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The future of franking credits

The future of franking credits

Hamish Wehl
— 1 minute read

The proposed changes to franking credit refunds have sparked intense debate among Australian investors, particularly retirees and SMSF members.

Hamish Wehl

With a federal election just around the corner, now is a good time to consider the role that franking credits and franking credit refunds play in your portfolio.

A brief history of franking credits

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Most investors with exposure to the Australian share market will be aware of the franking credit or dividend imputation system, which was introduced to prevent company profits from being taxed twice. Before the system was introduced, companies would pay tax on their profits, and when this profit was passed to shareholders, they would be taxed a second time on the same profit.

In 1987, a rebate was introduced for those who paid tax on dividends that they received, taken off their tax in the form of a credit to be used on any other tax owed that year.

‘Fully-franked’ dividends were marked only where the full tax on profits had been paid by a company. As a result, fully-franked dividends became sought after, as they carried with them the greatest franking credits.

In 2001, the government enacted changes that resulted in franking credits being paid out in cash to shareholders who didn’t have enough, or any, tax to offset.

In 2007, the ‘Simplified Superannuation’ reform made super benefits, paid from a taxed source, tax free for people aged 60 and over.

Superannuation withdrawals also became tax free, and were no longer classified as ‘taxable income’ and because of the previous changes six years earlier, many retirees found themselves untaxed while also receiving imputation refund cheques from the government.

Eight years later, the 2015 Treasury tax discussion paper warned the government of ‘revenue concerns’ about the dividend imputation system. While the cost of imputation credits was $550 million in 2001, the report outlined they were set to cost $5 billion in 2018.

Franking credits: Tax benefits and cash refunds (for now)

Franking credits have been a particularly active feature for most listed companies since the 2001 changes, with 184 companies on the S&P/ASX 200 paying some form of dividend in the past year. About half of these paid fully-franked dividends, a quarter paid partially-franked dividends and around a quarter paid unfranked dividends.

For many Australian investors, the tax offset features of franking credits have been an incentive to invest in the local share market. For some retirees, who do not have a tax bill to offset, the ability to earn additional income from their excess credits, via a cash refund, has been an important consideration in their investment and retirement plans.

Self-managed super funds with investments in franked shares have also been able to use franking credits to offset fund expenses if they satisfied the holding period rules. In retirement (pension) phase when the fund is exempt from tax, the fund would also receive a refund for its franking credits.

Potential future changes

According to the Australian Electoral Commission, the next federal election must take place by 18 May 2019. If its proposed reforms are successfully legislated, Labor will effectively unwind the decision that introduced cash refunds for excess franking credits.

Franking credits will still be used to reduce tax payments, but the proposed changes would mean that taxpayers will no longer be able to obtain cash refunds for excess credits if they exceed tax liabilities (currently equating to a full refund for investors with no tax liability).

The policy will only apply to individuals and superannuation funds, and not to bodies such as registered charities and not-for-profit organisations. Union bodies, as registered charities, have effectively been exempted.

Additionally, most industry and retail superannuation funds have significant tax liabilities due to large numbers of members in accumulation stage. The funds do not currently receive refunds as they don’t have an excess of credits. The policy therefore, while applying to them, will not impact them practically.

Investment funds and listed companies holding franking credits are also likely to be impacted. Some organisations have already initiated sell-offs and special dividend repayments to their shareholders in a bid to get ahead of the potential change.

Financial impact

There is little doubt older independent investors will be most exposed – as they are most likely to receive franking credits in the form of cash refunds, which then contribute to their income stream. Professor Deborah Ralston, chair of the SMSF Association, provides the example that around 70 per cent of taxpayers who rely on shares as their preferred savings vehicle over the age of 75 receive franking credits, with an average annual value of $6,300.

Retirees with SMSFs are likely to be impacted in a similar way. The SMSF Association estimates that it will cut around $5,000 of income from the median SMSF in retirement phase earning around $50,000 per year in pension income with a 40 per cent allocation in Australian shares.

Most of the tax-raising benefits of the proposal fall on retired individuals and SMSFs. To combat the accusation that these individuals have been unfairly singled out, a pensioner guarantee exemption has been proposed for recipients of a full or part aged care pension, and people on other allowances such as carers, pensioners, disability support, unemployed and parenting payments. This means SMSFs with at least one exempt person would also be exempt.

It should be noted that Labor has also proposed reducing the capital gains tax discount from 50 per cent to 25 per cent, which will apply to all investments, and also introducing a 30 per cent tax rate for family trusts. If you believe you may be impacted by any of these changes, you should seek professional financial advice.

Hamish Wehl – head of retail funds management, Cromwell Property Group

 

The future of franking credits
Hamish Wehl
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