Many Australian business owners know that companies can potentially access a lower company tax rate, but the rules are not based on size alone. A company must satisfy the definition of a base rate entity for the relevant income year, and getting this wrong can affect both its income tax return and the franking of dividends paid to shareholders.
For small business owners, the key is to understand that the test looks at two separate areas: the group’s aggregated turnover and the company’s own passive income. A profitable trading company may qualify, while a company with modest turnover may not.
What is a base rate entity?
A base rate entity is an entity that meets the conditions in the Income Tax Rates Act for a particular income year. For an ordinary company, qualifying as a base rate entity means its taxable income is generally taxed at the lower company tax rate of 25%, rather than 30%.
This status is assessed separately for each income year. It is not a permanent label that a business receives when it is formed, and it is not something a company elects into simply because it considers itself a small business.
A company must satisfy both of the following conditions:
- its aggregated turnover for the income year, worked out at the end of that year, is less than $50 million; and
- no more than 80% of its assessable income for that income year is base rate entity passive income.
Both tests matter. Passing the turnover test alone is not enough.
It is also important not to confuse a base rate entity with the broader idea of a “small business” used elsewhere in the tax system. Different concessions can have different eligibility rules, turnover measures and thresholds. A company can be a base rate entity for company tax purposes without necessarily qualifying for every other small business concession.
The aggregated turnover test: look beyond one company
Aggregated turnover is not simply the sales figure in your company’s profit and loss statement.
Broadly, it includes the annual turnover of:
- the company itself;
- entities connected with the company; and
- the company’s affiliates.
The law generally defines annual turnover as ordinary income derived in the ordinary course of carrying on a business. Amounts relating to GST are excluded when working out annual turnover.
The aggregation rules are designed to stop a larger business group from separating activities across several entities and treating each entity as completely independent for tax threshold purposes. This means a company may need to consider related companies, trusts, partnerships and other businesses when assessing its position.
Connected entities
An entity can be connected with another entity where one controls the other, or both are controlled by the same third entity.
For companies, partnerships and many fixed trusts, control can arise where an entity and its affiliates have rights to at least 40% of income distributions, capital distributions or voting power. The rules can also apply indirectly through chains of entities.
Discretionary trusts require particular care. Control may arise based on the trustee acting in accordance with a person’s wishes, or because income or capital distributions made in prior years meet the relevant control tests.
Affiliates are not simply business contacts
An affiliate is an individual or company that acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you in relation to the business.
However, a person or company does not become an affiliate merely because of a normal commercial relationship. A supplier, customer, landlord, franchisee, contractor or business partner is not automatically an affiliate simply because the businesses work closely together.
These questions can become complex in family business groups, businesses with multiple shareholders, and structures involving companies and discretionary trusts. The legal ownership percentages are important, but so are the practical arrangements and decision-making relationships.
Related-party income is not counted twice
The aggregation rules generally remove income from dealings between the relevant entities while they are connected or affiliated. This prevents the same income being counted multiple times just because it moves through entities within the group.
For example, if one company in a group charges management fees to another connected company, that internal charge may be excluded from the group’s aggregated turnover calculation. The group’s external business income remains relevant.
The passive income test: why the source of income matters
The second requirement is often overlooked. A company must have no more than 80% of its assessable income classified as base rate entity passive income.
The passive income test is applied to the company’s own assessable income. Unlike the aggregated turnover test, you do not add the assessable income or passive income of connected entities and affiliates when calculating the company’s 80% passive income percentage.
Base rate entity passive income includes assessable income from:
- certain company distributions and associated franking credits;
- non-share dividends;
- interest, or payments in the nature of interest;
- royalties;
- rent;
- gains on qualifying securities;
- net capital gains; and
- certain amounts received through a partnership or trust to the extent they can be traced to passive income.
This is a wide list, and it can produce unexpected outcomes for otherwise active businesses.
A trading company that earns most of its income from providing goods or services will often have little difficulty with the passive income test. But a company that holds investments, receives significant rental income, earns large dividends, or makes a substantial capital gain may need closer review.
Rent is not necessarily “active” for this test
A company may actively manage commercial premises, deal with tenants and spend considerable time on property operations. Even so, rent is specifically listed as base rate entity passive income.
That means an operating company that also owns investment property, or a company established primarily to hold property, should not assume that active involvement changes the character of its rental income for base rate entity purposes.
Capital gains can affect a single year
A net capital gain is included in base rate entity passive income. This is particularly relevant where a company sells an investment, property, shares or another capital asset.
The impact may be limited to the income year in which the net capital gain is included. However, that one event may be enough to cause the company’s passive income percentage to exceed 80%, meaning the company is not a base rate entity for that year.
The result can be surprising for a business that has traded actively for many years but completes a significant asset sale near EOFY.
Trust and partnership distributions need tracing
Where a company receives income as a beneficiary of a trust or as a partner in a partnership, the result depends on the underlying source of the income.
A distribution from a trust’s active business income is not automatically base rate entity passive income. However, if part of the distribution can be traced to interest, rent, royalties, dividends or other income on the passive income list, that part may be passive income for the company.
This tracing can be particularly important where a corporate beneficiary receives trust distributions from a discretionary trust that has a mix of trading income, investments and capital gains.
A practical example for a growing business
Consider a company that runs a professional services business. Most of its income comes from client fees, and it also earns a small amount of bank interest on cash held for working capital.
If the company’s aggregated turnover, including that of connected entities and affiliates where required, is below the applicable threshold, and its interest income remains a small proportion of total assessable income, it may qualify as a base rate entity.
Now assume the same company sells a long-held investment and includes a significant net capital gain in its assessable income. The company may still be under the aggregated turnover threshold, but the net capital gain could cause its base rate entity passive income to exceed 80% of assessable income for that year.
The company’s tax rate may therefore change for that income year, even though its core operating business has not changed.
This illustrates why the analysis should be completed as part of year-end tax planning, not treated as a simple checkbox when the company return is lodged.
Base rate entity status and dividend franking
The company tax rate applying to taxable income is not always the same rate used when calculating the maximum franking credit on dividends.
For franking purposes, the law uses the company’s corporate tax rate for imputation purposes. This is generally determined by assuming that the company’s aggregated turnover, assessable income and base rate entity passive income are the same as they were in the previous income year.
A newly established company is subject to a different rule because it does not have a previous income year.
This distinction matters because a company’s actual tax rate for the current year can differ from its franking rate for that year. For example, a company may become a base rate entity in the current year, but its ability to frank dividends paid during that year can still be affected by its previous year’s position.
A company cannot attach franking credits beyond the maximum amount permitted by its corporate tax rate for imputation purposes. Over-franking can create additional tax and administrative issues.
Before declaring dividends, business owners should ensure that their accountant has considered:
- the company’s prior-year aggregated turnover;
- the prior-year mix of active and passive assessable income;
- the company’s current-year expected tax position;
- the available balance in the franking account; and
- whether any distributions have already been made in the same franking period.
Dividend planning should not be left until after funds have been paid to shareholders.
A practical checklist before lodging or declaring dividends
A reliable base rate entity review normally involves more than looking at sales revenue. Before finalising the company tax return or declaring dividends, consider the following.
Identify the relevant company and income year
Base rate entity status is tested for each income year. Review the facts for that particular year rather than assuming the prior year’s outcome will continue.
Map the wider business group
List companies, trusts, partnerships and individuals with ownership, control or practical influence over the business. Consider whether any are connected entities or affiliates.
Calculate aggregated turnover carefully
Include the relevant annual turnover of connected entities and affiliates, while avoiding double counting of qualifying internal dealings.
Review the company’s assessable income by category
Separate trading income from rent, interest, dividends, royalties, net capital gains and income received through trusts or partnerships.
Test the passive income percentage
Compare the company’s base rate entity passive income with its total assessable income for the year. The test is met only where passive income is no more than 80%.
Check dividend and franking decisions separately
Do not assume the current company tax rate automatically determines the rate for franking dividends. The imputation rules require their own review.
Good bookkeeping makes this process much easier. Clear coding of interest, rental income, dividends, trust distributions and capital gains helps ensure that the company’s income can be reviewed accurately at year end.
The key takeaway
The lower company tax rate is available to companies that qualify as base rate entities, but eligibility depends on more than being a small or family-owned business. The company must satisfy both the aggregated turnover test and the passive income test for the relevant income year.
Businesses with related entities, investment assets, rental income, trust distributions or a planned asset sale should review their position early. This can help avoid incorrect tax assumptions and ensure dividend franking is handled properly.
can help you review your business structure, income mix and company tax position in the context of your broader tax planning.
This article is general information only and is not personal financial or tax advice. Tax outcomes depend on your specific circumstances, so speak with a registered tax agent or accountant, such as, before making decisions about company tax rates, dividends or business structures.