It’s a strange name but franking credits are big business. First introduced by the Hawke/Keating government in 1987, the concept of franked dividends has become a vital component of share investing.
Prior to the advent of franking credits, a company would pay tax on its profit and then distribute this after-tax profit to the shareholders. The ATO (Australian Tax Office) would then tax that same income stream without any consideration to the tax already paid on it. In effect, the ATO was double dipping on the tax it was taking on corporate profits with a tax rate at the time of 46% on companies and 49% on individuals. This meant that on $100 of company profit, should that be paid out as a dividend, the ATO would take 73 percent!
Franking changed this. Since 1987, the tax paid on a dividend income stream would take into consideration the tax already paid by that company. The effect of this is that the highest amount that can be taxed is equal to the top marginal tax bracket. In 2000, further changes were introduced and shareholders could receive a refund of the company tax paid if their personal tax rate was lower than that of the company. Australia is the only country in the OECD that provides refunds to shareholders for excess franking credits.
Here is an example:
Linda is retired and has 10,000 shares invested in a listed company. She has no other taxable income. The company declares a dividend of $0.70 per share, fully franked. Linda receives $7,000 in cash and $3,000 in “franking credits”. When completing her tax returns, Linda declares $10,000 of income (the cash and credits combined). Since she has no other income, her tax rate is 0%. Accordingly, she will get a refund of $3,000 from the ATO.
Why are they gaining attention?
Franking credits have become increasingly attractive and have gained attention as the cash rate has fallen over the years. As recently as 8 years ago, you could earn 6.3% on a term deposit – which is a healthy rate of return. Now, it’s hard to crack 3%. This has driven many people to buy dividend shares on the stock market, hoping to capture a higher income stream.
Franking credit refunds, as in the example above, have been in the news of late because of comments and draft policy from the Opposition Party about restricting the refund of franking credits to shareholders. While the dividend imputation system is safe and unlikely to change, the amendments introduced in 2000 allowing the refund of franking credits is under some pressure to change. The opposition has already made a number of concessions to protect those on pensions, but is firming up its stance on the proposed legislative changes.
While you’re earning an income, franking credits can help you to offset some of your tax and even more so if you’re borrowing money to invest. When you borrow funds to invest, the interest on your loan becomes tax deductible. This will, in many situations, cancel out the tax you would have to pay on the cash portion of your dividend. If you have franking credits, however, you can then use these to offset your personal income tax. This should, however, been seen as a bonus to certain styles of share investing rather than the reason to invest in the first place.
Who will be affected?
Those potentially greatest hit by the proposed changes to the refund of franking credits will be retirees. Anyone on a tax rate that is below the company tax rate would potentially be the recipient of franking credit rebates. Those that are retired and living off their retirement savings are the most likely to be impacted, with Self-Managed Superannuation Fund (SMSF) investors in the pension phase likely to be the hardest. Of the $10.7 billion of revenue that the opposition believes it will claw back in franking credit refunds, it’s estimated that $6.9 billion of this will come from superannuation funds. SMSF’s in the pension phase have a tax rate of zero. Because of this, they have traditionally been a very effective place to keep shares in companies that pay fully franked dividends as they get the full refund back of their franking credits. As an example, shares in NAB are trading at a dividend yield of around 7.3%, fully franked. If you receive a full refund of the franking credit, this increases the cash return to around 11.2%.
What does this mean for investors?
A drop in potential cash income from 11% to 7% is going to make a material difference for a lot of people. While the proposal will require Labour to win the next Federal election and have the changes pass both houses of parliament, it’s best that investors consider their options now rather than wait until it’s too late. Many investors will be re-examining the structure in which they own their assets or even the assets themselves. As always, seek the services of an independent professional who can help you to understand your options and keep on top of all the changes.
Brenton Tong has 20 years’ experience in the financial advice industry, including managing director of privately owned financial planning firm, Financial Spectrum. Consistently ranked one of Sydney’s top financial planners (Adviser Ratings), Brenton believes strongly in independent advice. This is why he has made it a cornerstone of Financial Spectrum that the firm rejects commissions.