Changes to the enterprise tax plan could hurt small business

Accountants need to be aware of the proposed changes and their potential impact on small businesses.

Proposed changes to the federal government’s company tax cut could see some small businesses missing out.

Small business owners around Australia had good reasons to rejoice when the federal government’s enterprise tax plan became law in May 2017. The plan saw the company tax rate fall to 27.5 per cent for businesses with an aggregated turnover of A$10 million or less in the 2017 financial year, with further cuts to come over the next 10 years.

That isn’t quite the end of the story, however. Legislation currently before parliament is set to further limit who can benefit from the lower rate – and as always, the devil’s in the detail.

The problem with passive income

If passed in its current form, the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 will stop companies from accessing the new, lower tax rate in any year where 80 per cent or more of their assessable income is “passive”. The Bill introduces a new concept, “base rate passive income”, defined to include interest, royalties, rents, capital gains, non-share dividends, and distributions from trusts or partnerships. The government’s stated aim is to ensure the tax cuts only benefit those who are actively carrying on a business, rather than simply investing.

Yet according to CPA Australia head of policy, Paul Drum, the Bill could have unintended consequences, especially when unforeseen or extraordinary circumstances lead a business to fail the test.

“CPA Australia supports the Bill and the government’s intention,” he says. “It’s about encouraging business in Australia, not creating tax minimisation vehicles for passive investment. However, there may be cases at the fringes where the Bill could have quite a different outcome to what appears to be the intended effect.”

When bad times hit good businesses

Drum gives the example of a primary producer hit by drought who continues to receive passive income from renting out a paddock or an investment property.

“You might have a farmer that for the last 20 years has been actively carrying on the business of primary production in a company that also owns some property that it rents out, but because of drought in one year his active farming income is zero,” says Drum. “He’s been paying tax at 27.5 per cent, then in that one year it jumps up to 30 per cent as his rental income  – which is passive income – exceeds the 80 per cent threshold. Then in the next year, when the drought’s over, he jumps back down to 27.5 per cent.

“Nothing he’s doing has changed. It’s just that his active income was wiped out because of drought. Then, in the very year a lower tax rate might have been of benefit to him, he actually pays the higher rate.”

Similarly, a business could suffer from an unexpected catastrophe, such as the illness or death of a key person. As a result, it might stop receiving active income for a time, while still earning rent or dividends. In this scenario, the business could fail the test and pay a higher rate on its already diminished earnings.

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Royalty roulette for small business owners

The proposed legislation could also affect businesses that receive income through payments that are technically royalties, such as software developers. “We’ve got governments talking about innovation and fintech, and trying to encourage these kinds of businesses to stay in Australia, so this would seem to be rather an unfortunate outcome,” he says.

To overcome this issue, Deloitte has suggested treating royalty income as active if it is generated by something originated by the company. Deloitte’s suggestion is to use a similar distinction to “tainted royalty income” in section 317 of the old Income Tax Assessment Act 1936.

What accountants need to know 

While CPA Australia has some concerns about the unintended consequences for outliers like these, Drum stresses that the organisation supports the overall intent of the proposed legislation. He points out that, without a passive income test, investment companies receiving fully franked dividends would see some of their franking credits lost forever, thanks to the differential between their own 27.5 per cent company tax rate and the higher rate paid by a large company.

Nonetheless, there are issues to be resolved over time. “A big part of it is interpretation of the law, and the tax office has already made a start on that by pushing out its draft ruling about what carrying on a business means for the purposes of these provisions. So that’s a very positive thing, but it doesn’t address all these things we’re talking about,” he says.

In the meantime, accountants need to be aware of the proposed changes and their potential impact: “Depending on your situation or your client’s situation, they could affect you, so it is important to be ready.”

Read next: Will cutting company taxes really pay off?

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October 2021
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