Tax Tip 386: The effect of Non-Cash Deductions on Company Franking Credits

Discussion in 'Accounting & Tax' started by Terry_w, 18th Jan, 2022.

Join Australia's most dynamic and respected property investment community
  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

    Joined:
    18th Jun, 2015
    Posts:
    41,420
    Location:
    Australia wide
    Companies can be a good vehicle to hold property. But there can be a minor effect on income with the payment of franking credits because of non-cash expenses such as depreciation. The depreciation amounts reduce the taxable income of the company which reduces the amount of tax the company pays, which in turn reduces the amount of franking credits available. This has the affect of making money trapped in the company without it having franking credits attached. When this money is paid out the shareholder recipient won’t have the benefit of franking credits.


    Example

    Bart sets up a company to hold property. It has $100,000 of rental income and $20,000 in depreciation claims.

    The company’s taxable income is $80,000 because the depreciation is a non-cash deduction - so the company actually has an income of $100,000 but only $80,000 is taxable.

    Tax on $80,000 is $24,000 at 30% flat tax rate.

    Let’s say the company later pays a $80,000 dividend – this could be fully franked.

    But the company would still have $20,000 in retained ‘cash’. If this is paid out there can be no franking credits as there is no tax paid on this component.

    If the shareholder receiving $20,000 in unfranked dividend had an otherwise low income it may not matter too much, but if the shareholder had a high income they might end up paying more tax on this.


    A strategy might be to have a discretionary trust hold the shares and pay non-franked dividends to the 18 year old+ kids when they are not working – up to $22,000 per year to use leave more franking credits in there for others.
     
    Piston_Broke likes this.
  2. Trainee

    Trainee Well-Known Member

    Joined:
    24th May, 2017
    Posts:
    10,121
    Location:
    Australia
    Franking Credits represent tax already paid. Excess franking credits can be refunded.

    So is leaving franking credits to others only so that some people pay less additional tax as a result of the dividend? As opposed to minimising tax payable overall between everyone?

    e.g. the company pays unfranked dividends to Bart's kids resulting in zero additional tax payable (as opposed to a refund if the dividends were franked), and pays franked dividends to Homer just so he pays less additional tax? Even though if you swapped it around (assuming the same tax year) and overall net tax paid / refunded within the family would be the same?
     
  3. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

    Joined:
    18th Jun, 2015
    Posts:
    23,080
    Location:
    Sydney
    Franking and profit are rarely the same values. Some companies amass large franking balances that shareholders cant use. Others have insufficient. Another way to maximise franking credits isnt just paying tax. A company will increase its franking balance by holding franked shares. The franking may pay some tax and also credit the franking account.
    The strategy of paying DOWN some share capital or to discharge loans from related parties is often ignored

    Simple strategy
    Fred and Wilma have a trust / company which was funded through them lending $$$ to. Lets say $500K. Over time the investment assets double and so it owns $1m of investments with $500K of debt. Paying the debt down rather than paying out profits is a option many dont consider. The small profit issue may be a lesser concern than discharging (or reducing) the debt which has no tax consequence. Cashflows arent always income.
     
  4. Piston_Broke

    Piston_Broke Well-Known Member

    Joined:
    30th Jul, 2015
    Posts:
    4,028
    Location:
    Margaritaville
    Companies may have other tax deduction expenses that may not be available to persons, or difficult to prove and claim thus ignored.
     
  5. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

    Joined:
    18th Jun, 2015
    Posts:
    23,080
    Location:
    Sydney
    There are even things like JMEI exploration credits., AMIT adjustments incl tax deferred amounts etc and more which play a part. A company receiving R & D concessions is a great example of some of the differences. In exchange for the refundable tax credits many of its otherwise deductible expenses lose deductibility. This can mean tax becomes payable but is offset by a larger tax refund. Tax credits and cash are almost never going to match. One of the common examples is a PSI entity which attribues its profit to the individual and in that case the entity will have a profit of $0. The ATO attribution rule unwinds franking mischief etc

    During the periods of cashflow boost many companies had cash but no profit. If it paid this out then it created a loss. The ultimate tax issue transferred to the receipient who was taxed at their marginal rate...so much for the idea of it being tax free. The entity either recognised a tax loss or paid less tax.
     
  6. Fara

    Fara Active Member

    Joined:
    7th Nov, 2020
    Posts:
    25
    Location:
    Sydney
    Following on from this what happens if the original income is franked dividends.

    Homer has a family trust that owns ASX shares. In a given tax year he receives franked dividends of $100 (includes $30 franking credit) and the trust has expenses of $20 i.e. Net Income of $80.

    Homer is on the top tax bracket so uses a bucket company and fully distributes the $80 to it. The bucket company has no expenses and pays tax on the $80 i.e. $24. However, when the trust distributed $80 of income to the company it also passed $30 of franking credit!

    Does Homer have any hope of recovering his $6 in excess franking credits?
     
  7. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

    Joined:
    18th Jun, 2015
    Posts:
    41,420
    Location:
    Australia wide
    How can Homer distribute to a bucket company? The trustee would be the one distributing to the company, It pays the net income with franking credits attached. There would be $30 in franking credits attached and the bucket company would pay 30% of the grossed up income in tax. If the income is only $80 it would pay $24 in tax. When the company pays a dividend it only has $24 in franking credits. to distribute.

    Homer is not part of this, unless he is the shareholder or beneficiary of the bucket company dividend that is eventually paid out. There is no excess franking credits, but the franking credits are lost to the tune of $6.

    I think that is how it works, but I am not an accountant so don't see the back end of transactions too often
     
  8. Fara

    Fara Active Member

    Joined:
    7th Nov, 2020
    Posts:
    25
    Location:
    Sydney
    Sorry ignoring all semantic errors with Homer/trustee distributions etc. the key aspect I am keen to understand is ....

    ...how to avoid or reduce losing these franking credits. I understand that distributing the net income to individual beneficiaries would make full use of the franking credits but in the instance that the beneficiary with the lowest tax rate is the bucket company (30%) what do you do?
     
  9. Trainee

    Trainee Well-Known Member

    Joined:
    24th May, 2017
    Posts:
    10,121
    Location:
    Australia
    Are the $6 franking credits just trapped in the trust? In which case one strategy would be to make sure the trust has unfranked income (from fixed income, reits, or just unfranked divs) to ‘absorb’ the expenses?
     
  10. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

    Joined:
    18th Jun, 2015
    Posts:
    23,080
    Location:
    Sydney
    Trusts dont maintain a franking account. Only companies. REITs pay trust income which can be franked or unfranked or even AMIT amounts and foreign income and CGT amounts etc. A REIT is just another type of trust. If a trustee wants to pay tax to utilise franking credits it may do so and face a franking shortfall between the 30c franking and the marginal rate of 45%. Where franking credits may exeed $5K there may also be a family trust election requirement or franking is lost. Its pretty hard to tax plan full efficiency of franking within a trust. It may also assist that a trust distributes franked income to a company beneficiary in which can no further tax is payable and that company may store the franking credits.

    Its wise to obtain competent tax advice when tax planning is considered. Most taxpayers lack sufficient technical skills to tax plan.