There has been a lot of talk lately about Laborโs proposal to no longer allow excess franking credits to be refunded. In our office we are very interested to see how this proposal would impact our clients and so we got out our calculators (or probably more accurate, our spreadsheet) and took a look at some different taxpayer situations.
Firstly, letโs get some tax basics out the way โ and bear with me, this gets a little technical. Franking credits represent the tax that a company has previously paid on its profits. The company pays dividends to its shareholders from its retained profits after tax has been paid. If it has paid enough tax the dividends will have franking credits attached to the dividend. As the current rules are designed to avoid double taxation the shareholder can claim a credit for the tax the company has already paid to reduce their tax payable. This means that where a company has Australian resident individual shareholders the final tax is actually paid by the individual, not the company.
For example, a company pays to its shareholder a franked dividend of $7,000. This represents the shareholderโs share of $10,000 of company profits, of which the company has paid tax at 30%. The franking credit attached to the dividend is $3,000, being 30% of the original $10,000 of profits. When the shareholder completes their tax return they include the $7,000 cash received plus $3,000 franking credit as income, a total of $10,000 of taxable income. They are then taxed at their marginal tax rate and are entitled to receive a credit for the $3,000 tax paid by the company.
Currently our tax laws allow for any excess franking credits to be refunded to the taxpayer. This means that if the franking credits exceed the tax payable on their tax return for the year then they will receive a cash refund. Essentially this ensures that the end tax paid on the profits is determined by the individualโs marginal tax rate.
Labor says paying out excess franking credits to taxpayers is costing taxpayers more than $5 billion a year and wants to abolish this. But what would be the impact of this change? As no legislation has been drafted, we canโt be absolutely certain but letโs look at some examples of how we think it might work out for some different tax payers.
We have Mel, Chris and Jane who each own the same number of shares in a listed company but their other annual income differs:
Mel โ has no other income
Chris โ has interest income of $25,000
Jane โ has wages of $70,000
They each receive a franked dividend of $7,000 from the listed company with a franking credit of $3,000 โ this adds $10,000 to their taxable income.
Under the current legislation the end tax on the original $10,000 of company profits would be:
| Mel | Chris | Jane | |
| Taxable income | $10,000 | $35,000 | $80,000 |
| Tax the company has paid | 3,000 | 3,000 | 3,000 |
| Net tax payable/(refundable) on dividend income by the shareholder | ($3,000) | ($900) | $450 |
| Total overall tax | – | $2,100 | $3,450 |
| Effective tax rate | 0% | 21% | 34.5% |
Laborโs proposed change to deny a tax refund of excess franking credits would result in the end tax being:
| Mel | Chris | Jane | |
| Taxable income | $10,000 | $35,000 | $80,000 |
| Tax the company has paid | 3,000 | 3,000 | 3,000 |
| Net tax payable/(refundable) on dividend income by the shareholder | – | ($900) | $450 |
| Total overall tax | $3000 | $2,100 | $3,450 |
| Effective tax rate | 30% | 21% | 34.5% |
The proposed change results in Chris being able to apply the franking credits from the dividend to offset the tax on her interest income, reducing the overall tax on the company dividend to 21%. Mel, who would otherwise pay no tax on the income is essentially paying 30% tax on the dividend because she is denied the refund of franking credits. For Jane the proposed change makes no difference to the overall tax.
Out of interest, what would happen if the same taxpayers received $10,000 interest income instead of the franked dividend?
| Mel | Chris | Jane | |
| Taxable Income | $10,000 | $35,000 | $80,000 |
| Total end tax | $0 | $2,100 | $3,450 |
| Effective tax rate | 0% | 21% | 34.5% |
The overall cash position for Mel under the current and proposed changes would be:
| Franked Dividend | Interest | |||
| Current | Proposed | Current | Proposed | |
| Dividend | $10,000 | $10,000 | $10,000 | $10,000 |
| Less: company tax paid | ($3,000) | ($3,000) | – | – |
| Less: individual tax | $3,000 | – | – | – |
| Cash to individual | $10,000 | $7,000 | $10,000 | $10,000 |
This is of course only one way to look at the proposed reforms to the refund of franking credits โ there are other aspects to consider. As a bunch of accountants we thought it was interesting that under the proposed changes the overall tax paid on dividend income earned by lower income earners could be higher than the overall tax paid on the same dividend income earned by a higher income earner.
By JENNIFER REES, BUSINESS ADVISORY MANAGER | ADELAIDE
Having a balanced attitude to life is something that Jennifer believes enables her to always keep things in perspective. No matter what the situation, she is always mindful of keeping the โbigger pictureโ in mind when working with clients and colleagues and thinking beyond the โmomentโ to other things they have happening in their lives.
