Franking credit refunds – what’s all the fuss?

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Franking credit refunds – what’s all the fuss?

Two things we learned from the Federal election outcome – one, don’t rely on opinion polls and two, don’t under-estimate the voting power of retirees.

One of Labor’s key election policies was to cease refunds of franking credits that exceed tax liabilities. This policy would have stripped tax refunds from individuals who rely on franking credit income. Retired investors would have been most affected, particularly those with Small Managed Super Funds in pension phase dominated by fully franked shares.

The Liberals campaigned on the basis that Labor’s franking credit policy was a ‘retiree tax’. The election outcome suggests that their campaign was highly effective in harnessing the retiree vote.

But just what are excess franking credits, how do they work and would you have been impacted?

Franking credits and how they work

Here’s the simple version: To avoid taxing company profits twice, tax must be paid at either the company or individual level, but not both. If it were paid at only a company level, high income people would benefit from the 30% tax rate. So, the current system taxes company profits at the individual’s level. Any tax paid already paid by the company is refunded.

Shareholders in a company pay tax on franked dividends at their personal marginal tax rates and receive a credit for tax on profits paid by the company. For example:

  1. A company makes a profit of $100 and pays company tax of $30 at the 30% rate.
  2. The company fully distributes the profit after tax by declaring franked dividends to shareholders of $70.
  3. When shareholders complete their tax return, they add the $70 of dividend to the $30 of franking to declare the $100 of taxable income. The $100 of company profit is therefore subject to tax.
  4. The shareholders pay tax on the $100 at their marginal tax rate and claim the $30 that was already paid as a tax credit.
  5. If the shareholder’s marginal tax rate is 45%, the tax is $45 but $30 is a tax credit and the shareholder pays the extra $15 to the ATO.

If the shareholder’s marginal tax rate is 0% (for example, someone with an income below the tax-free threshold of $18,200 or an SMSF in pension mode), the tax is $0 and the $30 is refunded to the shareholder. Under Labor’s policy, the franking credit could be used to pay tax on other income but there would be no refund for investors who cannot use the full $30 credits (with a few exceptions).

Who would have been impacted by Labor’s policy?

Labor’s policy would have most affected individuals on incomes below $37,000 since this is the threshold for the marginal tax rate of 32.5%. The removal of refunds of franking credits would have resulted in a minimum tax rate the same as the company rate (30%) for investors earning only fully franked dividend income. This is of course higher than the rate of tax paid by individuals with a marginal tax rate of 0% or 19%.

One could argue that Labor’s proposed change was unfair to low and middle income earners. It also compromised a company tax system that has had bipartisan support for nearly 30 years.

Self-funded retirees may have been materially impacted, particularly those with SMSFs in pension phase who have portfolios dominated by fully franked shares. For example, an investor with $1 million in Australian shares in a pension phase SMSF earning fully franked dividends of 4.2% receives $42,000 in cash and $18,000 in franking credits, giving a total income of $60,000. The loss of franking credits would reduce their income by 30%, a big change in lifestyle in retirement.

What now

The Liberals went to the election promising no changes to the current franking credits system. Given the election outcome, it will be interesting to see how long Labor stick with what was one of its ‘signature’ policies.