What are franking credits, how do they work and who is entitled to them?
What is a franking credit?
Franking credits are only available to Australian residents, and not to foreign owners of Australian companies.
A franking credit is an entitlement to a reduction in personal income tax payable to the Australian Taxation Office. The entitlement is offered to individuals who own shares in a company (“shareholders”) in recognition of the tax on profits paid by that company. It is attached to a dividend which the company pays to shareholders out of its after-tax profits. The value of the franking credit is equivalent to the tax paid on the individual’s share of the company profit before it was distributed as a dividend.
How does it work?
The rationale for the credit is to avoid double taxation. Because the company has already paid tax on the dividend, the accompanying franking credit reduces tax payable by the individual on their total taxable income. When the individual calculates the personal income tax owing on their taxable income, they are able to deduct the value of their accrued franking credits from the tax payable. (The ATO also includes the value of the franking credits when assessing taxable income.)
If a company is paying the full 30% company tax rate, a “fully franked” dividend of 70 cents per share will be accompanied by a franking credit of 30 cents per share, representing the tax that the company has paid on its $1 per share of pre-tax profits. Companies can vary the level of franking on the dividend according to the amount of tax they have paid; they cannot offer more franking credits than they have paid in company tax. They cannot offer franking credits for tax they have paid overseas.
Who is entitled to it?
Franking credits are only available to Australian residents, and not to foreign owners of Australian companies. Historically, the ATO did not refund individuals with cash for any franking credits in excess of their tax payable, but this was changed by the Howard government in 2000 to allow individuals to receive cash refunds even if they do not pay any personal income tax. It is Labor’s proposal to reverse this change that has sparked the current debate.
If it’s lower, your franking credits are rebated; they can be used to pay tax on other income, or you’ll get a cheque in the mail if you don’t have any tax to pay.
The net result is that a company’s distributed profits are taxed at your marginal tax rate.
Typically, franking credits are of most value for investors on the lowest tax rates. For tax-free investors they’re as good as cash.
In March this year Bill Shorten pledged that should Labor win the upcoming election they will axe cash refunds for excess imputation credits paid to individuals and in superannuation funds. This would reverse the cash refund of imputation credits introduced by John Howard two decades ago. It would also be introduced with no grandfathering or transition arrangements. Malcolm Turnbull rejected it as a “cash grab”. The removal of Malcolm Turnbull means the Liberals can renege on that position and even adopt the changes should they feel it politically expedient.
The measure was introduced by Bill Shorten to win votes from the “poor majority” by stopping the super wealthy, who were in a tax-free environment, getting tax refunds. In introducing the proposals, Bill Shorten used an example of an extreme franking credit refund of $2.5m to a single SMSF in the 2014-15 financial year. But in the end, it is the 610,000 people with less than $1.6 million in their super fund that will be hurt the most. The super wealthy (those with significantly more than $1.6 million in super assets), since the introduction of the $1.6 million transfer balance cap on super pay 15% tax on investment earnings and capital gains (if the asset was held less than 12 months or 10% if held more than 12 months) and as such will be able to utilise the benefit of franking credits to offset that tax.
In many cases, for the super wealthy, the introduction of the $1.6 million transfer balance cap and the removal of cash refunds of franking credits ends up being a nil sum game – no refund, but no tax payable, because the 30% company credits are offset by the 15% super tax. In other words, the franking credits negate tax on earnings above the $1.6 million. The wealthy still get the use of the imputation credits whereas those with less than $1.6 million in super, on the other hand, simply lose the tax refunds altogether.