A low-key tax ruling will have dramatic implications for thousands of small business owners.
SMALL business owners are in for a shock. They are going to pay extra tax on their profits on top of the 30 per cent corporate rate, even where they haven’t paid themselves a dividend out of their businesses.
While everyone’s attention was focused on that other profits-based tax, this change in small business tax policy has been overlooked. Most small business owners wouldn’t even be aware of it yet and the tax profession has been scrambling to come to terms with it in the last month or so. It’s big.
So, who’s behind this new tax hit on small business? It basically comes down to Assistant Treasurer Nick Sherry and the Australian Tax Office. Going straight to the top, I queried Senator Sherry in person when he visited Perth recently and I also have a letter from him on this change in tax policy.
How profits are taxed
Let’s start with some perspective. Imagine that you own shares in a large, listed company. The company runs a business and pays 30 per cent company tax on its profits each year. What does the company do with the remaining 70 per cent of profits? Basically, it either keeps it or pays it to you as a dividend.
Listed companies generally do both – paying a dividend satisfies your expectations as a shareholder while retaining some profits is necessary to fund working capital, acquire new equipment, pay off external debt or inevitably all three and more. Profit kept back for these purposes is often referred to as being ‘reinvested’ into the company’s business to facilitate business growth and, more importantly, allow businesses to employ more people.
Let’s say you get paid a $70 dividend (meaning the company has already paid $30 tax). You will have some more tax to pay if your personal marginal rate of tax is more than 30 per cent. If you are on the top personal tax rate of 46.5 per cent, you’ll get a tax bill for $16.50 (known as ‘top-up’ tax). The $30 of company tax already paid plus your $16.50 contribution to the government’s coffers means a total tax take of $46.50 or 46.5 per cent. But here’s the point. You only pay the top-up tax when you get paid a dividend.
Similarly with a small business, what does the owner do with the remaining 70 per cent of profits – pay him or herself a dividend or reinvest back into the business?
Small business owners actually have a lot less freedom of choice in the matter. They don’t have access to many of the funding sources that big businesses do. They have to rely on reinvesting their own profits to fund growth. Anyway, the logic of paying top-up tax only when you actually get paid a dividend out of the business also applies to the owners of a small business. Until now.
What will change?
For the 2010-11 year onwards, tax law will be applied differently such that most small business owners will be required to pay the top-up tax on profits kept back in the business. That is, you will get a bill for the top-up tax even though you haven’t decided to pay yourself a dividend. And what is considered a ‘small business’ caught up in all this can range from a corner deli to an engineering firm employing a hundred or more staff.
I know what you must be wondering, ‘When did all this happen? Where was the government announcement, the amending legislation, the fiery debate in parliament and the avalanche of talk-back radio calls?’ Here’s how it happened.
The tax laws are enforced by the Commissioner of Taxation. One of the many things the commissioner does is to issue what are called taxation rulings. They are not law, like a court decision, but merely the commissioner’s opinion on a particular tax law. Rulings are a double-edged sword. The commissioner is bound by these rulings when enforcing the law, which is great if a ruling is favourable to taxpayers, not so great when unfavourable. And things get strained when the commissioner decides to enforce the law based on a ruling that is just plain wrong. That isn’t new by the way; there have been court decisions over the years that have shown some rulings to be wrong.
But here’s where the rulings system has now taken a new twist. The commissioner issued a new taxation ruling last month, TR 2010/3. The ruling covers the everyday, common garden situation for hundreds of thousands of small businesses across Australia of operating a business through a trust with profit allocated to a company on which 30 per cent tax is paid.
The long-accepted legal position is that, although the allocated profit is an entitlement owing by the trust to the company, by it’s very nature, it is not a ‘loan’ made by the company back to the trust.
However, all of a sudden, the commissioner now says – in a ruling – that is exactly what it is. Just like that, a decades-old established legal position is tossed out the window in a ruling that is seriously lacking in legal support.
Treating (wrongly) the profit entitlement as the company having made a loan back to the family trust is the key to everything. It’s the release of a linchpin that triggers a chain reaction of complex tax laws in Division 7A of the Tax Act that apply only to private businesses.
To cut a long story short, the practical effect is this. The small business owner will be forced to pay themselves a dividend out of the business, thus triggering the top-up tax. As I’ve discussed, a small business can’t just pay out this money, it needs it. So the owners will have to lend the dividend money straight back into the business.
In the wash up, nothing really happens except that the business has to fork out for the top-up tax. In a perverse twist, the commissioner has cooked up a ‘round-robin’ tax scheme with two exceptions: it creates a tax bill out of thin air and operates in broad daylight.
Again cutting a long story short, this enforced round-robin of payment and re-lending of dividend money will happen over a seven-year period for each year’s profit. That’s a separate, seven-year round-robin cycle created for every year’s profit. The additional compliance costs and administrative burden make a mockery of all the efforts to reduce red tape for small business, let alone the extra tax bill itself. Big business and their owners are not affected.
Why this approach?
In recent years, the commissioner has fought some cases all the way up to the High Court on other issues, different from this one, relating to the taxation of trusts. Despite losing every time, the commissioner just kept going, desperately trying to get the result he wanted. The reason the commissioner kept losing was simply that he was wrong. The courts weren’t fooled and sent him packing.
Even though I think the commissioner’s position on this tax change is wrong, I would abide by the umpire’s decision from a test case. But apparently that’s not the way it’s going to happen this time.
There are thousands of small businesses that have reinvested their profits after paying the company tax rate that will now be hit with top-up tax, even though they have no capacity to pay a dividend. Don’t get me wrong – they would pay it one day anyway, just like when you get paid your dividend from a big company; but now it’s being forcibly brought forward by dictatorial decree.
You might think this is easily fixed by taking the commissioner to court to settle the matter.
But who’s going to do that on behalf of all small businesses? Even when you know you are in the right, it’s a pretty daunting prospect taking on a multi-billion dollar organisation.
In a nutshell
Many small businesses have profits remaining reinvested for years, decades even, before the owners get to pay themselves a dividend. But in the meantime, those reinvested profits serve a vital function in permitting a small business to grow and employ more people.
But now that’s all going to be dealt a serious blow because the business will suffer due to the owners being hit with the top-up tax. This will stunt growth and employment in the biggest employing sector in the economy.
Small business owners and their accountants need to start planning for this.
• David Montani is a director at business advisory firm MGI Perth and specialises in taxation advice. He is a member of the Liberal Party.