I don’t think it’s an exaggeration to say that the Australian Labor Party lost the 2019 federal election purely on the basis of their proposed changes to franking (aka imputed) credits. Whether you thought the Australian Labor Party were right or not, it’s hard to deny that the negativity toward that policy was a key influence in a closely fought election. So, what actually are franking credits? And why did Australia feel strongly enough to reject a potential government which proposed changes to them? In this article I’ll be looking at how franking credits work as well as how they apply to companies and their shareholders. Before I unpack that though, I’ll give a brief overview of how we got to where we are now…
The Bad Old Days
Prior to 1987, there was no imputation (i.e. franking credit) system in Australia. What this meant is that firstly, any profit a company would make would be taxed inside the company. If the company then paid some of those post tax profits to their shareholders, the shareholders would then pay additional tax on those dividends. This is best illustrated using an example:
- Let’s say ABC Ltd made a $100 profit in 1986. Back in 1986, the company tax rate was 49%. This meant that ABC Ltd would be left with $51, after paying its $49 income tax bill.
- Let’s also say that the same year, ABC Ltd decided to pay 100% of its profit to its one shareholder, Robert Hawke. Since Robert earned more than $35K that year, he paid tax on any dividend income at 60%. This means that of the $51 ABC Ltd dividend that Robert received, he paid a further $30.60 in personal income tax on it.
- So, to put it into perspective, of the $100 profit made in ABC Ltd, Robert only saw $20.40 of it, due to taxes paid both in the company and by Robert personally. That’s an effective tax rate of almost 80%!
What effectively was happening was that the same company profit generated and then paid to shareholders was being taxed twice. You would be forgiven for thinking this sounds a little unfair – it was!
The Frank Solution
In 1987, the federal Labor Government introduced the Imputation (i.e. franking credit) System to deal with this unfairness. Although companies continued to pay income tax on their profits and pay dividends to their shareholders, there were a couple of key changes in how this system worked:
- The shareholder now paid tax on the grossed-up dividend (i.e. the dividend received + the company tax previously paid). In the previous example, Robert Hawke would now be liable $60 tax on the dividend, being $100 x 60%.
- The shareholder would also receive a credit (i.e. franking credit) for their share of the tax already paid by the company on their dividend. In the example above, this would be the $49 paid by the company.
So, after introduction of franking credits, Robert Hawke now effectively sees $40 of his share of the $100 company profits. The company paid $49 income tax, and he would pay a further $11 (i.e. $60 income tax – $49 franking credit) on his individual tax return. It still wasn’t great for Robert, but that’s probably more of a reflection of the huge tax rates in Australia in the 1980s than anything else.
The Liberal Twist
In 2001, the federal Liberal Government took the imputation system a step further. They made franking credits refundable. To understand the implications of this, you need a basic understanding of the Australian individual income tax system. Australian individuals pay income tax each year based on a stepped system – essentially as your taxable income goes up each step, you pay proportionally more income tax.
But… if your taxable income is quite low, you don’t pay much tax at all. It’s quite possible that the company tax rate paid on profits may be more than the tax rate payable by low-income individuals. So, the Liberal government changed how franking credits work so that where there is an excess (i.e. the company has already paid more tax than the individual is required to), the excess amount is refunded. This actually benefited low-income earners the most. In 2019, the Australian Labor Party proposed to unwind the refundability of franking credits (amongst other things), but that’s a story for another day.
What it all means for you today
If you’re still reading this article, chances are you’re either in control of a private company or interested in investing in listed companies. Franking credits have implications for both:
- Control of a private company – every company, public or private, keeps track of its franking account balance every year. The franking account balance is a record of how much income tax a company has paid to the ATO but has yet to pass onto its shareholders. Some important things to note for those in control of private companies are:
- It’s often better to pay income tax inside the company than pass on 100% of profits (via wages) to individuals. This is because company profits vary from year to year, and the less profitable years may offer an opportunity to pass prior profits onto shareholders in a more tax-effective way. In contrast to company income tax, income tax paid by individuals will never be seen again.
- The income tax rate for small-to-medium businesses run through companies is set to drop over the coming years. There is a possibility that this may result in franking credits being trapped inside the company. Careful and ongoing analysis may provide opportunities to minimise the negative implications of this scenario.
- Small-to-medium business owners who operate a profitable business through a company should ensure they structure the sale of their business properly. When selling a business, you can either sell the business assets or the company itself. Selling the company itself will include its franking account, which a lot of business owners (and solicitors) don’t understand the true value of. Correctly structuring the sale of the business may offer the seller increased value.
- Share investors – regardless of whether you own shares in a public or private company, the franking credit rules largely operate in the same way. This presents some food for thought:
- The franking credits attached to franked dividends received by low-income individuals will be partly or fully refundable. Broadly speaking, if your income is < $20K p.a., you’ll receive a refund of all your franking credits when you lodge your corresponding tax return each year.
- Couples should consider how they structure their investments. If one partner in a couple earns significantly more than the other, they will pay proportionally more tax on both dividend income and any profits on the sale of the shares. It may be better for the lower earning individual to buy any company shares in their own name, as they will likely benefit most from the franking credit rules.
- Investments which generate franked dividends may offer retirees a tax-effective way of financing their retirement. Note – retirees need to consider the likely risk and return of any investments and should seek advice from a financial planner where necessary.
- Franked dividends generated inside self-managed super funds (SMSFs) will help to pay the annual income tax bill (and may generate refunds in some cases). Franking credits received by SMSFs entirely in retirement phase will be fully refundable.
As you can see, the franking credit system is complex but can provide opportunities for savvy business owners and investors. A good accountant will help clients understand their personal circumstances and how to make the most of franking credits.
