Tax Tip 288: How you could end up paying 47% in CGT Through a Company

Last time I showed how the end tax rate with a company holding shares and being taxed on capital gains could be as low as nil – nothing at all!!

See

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



But it can go the other way too. It could be much more than 30%. This is because the company tax rate of 30% is not the final rate of tax that is paid. Top up tax will need to be paid if the person receiving the dividends is on a tax rate greater than 30%.


Example

Ned set up a company himself with no legal or taxation advice he then went and bought shares in the company. The shareholder is himself. Net is working in IT and is on $200,000 per year and is paying the top tax rate so the company rate of 30% in tax was the main driving factor in him owning shares through the company.

After 2 years the shares have double and there is a $100,000 capital gain when they are sold.

Great things Ned

The company pays 30% tax and has $70,000 left.

Ned then takes that out as a dividend as he wants to reduce his non-deductible debt – something which he has also not taken advice on.


Ned receives $70,000 from the company which comes with $30,000 in franking credits


Ned’s new income is now $300,000 – his $200,000 from his wage plus his $100,000 from the shares (the $70,000 is grossed up to $100,000).

On $200,000 in income Ned was paying $67,097 in tax.

On $300,000 in income Ned will pay $114,097


That is an extra $47,000 in tax.

Ned has a franking credit of $30,000 but the top up tax will be $17,000


The net result is that Ned has paid 47% on the capital gains on the shares.

 

Great post and good worked example.

Under dividend imputation, company income and company tax are imputed to the shareholder. Companies are effectively taxed once, in the hands of the shareholder (at the shareholder’s marginal tax rate), avoiding any double tax, as intended. Think of any ‘company tax’ paid by the company as merely a prepayment of personal tax on behalf of the shareholder, much like PAYG withholding payments by an employer.

 

Payg is withholding on behalf of the individual, because the individual will get the income and has to declare the income.

company after tax earnings can be retained in the company forever without distribution.

company tax is not a prepayment because dividends do not have to be paid.

two different things because a company is a separate legal entity.

Would the more correct definition of the purpose of imputation be that company earnings that are distributed to individuals are taxed as if earned by the individual in that tax year, with a credit for company tax already paid (if any)?

 

Good points. However, if dividends are not paid, the franking credits accumulate in the company and are an asset, and hence valuable to the shareholder. They are not lost. There is a paper out there about why optimal dividend policy is to pay 100% of profits in dividends and retain capital via dividend reinvestment scheme, rather than retain (no dividends), so that the imputation credits get used immediately.

 

The example clearly suggests otherwise?

 

It will depend. Paper I mention related to optimal policy for public company with many hundreds of shareholders (Admittedly quite a different example to Terry’s). For a private company, with single or small number of shareholders, optimal policy can take account of individual shareholder tax rates and circumstances, and hence there is far more scope to effectively manage tax with different dividend arrangements.

 

That could make sense - especially with the proposed reductions in tax which could reduce the tax benefits of the franking credits in the future.

 

The final rate of tax can also easily exceed 47%.

+ Medicare levy surcharge (2%)
+ HELP debts (Ned is doing some postgrad studies)
+ Div 293 tax adding a further 15% tax to his employer super and his own salary sacrifice (an extra $3750 possibly)

Also if Ned had considered his shareholding in this company so that a disc trust owned the shares it could have been possible for Neds kids (2) to each get a large distribution as they are both 18+ and attending scripture college. Major tax savings may reduce the average tax rate from 47% to 0% (a total refund of $6071) and no Div 293, increased help repayment or MLS.

 

could be even worse.

Ned could have taken out the $70k as a loan without a complying loan agreement being put in place before the earlier of the lodgement date or due date for lodgement.

Ned will then have an unfranked dividend of $70k which will mean additional tax payable by Ned of $33k.

Close to a 63% tax rate.

 

Or even dual penalties. Div 7a non-complying is the company issue not taxpayer issue. Then property owner is taxed as a unfranked amount despite company paying tax. No credits. Dual taxation and penalties, interest, advice and objections. ???