, and
- a pooled superannuation trust.
It will thus be seen that partnerships (other than limited
partnerships) and trusts (other than corporate unit trusts and public
trading trusts) are not covered by the simplified imputation system.
Under the current imputation rules a company that has
an early balance date (ie in lieu of the next succeeding 30 June) has
a franking year that is aligned to its income year. A company that has
a late balance date (ie in lieu of the preceding 30 June) has a franking
year that ends on 30 June. This disparate treatment of companies that
have a late balance date has lead to unnecessary complexities.
Proposed section 203-40 deals with the franking
period rules for an entity that is not a private company. It will
result in all corporate tax entities having a franking year that is aligned
with its income year and will remove the complexities that arise to companies
with late balancing dates. The franking periods are generally for six
months and frankable distributions made during such six month periods
must be franked to the same extent.
Proposed section 203-45 provides that the franking
period for an entity that is a private company is the same as the income
year.
Proposed Division 205 deals with franking accounts.
It:
- creates a franking account for each entity that is, or has been, a
corporate tax entity
- identifies when franking credits and debits arise in those accounts
and the amount of those credits and debits
- identifies when there is a franking surplus or deficit in the account,
and
- creates a liability to pay franking deficit tax if the account is
in deficit at certain times.
These rules essentially replicate the rules relating
to franking credits and debits in the current law. The most significant
departures from the current law are that:
- entries are to be recorded on a tax paid basis rather than an after-tax
distributable profits basis, and
- the franking account will operate on a rolling balance account rather
than an yearly account with an annual balance transfer.
Under the current system a company credits its after-tax
profit available for distribution to its Franking Account. Thus if a company
derives a taxable profit of $100 and pays tax of $30, at a rate of 30%,
it would credit its Franking Account by $70. The current system operates
on a qualified dividend account basis or taxed income basis.
To accommodate the changes in company tax rate over time companies at
present maintain a number of different classes of franking accounts and
must carry out a number of complex conversions.
To avoid these complex conversions the new imputation
provisions in proposed Division 205 provide that a franking account
will record franking credits on a tax-paid basis. Thus if a company
paid income tax of $30 the corresponding franking credit will be $30.
Corporate entities will not have to convert entries in the franking account
to reflect taxed income.
Under proposed item 5 in the table in section 205-15
a franking credit will arise if an entity incurs liability for franking
deficit tax. The credit arises by incurring liability for, rather than
payment of, franking deficit tax. Further, the balance of the account
at the end of the year is brought forward to the beginning of the next
income year whether the account is in surplus or deficit. The effect of
the proposed measure is that the franking account will operate as a rolling
balance account compared to the current imputation rules that require
companies to establish new franking accounts from one franking year to
the next.
Under the current franking rules a company is required
to frank a dividend to the maximum extent possible having regard to the
surplus in its franking account at the time of its payment. The current
system also permits a company to allocate franking credits representing
tax paid on behalf of all members of an entity to only some of them.
Proposed Division 203 introduces a benchmark
rule where a corporate tax entity must frank all frankable distributions
made within a franking period at a franking percentage set as a benchmark
for that period. The rule for determining the franking percentage is set
out in proposed section 203-35. The franking percentage
of a distribution is calculated as follows:
100 x Franking credit allocated to the frankable
distribution/maximum franking credit for that distribution
Proposed subsection 202-60(2) ensures that as
in the current law an entity cannot allocate a greater franking credit
to a distribution than tax paid by the corporate tax entity on its underlying
profits.
Proposed section 203-15 states that the object
of Subdivision 203-15 is to ensure that one member of a corporate tax
entity is not preferred over another when the entity franks distributions.
The Explanatory Memorandum in paragraph 2.48 elaborates on this further
and states that the object of the benchmark is to discourage ‘dividend
streaming’ as follows:
It is a fundamental principle of the imputation system
that corporate tax entities should not be able to direct franked and
unfranked distributions to members in a way that maximises the benefits
to members. Otherwise the cost to revenue would be higher that originally
intended. Instead the benchmark rule ensures that, over time, the
benefit of franking credits is spread more or less evenly across members
in proportion to their ownership interest in the entity.(10)
The benchmark rule is therefore directed at dividend
streaming and the proposed measures include penalties for the breach of
the benchmark rule as discussed below. The anti-streaming rules are dealt
with in proposed Division 204.
Proposed subsection 203-20(2) provides that the
benchmark rule does not apply to a company if at all times during the
franking period, the company is a listed public company with a single
class of membership interest.
Commissioner’s powers to permit a departure from
the benchmark rule
Proposed section 203-55 gives the Commissioner
of Taxation (the Commissioner) the power to permit a departure from the
benchmark rule in extraordinary circumstances by a determination made
either before or after the frankable distribution is made. The entity
must make its application in writing under proposed subsection 203-55(6).
If the entity or a member of the entity is dissatisfied with the determination
of the Commissioner, the entity or member may under proposed subsection
203-55(7) object to it in the manner set out in Part IVC of the Taxation
Administration Act 1953.
Penalties for breach of the benchmark rule
A breach of the benchmark rule will not invalidate the
allocation of franking credits made to the distribution. However it will
result in a penalty to the corporate tax entity. The penalty is calculated
by reference to the difference between the franking credits actually allocated
and the benchmark percentage. The penalty is under proposed subsection
203-50(1) either:
- over-franking tax, if the franking percentage for the distribution
exceeds the benchmark franking percentage, or
- a franking debit (penalty debit), if the franking percentage for the
distribution is less than the benchmark franking percentage.
The over-franking tax is imposed by measures in the proposed
New Business Tax System (Over-franking Tax) Bill 2002.
A franking debit is equivalent to the extra franking
credit that should have been allocated according to the benchmark rule.
The additional debit cancels the unused credit. In consequence, if a franking
account is in deficit on the last day of an income year, the entity will
be liable to pay franking deficit tax under the proposed New Business
Tax System (Franking Deficit Tax) Bill 2002.
The benchmark rule sets the framework for ensuring that
over time the benefit of franking credits is spread more or less evenly
across members in proportion to their ownership interest in the entity.
The anti-streaming rules in proposed Division 204 are intended
to prevent the benchmark rule being undermined. The four specific rules
designed to prevent anti-streaming are as follows.
- Proposed Subdivision 204-B deals with linked distributions
and prevents the exploitation of a corporate tax entity’s benchmark
percentage by another corporate tax entity, or that other entity’s members,
by imposing a franking debit where there is exploitation. This rule
is based on subsections 160AQCB(3) and (4A) of the ITAA 1936 of the
current imputation system
- Proposed Subdivision 204-C prevents the substitution of a tax-exempt
bonus share for a franked distribution by imposing a franking debit
on the issue of the share as if it were a franked distribution. This
rule is based on subsection 160AQCB(2) of the ITAA 1936 of the current
imputation system
- Proposed Subdivision 204-D prevents the streaming of imputation
benefits to one member of a corporate entity in preference to another
by either imposing a franking debit or denying an imputation benefit
where there is streaming. This rule replicates section 160AQCBA of the
ITAA 1936, and
- Proposed Subdivision 204-E requires an entity to notify the
Commissioner where there is a significant difference in its benchmark
franking percentage over time, so that the Commissioner can assess whether
there is streaming. This is a new disclosure rule
The current tax system has 2 different mechanisms that
are designed to prevent the double taxation of company profits, namely:
- an intercorporate dividend rebate for companies and entities taxed
like companies, and
- a gross-up and credit approach for all other entities.
The provisions in proposed Subdivision 207-A of Division 207
are intended to ensure greater integrity and consistency by bringing
corporate tax entities receiving franked distributions wholly within the
imputation system instead of relying on the intercorporate dividend rebate
in section 46 of the ITAA 1936. The new imputation system will provide
a single rebate/tax offset mechanism, to prevent double taxation of company
profits, which is consistent across all entities. It will achieve this
by using a gross-up and credit approach that is consistent with
that currently used by individuals, superannuation funds and trustees
assessed under Division 6 of the ITAA 1936.
Proposed section 207-20 sets out the general rule
of grossing-up and tax offset as follows:
(1) If an entity makes a franked distribution to
another entity, the assessable income of the receiving entity, for
the income year in which the distribution is made, includes the amount
of the franking credit on the distribution. This is in addition to
any other amount included in the receiving entity’s assessable income
in relation to the distribution under any other provision of this
Act.
(2) The receiving entity is entitled to a tax offset
for the income year in which the distribution is made. The tax offset
is equal to the franking credit on the distribution.
Proposed Subdivision 207-B sets out the effect
of receiving a franked distribution through certain partnerships and trusts.
Under these provisions:
- a franked distribution to certain partnerships and trusts is treated
as flowing indirectly to members of the partnership or trust
- each member’s share of the franking credit on the distribution is
included in that members assessable income
- each member is then given a tax offset equal to that share of the
franking credit, provided the member is not itself a partnership or
trust through which the distribution flows indirectly, and
- where the trustee, rather than a member, is the taxpayer on a share
of the distribution, it is the trustee in that capacity who is given
the tax offset under this Subdivision.
Some recipients of a franked distribution must satisfy
a residency requirement under proposed Subdivision 207-C if their
assessable income is to include the franking credit on the distribution,
and they are to be entitled to a tax offset, under the general rule.
Proposed section 207-75 provides that if an entity
mentioned below is resident in Australia at the time a franked distribution
is made it is entitled to the gross-up and tax offset:
(a) an individual;
(b) a company;
(c) corporate limited partnership;
(d) corporate unit trust; and
(e) a public trading trust.
It is arguable whether the simplified imputation system
proposed to be put in place into the Income Tax Assessment Act 1997
by the three Bills is anything more than a tax law improvement project.
The imputation system as envisaged under the Exposure Draft released in
October 2000 as an important component of the unified entity regime (UER)
would have been properly classified as a New Business Tax System reform
measure. However, given the abandonment of the UER by Government in February
2001 any claims that the proposed simplified imputation system is a true
tax reform measure cannot be supported. This is particularly the case
as the Explanatory Memorandum states in paragraph 1.18 that the new imputation
system changes the mechanics of the current system and will provide the
same outcome as the current imputation system
Further, it is clear that the simplified imputation system
as proposed by the three Bills is not comprehensive. The Explanatory Memorandum
states in paragraph 1.4 that further rules are to be included in a later
bill and deal with largely with consequential amendments. It envisages
that further amending legislation will be required to cover rules relating
to:
- venture capital franking
- life insurance and exemption companies
- share capital tainting
- holding period and related payment rules, and
- certain transitional and machinery provisions.
- The joint Explanatory Memorandum to the New Business Tax System (Imputation)
Bill 2002; the New Business Tax System (Over-franking Tax) Bill 2002
and the New Business Tax System (Franking Deficit Tax) Bill 2002 (the
Explanatory Memorandum); paragraph 1.18.
- ibid., p. 3.
- Taxation Laws Amendment (Company Distributions) Act 1987 inserted
Part 111AA to the ITAA 1935 dealing with franking of dividends.
- Tax Reform: not a new tax; a new tax system: The Howard Government’s
Plan for a New Tax System (ANTS package); Circulated by the Hon.
Peter Costello MP, Treasurer of the Commonwealth of Australia (AGPS)
August 1998.
- ibid., p. 109.
- Publication: Review
of Business Taxation - A Tax System Redesigned, (Ralph Review).
- ibid., Overview ; para. 289, p. 64.
- ANTS package, p. 116.
- Ralph Review; Overview para.281, p. 62.
- Explanatory Memorandum; para. 2.48, p. 24.
Bernard Pulle
18 June 2002
Bills Digest Service
Information and Research Services
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