By Anthony J Cordato, Cordato Partners Lawyers
The federal government has introduced legislation to restrict real estate investment companies from qualifying for the lower corporate tax rate of 27.5% from the 2017/18 tax year if more than 80% of their income consists of rent or other passive investment income. This test is in addition to meeting the turnover test to qualify for the tax rate cut.
The passive income test is in line with the federal government’s desire to restrict the tax rate cut to companies with income from an “active” business.
Refer to CCH Books – Australian Master Tax Guide 2017/18 and Australian Income Tax Legislation 2017 – 3 Volume Set for more guidance on CGT and Income Tax.
Why has the legislation been introduced?
In reading the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 on 18 October 2017 for the second time, the Minister for Revenue and Financial Services, said:
This bill clarifies that passive investment companies do not qualify for the lower company tax rate. The amendments in this bill will introduce a clear test that enables companies to determine whether they are eligible for the lower rate of tax of 27.5%. Companies that derive more than 80% of their assessable income in passive forms will not be able to access the lower company tax rate. The “passive income” test replaces the “carry on a business” test as a requirement for access to the lower company tax rate. The new test will have effect from the 2017/18 income year.
The technical terms used are base rate entity and base rate entity passive income.
Base rate entity is a company with an aggregated turnover of less than the threshold of $25m in the 2017/18 income year, and less than $50m in the 2018 to 2024 income years.
Base rate entity passive income is assessable income from rent, interest income, royalties, net capital gain, distributions, franking credits and non-share dividends by a company. It extends to income of a corporate partner or trust beneficiary (a “bucket company”) which derives passive income through interposed partnerships or trust estates.
How will real estate investment companies be affected?
A real estate investment company which is a base rate entity is entitled to a corporate tax rate of 27.5%, as opposed to the standard company tax rate of 30%, provided they satisfy the test of “carrying on a business” in the 2017/18 income year.
Whether or not a rental property business is being carried on is explored in YPFD and Commissioner of Taxation (Case 1/2014 2014 ATC ¶1-063,  AATA 9). Whether or not a “rental property business” is being carried on is not clear cut. The Administrative Appeals Tribunal looked at various criteria before it decided that a couple who owned and self-managed nine rental properties were carrying on a business of letting properties.
By replacing the “carrying on a business test” with the “passive income” test, the ATO is looking to use a clearer “bright line” test to determine eligibility for the corporate tax rate of 27.5%.
In the Explanatory Memorandum to the Bill, this example is given (Example 1.3):
Jane and Dave Smith are the sole shareholders and directors of Smith Pty Ltd. Smith Pty Ltd holds a diversified portfolio of shares from which it earns dividend income as well as several term deposits from which it earns interest. It is also the beneficiary of a trust which owns a commercial investment property. All rental income earned by the trust is distributed to Smith Pty Ltd.
Smith Pty Ltd also earns a small amount of fee for service income. This is derived from the consulting services Jane Smith, a retired business woman, provides to a number of independent businesses year.
In the 2017/18 income year, Smith Pty Ltd had an aggregated turnover that is under the $25m aggregated turnover threshold. The amount of its assessable income was $900,000, comprising:
- dividends, rent and interest income of $620,000
- net capital gains of $180,000, and
- consulting income of $100,000.
Smith Pty Ltd is a passive investment company as 89% of its assessable income is base rate entity passive income.
Consequently, for the 2017/18 income year, Smith Pty Ltd’s corporate tax rate is 30%.
If it is possible to qualify for the 27.5% corporate tax rate, the tax saving of 2.5% is significant. To qualify, a property investment company needs a source of non-passive income which contributes at least 20% of its assessable income, such as: consultancy income, management fees or commissions. The lower tax rate only applies if the property investment company has a turnover below the turnover threshold.
CCH iKnow has information on the proposed changes around the company tax rate.