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Taxation:
Private individuals
In Australia we have a progressive tax system where the rate of
taxation increases with income.
Other countries have a flat tax rate where the rate of taxation is
constant across all levels of income. For instance, Russia has a flat
13% tax rate.
A poll tax is a tax which is the same for all persons regardless of their
income. For example when you leave Australia to travel overseas you
pay a “departure tax”.
Australian system:
There are 5 different groups or “tax brackets” depending on your
taxable income. As income increases, the rate of tax payable on that
income also increases. This is referred to as “progressive taxation”.
The tax rates vary with income as per the table below.
If your taxable income Y is between the lower limit L and the upper
limit U for a particular bracket, then you pay tax according to the
formula tax payable = M+(Y-L)  R

Tax Rates 2016-17

Tax Lower Upper Marginal Minimum Tax payable
bracket limit limit tax rate for this Bracket
(L) (U) R M
1 $0.00 $18,200 0.00% $0
2 $18,200 $37,000 19.00% $0
3 $37,000 $87,000 32.50% $3,572
4 $87,000 $180,000 37.00% $19,822
5 $180,000 No limit 45.00% $54,232
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In addition to this you have to pay the medicare levy which is 2% of

your taxable income. If your taxable income is below $21,655 then
you don’t have to pay this medicare levy.
If your taxable income is above $27,068 then you do have to pay the
medicare levy. If your taxable income is between these limits
($21,655 and $27,068) then you pay part of the medicare levy.
The medicare levy is a special tax dedicated to financing Australia’s
public health insurance system.

Example: if your income is $60,000 then

• You are in tax bracket number 3 since your income is in the range
from L = $37,000 to U = $87,000
• The minimum tax payable for this bracket is M = $3,572
• The marginal tax rate that applies to you is 32.5%.
• This rate applies to the part of your income that exceeds the lower
limit of $37,000, which is $60,000-$37,000 = $23,000
• Tax on this part of your income is $23,000×32.5% = $7475
• The tax payable is $3,572+$7,475 = $11,047
• M+  Y  L   R= 3572+(60000-37000)  0.32 5 = 11, 047
• Your Medicare levy is $60,000×2% = $1,200
• Your tax payable including the Medicare levy is 12,247

For each additional $1 you pay 32.5c in tax. This is what we mean by
marginal tax rate. In addition you pay 2% for the Medicare levy.
At an income of Y = 60,000 your average tax rate is 18.41%
(11,047/60,000)
And if we include the Medicare levy then it is 20.41%
(12,247/60,000)
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Other taxpayers:

Superannuation (retirement) funds:

Pay a flat tax rate of 15% on the contributions paid into them by the
employers. Employers can claim these contributions as a tax-
deductible expense. Contributions paid into the fund by employees
are paid from the after-tax income and thus don’t attract tax when
received by the fund.
Investment earnings / income of a superannuation fund is also taxed at
a flat rate of 15%

Pension funds:
Superannuation funds pay either a lump sum or a pension type benefit
to members when they retire. Some of the fund’s assets may be
segregated into a separate account and used for the purpose of paying
the pension benefits. The investment earnings of the pension fund
account is tax free (0% tax rate)

Corporations:
In Australia companies pay a flat 30% tax rate on their income. Small
Business have a reduced tax rate.
FOR ANY CALCULATION THIS COURSE USE A CORPORATE
TAX RATE OF 30% unless otherwise specified.
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Dividends:

Dividends are payments made by a corporation to its shareholders

(owners). It is the portion of after tax corporate profits paid out to
stockholders. A dividend payment is a fixed amount per share. A
dividend payment received by the shareholder is taxable income for
the shareholder. The amount of the income depends on the number of
shares they own.
The dividend payments come from the company’s after corporate tax
profits. Many investors buy shares for the purpose of receiving the
dividend income.

Capital Gains:

If you buy shares now for price C and sell them later for price P then
you would hope to be able to sell them for more than you paid for
them and thus make a profit on the transaction. The difference P-C is
a capital gain. Many investors buy shares and other assets hoping to
sell them later at a profit. Most investors would hope to make a
positive return on their investment taking account of both the
dividend income and the capital gain.
In Australia, if the holding period for the transaction was less than 12
months then the profit is regarded as income and taxed as income.
However, if the holding period is longer than 12 months then the
profit is regarded as a capital gain and is taxed more lightly. More
detail on this below.
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Classical taxation of dividends:

In the past in Australia dividend income was taxable at the taxpayer’s

marginal tax rate. The profits that generated the dividend were taxed
as income for the firm (at the company tax rate), then taxed again
when received by the shareholder. So, the original profits that
generated the dividend were taxed twice. This system was known as
“classical taxation” of dividend income.

For example if the firm earns $100K in profit before tax and has a flat
tax rate of 30% then the tax liability of the firm is $30K and its after
tax profit would be $70k = $100K - $30K. If all of this is paid out to
shareholders in dividends then the dividend payment would total
$70K. Suppose there are 10 shareholders each owning 10,000 shares
that is a total of 100,000 shares. The dividend per share would be
$0.70 and the shareholders would each receive total dividend income
of $7.0K (0.7×10,000)

Suppose the 1st shareholder is in tax bracket # 3 and the 2nd

shareholder is in tax bracket # 5.

The tax for shareholder 1=$7000×(32.5%+2%)=$2,415

The tax for shareholder 2 is $7000×(45%+2%)=$ 3,290

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Taxation of Dividends in Australia & dividend imputation:

For Australian shareholders, a dividend is taxed via the dividend
imputation system. This Imputation System is designed to avoid
double taxation for some investors. The objective is to tax corporate
income distributed as dividends at an effective rate equal to the
investor’s personal marginal tax rate.
Under this system, a company’s profits are still subject to company
tax but the company tax paid is passed on as a franking credit to the
shareholders. This franking credit can be used to offset the investor’s
other sources of taxable income.
Example: (Parrino p586)
Company Level
Income earned $100
Company tax (30%) $30
Profit after tax $70
Shareholder Level
Franked Dividend received in cash $70
Franking Credit $30
Taxable income $100
Tax payable (assuming the $45
shareholders’ marginal tax rate is 45%)
Credit for company tax already paid $30
Additional tax payable $15

At the company level, a company’s profits of $100 are first taxed at

the company rate of 30 per cent, resulting in an after-tax profit of $70.
Assuming that the company pays out 100 per cent of its after-tax
profit as dividends, the shareholders will receive the $70 as a fully-
franked dividend.
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The company tax of $30, paid by the company, will be passed on to

the shareholders as a franking credit of $30, making the taxable
income $100.
At the shareholder level, investors will be liable for tax at the
investor’s marginal personal tax rate of 45% (in this example). With
taxable income of $100, this investor has tax payable of $45. The
imputation credit of $30 can be used to offset the investor’s taxable
income. So the additional tax payable is $15 from the investor.
In the case of a shareholder with a lower marginal tax rate, for
example 15 percent. The tax payable would be $15. Taking into
account the franking credit of $30, the additional tax would be
$15 -$30 = -$15. The excess tax paid will be refunded by the
Australian Taxation Office.
Example:
Suppose you receive a dividend of amount D.
Assume the corporate tax rate is 30% and that the dividend is fully
franked and that your personal tax rate is T.
Calculate the franking credit and the additional amount of tax payable
as follows:
Let P be your share of the profit of the firm before company tax then
D D
P  1  0.30   D  P  
1  0.3 0.70
1
The dividend carries with it a tax credit of D   0.30 which is
0.70
the corporate tax already paid by the corporation on the profits that
generated the dividend. This tax credit is called a franking credit or
dividend imputation credit.
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This shows that the value of the franking credit can also be calculated
by the formula (Franked dividend × tc)/(1- tc), where tc is the company
tax rate
The amount D of the cash dividend generates a tax liability of
1
D  T where D is the cash dividend paid, and T is the
0.70
investor’s personal tax rate.
The additional tax payable by the shareholder on the cash dividend is
1
D   T  0.30 
0.70

Example:
You invest in XYZ corporation shares and you receive dividend
income of $1400. You are in tax bracket #4 and your marginal tax
rate is 37% and you pay 2% Medicare levy. How much tax do you
pay on the dividend you received?
Solution:
The dividend received was D = $1400. The company paid tax at the
rate of 30% on the profit P that generated the dividend.
Your share of the profit of the firm before company tax was P where
P  1  0.30   D  P  D 1  0.3   1400 0.70  $2000

The corporate tax paid by the company on this part of their profits
was $2000  0.30  $600 . Your tax on the dividend is based on this
“grossed up” before tax company profit before tax. You are taxed at
your marginal tax rate plus the Medicare levy of 2% on this income of
$2000.
Your tax bill for the income is thus 2000×39% = 780
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However the tax department considers that the company has already
paid $600 of this tax on the $2000 profit so you get a “tax credit” for
this amount. They call this an “imputation tax credit”.
The amount of tax payable by you on the dividend is
$780-$600 = $180
The net of tax dividend payment you get is
$1400-$180 = $1220
This is the same amount you would receive after tax if you’d received
the $2000 profit in your own name (instead of in the name of the
company) and paid tax on it at your marginal rate of 37% + 2%
Medicare levy i.e. 39%, since
$2000-2000×39%=$2000-$780 = $1220

The way the dividend imputation system works means that the tax
payable on the dividend you receive is equivalent to the tax you
would have paid on the corporate before tax profits if the income
were earned by you directly instead of via a corporation.
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Taxation of capital gains:

(Parrino p587)
If you buy an asset and sell it later for a price different from what you
paid for it you may make a capital gain or a capital loss.
The discount method of capital gains tax allows individual investors
to discount their capital gain by 50 per cent before being taxed at the
investor’s marginal personal tax rate if the shares are held longer
than 12 months.
The tax payable on the sale proceeds of P per share would be
 P  C   0.50  T where P is the sale price of the shares and C is
the cost of the shares and T is your personal marginal tax rate.
Thus, investors with high marginal personal tax rates may favour
returns in the form of capital gain over dividends.
No discounting applies in the case of a company.
The discount is 33.3% for superannuation funds.
Example:
Suppose you bought 100,000 XYZ shares 5 years ago for $10 each
and sold them today for $20 each.
If your marginal tax rate is 45% + 2% Medicare levy then the tax
payable on the sale proceeds would be:
(Use the discount method as the shares have been held for more than
one year)

Tax due = (P-C) × 1 ×T

2

=($2m  $1m) × 1 ×0.47=$235,000

2
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Tax deductible expenses

A common feature of the tax system in many countries is that certain
expenses incurred in earning income are allowed by the tax
authorities as “deductions” from income in measurement of taxable
income. This makes your taxable income lower so you pay less in tax.

Generally, income = revenue – expenses

for some expenses we are allowed to compute our income for tax
purposes in this way whereas for other expenses we are not allowed to

money spent on buying clothes for work may or may not be an

expense recognised for tax purposes. If you have to wear a uniform at
work it would be, but if you have to buy a suit for working in an
office it wouldn’t be
money spent on transport to and from work may or may not be
deductible
interest paid on a loan used to buy an income producing asset (e.g. a
rental property generating rent income) would be deductible but
interest paid on a loan used to buy a house you live in wouldn’t be
deductible
the rules about what is or is not an expense allowed for tax purposes
are quite complex and they vary depending on whether it is for a
business or for a private individual.
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Depreciation and Amortisation

(Text: Chapter 3 p70 “A closer look at some expense categories” and
Chapter 11 p396 “Tax rates and depreciation”)
A very important tax deduction is that for depreciation. The general
idea of depreciation is that fixed assets such as machines, cars,
buildings etc tend to fall in value over time. This decline in value is
called depreciation.
Amortisation is the process of writing off expenses for intangible
assets – such as patents, licences, copyrights and trademarks – over
their useful life. The rules that govern amortisation are complicated
and we will not look further at amortisation in this course.

Depreciation:
There are two main methods for computing depreciation and these
can be used both for tax purposes and for financial reporting purposes
These are
(i) The straight line depreciation method and
(ii) The reducing balance depreciation method

The decrease in value of the asset in each year can be computed using
either method. The depreciation expense is based on the historic cost
of the asset. The value of the asset at the end of each year is the value
of the asset at the start of that year less the depreciation expense for
that year.
This asset value is called the “written down book value”. It is not
necessarily the same as the true market value of the asset as a second-
hand asset. The true change in the value of the asset is not necessarily
the same as the depreciation expense as computed by these methods.
However, these methods are well established and used for tax and
financial reporting purposes.
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Straight Line Method

With straight line depreciation, the depreciation expense is of a fixed
amount each period. If the useful life of the asset is N years then

1
• the depreciation expense each year is cost  .
N
• the written down value of the asset at the end of year t is
 N t 
cost   
 N 

For instance, if the useful life of the asset is N = 5 years then the
depreciation expense each year is 20% of the original cost of the
asset.

Reducing Balance Method

With the reducing balance depreciation the depreciation expense for a
year is a constant proportion of the value of that asset at the start of
that year.
This means the amount of the depreciation expense reduces over time,
as does the value of the asset. If the RB depreciation rate is x % per
year then

• written down value at the end of year t is

t
 x 
WDV   original cost   1  
 100 
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• depreciation expense in year t is

  t 1
  x     x 
DE   original cost   1    

  100  
  100 
value of asset at start of year t

Generally, the depreciation rate x is higher for the RB method than it

is for the SL method
In Australia, the RB depreciation rate for an asset with a useful life of
1
N years is depreciation rate =2 
N
For example if N = 5 then

• the depreciation rate for the SL method is 20% but

• the depreciation rate for the RB method is 40%

important point to note re depreciation and amortisation

any depreciation expense or amortisation expense allowed for in
the measurement of income for financial reporting purposes and for
taxation purposes are not actual cash expenses incurred by the
business / taxpayer, they are notional amounts only.

Example
Assume you bought a car for $100,000 when it was new and that you
estimate its useful life to be 5 years for taxation purposes.

Compute
• the book value of the car at the start and the end of each year for 5
years, and
• the depreciation expense for tax purposes in each year for the 5
years you have owned the car
Do this for both the straight line method and the reducing balance
method.
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Note that the book value of the car at the end of the year is the book
value at the start of the year less the depreciation expense for the year
and the book value at time 0 (when the car was bought) is equal to the
cost of buying the car.

Solution
With a useful life of 5 years :

1
• the straight line depreciation rate per year is  100%  20% per
5
year
• the reducing balance depreciation rate per year is
1
2   100%  40%
5
• the book value of the car at times 0,1,2,3,4,5 years and the
depreciation expense incurred is as follows:
reducing balance method straight line method
Year book dep book book dep book
value at expense value at value at expense value at
start of for the end of start of for the end of
year year year year year year
1 $100,000 $40,000 $60,000 $100,000 $20,000 $80,000
2 $60,000 $24,000 $36,000 $80,000 $20,000 $60,000
3 $36,000 $14,400 $21,600 $60,000 $20,000 $40,000
4 $21,600 $8,640 $12,960 $40,000 $20,000 $20,000
5 $12,960 $5,184 $7,776 $20,000 $20,000 $0

Exercise:
Write a spreadsheet program to reproduce these calculations