House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer,the Hon Peter Costello)

Chapter 2 What are FTA benefits?

2.1 This chapter covers:

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increases in tax-free thresholds;

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decreases in rates of tax where there is a special income component, a capital gains component or a notional income;

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calculations in the case of primary producers;

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decreases in the rate of complementary tax; and

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section 98 trustee assessments.

General overview

2.2 The primary benefit available under the FTA is a $1,000 increase in the tax-free threshold of a taxpayer for each dependent child. It is referred to in this Explanatory Memorandum as the Part A benefit . The further benefit available where a dependant of the taxpayer is under 5 years of age is a $2,500 increase in the tax-free threshold of the taxpayer. This benefit is referred to as the Part B benefit . Collectively, the benefits are referred to as FTA benefits .

2.3 The full amount of both Part A and Part B benefits are to be available only where the taxpayer qualifies for the whole of an income year and satisfies the various income tests. This means that where, for example, a dependent student turns 18 years of age during the year or is a dependant of more than one taxpayer, only a reduced amount is or may be available.

2.4 For the 1996-97 year of income, the FTA benefits are half of the full amounts provided for a full year of income. This is because the Family Tax Initiative is to commence from 1 January 1997, that is half way through the 1996-97 year of income. This means that, for the 1996-97 year of income, the maximum Part A benefit for a child is $500, and the maximum Part B benefit is $1,250. The part of the 1996-97 year of income from 1 January 1997 is referred to in the Bill as the relevant part of the 1996-97 year of income .

2.5 An FTA benefit is generally an increase in the tax-free threshold of the taxpayer. The tax-free threshold is the level of taxable income at which a taxpayer becomes liable to the general rates of tax payable on taxable income. For resident taxpayers, the level of the tax-free threshold and the general rates of tax are contained in clause 1 of Part I of Schedule 7 of the Rates Act.

2.6 The tax-free threshold is currently $5,400. The rates of tax which apply to income above that level are:

2.7 Where a taxpayer's tax-free threshold would be increased above $20,700 because of FTA benefits, tax is payable at the rate of 14% (34% - 20%) on income above $20,700 up to the amount of the increased tax-free threshold. This matter is discussed further at paragraphs 2.13 - 2.16 below.

Specific benefits

Part A - primary FTA benefit

2.8 Section 20C provides for Part A benefits to be available to taxpayers. It does this by increasing the amount of $5,400 in clause 1 of Part I of Schedule 7 by $500 (for the 1996-97 year of income) for each resident dependent child of a taxpayer whose family income did not exceed the family income ceiling and who was a resident during the relevant part of the 1996-97 year of income (subsection 20C(1)) . The amount is $1,000 for each resident dependent child during the 1997-98 or later years of income (subsection 20C(2)) .

EXAMPLE

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A taxpayer has sole responsibility for 5 dependent children.

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The Part A benefit entitlement for the 1996-97 year of income is $2,500 ($5,000 for subsequent years).

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The taxpayer's tax-free threshold for 1996-97 is now $7,900 ($5,400 + $2,500). (The figure will be $10,400 for 1997-98 and later years)

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The tax saving is $500 (20% of $2,500) ($1,000 for subsequent years).

Part B - further FTA benefit

2.9 The Part B benefit is provided for in section 20D . Entitlement to this benefit is subject to the taxpayer having at least one dependant under 5 years of age, in addition to residency and income level requirements being met. The new section provides for the $5,400 in clause 1 of Part I of Schedule 7 to be increased by $1,250 (1996-97 year of income - subsection 20D(1) ) or $2,500 (1997-98 and later years of income - subsection 20D(2) ) in addition to any amount to which the taxpayer is entitled as a Part A benefit.

EXAMPLE

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The taxpayer's tax-free threshold as increased under the example after paragraph 2.8 above is $7,900.

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Part B benefit entitlement is $1,250 ($2,500 for subsequent years).

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Tax-free threshold becomes $9,150 ($7,900 + $1,250). ($12,900 for subsequent years)

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The tax saving from the Part B benefit is $250 (20% of $1,250).

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The total tax saving for 1996-97 is $750 ($1500 for subsequent years).

Part-year workforce period and part-year residency period

2.10 If a taxpayer is a resident for only part of the year, or ceases full-time study for the first time during the year, the taxpayer's tax-free threshold is reduced. The amount of the reduction is proportional to the number of months during which the taxpayer was either a non-resident, or was engaged in full-time study.

2.11 If a taxpayer falls into one of these categories, the reduction in threshold, to take account of part-year residency or ceasing full-time study for the first time, will be worked out before any FTA benefits are calculated. [Item 1, Schedule 1, new section 16A]

Exceptions to the normal increase of tax-free threshold

2.12 The increase in the tax-free threshold as outlined above will be applicable to most taxpayers. However, in a number of circumstances an increase in the threshold does not produce the level of benefit intended under the Family Tax Initiative. The circumstances are listed below and discussed in detail in the following paragraphs. The circumstances are where:

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the increased tax-free threshold exceeds $20,700 (paragraphs 2.13 to 2.16);

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the taxable income includes a special income or capital gains component (paragraphs 2.17 to 2.22);

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a taxpayer is a primary producer who is entitled to a primary production rebate or liable to pay complementary tax (paragraphs 2.23 to 2.25);

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a taxpayer is liable to pay complementary tax and has insufficient ordinary tax payable to fully utilise entitlement to FTA benefits (paragraphs 2.26 to 2.32.); or

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a taxpayer has a notional income determined under section 59AB or 86 of the Assessment Act (paragraphs 2.33 to 2.35).

Increased tax-free threshold exceeds $20,700

2.13 For most taxpayers their increased tax-free threshold will be under $20,701 and therefore remain in the range that is taxed at the rate of 20%. However, FTA benefits available to some taxpayers - those with 13 or more children one of whom is under 5 years of age - will increase their tax-free thresholds over $20,700. Such a threshold is in the 34% tax rate range.

2.14 Section 20E deals specifically with this situation. It provides that Part A and Part B benefits otherwise available through sections 20C and 20D are not available and, instead, reference is to be made to the table contained in section 20E rather than the table contained in clause 1 of Part I of Schedule 7. [subsection 20E(1)]

2.15 The table in subsection 20E(2) operates in a similar fashion to the table in clause 1 of Part I of Schedule 7. Its effect is to free from tax the first $20,700 of taxable income and to tax at the rate of 14% that part of taxable income that exceeds $20,700 but does not exceed the adjusted tax-free threshold (see below). Taxable income subject to the 14% rate of tax would, apart from FTA benefits, have been taxed at the rate of 34%.

2.16 Adjusted tax-free threshold is defined as $5,400 as increased by the taxpayer's tax-free threshold increase . Effectively, tax-free threshold increase is defined to mean the sum of the amounts that the taxpayer would have been entitled to as Part A and Part B benefits had the taxpayer been entitled to those benefits but for the application of subsection 20E(1) . [subsection 20E(3)]

EXAMPLE

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Taxpayer has 14 children one of whom is under 5 years of age.

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The taxpayer is entitled to a Part A benefit of $14,000 and to a Part B benefit of $2,500. This increases the taxpayer's tax-free threshold to $21,900.

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The taxpayer will not pay tax on income up to $20,700.

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Tax will be payable at 14% on the amount of $1,200 ($21,900 - $20,700).

Taxable income includes a special income or capital gains component

2.17 Where a taxpayer's taxable income includes either a net capital gain or abnormal income (these are referred to as either a special income component or a capital gains component), the normal rates table in clause 1 of Part I of Schedule 7 does not apply because of the averaging rules which apply to those kinds of income. Instead, tax payable is determined by a rate calculated under formulae contained in clauses 2 and 3 of Part I of Schedule 7, clause 2 of Part I of Schedule 9, clause 3 of Part I of Schedule 11, and clause 3 of Part I of Schedule 12 of the Rates Act.

2.18 Each formula provides for the calculation of a rate of tax to be applied to every $1 of a taxpayer's taxable income (or share of net income in the case of a trustee). Basically, the formulae operate to add to the tax normally payable on taxable income apart from the special income or capital gains component, 5 times the incremental tax payable if 20% only of the special income or capital gains component were included in taxable income. The formulae in Schedules 11 and 12 also add in the special amount of Division 6AA tax payable on any part of a special income component that comes under that Division. In all cases, the resulting sum is divided by the amount of taxable income to produce the rate of tax payable by the particular taxpayer on every $1 of taxable income.

2.19 The method of calculation of the rate of tax payable by a taxpayer with a special income or capital gains component as set out in the clauses mentioned in paragraph 2.17 above does not provide for the correct amount of FTA benefits to be made available in the same manner as used for most taxpayers. In a number of situations a vastly different amount of benefit could result.

2.20 Section 20F deals with cases where a taxpayer is entitled to FTA benefits and has a special income or capital gains component included in taxable income. It does this by providing a different manner of making the FTA benefit available to the taxpayer. Instead of an increase in the tax-free threshold, the rate of tax determined under one of the formulae, without taking the FTA benefit into consideration, is to be reduced by an FTA benefit rate.

2.21 An FTA benefit rate is worked out using the formula:

(tax-free threshold increase * lowest marginal rate of tax) / taxable income


where tax-free threshold increase is defined to mean the amount of FTA benefits to which the taxpayer would have been entitled had the taxpayer otherwise been entitled to Part A or Part B benefits. Where the taxpayer is a trustee assessed under section 98 of the Assessment Act, 'taxable income' in the formula becomes 'share of net income'. [section 20F]

2.22 The method contained in section 20F provides full FTA benefit entitlements to all taxpayers with special income or capital gains components included in their taxable incomes.

EXAMPLE

A taxpayer has a taxable income as follows:

Taxpayer is a primary producer

2.23 A taxpayer who is a primary producer may be entitled to a rebate under subsection 156(4) or (5) of the Assessment Act or may be liable to pay complementary tax under subsection 156(4A) or (5A). In determining the amount of any rebate or complementary tax payable, it is necessary to ignore FTA benefits. However, FTA benefits are fully delivered to primary producers in the calculation of the tax payable on their taxable income (see the example below) and in adjustments in certain circumstances to complementary tax payable (see paras. 2.24 to 2.32 below).

2.24 Items 3 to 6 of Schedule 1 of the Family (Tax Initiative) Bill 1996 provide for FTA benefits to be ignored when calculating the tax ordinarily payable by a taxpayer on the taxpayer's taxable income for section 156 purposes. This is achieved by the insertion of the words 'and Division 5 of Part II of the Income Tax Rates Act 1986 ' in the relevant places in the subsections mentioned in the previous paragraph.

2.25 Similarly, the Bill provides for FTA benefits to be ignored when making calculations of the notional rate of tax payable, as determined under Schedule 8 of the Rates Act, as used for section 156 purposes. This is achieved by the insertion of clause 3 into Division 1 of Part I of Schedule 8. That clause provides that the notional rate is to be calculated as if Division 5 of Part II had not been enacted. [items 3 and 4]

EXAMPLE:

Adjustments to complementary tax

2.26 A taxpayer who derives income from primary production may be liable to pay complementary tax. The circumstances for liability are set out in subsections 156(4A) and (5A) of the Assessment Act. Where payable, complementary tax is payable in addition to any income tax otherwise payable on taxable income.

2.27 Where the tax-free threshold as increased by an FTA benefit exceeds taxable income and complementary tax is payable, the full value of an FTA benefit would not be able to be offset against the total tax payable including complementary tax.

2.28 Section 20G deals with this situation. It applies only where a taxpayer is liable for complementary tax and the taxpayer's adjusted tax-free threshold exceeds taxable income. Adjusted tax-free threshold is defined as the normal tax-free threshold ($5,400) as increased by FTA benefits available under sections 20C and 20D .

2.29 Section 20G operates in a similar manner to that outlined above for special income and capital gains components; the rate of complementary tax otherwise payable (as calculated under subsection 12(3) or (4) and Schedule 8 of the Rates Act without FTA benefits being taken into account) is reduced by an FTA benefit rate. In the present circumstances, however, the amount of the FTA benefit relevant is only the amount of the "unused" FTA benefits. Two formula are necessary to calculate the amount of the reduction of the complementary tax.

2.30 The first formula is contained in subsection 20G(1) and applies where taxable income exceeds normal tax-free threshold (i.e. $5,400). The new section provides for the calculation of the 'unused' FTA benefit rate and for that rate to be deducted from the rate of complementary tax otherwise payable. The 'unused' FTA benefit rate where taxable income exceed $5,400 is contained in new subsection 20G(1) as follows:

[(adjusted tax-free threshold - taxable income) * lowest marginal tax rate] / deemed taxable income from primary production


2.31 The second formula is contained in subsection 20G(2) and applies where adjusted tax-free threshold exceeds taxable income and taxable income is less than normal tax-free threshold (ie; $5,400). In this situation, a taxpayer's entire FTA entitlement would be 'unused'. However, the formula in subsection 20G(1), if used when taxable income is less than normal tax-free threshold, would be based on an amount greater than the FTA benefit to which a taxpayer was entitled (taxable income would be less than $5,400). The second formula ensures that this is not the case. It bases the 'unused' FTA benefit rate on the amount of the benefit. The formula is:

(tax-free threshold increase * lowest marginal tax rate) / deemed taxable income from primary production


2.32 Similar formulae, contained in subsections 20G(3) and (4) , apply in relation to a share of the net income of a trust estate assessed under section 98 of the Assessment Act.

EXAMPLE:

Taxpayers with rates of tax determined by reference to a notional income

2.33 Schedule 9 of the Rates Act provides for the calculation of a rate of tax to be applied to every $1 of ordinary taxable income of a taxpayer who has a notional income determined under section 59AB (balancing charge on depreciated property) or section 86 (premium on lease) of the Assessment Act. The provision of FTA benefits through increases to tax-free thresholds does not produce the level of benefit intended in all these cases. To achieve the correct result, it is necessary to ignore the direct application of FTA benefits and, instead, to adjust the rate otherwise applicable in a manner similar to that outlined above in respect of taxpayers whose taxable incomes include special income or capital gains components (see paragraphs 2.17 to 2.22 above).

2.34 Section 20H provides for the rate of tax otherwise payable by a taxpayer to whom Schedule 9 applies to be reduced on account of FTA benefits. It does this by providing that the relevant taxpayer is not entitled to the benefits provided by sections 20C and 20D and, instead, for the calculation of an FTA benefit rate to be used to reduce the rate of tax otherwise applicable to the taxpayer.

2.35 The formula for calculating the FTA benefit rate is set out in section 20H as follows:

(tax-free threshold increase * lowest marginal rate of tax) / ordinary taxable income


Ordinary taxable income is used because the rate of tax determined under Schedule 9 of the Rates Act is applied to ordinary taxable income.

EXAMPLE:

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In addition, the taxpayer is entitled to FTA benefits in respect of 3 children over 5 years (ie; $3,000).

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These features produce the following figures that are calculated without FTA benefits being taken into account:

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Tax on notional income ($16,000-$5,400 x 20%) $ 2,120

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Rate of tax on notional income ($2,120/$16,000) 13.25%

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The rate of FTA benefit is calculated using the formula in section 20H to be ($3,000/$22,000 x 20%) 2.73%

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The rate of tax to be applied to ordinary taxable income after taking FTA benefits into account is (13.25% - 2.73%) 10.52%

Trustee assessment where beneficiary would be entitled to FTA benefits

2.36 Schedules 10 and 12 of the Rates Act apply where a trustee is assessed under section 98 or 99 of the Assessment Act. The Schedules operate to provide that the rate of tax to be applied to a beneficiary's share of the net income assessed under section 98 is the rate that would be applicable were one individual to be assessed and liable to pay tax on a taxable income equivalent to the share of net income.

2.37 Section 20J operates to ensure that, in the application of Schedules 10 and 12 to a beneficiary who is entitled to an FTA benefit, that the FTA benefit is taken into account when calculating the tax payable by the trustee for the beneficiary.