A lot has been publicised about the dropping of the promised company tax rate cut in the 2012 budget and the negative effect of this on small business. But does the company tax rate really matter to most small business owners?
First we need to look at the fact that the vast majority of small business owners cannot afford to leave all the profits of the business in the company. Funnily enough they need to live so they pay themselves through dividends and/or salary. The interaction of the dividend imputation system and the tax system then, assuming that both the company and the owners are Australian tax residents, negates the effect of the corporate tax rate in favour of the individual tax rates, rendering a change in the corporate tax rate meaningless.
But what about those small business owners that have left profits in their company in the past to pay out dividends in retirement, surely a cut in the corporate tax rate would be a be win for them?
Not necessarily. Whilst a drop in the corporate tax rate may mean more mon ey left in the company to re-invest in the future, there is a negative effect on the payout of retained earnings that are already in the company and taxed in prior years at higher rates (the current 30%, or even prior corporate rates of up to 49% as the rate peaked in 1988). Surely this cannot be true? The reason ing comes in the imputation system and how the company tax paid on earnings is “credited” to the shareholder. The example below looks at $100 earned in a company when the corporate tax rate is 40%, meaning $60 is retained after $40 tax paid. This $60 is then paid as a fully franked dividend in a future year when the tax rate is 30% to a shareholder/taxpayer on the 31.5% person al tax rate.
The shareholder would need to include the $60 dividend plus the franking credit in their taxable income. The franking credit is worked out based on the tax rate when the dividend is paid rather than when the income was earned and as such the franking credit would, in this case, be $25.71. So $85.71 would be added to the taxable income of the shareholder, tax at 31.5% being $27.00 less the franking credit of $25.71, leaving an extra tax bill of $1.29. So although the company earned $100, the shareholder gained net on ly $58.71, paying over 40% tax despite being on a modest tax rate.
What if the corporate rate had not reduced to 30% but stayed at 40%, we must pity the poor “battler” here mustn’t we? Well maybe not. Keeping all the numbers the same for the above example except the changing corporate tax rate, whilst the shareholders taxable income increases by $100 rather than $85.71, they have $40 of imputation credits attached rather than $25.71. Tax on $100 at 31.5% being $31.50 less $40 in imputation credits, leaving the shareholder with a refund of $8.50 rather than a payable of $1.29. Here the shareholder gains net $68.50 after tax rather than the $58.71 in the reducing corporate tax rate example above.
By reducing the corporate tax rate by 10% our poor “battler” lost 14.3% of their after tax dividend.
I know that in the lower rate example the franking credits stay in the company to pay out later. But in a small business this is not always practical, and in the absence of an increasing corporate tax rate or untaxed income in the company (rare in small business), these “extra” tax credits end up being stockpiled, never able to be used and often lost on eventual wind up of the company.
Yet another example of the importance of discussing your financial affairs regularly with your Accountant at Jacoby Cameron & Co.
Martin White FCA
