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Lecture 3

Lecture 3 - Companies

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Queensland University of Technology

LECTURE 3 - COMPANIES What is a company?  A company is defined in as: (S 995-1 ITAA 1997) (a) A body corporate; or (b) Any unincorporated association or body of persons, but does not include a partnership. o Includes a club, association or society (including non-profit)  A company is a separate legal entity. o Hence, it has a taxable income. It pays incometax in its own right on its taxable income.  In the company tax return, the company includes its assessable income and deducts its allowable deductions on the basis that it is a resident taxpayer. o Includes both Australian and foreign-sourced income and deductions. The advantages and disadvantages of companies Advantages  Limited liability  Unlimited life – perpetual succession  Control of the company’s assets can be separated from the distribution of income;  Different dividends can be paid on different types/classes of shares;  Companies may have different rebate/offset entitlements from individuals;  Companies can claim a deduction for salaries paid to all employees including owners and superannuation contributions paid on behalf of all employees including owners; and  Companies have flexible fundraising options (eg. Easier borrow facilities, ability to sell more shares). o Debt financing requires guarantees Disadvantages  Strong legal obligations required to be met in order to establish a company;  Ongoing legal obligations;  Ongoing accounting and record-keeping obligations;  Obligations on the directors of companies with severe penalties for breach;  Relatively complex taxationand recording requirements;  No tax-free threshold; and  Subject to rules restricting its ability to carry forward losses and bad debts (such as the continuity of ownership test or same business test). How is a company taxed?  Taxable income is determined by including its assessable income and deducting its allowable deductions on the basis that it is a resident taxpayer.  However, thereare some differences: o Companies pay tax at a flatrate of 30%; o No tax-free threshold; o Companies do not pay the1.5% Medicare levy nor the 1% Medicare levy surcharge; o Companies do not get many of the rebates that individuals do (eg. Spouse rebate, invalid relative rebate, zone rebate, net medical expense rebate); o A company is subject to rules restricting its ability to carry forward tax losses and bad debts; o The debt/equity rules specifically apply to companies (Div 974ITAA 1997); o Thesubstantiationrulesforcar,travelandotherexpensesdo not apply to companies; o A company must appoint a public officer to sign income tax returns and deal with the ATO on behalf of the company;(S252ITAA1936) o Companies are not eligible for the CGT discount method;  Have access to awide range of CGT rollover relief provisions; and o Only companies are eligible for the 125% and 175% research and development tax concessions (Ss 73b to 73z ITAA 1936). Classification of Companies – Public or Private?  A private (or proprietary) company under company law can be a public company for taxation purposes and vice versa.  A private company is one that is not a public company in relation to the yearof income (S103A(1) ITAA 1936).  A company is a public company if (S 103A(2) ITAA 1936): o Its shares were listed on a stock exchange (anywhere)on the last day of the income year; o Or being a subsidiary of a public company o Despite being listed, a company will not be a public company where at any time during the income year 20 or fewer persons held 75% or more of the company's capital, voting or dividend rights; o A subsidiary of a listed public company (S 103a(4)); o A non-profit company; o A mutual life assurance company; o A friendly society; o A registered organisation; or o A statutory body or a company in which a government body established for public purposes had a controlling interest on the last day of the year of income. Why is the Distinction Important?  The distinction between a public and a private is important for the following reasons: (a) Excessive payments made by private companies to their shareholders, directors or associates may be treated as unfranked dividends and disallowed as a deduction to the company (S 109 ITAA 1936 and 26-35 ITAA 1997); (b) The Commissioner applies more stringent rules to a private company in respect of other benefits (eg. Loans, debts forgiven etc.) For shareholders and associates (Division 7A); (c) The continuity of ownership tests are not as strict for public companies (S 165-165(7)); (d) The benchmark franking rules differ for private companies because a private company only has one franking period compared to two in the case of a public company; and (e) The timing for issuing dividend (or distribution) statements. Residency of Companies  A company is considered to be a resident of Australia if it is (S 6-1 ITAA 1936): (a) Incorporated in Australia; or (b) Not incorporated in Australia, but carries on business in Australia and has its central management and control in Australia; or (c) Not incorporated in Australia, but carries on business in Australia and has its voting power controlled by shareholders who are residents of Australia. Test 1 Is the company incorporated in Australia? Yes No RESIDENT Does the company carry on business in Australia? Yes Test 2 No Yes Is the central management and control in NON-RESIDENT Australia? No Yes Is the voting power controlled by resident No Australian shareholders? st 1 Test  A company is automatically considered a resident for Australian taxation purposes if it is incorporated in Australia. (S 6(1)) 2 Test  If a company is not incorporated in Australia, it is only regarded as a resident for Australian taxation purposes under the second test if it carries on business in Australian and its central management and control is based in Australia. o A company’s central management and control is generally based on where the directors meets and make decisions regarding the company  The location of central management and control is a question of fact.  A key factor is the place where the directors meet to manage the company's affairs  This is only policy decisions – NOT operating decisions  A company carries on business in Australia where it trades and derives its business profits, not necessarily where its central management and control is located. The two termsare independent of each other. 3 Test  A company is a resident for Australian taxation purposes if it carries on business in Australian and its voting power is controlled by shareholders who are residents of Australia. o Control normally =more than 50% o In determining the control of voting power, it may be necessary to have regard to all voting rights, not necessarily just those attached to issued shares Calculation of a Company’s Taxable Income Foreign Income  Where a resident Australian company receives foreign income (eg. interest or dividend income), it must include the gross amount in its assessable income. o The company must gross-up of the amount of the foreign income by the foreign withholding tax deducted (S 128D).  Whilst the company includes the gross amount of foreign income in its assessable income and pays Australian tax (@ 30%) on this amount, it is entitled to a tax offset (or credit) for this amount (Ss 770-10; 770-70 and 770- 75). Franked Dividends  Where an Australian resident company receives a franked dividend, it must include not only the amount of the dividend in its assessable income (S 44(1)(a) ITAA 1936), but also the franking (or imputation) credit (S 207-20(1) ITAA 1997) o However, whilst the company is entitled to a credit in respect of the franking (or imputation credits), unlike other shareholders, excess imputation credits are not refundable to companies (S 67-25 of the ITAA 1997).  Franking credit = franked dividend x 30/70 x % franked Company Losses  Tax loss = allowable deductions exceed assessable income. o Company has a negative taxable income (Division 36 ITAA 1997)  A tax loss incurred in one income year may be carried forward and deducted in arriving at the taxpayer's taxable income of succeeding income years. o A tax loss may be carried forward indefinitely until it is absorbed or exhausted (Case W52 89 ATC 486).  A company cannot carry forward prior year losses for offset against future years’ income unless it satisfies either (S 165-10 ITAA 1997): (a) The “continuity of ownership test” (S 165-12); or (b) The “same business test” (S 165-13).  The tests must be applied in this order. If the “continuity of ownership test” is satisfied, then there is no need to consider the “same business test”. o However, if the “continuity of ownership test” is failed, then the “same business test” can be considered. Continuity of Ownership Test  The “continuity of ownership test” requires that the same persons own the same shares that gave them more than 50% of the voting power, rights to dividends, and rights to capital distributions at all times during the “ownership test period time” (S 165-12).  The ownership test period time is the period from the start of the loss year to the end of the income year. Primary Test  The primary test applies where all shares are beneficially owned by individuals. o This primary test applies to tax losses, net capital losses and bad debt deductions after 21 September 1999.  In order to pass the continuity of ownership test, the company must demonstrate that the same shareholders who owned more than 50% of the voting power, rights to dividends, and capital rights in the company at the start of the loss year (ie. the start of the income year in which the loss was incurred) continue to own more than 50% in the company at all times until the end of the income year in which the brought forward loss is to be used. Secondary Test  There is an alternative test which applies where the company is beneficially owned by individuals through an interposed company or companies.  The “trace through” or “alternative test” is satisfied if it is reasonable to assume that there are persons who between them at all times during the ownership period are able to (S 165-12(6)): o Control the voting power; o Receive more than 50% of any dividend paid; and o Receive more than 50% of any distribution of capital.  A “person” includes a company and although the Act states “persons”, the test can be satisfied by a single person (S 165-175).  The continuity of ownership test (both the primary and alternative tests) requires the same people to control more than 50% of the voting power of the company (S 165-15) Same Business Test  If a company fails the “continuity of ownership test”, it may still be able to deduct a tax loss from an earlier income year if it satisfies the “same business test” (S 165-13).  A company satisfies the “same business test” if it carries on the same business throughout a year of income as it carried on immediately before the change in ownership. (S 165-210(1)).  To satisfy the same business test, the company must not derive assessable income from a business or transaction of a kind in which it did not engage in prior to the change in ownership of the shares (S 165-210(2)). o A company cannot commence a business or initiate a transaction in order to meet the same business test (S 165-210(3)). Rules on How Tax Losses are Deducted  If a company passes either the “continuity of ownership test” or “same business test”, then it is able to offset its carry-forward tax losses against the taxable income for the current year. o Losses are recouped on a first-in, first-out basis.  Companies can choose how much of a tax loss they wish to recoup in the current year. There are two reasons why a company would not want to recoup the entire tax loss equivalent to their taxable income. (a) Companies do not have to use up tax losses against fully franked dividends received, which is effectively tax-free when received by a company. Companies are able to choose how much of the tax loss they wish to offset against the current year’s taxable income so as to take advantage of the franking credit that flows from the franked dividend. (b) Companies will be able to identify the otherwise wasted tax loss by reference to the amount of any unused franking tax offset as part of the calculation of income tax payable for a year of income. The excess franking credit will be converted back to the equivalent amount of tax loss allowed to be carried forward as a prior year loss and considered for deduction in a later year of income. o This will ensure that companies do not lose the benefit of unused franking credits which are not refundable to companies. What is a dividend?  A “dividend” is defined to include: (a) Any distribution made by a company to any of its shareholders, whether in money or other property; or (b) Any amount credited by a company to any of its shareholders as shareholders (S 6(1) ITAA 1936). o Dividends can include cash, dividend reinvestment or bonus shares What is profit?  A dividend can be paid out of profits. Over the years, the courts have defined “profit” as including: o Current year profit as determined by AASB Accounting Standards (ie. Revenue minus expenses); o Retained profits, despite the fact that the company may have a current year loss; o A capital profits reserve (ie. A realised reserve created on the sale of an asset) and; o An asset revaluation reserve. Deemed dividends  Most of the deemed dividend provisions only apply to private companies for taxation purposes.  The following represent the most common instances where company distributions or payments will be deemed dividends: o Distributions of income by liquidators (S 47); o Off-market share buy-backs (S 159GZZZP); o Profits distributed or credited by a private company to a shareholder or an associate as an advance, payment, loan or debt forgiven (Division 7A); o Excessive remuneration paid or credited by a private company to a shareholder, director or associate (S 109); o Bonus shares issued where there is a choice between dividends and shares where S 6BA(5) applies and S 6BA(6) does not; and o A distribution to a shareholder from a “tainted share capital account” (Division 197). Dividends assessable to shareholders  A resident individual taxpayer is required to include in their assessable income, all dividends paid by a company out of profits derived by it from any source. The amount of the dividend received is included in the taxpayer’s assessable income (S 44(1)(a) ITAA 1936)  However, the amount of the imputation (or franking) credit is also regarded as assessable income (S 207-20(1) ITAA 1997). o In the case of a foreign dividend, the gross amount (ie. dividend received plus the withholding tax deducted, if any) is included in the taxpayer’s assessable income.  A resident individual taxpayer receives a credit for any imputation credit or foreign tax paid.  However, as previously mentioned, the credit for the foreign tax is the lesser of the foreign tax credit or the average Australian tax payable on the foreign income (Ss 770-10; 770-70 and 770- 75). Division 7A  Division 7A (comprising Ss 109B to 109ZE of the ITAA 1936) operates to automatically deem certain loans made by private companies to a shareholder or a shareholder’s associate as dividends to the extent that there is a distributable surplus in the company. Application of Div 7A Did one of the following transactions occur on or after 4 December 1997? No  the company paid an amount to a shareholder Has one of these transactions (or associate): S 109C occurred through an  an existing loan was significantly altered: S interposed entity? 109D(5)  the company lent an amount to a shareholder or associate which was not fully repaid by the end of the current year: Ss 109
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