Franking credits trap: Businesses warned to plan ahead this EOFY to avoid “tax leakage”

Less than a month out from tax time small businesses are being warned not to tempt fate with the tax office, with new funding allowing for increased scrutiny over everything from expense claims to suspected black economy activity.

With new data from the Single Touch Payroll (STP) rollout and increased funding for stamping out illegal activity, the ATO has said it will be on the lookout for businesses which fail to report all of their income and claim private expenses for their business.

The small business tax gap has recently been estimated at around $10 billion, which is far higher than large corporates and is driving tax office interest in a tougher approach.

In a statement circulated last week, assistant commissioner Peter Holt said the usual suspects, including firms claiming expenses without adequate proof, were on the ATO’s radar.

“We’re focusing on addressing common issues we see when small businesses lodge their returns,” he said.

“For example, you’re a sole trader landscape gardener who usually works in Perth but took on a job in Broome. While you’re up in Broome, you do some sightseeing. That’s a private expense and you can’t claim the cost of that.”

Meanwhile, BDO’s national tax director Lance Cunningham says anyone engaging in the black economy will face a cashed up tax office.

“Businesses who are engaging in the black economy should be on edge, given the significant funding that has been allocated to the ATO to combat such behaviour,” he tells SmartCompany.

“However, we hope the implementation of these new measures don’t impose significant new compliance burdens on honest businesses, in order to capture the cheats.”

Common issues aside, small businesses will need to be wary of a reduction in the corporate tax rate to 27.5%, which has implications for franking credit dividends.

The franking credit trap

Businesses with less than $50 million in turnover at 30 June 2018 have a maximum franking tax rate of 27.5%, but if a company pays a dividend based on profits from a previous year when the tax rate was higher (30%), the difference (2.5%) could become “trapped”.

Small-business accountant Lisa Greig, founder of Perigee Advisers, says, some business owners risk “tax leakage” if they don’t develop a plan for their franking credit dividends.

“A lot of mum and dad businesses leave money in their company as superannuation for when they retire, they drip feed it out,” Greig tells SmartCompany.

“But if they leave all this tax they paid at 30% in there they’re only going to be able to get it out at 27.5% in their tax return.”

Companies are being advised to consider the franking rate they’re subject to for 30 June this year and the rate they’ll be subject to in the coming years, with the tax rate slated to decrease further to 25%.

The company tax rate for small businesses will reduce to 26% in 2020-21 and to 25% from the 2021-22 financial year – which means the risk of trapped franking credits will be an ongoing issue for companies.

Businesses which are moving from a 30% franking rate to 27.5% should consider paying out dividends before tax time this year, Greig says.

“You’ll never be able to frank at that percentage ever again,” Greig explains.

In a note circulated to clients earlier this year, consultancy firm BDO also advised its clients about the danger of trapped franking credits, noting shareholders in companies on the 27.5% rate will have to pay a higher top-up tax.

For example, the firm said: consider a company with a $100 profit paying 30% tax and a $70 balance as a franked dividend to shareholders.

“If the shareholder’s marginal tax rate in 47%, they will pay tax on the $70 franked dividend of $17 (after franking offset) leaving the shareholder with $53 after tax,” BDO said.

“However, if the company pays tax at 27.5% tax on the $100 income it can pay a $72.5 franked divided franked at 27.5%, in which case the shareholder pays $19.50 on the $72.50 franked dividend leaving the shareholder with the same $53 after tax.”

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