If you’ve never heard of franking credits, chances are you’ve never invested in shares. If you have, then you’ll know why it’s creating so much debate at the moment. The system of franking credits — also known as dividend imputation — benefits millions of Australian shareholders. That’s why any proposed change to the system poses a risk for your wealth.
If you’ve invested in the stock market before, you’ll probably need no introduction to how franking credits work. But it’s worth revisiting how this system works if you want to understand why it’s such a big issue, and how investors use it improve their investment portfolio and wealth.
How franking credits prevent double taxing of company profits
The Hawke-Keating Labor government introduced franking credits in 1987 in a bid to prevent double taxing which had, up to then, forced both companies and shareholders to pay tax on their earnings.
Before the introduction of the law, companies had dividend payouts to shareholders taxed at the corporate rate of 30%. Investors who received these dividend payments would pay an additional tax at their standard income tax rate (as a quick reminder, a dividend payment refers simply to the money that a company decides to give back to shareholders from its annual profits).
Prior to the introduction of the franking credits system, if you’d received a dividend payment from a company in which you owned shares, you had to pay tax on those earnings. And it wouldn’t matter if the company had already paid corporate taxes on their profits. Your dividend earnings were regarded the same as any other income source you received during the year.
The 1987 law changed all that. Today investors only have to pay the difference between what a company pays in taxes (set at a corporate tax rate of 30% on profits), and their own marginal tax rate. For example, if your income tax rate is 30%, you wouldn’t have to pay any additional taxes because the company you hold shares in would’ve already paid their 30% tax on profits. If your income is taxed at 45% for instance, then you’d only be liable to pay the difference. That means you’d only pay a 15% tax on your dividend payouts, instead of the standard 45% tax rate for any other income.
The franking credits system allows investors to claim a tax credit that amounts to a corporate tax rate of 30%. You can see the immediate benefits of this as a shareholder, because it means that it reduces your tax liability to nothing.
In 2000, a revision to the law made franking credits fully refundable. For example, if you earned less than the tax free income threshold of AU$18,200, not only would you not pay any tax, but you could get franking credits back in full in cash. That made the system an attractive investment strategy, especially for retirees that could manage the amount of income they earned during the year.
Then in 2006 another change to the franking credits system allowed anyone over the age of 60 to earn income on their superannuation without paying any tax on it. That means that if you’re a retiree, you can arrange your earnings to ensure that none of your income is taxable. That would free you up to convert any franking credits into cash at the end of the year.
Why the government wants to reduce franking credit tax breaks
The government claims the current system favours the wealthy too much. And they believe investors are exploiting the franking credits system. If you’ve been staying up to date with the economic rut Australia finds itself in, you’ll know the government is looking for ways to plug holes in the budget.
To improve budget deficits, they’re targeting the AU$30 billion franking credits system, which they claim is costing the budget AU$5 billion every year. Under the current system, around AU$10 billion of franking credits goes to Australian households every year, with another AU$20 billion split between companies and superannuation funds.
The government wants to put an end to one specific tax break which they say would free up to AU$5 billion in the budget every year. The rule they want to abolish currently allows any investor, who has no taxes to offset against their franking credits, to get a cash payout from the Australian Taxation Office (ATO). The government says that this cost the nation AU$4.6 billion in the financial year for 2012-13. And they’re pointing to the fact that no other country allows this practice.
Currently, the wealthiest 10% of Australian households — those earning over AU$207,000 a year — get 75% of all franking credits that go to households. The National Centre for Social and Economic Modelling (NATSEM) have created models showing that the wealthiest 20% of households earn up to AU$8.3 billion in franking credits, while the poorest 20% get AU$164 million.
And NATSEM say that with 61% of superannuation funds held by the wealthiest 20% of households, the AU$10 billion that goes to super funds and charities also finds its way to the wealthiest households.
What a change to the franking credits system means for you and your self-managed super fund
If you’re one of the many Australian investors who rely on the franking credits system as an investment strategy for your portfolio, you’re in line to feel the effects of the government’s latest cash grab. The investors with the most to lose if the government gets their way are retirees, especially those with self-managed super funds (SMSF). Let me explain why.
If you have investment income in an SMSF, you’ll get taxed at 15% on that income prior to accessing your superannuation money. Once you qualify for age pension, the tax on your SMSF goes down to 0%.
For any income on your investments — such as dividend payouts — franking credits will offset the tax on those dividends, and you’d be in line to receive a cash payout from the ATO. That money goes straight into your pocket at the end of the year. So you can now see how important franking credits can be to the success of an SMSF investment strategy.
If you’ve been thinking about moving your super into a self-managed super fund, you’ll need to know whether it’s right for you and your investment portfolio. A growing number of Australians now use self-managed super funds to increase their wealth. The Daily Reckoning’s feature editor, Vern Gowdie, has written a seven point plan to help you decide if an SMSF can work for you. His report ‘How to Know if a Self-Managed Super Fund is Right For You’, will also guide in you what investments are worth placing into your SMSF. For details on how you can download a free copy of Vern’s report, click here.
Contributor, The Daily Reckoning