The Small Business Tax Increase the Government doesn't want you to know about

May 10, 2017

While the headlines of the previous budget proclaimed small business owners would be paying less tax, many small business owners will actually be paying more tax as a result of the tax cuts.

If you run your business through a Company, and your turnover is below $10m, your Company will be paying less tax from 1/7/16 as the Company tax rate for these Companies has dropped from either 30% or 28.5% to 27.5%. This does mean a boost in cash flow for these companies but when the funds ultimately find their way to the business owners as dividends, the business owners will actually need to pay more tax than they otherwise would have without the tax cut.

This is because when a business owner receives a dividend from their Company, they are entitled to a credit for tax paid by the Company. However Companies are now only entitled to provide a credit based on their current tax rate rather than the tax rate they actually paid. The result is that any earnings retained in a Company from a year with a higher tax rate will attract additional tax for the shareholder when paid out. Below is an example of how this works on prior year profits before and after the tax cut.

Pre Tax Cut

Prior Year Profits in Company

$100,000

Tax in Company

$30,000

Dividend paid to Shareholder

$70,000

Tax credit available to shareholder

$30,000

In this example the shareholder pays tax at their marginal rates on the dividend and receives a tax credit for the full amount of tax paid by the Company.

Post Tax Cut

Prior Year Profits in Company

$100,000

Tax in Company

$30,000

Dividend Paid to Shareholder

$70,000

Tax credit available to Shareholder

$27,500

In this example the shareholder has to pay an additional $2,500 catch up tax on their dividend. This is because under the new rules the Company is only eligible to provide a tax credit based on current tax rates, despite having paid tax in the past on these earnings at a higher tax rate.

The only real winners of the tax cut are foreign investors because the only tax they have to pay is the amount of their franking credit. Businesses run through a structure other than a Company generally obtain a small benefit as long as they don't have a structure which prevents them from claiming a small business tax offset. Businesses run through a Company get a cash flow boost but in the end will pay extra tax on retained profits that were earned in years where the tax rate was higher. The impact will worsen when the Small Business Company tax rate is further cut to 25% by 2027.