Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 7 - Simplified imputation system - franking deficit tax offset
Outline of chapter
7.1 Schedule 7 to this bill will amend Part 3-6 of the ITAA 1997 to insert rules in the SIS to allow entities which have incurred an FDT liability to offset this amount against an income tax liability. Special rules are provided for life insurance companies to ensure that an FDT liability can only be offset against that part of the company's income tax liability that is attributable to shareholders.
7.2 The new rules will also replace the franking additional tax penalty provisions which operated under the former imputation rules in Part IIIAA of the ITAA 1936 where there was an excessive franking deficit. Instead of a separate penalty, a new rule will operate to reduce an entity's FDT offset by 30%.
Context of amendments
7.3 The rules which will allow FDT to be offset against company tax generally replicate the former provisions contained in Subdivision C in Division 5 of Part IIIAA of the 1936. However, changes are made to reflect the new rules and terminology of the SIS rules. The law has been rewritten using clearer and more accessible drafting techniques of the tax law improvement project.
7.4 In Minister for Revenue and Assistant Treasurer's Media Release No. 134 of 20 December 2002 the Government announced that it will replace the former franking additional tax penalty provisions with a simplified penalty for an excessive franking deficit. Broadly, franking additional tax applied where a company had a franking deficit at the end of the year and the deficit was more than 10% of all the franking credits that arose during the year. The new rule will operate instead to reduce an entity's FDT offset by 30% where there is an excessive franking deficit.
Summary of new law
7.5 This bill amends Part 3-6 of the ITAA 1997 to allow entities that have incurred an FDT liability to offset that amount against an income tax liability. Any unapplied amounts can be carried forward and offset against future income tax liabilities. In the case of life insurance companies the amount of the offset that can be applied will be limited to the company's income tax liability for the income year that is attributable to shareholders.
7.6 The new provisions generally replicate the provisions of the former imputation system but have been greatly simplified. The main departures from the former rules are:
- •
- the FDT offset will be treated as a tax offset and therefore be part of a taxpayer's assessment - this removes the need for the Commissioner or taxpayer to make a determination on an offset entitlement:
- -
- a consequence is that machinery and administrative provisions contained in sections 160AQKB to 160AQS of Part IIIAA of the ITAA 1936 do not need to be replicated;
- •
- for life insurance companies a series of complicated formulae are replaced with a general rule which operates to limit the amount of FDT offset to that part of an entity's income tax liability that can be attributed to shareholders; and
- •
- replacing franking additional tax with a simplified rule for an excessive franking deficit.
7.7 The new FDT offsetting rules will come into operation as from 1 July 2002, the date that SIS rules came into operation. Although the rules are retrospective, they do not adversely affect taxpayers. If the rules did not apply from this date, companies would not be able to apply an FDT liability against their income tax assessment for the 2002-2003 income year.
7.8 Transitional rules are also included to ensure a proper transition for the removal of the franking additional tax for late balancers and also to allow entities with unapplied amounts of FDT and deficit deferral tax incurred in earlier years to be offset against future income tax liabilities.
7.9 The rule which replaces the franking additional tax will generally operate in respect of FDT liabilities arising at the end of the 2002-2003 income year and later years.
Detailed explanation of new law
7.10 The Australian imputation system prevents the double taxation of company profits by allowing the company to impute to its shareholders (as an imputation credit attached to a franked dividend) the tax that it has paid on the income that it distributes to them.
7.11 Resident companies can frank dividends paid to shareholders even though the company may have insufficient credits to support that level of franking. Where this occurs a company's franking account may go into deficit. Where a deficit exists in the company's franking account at the end of the income year, that company would be liable to pay FDT.
7.12 The FDT is not a penalty, but merely a payment required to make good the amount imputed to shareholders which exceeds the amount of tax actually paid.
7.13 Under the former imputation rules in Part IIIAA of the ITAA 1936, the liability to FDT could be applied to reduce the company's income tax liability for the relevant income year, including an amended assessment which increases an income tax liability. Any unapplied amounts could be carried forward to be offset against an income tax liability in a later income year. The rules operated so that the Commissioner was required to determine the company's entitlement to an FDT offset or a company could self-determine their own entitlement.
7.14 FDT cannot be offset against PAYG instalments payable, but may be taken into account in any application for variation of such instalments.
Franking deficit tax offsetting rules
7.15 A corporate tax entity that meets a residency requirement is entitled to apply an FDT tax offset to reduce its income tax liability for an income year where the following conditions are met:
- •
- the entity has incurred a liability to pay FDT in an income year; or
- •
- it has an unapplied amount of FDT tax offset from a previous income year (including an unapplied amount from an income year when it did not satisfy the residency requirement).
[Schedule 7, item 5, subsection 205-70(1)]
7.16 A method statement is provided which sets out how the amount of the tax offset is worked out. The six steps involved are as follows:
- Step 1: calculate the entity's liability to FDT as required under section 205-45.
- Step 2: if the amount in step 1 is more than 10% of the total franking credits that arose in the entity's franking account in the income year, reduce the amount calculated in step 1 by 30%.
- Step 3: calculate the entity's liability to FDT for an income year in which the entity did not satisfy the residency requirement where the entity has not previously claimed the amount as a tax offset.
- Step 4: if the amount in step 3 is more than 10% of the total franking credits that arose in the entity's franking account in the income year, reduce the amount calculated in step 3 by 30%.
- Step 5: add the amounts calculated under step 2 and step 4.
- Step 6: if there is any unapplied FDT offset from a previous year add this amount to the amount calculated under step 5. This step allows any unapplied FDT tax offsets from previous years to be applied against an entity's income tax liability for the current income year.
[Schedule 7, item 5, subsection 205-70(2)]
7.17 Steps 2 and 4 of the method statement replaces the former franking additional tax penalty provisions with a 30% reduction in the amount of the tax offset.
Example 7.1
In the 2003-2004 income year a company's franking account has a $3,000 franking deficit at the end of the income year and the company will incur a liability to FDT for this amount. During the year the company's franking account had $10,000 of franking credits. As the franking deficit exceeds the total franking credits by more than 10%, the company's offset entitlement is reduced under step 2 to $2,100. The remaining $900 FDT liability (being 30% of the deficit) produces no offset entitlement.
7.18 The tax offset can be applied not only against an income tax liability arising from an original assessment but also against an increased income tax liability resulting from an amended assessment for the current income year.
7.19 The tax offset is deducted from the entity's income tax liability after all other tax offsets (including foreign tax credits) have been deducted. [Schedule 7, item 5, subsection 205-70(3)]
Example 7.2
For the 2002-2003 income year X Co has a franking deficit of $60,000. Accordingly, at the end of the income year, the company became liable to FDT of $60,000. X Co also has an unapplied FDT offset from the previous year of $40,000.
X Co lodges its income tax return on 21 February 2004 and is assessed on that day. Before tax offsets are applied its income tax liability is $540,000. It is entitled to a foreign tax credit of $50,000. After subtracting this tax offset its income tax liability is $490,000. It can further subtract an FDT offset of $100,000. Its final income tax liability for 2002-2003 is $390,000.
7.20 The residency requirement for a corporate tax entity claiming the FDT offset is contained in subsection 205-25(1) of the ITAA 1997 [Schedule 7, item 4, subsection 205-70(4)]. As a result of an amendment to be made by Taxation Laws Amendment Bill (No. 7) 2003, a company will satisfy the residency requirement for the purpose of applying an FDT offset where either of the following are satisfied:
- •
- if the liability to FDT arises before the end of an income year - the entity is an Australian resident for more than one half of the immediately preceding 12 months;
- •
- if the liability to FDT arises on or after the end of an income year - the entity is an Australian resident at all times during the income year; or
- •
- the entity is an Australian resident for more than one half of an income year.
7.21 Taxation Laws Amendment Bill (No. 7) 2003 contains amendments to include imputation rules for life insurance companies in the SIS. These rules provide that franking credits and debits only arise in the franking account of life companies to the extent that the payment or refund of tax or the receipt of franked dividend income is attributable to the shareholders of the company.
7.22 This bill will amend the rules included in Taxation Laws Amendment Bill (No. 7) 2003 to provide FDT tax offset rules for life insurance companies. The amendments seek to ensure that an FDT offset can only be applied to that part of the company's income tax liability that is referable to shareholders. If this rule was not included a life company could over-frank the payment of dividend and apply the resulting FDT liability to offset the company's final income tax assessment liability including that part that is not attributable to shareholders.
Franking deficit tax offsetting rules
7.23 The tax offset rules set out in section 205-70 apply to life insurance companies but modified on the basis that references to an amount of income tax liability in that section were a reference to that part of the income tax liability that is attributable to shareholders [Schedule 7, item 5, subsection 219-70(1)]. This rule has the effect that the amount of FDT tax offset that can be applied by a life company is limited to the amount of the entity's income tax liability that is attributable to its shareholders after all other tax offsets have been deducted.
7.24 In working out the amount of income tax liability that is attributable to a company's shareholders, regard must be had to the company's accounting records. [Schedule 7, item 5, subsection 219-70(2)]
7.25 Sections 219-15 and 219-30 in Taxation Laws Amendment Bill (No. 7) 2003 set out events that give rise to franking credits and debits for life insurance companies. In working out franking credits or franking debits that arise where there is an FDT tax offset a modification is made to the shareholders' ratio as referred to in the method statement in section 219-50. This is referred to as the 'revised shareholders' ratio' which is worked out as follows:
- Step 1: work out the amount that remains after the amount of FDT tax offset has been subtracted from the amount of income tax that is attributed to shareholders for the income year.
- Step 2: divide the amount worked out under step 1 by the life insurance company's income tax liability for the income tax year after the tax offset has been applied in relation to the year.
[Schedule 7, item 5, subsections 219-75(1) and (2)]
7.26 A further rule is required to ensure the correct amount of franking credits or debits arise in the case of an amended assessment where either:
- •
- a tax offset was applied in the earlier assessment; or
- •
- a tax offset is applied in making the amendment of the previous assessment.
[Schedule 7, item 5, subsection 219-75(3)]
7.27 The rule operates to treat the reference to shareholders' ratio in section 219-55 of Taxation Laws Amendment Bill (No. 7) 2003 as if it were a reference to a revised shareholders' ratio. [Schedule 7, item 5, subsection 219-75(4)]
Example 7.3: Offset entitlement in respect of an original company tax assessment
X Co is a life insurance company. During the income year 2002-2003 X Co imputed to its shareholders more tax than it paid and as a result it has incurred an FDT liability of $68,000.
On 21 February 2004 X Co's income tax liability for the income year 2002-2003 is assessed as $400,000. Of that liability $80,000 is attributable to the shareholders' share of the income tax liability as calculated under the method statement in section 219-50 (i.e. shareholders' ratio of 20%). This is the amount of the company's income tax liability that would normally give rise to franking credits.
The company's FDT offset entitlement that can be applied against the 2002-2003 income tax liability is $68,000. The company's liability is reduced by the amount of the offset. Accordingly, that liability is reduced to $332,000. The company has paid $300,000 in PAYG instalments in the income year and it pays a further $32,000 on assessment.
The franking credits that will arise under item 2 in the table in section 219-15 is calculated by first determining the revised shareholders' ratio using the method statement in subsection 219-75(2):
- Step 1: the difference between that part of the company's income tax liability that is attributable to its shareholders and the amount of the tax offset that has been applied (i.e. $12,000).
- Step 2: divide the amount arrived at in step 1 by the company's income tax liability for the income year reduced by the tax offset (i.e. $12,000/$332,000). The revised shareholders' ratio is 3/83.
Using this ratio the amount of franking credits arising on the payment of PAYG instalments is $300,000 ? 3/83 (i.e. $10,843) and the payment of company tax is $32,000 ? 3/83 (i.e. $1,156).
On assessment the amount of franking credits that arise are $10,843 + $1,156 = $12,000.
Example 7.4: Tax paid after assessment
The same as Example 7.3 except the outstanding tax of $32,000 is paid after assessment.
The franking credits that arise are as follows:
- •
- under item 3 in the table in subsection 219-15(2)
$10,843 * ((3 / 83) * 300,000)
- •
- under item 4 in the table in subsection 219-15(2)
$1,156 * ((3 / 83) * 32,000)
The total amount of franking credits on and after assessment is $12,000.
Example 7.5: Amended company assessment
Following from Example 7.3, assume that X Co receives an amended assessment on 31 March 2004 which reduces the company's income tax assessment from $400,000 to $300,000 before taking into account any tax offset entitlement.
The amount of the amended assessment attributable to shareholder's funds is $60,000 (i.e. 20% shareholders' ratio). This is the amount of the company's liability to pay income tax that would normally give rise to franking credits.
The reduced offset entitlement will be $60,000. The balance of $8,000 can be carried forward to a subsequent year.
The company's liability to pay income tax is reduced by the amount of the tax offset. Accordingly, that liability is reduced to $240,000 (i.e. $300,000 - $60,000). The company receives a refund of $92,000. That is, the difference between the amount previously paid of $332,000 and the new income tax liability for the year.
Determine the revised shareholders' ratio using the method statement in subsection 219-75(2):
- Step 1: the difference between that part of the company's income tax liability that is attributable to its shareholders and the amount of the tax offset that has been applied (i.e. $60,000 - $60,0000) which equals zero.
- Step 2: divide the amount arrived at in step 1 by the company's income tax liability for the income year reduced by the tax offset (i.e. 0/240,000). The revised shareholders' ratio is zero.
The amount of franking credits that arise under the item at the time of the amended assessment is zero. Because of the operation of subsections 219-75(3) and (4) the franking credits that arose on the original assessment will be cancelled. The adjustment is a franking debit of $12,000 that arises on the day of the amendment of the assessment.
Example 7.6: Amended company assessment resulting from a change in shareholder ratio
Following on from Example 7.3, assume that X Co receives an amended assessment on 31 March 2004 because there has been a change in the shareholder's ratio from 20% to 15%. That is, of the assessed amount of $400,000, $60,000 is attributable to the shareholder's share of the income tax liability as calculated under the method statement in section 219-50.
The amount of FDT offset that can be applied against X Co's income tax liability is $60,000. The balance of $8,000 can be carried forward to a subsequent year.
The company's liability to pay income tax is reduced by the amount of the offset. Accordingly, that liability is reduced to $340,000 (i.e. $400,000 - $60,000).
The company has paid $300,000 in PAYG instalments and $32,000 on assessment. The company has an increased tax liability of $8,000 which it pays on receiving the amended assessment.
The amount of franking credits that can arise at the time of the amended assessment is zero. Because of the operation of subsections 219-75(3) and (4) the franking credits that arose on the original assessment will be cancelled. The adjustment is a franking debit of $12,000 that arises on the day of the amendment of the assessment.
Application and transitional provisions
7.28 Subject to rules inserted into the IT(TP) Act 1997, the amendments in items 1 to 8 will apply to events that occur on or after 1 July 2002, the start date for the SIS rules. [Schedule 7, item 9]
Income Tax (Transitional Provisions) Act 1997
7.29 Apart from an exception that deals with late balancers, section 205-70 of the ITAA 1997 which deals with the FDT tax offset will apply in relation to an entity's assessment for the 2002-2003 and later income years. [Schedule 7, item 10, subsection 205-70(1)]
Late balancers - 2001-2002 income year
7.30 A transitional rule is required for late balancers for the 2001-2002 income year to ensure that the FDT offset rules apply properly for that year in relation to the removal of the franking additional tax penalty provisions.
7.31 The method statement in subsection 205-70(2) of the ITAA 1997 used to calculate an entity's tax offset entitlement is modified by the removal of step 2 (i.e. the rule that replaces franking additional tax where there is an excessive franking deficit). [Schedule 7, item 10, subsection 205-70(2)]
7.32 Under the modified method statement an amount of FDT will only arise under step 1 where an entity ceases to be a franking entity before the end of the income year. This is because an FDT liability will not arise at the end of the income year because of section 205-35 of the IT(TP) Act 1997. This provision operates so that an entity is not liable to pay FDT at the end of the 2001-2002 income year. Instead, the deficit is carried forward to the start of the 2002-2003 income year.
Late balancers - 2002-2003 income year
7.33 A transitional rule is also required for late balancers for the 2002-2003 income year to ensure that the removal of the franking additional tax penalty provisions apply properly in relation to late balancers who make an election referred to in section 205-20 of the IT(TP) Act 1997. The effect of an entity making this election is that their liability to pay FDT is determined under transitional provisions in sections 205-25 to 205-30 of the IT(TP) Act 1997. These provisions provide that the entity's FDT liability, if any, is determined at 30 June rather than the end of their income year.
7.34 The modified method statement provides that FDT incurred before 30 June 2003 is not subject to step 2 of the method statement in subsection 205-70(2) of the ITAA 1997 (i.e. the rule that replaces franking additional tax which reduces the offset by 30%) but step 2 is applied in relation to FDT liabilities incurred on or after that date. Step 2 also does not apply in relation to an FDT liability incurred in the 2001-2002 income year where the entity did not meet the residency requirement in that year [Schedule 7, item 10, subsection 205-70(3)]. Step 3 of the method statement will only apply where an entity ceases to be a franking entity before 30 June 2003.
Late balancers - later income years
7.35 A modified method statement will apply to late balancing entities that make an election under section 205-20 of the IT(TP) Act 1997 to have its FDT liability determined at 30 June. The method statement takes into account that in relation to the rule which reduces the offset by 30%, it is the franking credits that arose in the entity's franking account during the 12 months prior to 30 June that are relevant. The method statement also ensures that the 30% reduction to the FDT offset amount works appropriately for entities ceasing to be franking entities after 30 June in an income year [Schedule 7, item 10, subsection 205-70(4)]. This rule will have application for each income year that the entity makes an election to have its FDT liability determined at this date.
Tax offset for the first income year
7.36 A transitional rule applies to ensure any unapplied amounts of deficit deferral tax or FDT incurred in a previous income year are taken into account in determining the amount of an entity's entitlement to a tax offset in the first income year the new rules apply. These amounts, to be taken into account in step 6 of the method statement in subsection 205-70(2) of the ITAA 1997, are:
- •
- for ordinary companies these are liabilities referred to in paragraph 160AQK(1)(a) of the ITAA 1936; and
- •
- for life insurance companies these are liabilities referred to in paragraph 160AQKAA(1)(a) of the ITAA 1936.
[Schedule 7, item 10, section 205-75]
Determinations for income years ending before 1 July 2002
7.37 A transitional provision is included to ensure that determinations referred to in the former FDT offset rules in Subdivision C of Division 5 of the ITAA 1936 can be made in relation to income years ending before 1 July 2002 after 1 July 2002 even though the determination is made after 1 July 2002. [Schedule 7, item 10, section 205-80]
Consequential and related amendments
Income Tax Assessment Act 1936
7.38 An amendment is made to subsection 160AO(2) to change the meaning of 'the amount of Australian tax' so that it reflects that the FDT offset is not taken into account in calculating the amount of Australian tax. [Schedule 7, item 11]
7.39 The amendment made by item 11 applies to an entity's assessment for the 2002-2003 income year and later income years. However, for late balancers the relevant assessment is for the 2001-2002 income year and a later income year. [Schedule 7, item 11]
Income Tax Assessment Act 1997
7.40 Notes are inserted at the end of subsections 219-50(1) and 219-55(1) to provide cross references to the FDT offsetting rules. [Schedule 7, items 6 and 7]
7.41 The Guide Material to Division 205 and section 205-5 is amended to reflect the new tax offset rules. [Schedule 7, items 1 to 4]
7.42 Section 13-1 of the ITAA 1997 is amended to reflect the FDT offset. [Schedule 7, items 13 and 14]
7.43 The rules contained in Taxation Laws Amendment Bill (No. 5) 2003 allow corporate tax entities to convert excess franking credits into a tax loss. The amendment will ensure proper interaction of those rules with the FDT offset rules. [Schedule 7, item 15]
7.44 An amendment is made to section 67-30 of the ITAA 1997 to ensure that the priority rule for refundable tax offsets interacts properly with the FDT offset rules. [Schedule 7, item 16]
7.45 The definition of 'residency requirement' in subsection 995-1(1) of the ITAA 1997 is amended to include a reference to the residency requirement in the new FDT offset rules. [Schedule 7, item 17]
7.46 The amendments made by items 13 to 17 apply to an entity's assessment for the 2002-2003 income year and a later income year. However, for late balancers the relevant assessment is for the 2001-2002 income year and a later income year. [Schedule 7, item 18]
Taxation Administration Act 1953
7.47 An amendment is made to the method statements in sections 45-340 and 45-375 in Part 2-10 of Division 45 of the TAA 1953 to ensure that the FDT offset is not taken into account in formulating the rate of PAYG instalments. The FDT offset will be ignored because it is allowed only on assessment like other offsets that are already excluded and it is not necessarily reasonable to assume that an entity will again be liable to pay FDT in the subsequent income year. [Schedule 7, items 19 and 21]
7.48 The amendment made to section 45-340 of Schedule 8 to the TAA 1953 applies in relation to the calculation of an entity's adjusted tax as follows:
- •
- for a base year that is the 2002-2003 income (or for late balancers, the 2001-2002 income year); and
- •
- in relation to a PAYG instalment period that includes or starts on the date of Royal Assent of this bill.
This ensures that the Commissioner is not required to recalculate an instalment rate given to an entity prior to the commencement of the amendments in this bill. [Schedule 7, item 20]
7.49 The amendment made to section 45-375 in Schedule 8 to the TAA 1953 generally applies in relation to the calculation of an entity's benchmark instalment rate, or benchmark tax for an income year in relation to an entity's assessment for the 2002-2003 income year or a later income year. However, for late balancers the amendment applies where the relevant assessment is that for the 2001-2002 income year or a later income year. [Schedule 7, item 20]