Tighter super contribution criteria, especially for non-concessional contributions, has meant greater focus by financial services professionals on alternative, non-super investment opportunities, including personal investment, corporate structures and investment bonds (which are effectively taxed after 10 years at the corporate tax rate).
This article examines when investing in a structure taxed at the corporate rate becomes an attractive alternative to personal investment. Recent changes to personal income taxation and the corporate tax rate are relevant to this examination. In addition, consideration is given to announced proposals which are not law.
2018 Federal Budget changes
The Government’s Personal Income Tax Plan, announced in the 2018 Federal Budget, became law on 21 June 2018. One immediate impact of these personal income tax changes is an increase in the effective tax-free thresholds. The effect of various tax offsets increases the tax fee threshold of $18,200 to the level shown in Table 1 below.
|Under age 65||$20,542||$21,595|
|Age 65+ (married, each spouse*)||$28,973||$29,609|
|Age 65+ (single)||$32,278||$32,914|
* assumes both spouses have equal taxable income
These thresholds, especially for those age 65 and over, represent a significant planning opportunity for financial services professionals and their clients. Depending on the level of a client’s other taxable income, a significant amount of capital can be used to generate tax free returns.
Effective marginal tax rates in 2018-19
The effective tax rate on income in excess of the tax-free threshold can be surprisingly high, given that the loss of tax offsets after certain thresholds adds to the marginal tax rate and Medicare levy.
For example, consider Sam who is age 65 and single. Sam’s next dollar of taxable income above $37,000 results in only 46.5 cents after tax, implying an effective marginal tax rate (EMTR) of 53.5 per cent. This EMTR is comprised of:
- 32.5 per cent – ‘headline’ marginal tax rate
- 12.5 per cent – reduced Seniors and Pensioners Tax Offset (SAPTO)
- 10.0 per cent – Medicare levy (in phase-in range)
- 1.5 per cent – reduced Low Income Tax Offset (LITO)
- -3.0 per cent – increased Low and Middle Income Tax Offset (LAMITO).
Sam’s EMTRs to $100,000 of taxable income are shown by the black line in Chart 1 below.
Chart 1: Effective marginal tax rates for a single age 65 and over
Sam’s income tax liability (including Medicare levy) on income in the range from $32,914 to $50,000 is $8,002, implying an average tax rate of 46.8 per cent. This is almost equivalent to the top marginal tax rate applicable from $180,000.
Interestingly, the average tax rate on income in the range $32,914 to $90,000 is 38.7 per cent, very similar to the 39.0 per cent tax rate (including Medicare levy) that applies to taxable income in excess of $90,000. The average tax rate Sam pays on income in excess of $32,914 is shown in Chart 1 (red dashed line).
An alternative way to view the tax rates that apply to a single person age 65 and over is shown in Table 2 below.
|Income range ($)||Average tax rate (incl Medicare levy) on income in stated income range|
|0 - 32,914||Nil|
|32,914 - 180,000||39%*|
* average tax rate on income in the range $32,914 to $180,000, rate is rounded to zero decimal places
For a senior couple (over age 65) with equal levels of taxable income, where the effective tax-free threshold is $29,609 each, the average tax rate on income in the range $29,609 to $90,000 is 36.5 per cent. Chart 2 shows the EMTR and average tax rate position for a senior couple member where each spouse has the same level of taxable income.
Chart 2: Effective marginal tax rates for a senior couple member (equal income)
Comparing individual MTRs with the corporate tax rate
A number of the proposed changes to the corporate tax rate have been passed by Parliament, reducing the rate applicable to certain small and medium businesses. Affected businesses are those with aggregate turnover of less than $50 million and passive income of not more than 80 per cent of the entity’s total assessable income. Table 3 below summarises these changes.
|Income year||Certain small and medium businesses||All other corporate tax entities|
|2021-22 and later||25%||30%|
However, the tax rate that applies to corporate beneficiaries of family trusts, investment bonds and passive investment companies remains at 30 per cent.
The after-tax return of the Balanced portfolio (see Appendix) subject to tax at the corporate tax rate is 4.8 per cent per annum. This is comparable to the 4.9 per cent after-tax return achieved at the individual tax rate of 39 per cent (including the 50 per cent CGT discount and the Medicare levy).
Because of the 50 per cent CGT discount individuals receive (compared to nil CGT discount for corporate entities), the relative appeal of the corporate tax rate over individual marginal tax rates depends on the ratio of income to capital gains in the return assumptions used – a high ratio of income will tilt the favour towards the corporate tax rate over the individual marginal tax rate. The Balanced portfolio return rates comprise 49 per cent income and 51 percent capital gains.
|Portfolio||Gross return (per cent per annum)||Income / capital gain ratio||After tax return at corp tax rate (30 per cent)||After tax return at 39% individual MTR|
These portfolios and the assumed returns of the various asset classes are shown in Chart 3 below. For the defensive asset classes (cash, international fixed interest and Australian fixed interest), taxation at the corporate rate is preferred to individual tax rates of 39 per cent and 47 per cent. However, for the growth asset classes (property, Australian equities and international equities) the conclusion is not as clear.
There are only slight differences between the corporate tax rate and the individual tax rate of 39 per cent in the after-tax returns for our three standard portfolios (conservative, balanced and growth), but the corporate tax rate is clearly preferred to the top individual tax rate of 47 per cent.
Chart 3: Portfolio returns: pre-tax and after-tax
The former proposal to reduce the corporate tax rate for all corporate entities to 25 per cent would significantly shift the preference towards corporate tax structures over individual taxation at 39 per cent for all portfolios and asset classes other than international equities.
The impact of reducing the CGT discount
The Labor Party’s housing affordability package, first announced in 2016, includes a proposal to reduce the CGT discount for individuals from 50 per cent to 25 per cent in certain circumstances. This measure would impact on returns from securities and managed funds, and if legislated, will significantly change the results shown in Chart 3. The corporate tax environment becomes a clear preference, as shown in Chart 4 below.
Chart 4: Portfolio returns: pre-tax and after-tax (reduced CGT discount)
Presently, there is a fine balance between after-tax portfolio returns taxed at the corporate tax rate and the 39 per cent individual tax rate.
Given this fine balance, changes to either the corporate tax rate or individual income tax rates have potential to swing preferences markedly. If either a reduction in the corporate tax rate or an effective increase in individual tax rates (for example, Labor’s proposed CGT discount reductions) are legislated, it is likely there will be a significant shift towards corporate tax structures (including investment bonds) for private investment purposes.
The after-fees pre-tax projection rates used in this article are based on the asset class weightings, long term income and capital growth projection rates and other assumptions in the table below.
These rates aren’t guaranteed, are provided as an illustration only, and may vary from actual results. The projection rates aren’t intended to be and shouldn’t be relied on when making a decision about a particular financial product. Before making any financial decisions a potential investor should seek personal financial advice from a financial services professional.
|Asset Allocation||Capital Growth||Income||Franking Percentage||Tax free proportion||Tax deferred proportion|
|Australian Fixed Interest||20%||6.5%|
|International Fixed Interest||10%||6.0%|
|Earnings rate pre-tax||-||3.45%||3.0%|
|Asset turnover rate per annum||20%||-||-||-||-||-|
|Portfolio asset allocations||Balanced allocation||Growth allocation|
|Australian Fixed Interest||35%||20%||10%|
|International Fixed Interest||10%||10%||0%|