There has been quite a lot of media coverage over the past 6 to 8 months about the Labor Party’s election proposal to stop the Australian Tax Office giving cash refunds for people or self-managed superannuation funds who have franking credits but do not have sufficient taxable income to have a tax liability.
So what is the history behind our current franking credits system?
In 1987, the Hawke-Keating Government (based on recommendation from the Campbell Review commissioned by the Fraser Government) introduced the dividend imputation system to remove double taxation of company profits. The Campbell Review recommended that where company profits are passed onto shareholders as dividends, that money should only be taxed once – in the hands of the individual as income tax. If the dividend imputation scheme was not in operation today, the Government’s tax take from shareholders in the top income tax bracket would be 61.5 cents of every dollar of company profit.
Under the dividend imputation system, a company pays tax on its profits at the company tax rate and may then pay the remainder to shareholders as a franked dividend. Essentially, company tax operates as a withholding tax because it is easier for governments to recover tax from companies than individuals. The shareholder then has to declare the entire amount of the profit – i.e., the already taxed portion of the profit AND the franked dividend – and is assessed for income tax at their applicable income tax rate of the whole profit. The shareholder is then entitled to a credit for the portion of tax already paid by the company (which is 30% of the profit for most publicly listed companies).
For individuals, dividend income is part of their taxable income, so the franking credit scheme is unlikely to be controversial where he or she is liable to pay tax. However, it is where self managed superannuation funds operate that the dividend imputation scheme, as introduced by the Hawke Government required some tweaking.
Superannuation consists of three phases. Those who haven’t hit retirement age will know that 9% of your income is paid into your superannuation fund. The government taxes this superannuation contribution at a lower rate of 15% and any earnings on that amount in the super fund are also taxed at that lower rate. This contribution and wealth building is known as the accumulation phase. When a person retires and becomes entitled to access his or her superannuation, the person can commence being paid an income stream from the accumulated money when the fund moves into the second and third phases – the transition to retirement and the retirement phase.
Under the current rules, once a person moves into the retirement phase, their superannuation is not taxed. That tax exemption includes no tax on earnings on funds in the retirement phase. From 1 July 2017, the retirement phase is capped at $1.6m so if the person’s super funds hold more than $1.6m in assets, the amount greater than the $1.6m cap must stay in the accumulation phase (where it is subject to tax).
This is where the issue arises regarding franking credits. Because a person is the retirement phase has no assessable taxable income and isn’t liable to pay income tax, their franking credit would be useless because they have no tax liability against which the franking credit can be offset. The result would be that tax on their company dividends has been paid to the ATO by the company at the company tax rate, while super funds which have a tax liability can use the credits to get back 15%.
So, person A is taxed on their company profits at 15%, while person B in the retirement phase has their company profits taxed at 30%.
To redress this inequity, the Howard Government in 2000 decided that excess franking credits (credits you have when your tax liability is zero) would be paid as a cash refund. As this has now been the status quo for 19 years, many people have planned their retirement investments around it. One of the side effects of this is a somewhat unhealthy level of investment by SMSFs in companies simply for their dividend payments, exacerbated an extended period of record low interest rates which make dividend producing companies a more attractive investment than bank interest. Many companies seem to have been happy to encourage investment in them by paying a higher percentage of their profits in dividends rather than reinvest their funds in capital or employment. But that’s a story for the investment bloggers.
Under the Labor Party’s proposal, the cash refund will stop and we’re back to square one where the retiree pays 30% tax on the profit but everyone else pays 15%. The proposal has been sold as “why should people who pay no tax get a cash payment from the Government?”. Many people will agree with this. I’m not here to argue the politics but the claim is not quite accurate. The purpose of the “credit” is that it is a refund of company tax, leaving the taxpayer to bear the burden the personal income tax only. It just so happens that the superannuation law say that Person B’s income tax on their super should be zero, so if the Government does not pay a cash refund to those people it has overtaxed them. There are many who will say a cash refund also inequitable, why should people who have over a million dollars in assets pay zero tax on their share earnings while everyone else pays 15%? However, the way to redress that imbalance is to reform the superannuation rules, company tax or our income tax regime so that consistent rules apply to everyone, not to apply an inequitable system which pays no heed to the rationale behind it. Tax laws are no different to any other law. They should be based on logical reasons to have the law and consistent application of that law.
In any event, people will make up their own minds about it come election day.
The important thing for people in the retirement phase, who will be faced with the reality of losing their excess franking credits should the Labor Party wins government this Saturday, is that they need to consult with their financial adviser who can tell them how to best structure their superannuation in retirement post 18 May 2019 to maximise their retirement income.