Trapped Franking Credits

Trapped Franking Credits

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As you would now be aware, corporate tax rates for companies that are base rate entities (BRE), have been progressively reducing from the historical 30 percent to 25 percent in the 2022 financial year.

Companies that are not considered to be a BRE, will continue to have a corporate tax rate of 30 percent.

 

What is a Base Rate Entity?

Section 23AA of the Income Tax Rates Act 1986 outlines that a base rate entity is entitled to the benefit of the lower tax rates and subsequent franking rates, if the following conditions have been satisfied:

    • No more than 80 percent of the company’s assessable income for the income year is passive income; and
    • The company’s aggregated turnover for the income year, is less than the relevant threshold for the income year (ie. $25 million in the 2018 financial year and $50 million in the 2019 financial year)

 

Passive Income

Passive income is commonly defined as income that has not been derived from actively being involved in a business. Examples of passive income include:

    • Interest;
    • Rental income;
    • Royalties;
    • Dividends (except non-portfolio); and
    • Net Capital Gains.

 

Franking Rates

The maximum franking rate that a company can utilise is equal to the tax rate applicable in the financial year that the dividends are paid. It is important to note that the maximum franking rate is not determined by the rate at which the profits were actually derived and taxed.

Below is a summary of the franking rates applicable between the 2019 and 2022 financial years, for a BRE that has an annual threshold of $50 million:

 2019/20 Financial Year2021
Financial Year
2022
Financial Year
Turnover is < $50 million & passive income is < 80% of assessable income27.5%26%25%
Turnover is > $50 million &/or passive income is > 80% of assessable income30%30%30%

 

Implications in Reduction of Tax Rate

A company that has paid tax at the historical rate of 30 percent in previous financial years, would have accrued franking credits of $30 for every $100 of taxable income.

As outlined in the above table, from 1 July 2022, the maximum franking rate for a BRE will be 25 per cent.

In summary, this means that any dividends paid in the 2022 financial year, will have a maximum franking rate of 25 percent. This results in the balance of the franking credits becoming “trapped” in the company and are unable to be passed on to shareholders.

Below is a representation of the “trapped” franking credits between the various tax rates:

 Tax Rate 30%Tax Rate 27.5%Tax Rate 26%Tax Rate 25%
Franking Credit$ 30.00$ 26.55$ 24.59$ 23.33
Lost Franking Credit ($)-$ 3.45$ 5.41$ 6.67
Lost Franking Credit (%)-11.5%18%22%

 

Members Voluntary Liquidations

As a company continues to trade, up to 22 percent of its accrued franking credits (utilising the 2022 tax rates) can be trapped and never utilised. In addition, members may have to fund the shortfall between the available franking credit and their marginal tax rate.

One solution is to place the company into a Members Voluntary Liquidation (MVL) and pay dividends to shareholders in a tax effective way.

If the company ceases to trade, it may no longer be considered a BRE and will revert to the original 30 percent tax rate. In this instance, all distributions can then be franked to the maximum 30 percent, to the extent of the available franking credits.

For companies that are progressing towards a close down scenario, it will be worth planning the eventual liquidation and deregistration around the available franking credits.

An MVL is one alternative that can be used to prevent the wastage of available franking credits.

You can refer to the MVL section on our website here and download our fact sheet for further details on the process and tax benefits of an MVL.

About Us

SV Partners has a range of comprehensives business recovery and insolvency related services.

Our job is to ensure the right approach is adopted to ensure your clients receive the best outcome for their situation.

If you would like to discuss the benefits of an MVL and the applicable “trapped franking credits”, contact us to ensure that you benefit from the involvement of our most experienced practitioners.

 

Article written by Joshua Robb, Director – SV Partners Newcastle

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