Converting excess franking offsets of a Pooled Development Fund to a tax loss

For the purposes of step 2 of the Method Statement in subsection 36-55(2) of the Income Tax Assessment Act 1997 (ITAA 1997), does the reference to 'corporate tax rate' mean 30% for the relevant income years?

Yes. 30% is the applicable tax rate for the purposes of step 2 of the Method Statement in subsection 36-55(2) of the ITAA 1997 for the relevant income years in accordance with the definition of 'corporate tax rate' in subsection 995-1(1) of the ITAA 1997.

The taxpayer is a company that is a Pooled Development Fund (PDF) as defined in subsection 995-1(1) of the ITAA 1997.

For the 2006-07 income year, the taxpayer reported a tax loss in its tax return, which was carried forward to subsequent income years.

In respect of the 2006-07 income year (the relevant income year), the tax losses resulted from the taxpayer having 'excess franking offsets' as defined in subsection 36-55(1) of the ITAA 1997.

The taxpayer has been a PDF since its establishment.

Section 36-55 of the ITAA 1997 allows for the conversion of excess franking offsets to a tax loss. To calculate the amount of tax loss, a taxpayer is required to follow the Method Statement under subsection 36-55(2) of the ITAA 1997, which provides:

Method Statement Step 1. Work out the amount (if any) that would have been the entity's *tax loss for that year under section 36-10, 165-70, 175-35 or 701-30 if the entity's *net exempt income for that year (if any) were disregarded. Note: See section 36-20 for the calculation of net exempt income. Step 2. Divide the amount of *excess franking offsets by the *corporate tax rate. Step 3. Add the results of step 1 and 2. Step 4. Reduce the result of step 3 by the entity's *net exempt income for that year (if any). The result of this step is taken to be the entity's *tax loss for that year. However, if the result of this step is nil or a negative amount, the company does not have any tax loss for that year.

When applying step 2 of the Method Statement, the reference to 'corporate tax rate' means 30%, regardless of whether the taxpayer's taxable income is subject to the general corporate tax rate of 30% or a concessional rate of tax for the reasons explained below.

Section 36-55 of the ITAA 1997 applies to a PDF because a PDF is a corporate tax entity, as per the definition in subsection 995-1(1) of the ITAA 1997.

PDFs are generally taxed at either 15% or 25%, depending on the type of income they derive. This difference in tax rate from the corporate tax rate of 30% raises the issue of whether step 2 in the Method Statement in subsection 36-55(2) of the ITAA 1997 above is referring to 30%, 15% or 25%.

'Corporate tax rate' is defined in subsection 995-1(1) of the ITAA 1997 as: the rate of tax in respect of the taxable income of a company covered by subsection 23(2) of the Income Tax Rates Act 1986.

Subsection 23(2) of the Income Tax Rates Act 1986 (ITRA 1986) provides: The rate of tax in respect of the taxable income of a company not being: (a) a life insurance company; or (b) an RSA provider; or (ba) an FHSA provider; or (c) a company to which subsection (4C) or (4D) applies; is 30%.

Therefore, the rate of tax of a company covered by this section is 30%. Accordingly, the plain meaning of the phrase 'corporate tax rate' for the purposes of subsection 36-55(2) of the ITAA 1997 means 30%.

In the present context, this plain meaning is supported by the following statements in the Supplementary Explanatory Memorandum (the Supplementary EM) to the Taxation Laws Amendment Bill (No. 5) 2003, which inserted section 36-55 into the ITAA 1997: 5.1 The amendments contained in Schedule 8 will ensure that corporate tax entities are no longer required to use up ('waste') losses that could be deductible in a later year of income against franked dividend (effectively tax-free) income. ... 5.3 Secondly, corporate tax entities will be able to treat a current year loss that would otherwise be used up against franked dividend income as a tax loss for that income year and be able to carry forward the tax loss for consideration as a deduction in a later year of income [emphasis added].

In addition, the Supplementary EM sets out the 'policy objective' of the amendments as follows: 5.65 The overall objective is to ensure that corporate tax entities have the full benefit of deducting current and prior year losses against taxable income.

It is important to note that the policy intent of section 36-55 of the ITAA 1997 is not to preserve excess franking offsets, but rather to preserve any loss that would result if the dividend income was quarantined. The reference to excess franking offsets is merely the mechanism to allow for the preservation of these losses.

The example below illustrates the 'losses' that section 36-55 of the ITAA 1997 intends to preserve:

Example 1

A PDF has other assessable income of $100 and allowable deductions of $200 for an income year. In addition, the PDF receives a fully franked dividend of $70 (with a $30 franking credit attached). All of the assessable income of the PDF is SME assessable income and therefore the PDF's taxable income is subject to tax at 15%.

If the dividend income was quarantined, the tax treatment of the PDF would be as follows: Assessable income: Dividend 70 Other assessable income 100 Gross-up 30 Less Deductions: 200 Total assessable income: 100 Tax loss: (100) Tax @ 15%: 15 Franking offset: 30 Tax payable: Nil Excess franking offset: 15

Assessable income:

Dividend | 70 | Other assessable income | 100

Gross-up | 30 | Less Deductions: | 200

Total assessable income: | 100 | Tax loss: | (100)

Tax @ 15%: | 15

Franking offset: | 30

Tax payable: | Nil

Excess franking offset: | 15

Section 36-55 of the ITAA 1997 aims to preserve the above tax loss of $100. Due to the concessional tax rate of the PDF, excess franking offsets result for the PDF. It is not the object of section 36-55 to preserve the above excess franking offset of $15. There is no mechanism in the Tax Acts specifically designed to allow the PDF to recoup this excess franking offset of $15. Accordingly the PDF should be entitled to deduct a tax loss of $100 in the subsequent year of income.

Rather than quarantining the dividend income, this $100 tax loss is preserved by section 36-55 of the ITAA 1997 in the following way: Assessable income: Other assessable income 100 Dividend 70 Gross-up 30 Total assessable income: 200 Less deductions (200) Taxable income: Nil Excess franking offset: 30 Divide by 'corporate tax rate' 30% Tax loss to be carried forward (100)

Assessable income:

Other assessable income | 100

Dividend | 70

Gross-up | 30

Total assessable income: | 200

Less deductions | (200)

Taxable income: | Nil

Excess franking offset: | 30

Divide by 'corporate tax rate' | 30%

Tax loss to be carried forward | (100)

Therefore, 'corporate tax rate' means 30% for the relevant income year for the purposes of step 2 of the Method Statement in subsection 36-55(2) of the ITAA 1997, regardless of the tax rate applicable to the taxpayer's taxable income.