Who’s Frank?
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.
Article by:
Comments7
"Ken - long post but you just show you've got the cart before the horse. Companies should pay company tax. Full Stop. Individuals should pay income tax. Full Stop. All this creative accounting just allows wealthier people to minimise their tax. And to Dave Ward - "Hey, I have never been a burden to tax payers..." - If you've driven on the road you've been a burden to tax payers. This "never been a burden" idea is one that is promoted by IPA type hacks and lazily trotted out whenever the question of tax reform is brought up. The self entitlement and lack of self awareness is astounding. Who pays for the army, police, firies or ambo's? Did you use electricity (prior to being flogged off to the private sector), did you drive on roads (prior to being flogged off to the private sector), ever bulk billed or gone to a public school? Libertarian fantasists see none of this. Governments need to raise tax for the benefit of all in society - Taxes need to be paid. Thinking the ATO is "not entitled" is just looking at the miniature of the law - fair enough, that's your job. But if the law changes (as is the proposal), the ATO will be entitled to not refund the individual. Accountants and Financial Advisers will have to find other loopholes and strategies to help their clients. God knows there are plenty available."
Not a Commie! 14:33 on 18 Mar 19
"There is far more and investors will make changes. This will cause difficulty for Australian companies attracting funds from cap raising and thus will hinder these very large companies future growth. Additionally, investing in overseas markets will become far more popular and will further exacerbate the issue of investing domestically. Its a big loss for a government to be so stupid. "
Ken 19:30 on 15 Mar 19
"Hey, I have never been a burden to tax payers, always done the right thing. Retired now and if we lose these franking credits i will take all the money we have invested in Aussie shares and buy international shares with a higher yield. Who is the loser.. wake up young Australians. "
Dave Ward 16:20 on 15 Mar 19
"Im a little flabbergasted with the comments already posted but will put my case forward in detail. Imputation and Franking Credits are simple, and easily understood, when considered from the ATO’s viewpoint. Our imputation system is designed to prevent double taxation and too ensure tax is paid by the “receiver” at the receivers “marginal tax rate”. Its sole purpose is a tool which is used to match the actual tax received by the ATO with the tax liability of the receiving shareholder. Even though some tax is paid by the dividend payer, imputation acts to ensure that the combined taxes paid by the payer and the receiver combined equals the tax liability of the receiving shareholder. That is, imputation acts to ensure that the ATO receives, and retains, tax equal the receiving shareholder’s tax liability on the “grossed up dividend”. No more, and No less. This is easiest understood with an example. Lets take a company which has made $10,000 profit, and wishes to distribute this to its only shareholder. BUT, under out tax laws, the dividend paying company MUST pay company tax of $3,000 on that $10,000 BEFORE distribution of the dividend to the receiving shareholder. The dividend payer now only has $7,000 to distribute to the share holder and the remaining $3,000 is paid to the ATO. At the end of the year the receiver must declare the WHOLE $10,000 as income, even though he only received $7,000. That’s the law. Let’s say the shareholder has a marginal tax rate of 19%, therefore his tax bill is $1,900…..Therefore, the ATO is only entitled to keep $1,900 of the $3,000 it has been paid. So the ATO therefore MUST refund $1,100 to the receiving shareholder. Once the refund is made, the ATO has retained ONLY the tax it was entitled to, namely the $1,900 tax liability of the receiving shareholder. So it’s all balanced, and correct. The dividend receiver did receive a FC cash refund BUT the ATO has received the $1,900 tax it was entitled to. Special Case : Non-taxpayers There some cases where the government has set a 0% tax rate for a shareholder. This is the case for ALL superannuation funds, not only Self Managed Funds. The zero tax rate also applies to individuals receiving below the tax threshold of $18,200. What does a 0% tax rate, as set by government really mean ? It means two things firstly the shareholder pays no tax on income, AND, as a consequence the ATO is NOT entitled to tax on that shareholder’s income. That is what 0% tax means, how can the government expect to receive tax from a taxpayer the government has declared has a 0% tax rate ? ….Clearly it can’t ! So, in the example above, if the share holder had a zero tax rate, and the dividend payer has sent $3,000 to the ATO, then the ATO holds $3,000 to which it is NOT entitled. Therefore, the ATO would refund the $3,000 it holds to the didvidend receiver. When the ATO refunds the $3,000 ireceived from the payer, It has retained NO TAX. ……Because the government set a zero tax rate for ALL super funds in pension phase. Simple, isn’t it ? Conclusion: No “loopholes”, no “tidy little arrangements”, no “welfare”, just shareholders being taxed at their government-set rate of 0%. Ie the receiver paying no tax, and the ATO receiving no tax, just as it would on otherincome types, such as interest. A note on 0% taxpayers Some people believe the 0% tax rate is too generous. Maybe it is, Maybe it is not. BUT that is a completely different topic. All our imputation system does, and it does it perfectly, is to deliver tax to the government at the government set shareholders tax rate, whether the tax rate is 0%, or 47%. The ATO always receives the tax it is due, as per the government set tax rates for various taxpayers. It works perfectly, and needs no change. Supporters of Labor’s franking policy are supporting unfairness and discrimination by allowing the ATO to retain taxes it is NOT entitled to. "
ken 16:12 on 15 Mar 19
"All the supporters of the proposed change talk about this as if it were a welfare payment, which it is not. And that the money will be spent on schools and hospitals, which it won't. Think about this - all of the people who pay no tax, own franked shares and currently get a refund from the ATO (let's say $1b in total), sell their shares, and people who pay tax buy those franked shares. The ATO will give those people a tax credit of $1b. So the "unfair rort" is eliminated and the amount of surplus to build schools and hospitals is,,,,$0. "
John Phelan 16:04 on 15 Mar 19
"The policy change seems to make sense to me - to be fair I don't rely on them for income. But how many people do? Even if the number was 500,000 people - getting 10.7 Billion means each one of those 500,000 gets about 20K. Most advisers I have read in media seem to think the change is a bad thing it's such a lot of money to be saved that can be used to pay for other stuff..."
Lance 15:44 on 15 Mar 19
"The sooner Labor fix this refund issue the better. It is a rort that never should have been in place in the first place. It will effect some retiree's strategies, but the government could using some of the proceeds to increase the age pension to help those affected. The majority (not all) of people who benefit from this refund do not need it. The retiree's that will "lose" the most can afford it and can afford to alter their strategies accordingly. $10.7 Billion is a lot that can be spent on hospitals, schools and can provide the kitty to underwrite new coal fired power acquisition by the state."
Steven Kannerbry 14:47 on 15 Mar 19