Cuffelinks received the following letter from a reader on the little-covered impact of Labor’s proposed franking policy on those who do not have an SMSF and are not pensioners. Jon Kalkman responds.
To the Editor, Cuffelinks Newsletter.
Firstly I have to thank you for your informative and interesting newsletter. I do enjoy reading it.
There has been much discussion about Labor’s plan to stop reimbursing excess franking credits to SMSF investors whose franking credits exceed their tax payable and I can understand why a political party would be upset to see some very wealthy SMSF owners with several million dollars paying no tax or little tax and receiving tens of thousands of dollars in reimbursed franking credits.
The Labor Party’s attempt to claw back some of this money is not the proper way to do it as most commentators agree. However, there is another group of investors who do not seem to feature in the discussions I have seen so far. That is the retirees who have for whatever reason elected to remain outside of the superannuation system, invest in Australian equities and pay the required tax on their income. My wife and I are in that situation.
If I have interpreted Bill Shorten’s proposals correctly, and I may not have, it seems to me that people in our position will be taxed on their grossed-up income that includes their franking credits but will end up paying tax on income they never receive.
Let me give you an example to illustrate the unfair loss someone like us would incur if your proposal goes ahead in the manner that you outlined.
Let us take the example, for simplicity, of a couple who have $1,000,000 in Australian equities in joint names earning a fully franked 4% dividend from those shares. They cannot claim the aged pension because they have too many assets.
Their income would be $40,000 in net dividends plus $17,143 in franking credits – a total of $57,143. Their individual incomes would be $28,571 each. Their tax payable on that income would be $4,121.70 each or $8,243.40 for the two.
If they do not receive their franking credits of $17,143 they will lose $8,899.40 of the income they have paid tax on.
Has the Labor Party considered these tax payers? I wonder if they will take these people into account?
Regards, Dean Lines
Here is Jon Kalkman’s response:
The legal foundations for imputation credits
The owner of an asset is responsible for the tax on the income produced by that asset. Thus, shareholders are responsible for the tax on the dividends they receive as income. The tax payable depends on their marginal rate. If the shareholder is a super fund the tax paid by an accumulation fund is 15%, and a super pension fund pays no tax on any income it earns. Some readers are astonished at this, but this has been the case since 1992 for all super funds paying a pension, including retail and industry funds as well as SMSFs.
A PAYG taxpayer has tax withheld at source. If she earns $50,000 then her employer has to send $8,500 to the ATO. Her taxable income is $50,000 not $41,500. She might claim she is paying tax on money she never sees but her taxable income includes the tax already paid.
The same applies to franking credits. They are not a gift from the company or the government. They are part of the taxpayer’s taxable income. Any person whose taxable income is $30,000 has an after-tax income of $28,203. But under Labor’s policy, the shareholder whose taxable income of $30,000 happens to include $9,000 of prepaid tax has an after-tax income $21,000. This in the name of fairness?
Franking credits are prepaid taxes
According to the Australian Tax Office (ATO) website (update 28 June 2017):
“Dividends paid to shareholders by Australian resident companies are taxed under a system known as imputation. This is where the tax the company pays is imputed, or attributed, to the shareholders. The tax paid by the company is allocated to shareholders as franking credits attached to the dividends they receive.”
Shareholders are the owners of the company and therefore also owners of the profits, some of which are distributed as dividends. The effect of the imputation system, introduced in 1987, is to provide Australian shareholders (taxpayers) with a tax credit for tax already paid by the company on their behalf. This tax credit can then be applied to their own tax liability according to their marginal tax rate. Before 2001, if that tax credit exceeded their tax liability, the excess was retained by the ATO. That applied to all taxpayers. Since 2001, any excess tax paid has been refunded as cash to every eligible taxpayer (shareholder) without exception.
As the company tax rate is currently 30%, if the shareholder’s marginal tax rate is 47%, the tax credit is insufficient to meet the tax liability and the taxpayer needs to pay the difference of 17%. If the marginal tax rate is below 30%, the excess is refunded to the shareholder as cash.
The purpose and effect of the present system of imputation credits is to ensure that shareholders pay tax on their dividends at their marginal tax rate.
Avoiding double taxation
The imputation system applies to all Australian shareholders and taxpayers whether they are an individual, super fund, church, charity or some other legal entity. The refund of excess tax is identical to PAYG employees whose tax deductions are such that they find they have paid too much tax. What matters is the marginal tax rate, not the type of taxpayer.
Under the Labor policy, any taxpayer who presently receives a cash refund for the excess tax already paid will no longer receive it unless the shareholder meets one of the criteria of the policy exemptions: age pensioner or welfare recipient, a church, a charity or a union. In these cases, the franking credit is a tax credit refundable as cash, even if their marginal tax rate is below 30%. For some taxpayers, the franking credit will be as good as cash to pay their tax, for others it will be actual cash, and for many others, it won’t be either.
Super funds have low marginal tax rates. An industry fund is a single taxpayer covering members in both accumulation and pension phase and it will have income from a range of assets, and will therefore have sufficient tax liability to be able to use these tax credits to set against that tax. It is possible for large SMSFs to mirror industry funds with some members in accumulation phase, because either they are not yet retired or they are retired and have more than $1.6 million and are forced to hold the excess in accumulation phase. They too will likely have sufficient tax liability to be able to use these tax credits.
By definition, an SMSF exclusively in pension phase, typically run by a retired couple, only has income that pays no taxes, regardless of the size of that income. Therefore, the SMSF presently receives a full cash refund from franking credits for this excess tax paid. Under Labor’s policy, many SMSFs will lose a significant portion of their income, depending on their asset allocation to Australian shares. Many believe that mid-sized SMSFs are the target group of this policy.
The reader question: application to individual taxpayers
Now, more directly on to the reader question.
The proposed policy applies equally to individual taxpayers, for whom marginal tax rates are progressive. Because the franking credit is attributed to the shareholder, it is money withheld by the ATO until the shareholder’s tax return is completed, just like a PAYG taxpayer. As attributed income it becomes part of the shareholder’s taxable income.
Taxable income = dividends plus franking credits
As an example, consider a couple with $1,000,000 invested in Australian shares outside super and no other income. Assume they earn 4.2% dividends. Their dividends are $42,000 and their franking credits are $18,000. Their taxable income together is $60,000, and the franking credit represents 30% of the total which is the company tax portion of the profit attributed to the shareholder. So their taxable income is $30,000 each and they are each entitled to a franking (tax) credit of $9,000. The tax on $30,000 is $1,797 after the Low Income Tax Offset but their tax credit is $9,000 so they are each entitled to a tax refund of $7,203 or $14,406 together. Their after-tax income as a couple is $56,406.
According to Chris Bowen, they do not pay any tax so they shouldn’t get a refund. Under the proposed policy, this couple’s after-tax income is $42,000 from the dividends alone or a reduction of about 25%. They each have taxable incomes of $30,000 but they only receive $21,000 each after tax. For these individuals, having their tax refund of $7,203 withheld is effectively a new tax.
If this couple were of pension age, they would not be eligible for the age pension because of the assets test. If instead, this couple had less assets, say, $800,000, they would be eligible for a small part age pension of about $100 per fortnight but, because they now qualify for the exemption, they also keep their franking credits. For this couple, their dividends are $33,600 (4.2%) and their franking credits are $14,400. Their taxable income together is $48,000. Their taxable income is $24,000 each and they are each entitled to a franking (tax) credit of $7,200. The tax on $24,000 is $657 after the Low Income Tax Offset but their tax credit is $7,200 so they are each entitled to a tax refund of $6,543 or $13,086 together. Their after-tax income is $46,686 plus the age pension of $2,852. They are better off for income than the couple who have $1 million.
Labor’s misguided imputation policy
This policy therefore creates perverse incentives for retirees to reduce their assets to qualify for both the age pension and the franking credit cash refund.
Any individual whose marginal tax rate is below 30% will be denied the cash refund if they do not meet one of the exemption criteria. Think of the couple with a non-working spouse where the shares are placed in name of the spouse with the lower marginal tax rate or a worker on a low marginal tax rate with some Australian shares. They will lose a refund of their franking credits under this policy.
Labor’s franking policy is not a return to pre-2001 conditions. Before 2001, no taxpayer received a cash refund for excess franking credits. With these proposed exemptions, it is difficult to escape the conclusion that this policy is a political exercise rather than an economic one.
Jon Kalkman is a former Director and Vice President of the Australian Investors Association. This article is general information and does not consider the circumstances of any investor.