The Imputation system that applies to company taxation contains many traps for the unwary company director. The Imputation system came into effect on the 1st July 1986. Prior to this date, a company paid tax on its income. In addition, it was mandatory to declare a certain amount of its income as dividends to shareholders. The shareholders were taxed on these dividends. Shareholders were not given any credit for the tax paid by the company. In effect, there was double taxation of some of the company's income i.e tax was paid by the company on the income and tax was subsequently paid by the shareholders on the income.
From 1st July 1986, a new system came into force. As previously, a) tax was paid by the company on its income and b) tax was paid by the shareholders on dividends received. But the big innovation was that the shareholders were now given a credit for the tax paid initially by the company. The dividends were said to be "franked". However, shareholders could only be given a credit to the extent of the tax paid by the company. For instance, if the company had paid $1000 in company tax, then it could only pass on a credit of $1000 to its shareholders. Many persons assumed that the new tax regime enhanced the attractiveness of a company as the preferred vehicle for carrying on a business. But the new regime contains a number of pitfalls. Falling into one of these could be a costly occurrence. I shall now examine some of them.
TRAP NO. 1 -PAYING TAX IN ONE KING HIT.
Prior to 1990, it was common practice with regard to family companies for the accountant/tax agent, after the end of the year, to compute the profit of the company and then to distribute the profit to the directors. Consequently, the company as such made no profit and all income was taxed on the directors as directors' wages. The company paid no tax and the directors got the benefit of all Rebates etc due to them. In 1989, the Tax Office issued a Ruling which effectively banned this practice. Now, only actual wages and bonuses paid to directors can be treated as directors' wages. The remaining income of the company must be taxed as company income.
When the tax payable on the income is determined, the amount of the tax liability determines how it must be paid. If the liability is over $20000, then 85% must be paid by the following 15th July and the rest by 15th March. If the tax bill is for less than $20000, then it is normally be paid in one lump sum on the 15th December. The current tax rate is 39%. Many companies experience a cash flow crisis when told to pay 39% of their net profit in tax. In some cases, this will be in excess of what would have been payable if the business had been trading as a Partnership.
TRAP NO. 2 - REBATE ONLY FOR COMPANY TAX PAID
It will be remembered from what has been said above that individual shareholders are given a credit for company tax paid. In a way, it is analogous to employees being given a credit for PAYE tax deducted during the year. But there is a big difference. If an employee has overpaid his tax during the year, he will get a refund from the Tax Office after the end of the year. A shareholder will get no such refund. The reason for this is that the company tax paid is treated as a Rebate. Suppose the total tax payable on John Smith's income (which included a dividend) was $3000. He had a dividend imputation credit of $4500. John Smith will have a Nil assessment. He will not get a refund of $1500 (i.e. $4500 less $3000). In a loss situation or where the total income of the tax-payer is under the threshold of $5400, the Rebate will be entirely wasted.
TRAP NO, 3 - PAYROLL TAX
Payroll tax is imposed by the various State Governments. When the wages bill for employees exceed a certain amount, then Payroll tax becomes payable. If the business vehicle is a Partnership, the partners are not included as employees. But if a company is formed, then the directors' wages form part of the payroll. Quite conceivably, a business entity might pay no Payroll tax as a partnership but once the directors' wages are included in a company structure, then the threshold will be exceeded and Payroll tax will be payable.
TRAP NO. 4. - NEVER DECLARING A DIVIDEND
Neither under company law nor under taxation law is there a requirement on a company to pay a dividend to shareholders. A company could, therefore, pay its company tax each year on its profits and never declare a dividend. Some private companies are, at present, following this policy. However, all profits must eventually be distributed as dividends and tax paid on them. The evil day can be postponed until the company is eventually wound up. In that case, all the accumulated dividends would be taxed in one lump sum in one year. This would push the shareholder into a high tax bracket. However, it must be remembered that the company has had the use of the money in the meantime and that it is expected that company tax rates will fall further in the future. If a company does decide not to declare dividends, then it should, at least, inform the shareholders each year of their accrued tax liability.
TRAP NO. 5 - CAPITAL GAINS
Capital Gains tax is payable when an asset purchased after September 1985 is sold at a profit. From the profit is subtracted the increase in the CPI index. For example, a company buys an investment property in 1986 for $100000. It sells it in 1989 for $200000. Assume that the CPI factor would have increased the cost of $100000 to $125000. Capital Gains tax will be levied at 39% on $75000 (i.e. 200000 less $125000). Tax at 39% on $75000 is $29250. Only this amount of $29250 can be passed on the shareholders as a credit. However, the actual profit made by the company was $100000. The company will have to distribute this $100000 as a dividend. The shareholders will be taxed in full on $100000. Consequently, they will lose the allowance for the increase in the CPI. If the shareholders had held the asset as individuals, they would have received this CPI increase allowance as individuals. Consequently, they have lost money by allowing the company to hold the asset instead of holding the asset themselves as individuals.
TRAP NO. 6 - SALE OF GOODWILL
When a business is sold, the profit on the sale of the Goodwill is subject to Capital Gains tax. However, there are two deductions allowed from the profit. The first is the increase in the CPI which we have dealt with in the above example. The second deduction allowed is that only 50% of the profit on the Goodwill is subject to Capital Gains tax. Assume that the figures are the same as in the previous example. Goodwill was bought for $100000 in 1986 and sold for $200000 in 1989. The net gain after allowing for the CPI increase was $75000. Only half of this is subject to capital gains tax i.e $37500. However, as in the previous example, the full net gain of $100000 must be distributed to the shareholders as a dividend. They will be taxed in full on the $100000. They will get a credit only for the tax paid on $37500. Consequently, the shareholders lose a) the CPI allowance and b) the 50% Goodwill allowance. If the shareholders had owned the business as partners, they would have been taxed only on $37500 and not on $100000.
The lesson to be learnt from the last two examples is that where an asset is likely to increase in value over time, then it should be held by individuals and not by a company.
FRINGE BENEFITS TAX
However, on the brighter side, forming a company can have some tax advantages. For example, Fringe Benefits Tax is payable by a company which provides a vehicle to its directors or employees for their own private use. However, no Fringe Benefits Tax is payable by a company if the vehicle can be classed as a commercial vehicle and it is used only by the employee a) on company business and b) on travel to and from work by the employee. If the business structure had been a Sole Trader or Partnership, then the travel to and from work would be classed as private travel and would not be deductible for tax. Forming a company has made the private travel tax deductible.
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