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Franking on the Chopping Block

If it wins government, Federal Labor proposes to discontinue refunding cash for unused franking tax credits that can arise from Australian share dividends. Though we value public amenity, giving up tax benefits is generally unwelcome. So, we thought it would be helpful to put the proposal in perspective and cast this over our model portfolios to see its possible effect.

But first some background…

Background

Dividend imputation is to offset double taxing, otherwise dividend income would be taxed first within a company as profits then again in shareholders’ hands. Franking credits pass company tax credits through to the shareholder to reduce their tax by the amount they paid in corporate tax as a shareholder. This can be used whether the shareholder is a person, a super fund, or a trust.

Dividend imputation was begun by Paul Keating in 1988 and in 2000, Howard/Costello allowed unused franking credits to be paid back as cash. Labor want to return to the imputation system originated by Paul Keating.

Immediate Impact

The big losers would be tax-free pension accounts. So a couple with the $1.6m limit in a pension account each ($3.2m combined), invested in a typical ‘balanced’ portfolio, might lose about $15,360 p.a. of after-tax income ($7,680 p.a. each).  This equates to around 0.48% p.a. of their total income, assuming a gross yield on the balanced portfolio of 4.14% p.a. reducing to 3.66% p.a. under the proposed system. If invested solely in Australian Shares, this couple might lose as much as $40,960 p.a. in after-tax income ($20,480 p.a. each). We’ve tabled the potential impact on different pension account balances using these same assumptions below:

The change is a general tax effect on all investment, not just super. Some super funds contain both pension and accumulation accounts, so any franking credit might be fully utilised by the fund to cover taxes within its accumulation accounts. The taxes it could cover include 15% on concessional contributions, 15% on fund income and 10% tax on realised gains held over a year.

Investors paying more than the company tax rate (30%) would not be impacted by these proposed changes as they could still use franking credits to reduce their taxable income by the amount they paid in corporate tax as a shareholder.

Adjustment Over Time

While in the short term pension funds would particularly would feel the impact on their income, investors and the companies that pay the imputation credits would gradually adjust.

Since imputation credits began in 1988, Australian companies have increased their payout ratios (amount of profits paid out as dividends) from around 60% to 80%. They’ve been motivated by income hungry investors gobbling up the shares of those companies that paid out more. This encouraged Australian companies to invest less back into growing their businesses. So, if franking credit cash refunds were no longer allowed, companies might begin to reposition more strongly for growth with a little less investor focus on franking.

If franking credit refunds are removed, it may lessen the myopic ‘home bias’ many Australian investors feel, encouraging them to increase their interest in other opportunities in global markets. It would be unfortunate if it moved more into investment housing during the current peak phase of that market. Regardless, total investment returns are all that really matter – retiree income can either use investment income received or by shaving off capital growth.

Conclusion

There’s a lot of water to pass under the bridge before this change might occur. But the bottom line is that if you’re fortunate enough to have your savings in a Pension Account, it’s likely that aside from some initial discomfort, we’d find ways to adjust and make up this ‘lost’ income effect. Australian companies would also adjust and assist in making up the impact on shareholders – perhaps by focusing more on growth than on dividends as occurs elsewhere in the world.

Many more tax discussions will occur between now and the next Federal election – another option might be to reduce company tax to the extent of the imputation advantage – this may attract foreign investors but reduce Australia’s tax take.

In the meantime, if you would like to discuss this further please call to speak with one of our advisers.

If you would like to discuss the information in this article or your investment options with one of our wealth management professionals, get in touch today!

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Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.