Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 1 - Overview of the imputation system
1.1 This chapter provides an overview of Part 3-6. Part 3-6 introduces the new imputation system rules applying to companies, corporate unit trusts, public trading trusts and limited partnerships, operative from 1 July 2002.
1.2 The changes made to the imputation system are broadly consistent with the recommendations made by the Review of Business Taxation in its report, A Tax System Redesigned .
1.3 This chapter focuses on explaining the features of the new imputation system that differ from the current imputation system in Part IIIAA of the ITAA 1936. It also outlines the key features of the new system.
1.4 Some other rules dealing with the new imputation system are not included in these bills. These other rules will be included in a later bill and deal, largely, with the consequential amendments arising from the new imputation system. These other rules include provisions relating to:
- venture capital franking;
- life insurance and exempting companies;
- share capital tainting;
- holding period and related payment rules; and
- certain transitional and machinery provisions (including the existing offset of franking deficit tax against income tax).
1.5 This section explains the terminology commonly used in relation to franking and imputation. Many of these terms are defined in the bill which contains amendments made to the dictionary and core concepts in the ITAA 1997. [Schedule 2, items 1 to 45, section 995-1 of the ITAA 1997]
1.6 The income tax law taxes companies, corporate unit trusts, public trading trusts and corporate limited partnerships as taxpayers separate from their members. Members of these entities include shareholders, beneficiaries and partners.
1.7 Entities that are taxed separately from their members are called corporate tax entities , and they are taxed at the company tax rate, which is currently 30%.
1.8 To prevent double taxation of the distributed income of corporate tax entities (i.e. once when it is received by the entity and again in the hands of the members on distribution), the income tax paid by the entity will generally be imputed (i.e. passed on) to the members. Providing the means for imputing the tax paid by the corporate tax entity is the function served by both the current imputation system and the new provisions explained in this explanatory memorandum.
1.9 The imputation system is the taxation law governing how and when income tax paid by a corporate tax entity is imputed to the entitys members. It may also be referred to as the franking system , because the tax is imputed to members by means of franking (in the sense of stamping or marking) distributions of the entity when made to members.
1.10 In essence, a franked distribution is one that is marked as carrying tax credits that can be imputed to members. Those tax credits reflect the tax already paid by the entity on the entitys profits that are distributed to the member.
1.11 The tax credits that can be imputed to members are recorded in the entitys franking account as franking credits . Franking credits reflect income tax paid directly by the entity, or underlying tax paid through other corporate tax entities that is imputed to the entity.
1.12 When a franked distribution is made to a member of an entity, the franking credit is referred to as an imputation credit in the members hands. Imputation credits usually reduce income tax by giving rise to a tax offset known as the franking rebate . In addition, if the recipient is a corporate tax entity itself, an imputation credit is also allowed as a franking credit in the entitys own franking account, which may in turn be distributed to the entitys members.
1.13 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 to which the imputation credits exceed tax payable by these entities.
1.14 The Government instituted the Review of Business Taxation to consult on its plan to comprehensively reform the business income tax system as outlined in its release of Tax Reform: not a new tax, a new tax system . The Review of Business Taxation made recommendations to the Government designed to achieve a more simple, stable and durable business tax system.
1.15 The Review of Business Taxation recommended the redesigning of the company tax and imputation system to achieve:
- integrity through the entity chain;
- simplification of the franking account;
- refunding excess imputation credits; and
- the reduction of the company tax rate.
1.16 These bills are part of the legislative program implementing the New Business Tax System. Measures such as refunding excess imputation credits and the reduction of the company tax rate have already been introduced and passed.
1.17 The new imputation provisions will broadly change the mechanics of the current imputation system to achieve:
- simpler rules and consequent reduction in compliance costs;
- increased flexibility in franking distributions; and
- consistency of treatment across entities receiving franked dividends.
1.18 Whilst the new imputation system changes the mechanics of the current imputation system, the new imputation provisions will generally provide the same outcome as the current imputation system.
1.19 The object of the new imputation system, as with the existing system, is to integrate the Australian corporate tax system and the taxation of its members by allowing corporate tax entities to pass on credits for income tax paid to their members and to allow the Australian members to claim a tax offset for that credit and in some circumstances claim a refund if they are unable to fully utilise the tax offset.
1.20 The objects of the new imputation system are also to ensure 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.
1.21 The simplification of the franking account rules means that a corporate tax entity will:
- maintain its franking account on a tax-paid basis; and
- align its franking year with its income year.
1.22 The current system operates on a qualified dividend account basis (or taxed income basis) under which the companys franking account operates on an after-tax basis. For example, if a company derives $100 taxable profit and pays tax of $30 (at a 30% rate), it would credit its qualified dividend account by $70 - the after-tax profit available for distribution.
1.23 Operating the franking account on this qualified dividend account basis has required companies to maintain a number of different classes of franking account and to carry out a number of complex conversions to accommodate changes in the company tax rate.
1.24 To avoid this, the new imputation provisions provide that a corporate tax entitys franking account will record franking credits on a tax-paid basis. On this basis, if a company paid income tax of $30 the relevant franking credit would be $30. This will also mean that corporate tax entities will not have to convert entries to the franking account to reflect taxed income.
1.25 The mechanics of the franking account and what constitutes a franking debit or franking credit are discussed in Chapter 4 of this explanatory memorandum.
1.26 Under the current imputation rules a companys franking year is dependent upon whether it determines its taxable income and lodges its income tax return:
- in lieu of the next succeeding 30 June - the company has an early balance date;
- in lieu of the preceding 30 June - the company has a late balance date; or
- on a 30 June basis.
1.27 Broadly, under the current imputation rules a company that has an early balance date has a franking year that is aligned to its income year whilst companies that have a late balance date or a 30 June balance date have a franking year that ends on 30 June. This disparate treatment of companies that have a late balance date has led to unnecessary complexity.
1.28 The introduction of franking period rules (discussed in paragraphs 2.58 to 2.64) will result in all corporate tax entities having a franking year that is aligned with its income year. Certain transitional rules will apply to late balancing companies to reduce the initial impact of the alignment (discussed in paragraph 1.53).
1.29 To impute tax it has paid to its members a corporate tax entity must frank a distribution. This is done by allocating franking credits to the distribution. Only frankable distributions may be franked.
1.30 The current imputation system contains complex required franking amount rules that require companies to frank dividends to the maximum extent possible. This led to some criticism from businesses who were unable to provide certainty for shareholders about the extent to which dividends will be franked in the future. This lack of flexibility is addressed under the new provisions.
1.31 Under the new imputation system a corporate tax entity will be allowed to determine the extent to which it will frank a frankable distribution, having regard to the existing and expected surplus in its franking account and the rate at which earlier distributions have been franked. Generally the only restriction on a corporate tax entitys ability to frank a distribution will be the requirement to frank all frankable distributions within the franking period to the same extent - known as the benchmark rule.
1.32 The franking percentage is a measure of the extent to which a corporate tax entity chooses to frank a frankable distribution. The level to which a corporate tax entity may frank a distribution is capped by a maximum franking credit , which is broadly the maximum amount of income tax that may be paid by the entity on the profits distributed.
1.33 The amount of franking credit allocated to a frankable distribution is taken to be the amount disclosed in the distribution statement accompanying the recipients distribution.
1.34 The benchmark franking percentage will be the franking percentage in relation to the first frankable distribution made during the franking period. If a corporate tax entity does not make any frankable distributions during the franking period it will not have a benchmark franking percentage.
1.35 A corporate tax entity will be required to frank all frankable distributions made within the franking period to the same extent. This is called the benchmark rule and it is designed to prevent a corporate tax entity streaming distributions within a franking period. Certain entities are excluded from the benchmark rule (see discussion in paragraph 2.54).
1.36 If the benchmark rule is breached the corporate tax entity will be subject to either:
- underfranking penalty debits; or
- overfranking tax.
1.37 Chapter 2 provides further discussion on how a corporate tax entity franks a distribution.
1.38 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.
1.39 Greater integrity and consistency is provided 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.
1.40 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.
1.41 Under this approach a resident recipient of a franked distribution will generally:
- gross-up the amount of the distribution to reflect the before-tax profit of the corporate tax entity - that is, the amount of the distribution plus the attached franking credit (called an imputation credit in the hands of the recipient); and
- receive a tax offset (also referred to as a franking rebate) for the imputation credit. In certain circumstances, this tax offset is refundable.
1.42 In effect, the same treatment applies to taxpayers who receive franked distributions indirectly through a trust (other than a corporate unit trust or a public trading trust) or a partnership.
1.43 Chapter 5 provides further discussion on the effect of receiving a franked distribution.
1.44 The benchmark rule lays down 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. To prevent the undermining of this framework, 4 specific rules are required, namely:
- rules applying to streaming arrangements involving linked distributions;
- rules applying to streaming arrangements involving tax-exempt bonus shares;
- rules applying to arrangements where an entity streams distributions to provide imputation benefits to members who benefit more from imputation credits than other members; and
- a disclosure rule that forms part of the anti-streaming rules.
1.45 These rules ensure that franking credits representing tax paid on behalf of all members of an entity are not allocated to only some of them. These rules are referred to as anti-streaming rules, because they prevent the streaming, or disproportionate allocation, of franking credits to certain members. The first three rules are consistent with the anti-streaming rules contained in the current law.
1.46 Further discussion of these rules may be found in Chapter 3.
1.47 This table sets out the key differences between the former imputation system and the new imputation system.
|New law||Current law|
|Franking credits arising from income tax paid are expressed on a tax-paid basis (e.g. a $30 income tax payment results in a franking credit of $30). As a result, the tax offset received by a member equals the face value of the franking credit allocated to that member.||Franking credits arising from income tax paid are expressed on an after-tax distributable profits basis (e.g. a $30 income tax payment would result in a franking credit of $70, assuming a 30% tax rate). As a result, the tax offset received by a member equals the adjusted amount of the franking credit allocated to that member. The adjusted amount reconverts the after-tax distributable profits to the amount of the underlying tax paid.|
|Corporate tax entities may select their preferred level of franking having regard to their existing and expected franking account surplus and the rate at which they franked earlier distributions. However, generally, all distributions made within a franking period must be franked to the same extent. This is referred to as the benchmark rule.
In cases where there is excessive variation of the benchmark franking percentage between franking periods, there may be a requirement for the corporate tax entity to disclose this variation to the Commissioner.
|Complex required franking rules complemented by estimated debit determination rules provide that a company must frank a dividend to the maximum extent possible on the basis of the surplus in its franking account at the time of payment of the dividend.|
|There are no complex franking rules that prescribe the method in which companies are required to allocate franking credits to a distribution that it makes. The distribution statement provides evidence of the extent to which a distribution is franked.||Companies are required to follow complex franking rules when franking a dividend including the requirement of making a declaration stipulating the extent to which a dividend is franked.|
|Public companies will continue to be required to provide distribution statements at the time the distribution is made. However, private companies will be permitted to provide distribution statements up to 4 months after the end of the income year in which the distribution is made. This facility will also allow private companies to retrospectively frank distributions.||Companies are required to provide dividend statements to members at the time, or before, the dividend is made.|
|Resident corporate tax entities that receive a franked distribution from another corporate tax entity must gross-up the distribution by the amount of the attached franking credit and are entitled to a tax offset in the same way as resident individuals and superannuation entities.||Resident companies that receive a franked dividend from another company must include the net amount of the dividend in assessable income and may receive the intercorporate dividend rebate under section 46 of the ITAA 1936.|
|An entitys franking account will always be based on the entitys income year.||The franking year of a late balancing company may differ from its income year.|
|The franking account is a rolling balance account: the balance of the account at the end of the last day of an income year is brought forward to the beginning of the first day of the next income year. However, if the account is in deficit on the last day of an income year, the entity will be liable to pay franking deficit tax.||If the franking account is in surplus at year-end, the amount of that surplus will be carried forward and registered in the account as a credit on the first day of the following year. If the account is in deficit, that deficit will not be carried forward. However, the company will be liable to pay franking deficit tax.|
|An over-payment of corporate tax that eliminates a franking deficit at the end of an income year and is refunded shortly afterwards is addressed by a simple re-calculation of franking deficit tax for that year.||Refunds of over-paid tax may result in a deficit deferral amount that triggers a liability to a separate tax (deficit deferral tax).|
1.48 The new imputation system applies in respect of events occurring (e.g. franked distributions) on or after 1 July 2002. [Schedule 1, item 1, section 201-5]
1.49 Conversely, the existing imputation system ceases to apply in respect of events occurring on or after that date. [Schedule 3, item 1, section 160AOAA]
1.50 Consistent with the rules contained in the consolidations regime, the intercorporate dividend rebate will continue to apply in respect of unfranked dividends paid within wholly-owned groups until 30 June 2003. The intercorporate dividend rebate does not apply to franked dividends paid on or after 1 July 2002, instead a tax offset provided under the new imputation system applies instead. Rules to give effect to this outcome will be contained in a later bill.
1.51 Special transitional rules apply to convert franking account balances that exist at the end of 30 June 2002 into equivalent tax-paid franking account balances. If a taxpayers franking year ends on 30 June 2002 and its franking account is in deficit at that time, the taxpayer will continue to be liable to franking deficit tax (and possibly deficit deferral and franking additional tax) under the existing provisions contained in the ITAA 1936. These special transitional rules apply to taxpayers that have an income year ending on 30 June (i.e. ordinary balancers). Equivalent provisions will be introduced in a later bill for taxpayers that are not ordinary balancers. [Schedule 4, item 2, section 205-10]
1.52 Further transitional rules apply to ensure that inappropriate estimated debit determination consequences do not arise after 1 July 2002. [Schedule 3, item 2, section 201-1; Schedule 4, item 2, sections 205-1 and 205-5]
1.53 To reduce the initial impact of the alignment of franking and income years, special transitional provisions will be introduced at a later time. The effect of these rules will be to allow late balancing companies an extended transitional franking year (13 to 17 months) starting on 1 July 2002 and ending on the last day of their 2002-2003 income year. In effect, the extended year would enable these companies to borrow franking credits from their 2002-2003 franking year to reduce or eliminate a franking deficit attributable to dividends paid during the period from 1 July 2002 to the end of the companys 2001-2002 income year. This will give these companies more time to adjust to the new imputation system and avoid the imposition of franking deficit tax.