When is a company 'carrying on a business'?
Once upon a time, it was clear what the tax rate was that applied to a company. There was only one rate that could apply and that was it. Along came the two-tiered corporate tax rate system in the 2016 income year, the idea being that small business companies should get a lower tax rate of 28.5% instead of the usual 30%.
That was all very well until the plan changed again and it was decided that small business companies should get a rate of 27.5%, with the eligibility turnover planned to increase progressively until all companies, whatever their size, could access the lower rate.
With this change came the introduction of a new term, a ‘base rate entity’, into the Income Tax Rates Act 1986 (Cth) (Rates Act) which is used to determine which companies can access the lower company tax rate of 27.5%. At the time of writing, the term ‘base rate entity’ is defined in the law as:
Section 23AA Meaning of base rate entity
An entity is a base rate entity for a year of income if:
(a) it carries on a business (within the meaning of the Income Tax Assessment Act 1997) in the year of income; and
(b) its aggregated turnover (within the meaning of that Act) for the year of income, worked out as at the end of that year, is less than $25 million.
Suddenly, the term ‘carries on a business’ is pushed into the foreground. It is worth noting that, to determine whether a company was eligible to access the 28.5% company tax rate in the 2016 year, the company had to qualify as a ‘small business entity’ per s 23(2) Rates Act.
Perhaps it is worth mentioning at this point in time that the definition of ‘small business entity’ contained in s 328-110 of the Income Tax Assessment Act 1997 (Cth) also turns on the expression ‘carry on a business’, though we seem to have conveniently skipped over that until now.
While the first indication of the ATO’s views of what it means to ‘carry on business’ is contained in footnote 3 to TR 2017/D2 (a ruling about the central management and control of foreign resident companies), this certainly wasn’t enough guidance to assist small business owners to determine whether they could apply the lower company tax rate to their company.
Notably, the footnote also pertains to the expression ‘carry on business’ and not ‘carry on a business’.
And so ensued a lengthy discussion with the ATO about what it means to ‘carry on a business’ for the purpose of the expression in s 23AA. This has resulted in the release of TR 2017/D7.
The Tax Institute has formed the view that to determine when a company is carrying on a business is a question of fact and requires an inquiry into the facts and circumstances of the particular company in question.
The focus should be on the nature of the activities being carried on by the entity, including the passivity of the activities being undertaken. The chosen structure of the entity, whether a company, individual or some other structure, should not unduly influence the determination of whether the entity is carrying on a business.
In September, the government released for consultation the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 exposure draft.
This exposure draft aimed to implement the government’s intended policy that only companies deriving income actively, and not passively, should be able to access the lower company tax rate. The exposure draft and associated explanatory memorandum did not discuss what it means when a company is carrying on a business. This was deliberately left open for the ATO to interpret.
On 18 October 2017, the Bill was tabled in parliament. It now removes the ‘carrying on a business’ requirement from the ‘base rate entity’ definition altogether and replaces it with a ‘bright line’ test that puts a ceiling on the amount of passive income a company can derive before it can access the lower corporate tax rate. While, on its face, it looks like the problem is solved, at least for the 2018 income year onwards , it implies that a company that receives only royalty or rental income is deriving only passive income even if, for example, it owns and actively manages a multitude of properties or is in the business of software development. The question arises: is the problem really solved or has it just been kicked down the road?
At the time of writing, The Tax Institute had not yet had the opportunity to form its view on the ATO’s draft guidance in detail. We are consulting with members. However, you can be sure about how we are likely to approach the issue — that it simply is not enough to assume that, just because there is a company structure in place, the company is in fact carrying on a business. It will almost always come back to the activities it is carrying out.
Reference1. The ‘carrying on a business’ requirement remains relevant for the 2016 and 2017 income years.
* Stephanie Caredes is The Tax Institute’s Tax Counsel. This article was first published in the November 2017 issue of the Institute’s member-only Taxation in Australia journal.