Why franking credits are crucial to Australia’s next election

One of the most disturbing things about the looming Federal Election is that one of the core issues it will be fought over is so confusing.

I suspect if you took a poll of Australians and asked them what is meant by “franking credits’’ or a” franked dividend”, a majority would struggle to define them.

It is even more difficult when you throw in a few extra terms like “dividend imputation’’, “grossed-up dividends” and “refundable excess franking credits”, which tend to make even a committed voter’s eyes glaze over.

However, the $5 billion a year issue being tussled over between the current Liberal/National Party Government and the Labor Opposition is a vital one for all taxpayers in general and for retirees in particular.

What are franking credits?

Fortunately, it is not too difficult to decipher the taxation principles underlying this important policy argument and to then understand the full impact of what Labor is proposing.

In simple terms, a franked dividend is one on which the company issuing the payment has already paid tax, usually at the company tax rate of 30%.

Because the dividend or profit distribution is tax paid, it is “franked” or in other words marked so that the recipient knows that tax has already been paid on these company profits.

Just as a wage earner might be due to a tax refund or face a tax bill after their tax is finally calculated at the end of the financial year when all payments and deductions are added together and calculated, so someone who owns shares will add their franking credits to the column of taxes already paid in arriving at their final tax calculation.

The same applies for a superannuation fund, which can use franking credits to offset and reduce tax that might be payable.

Individual tax rates are important

So, for a worker on the top marginal rate of 45%, the company tax credit of 30% of the dividend will still leave them with a bit more tax to pay on this dividend.

Likewise for workers on the 37% and 32.5% tax rates, although those on the 19% rate would get a refund of 11% of the dividend.

The issue that is being fought over – and the reason the LNP Government has dubbed the Labor move a “retiree tax” – is that a person with a zero-tax rate at the moment can claim back the tax the company has paid on their behalf.

Most self-funded retirees over the age of 60 who live off their superannuation are not required to pay tax and so they get to claim back the company tax that has been paid on their behalf by companies they own shares in.

As a matter of taxation principle, this makes perfect sense – the company has paid tax on the dividend so those franking credits should rightfully be placed on the person’s tax return at the end of the year and the Australian Tax Office will then send them a refund.

The original Labor policy was to no longer allow any refunds for franked dividends for zero rate taxpayers, although that position has been changed so that retirees on the Government aged pension are now exempted and can still claim a refund for franked dividends.

From here, the facts of this debate start to be overwhelmed by the partisan rhetoric so I’ll just summarise the major arguments both sides make in defending their positions:

Labor

Shadow Treasurer Chris Bowen has said that since it was introduced 20 years ago by the Howard Government, the policy of allowing tax refunds on franking credits for those on zero tax rates had seen costs blow out from almost nothing to $5 billion or more a year.

He said this money is primarily paid to people who are already wealthy and the money could be much better spent on schools and hospitals.

In his most controversial statement in the debate, Mr Bowen said that retirees worried about the policy “are of course perfectly entitled to vote against us” – a statement some have taken literally and others have taken to show that Labor doesn’t care about self-funded retirees.

Liberal National Government

Prime Minister Scott Morrison has campaigned strongly against the proposed tax changes, quoting Treasury research saying they will not raise nearly as much as revenue as Labor claimed ($10.7 billion in the first two years and $55.7 billion over 10 years) because people will rearrange their tax affairs.

He has also supported the chair of the House Economics Committee, Victorian Liberal Tim Wilson, who has been touring the country with the committee hearing from angry retirees impacted by the changes.

Retirees

There has been quite a lot of anger in the retiree community against these changes. To summarise most of the arguments, some say it is unfair to change the rules when people have spent years planning for their retirement.

Others point out that now that superannuation rules have been changed to already tax those with more than $1.6 million in super accounts, the main people hit by these changes will have between $800,000 and $1.6 million in retirement savings to provide a private pension, which hardly qualifies them as fat cats.

Around 900,000 retirees would lose money from the changes and some say why should they bear an effective 20% pay cut when nobody else in the community is.

There are also many predictions that some self-funded retirees will qualify for the age pension faster due to the changes, costing the taxpayer in other ways.

Some of the other arguments against the changes are that they would prompt people to change their investments from tax paying companies to those non-taxpaying companies that pay out unfranked dividends due to accumulated tax losses, which seems to be a perverse corporate signal.

Practicalities

Whoever wins the election that must be held before May, there are some practicalities to consider before anyone should start changing their investment strategies.

One is that Labor might not win Government or at least may not win a majority in the Senate, which would make it difficult to get its legislation through.

Another is that the actual legislation hasn’t been seen yet, although some tax planners have already been suggesting that trusts and other vehicles could be used to circumvent the planned changes.

Despite this uncertainty, there has been pressure on some companies such as BHP, Rio Tinto and the big banks to consider distributing their significant franking credits to shareholders before their value is reduced for some investors.