Tax Tip 287: How Capital Gains Through a Company can be Tax Free

Tax Tip 287: How Capital Gains Through a Company can be Tax Free

Companies pay a flat 30% tax on capital gains (or 27.5% in some cases). But this is not the final tax on that income as there is tax to be considered again when the income comes out of the company.

Where the income of a company is paid out as a dividend the potential final tax rate could even be much lower than 30% - it can even be nil.


People just assume companies pay 30% flat tax and often think no further.


Example

Homer has twins who are currently 16, but they will turn 18 in a few financial years. The trouble is that Homer, as director of Homer Pty Ltd wants to cause the company to sell a parcel of shares now as he thinks the market will drop. This will trigger CGT. Homer thinks, ‘bugger, a flat 30% tax rate’, but then realises this is not the final result.

The capital gain from the shares is $100,000.

Tax on this will be $30,000 in the hands of the company. The company also has $30,000 in franking credits as a result.

Homer causes the company to sell and to retain the income (and perhaps to reinvest it).

The twins become 18 in just over a year and can then receive income and be taxed at adult tax rates.

They are still not working while studying and have no other income so Homer causes the company to pay a $30,000 dividend to the shareholders. This dividend goes to the trust which owns the shares and Homer controls this trust as well and causes the dividend income to go to his 2 daughters in equal shares.

They get $15,000 in dividends each, but they also get the franking credits as well as the dividend was fully franked.

The franking credits on $15,000 in fully franked dividends is $6,428 making a taxable income of $21,428 per twin.

On a taxable income of $21,428 there is no tax payable. So each twin gets $6,428 refund from the ATO due to how the imputation system works.


The company has paid out $30,000 and $12,856 in credits

It still has $40,000 in retained earnings plus $17,144 in franking credits.

The next year the company does the same thing – it pays another $30,000 dividend out and the twins pay no tax as they are still not working.

After the second year the company has just $10,000 in retained earnings plus $4,288 in franking credits.

In the 3 year the twins are working at Maccas while attending uni and they each earn $13,000 per year in income from this.

The company pays another $10,000 in dividends to the trust and then $5,000 to each plus $2,142 in franking credits.

This equates to $7,142 in taxable income plus the $13,000 from work means $20,142 in taxable income and no tax payable.


In this situation the company did not get a 50% discount when it sold its shares, but the income from the capital gains was able to be taxed initially but with a refund for all of the tax paid at a later date so the end tax rate was zero.


Ps. I am not a trained mathematician so the figures may be out so use this as a general guide only and get tax and legal advice before considering ownership structure for holding shares.


Note that the same result could have been achieved whether the investment vehicle was a trust or a company.

 

Terryw, is the $21428 figure from the normal threshold plus the low income tax offset?

 

There are low income tax offsets which allow for a bigher tax free threshold then the $18,200.
Tax Tip 197: How much can be earned without having to pay tax? Tax Tip 197: How much can be earned without having to pay tax?

I just use this calc which is very easy to use TaxCalc - Calculate your tax. 2019-2020 financial year

 

Lets assume one twin works at Maccas whilst the other one doesn't.

Is it possible to stream the income, sans franking credits, to the one with no job, and income avec franking credits to the one who does?

I think the answer is no and I hope you follow my French.

 

Covered that here:

Tax Tip 201: Can a Trust Distribute Franking Credits to Someone Other than the Dividend Recipient? Tax Tip 201: Can a Trust Distribute Franking Credits to Someone Other than the Dividend Recipient?

 

Generally speaking company dividends are paid to shareholders and to respective classes of shareholder. The rules for tax purposes are complex to avoid franking manipulation but broadly speaking where more than one class of shareholder exists then it is possible to stream a dividend to one class and not the other provided the classes do have different rights BUT it does come with some elements of concern and coul;d even pose a Part IVA issue to make these changes to achieve a tax outcome. It would be unusual to have members of the family especially minors with different classes of share etc. This is where a Disc Trust as shareholder makes more sense so that company to trust is more effectively flexible. Then there also needs to be care with trust resiultions etc However changes to shareholdings must also consider CGT and even duty risks (if the company owns a property for example)

This is why structure is so important and involves many complex areas of advice at formation and afterwards

 

It depends on what the trust deed says. First step - read the deed.

 

Even if the deed allows it I don't think it is possible as the franking credits are something that attaches to the income.

 

The franked income declared by the company and the proportionate share of franking credits remain attached - correct. Efforts to manipulate mean the franking credit is cancelled. Franking credit trading schemes are same.

If a trust is the shareholder the 45 day holding period rule, FTE and other rules can also cancel the franking credit entitlement even if it is a share of franked income. The deed can permit streaming but if the trustee was to change the franking for one beneficiary it could cancel the franking for all too. But there can be ways to maintain the franking by streaming income in different elements (foreign income, Cap gains, franked, unfranked, interest etc to different beneficiaries. This question comes up with foreign beneficiaries where the income charecter may be very important.

Contrary to what most people are led to believe one way can be to direct a loss element to a nominated beneficiary too ! We often read a trust cant distribute a loss...It can. The net income must be at least $1 BUT this could be a loss of $10K and a CGT gain (net) of $10,001 which for tax purposes would be $0 after rounding.

 

Yep, agree. I read the question as two different forms of income. Need to brush up on my French!