Understanding franking credits and how they impact you

May 2, 2019

One of Labor's major policies coming into this election is the removal of franking credit refunds. This article explains how franking credits work and what the impact of the proposal might be. Labor have guaranteed that the policy won't apply to people who are receiving a government pension or allowance or to Self Managed Super Funds who had at least one member in receipt of a government pension or allowance as at 28 March 2018. The policy is proposed to apply to Self Managed Super Funds that have a member who became a recipient of a government pension or allowance after the 28th of March 2018 so it will affect some pensioners.

Franking credits were introduced in 1987 to avoid double taxation of dividends. Before franking credits were introduced, a Company would pay tax on its profits and when it paid those profits to its shareholders, the profit was taxed again in the Shareholders Tax Return without any allowance for the tax that had already been paid. Since 1987, a company pays tax on its profits and when it pays these profits to its shareholders, it is also able to pass on a franking credit to the shareholder equivalent to the tax that has already been paid on those profits. Since 2001, if these franking credits resulted in your Tax Return being in a refund position, you have been able to claim back that refund. The current system of franking credit refunds results in any profit being earned by the Company eventually flowing through to be taxed at the shareholders tax rate. If franking credit refunds are disallowed, shareholders who are at a 0% tax bracket will effectively be taxed at 30% on their dividend income. Below are two examples of the different approaches:

Shareholder with $20,000 taxable income

Before Franking Credits

Current Situation

Labor's proposed policy

Company Profit

$100

$100

$100

Tax paid by Company

($30)

($30)

($30)

Amount paid to Shareholder

$70

$70

$70

Franking Credit available to Shareholder

$0

$30

$30

Gross Dividend included in Individual's Tax Return

$70

$100

$100

Tax paid by Shareholder including Franking Credits

$0

$30 refund

$0

After tax amount received by Shareholder

$70

$100

$70

Shareholder with $50,000 taxable income

Before Franking Credits

Current Situation

Labor's proposed policy

Company profit

$100

$100

$100

Tax paid by Company

($30)

($30)

($30)

Amount paid to Shareholder

$70

$70

$70

Franking Credit available to Shareholder

$0

$30

$30

Gross Dividend included in Individual's Tax Return

$70

$100

$100

Tax paid by Shareholder including Franking Credits

($24.15)

($4.50)

($4.50)

After tax amount received by Shareholder

$45.85

$65.50

$65.50

From the above tables you can see that if you are earning $50,000 of income you would not likely be affected by Labor's proposal (unless your other unfranked income is less than $37,000). However if you are earning $20,000 you will lose 30% of your franked dividend income. This would create an uneven playing field for different types of income. If you earn $20,000 and have $100 of interest income you would pay no tax on the interest but if you have $100 of gross franked dividend income you would pay $30 tax on the dividend. Anybody who receives franked dividend income and has less than $37,000 of other taxable income will either pay more tax under this proposal or adjust their arrangements to avoid the tax.

Labor have also not stated their policy on how the refusal of a franking credit refund will affect other income tests. It is possible that the gross dividend including franking credits is still included in your taxable income even though you don't receive the benefit of the credits. This will impact on any income tests for which taxable income is used such as the seniors health care card and family tax benefits.

While this policy has been described as a "Retiree Tax" it will also have a large impact on small businesses run through a Company structure. Many of these businesses pay tax at 27.5% (small business company tax rate) in their Company and when dividends flow through to the shareholders (generally those running the business), their personal average tax rate is usually less than 27.5% so they receive a partial refund of franking credits. An individual would have an average tax rate of 27.5% at around $150,000 of taxable income. This policy can significantly increase tax for small businesses run through a Company.

Self Managed Super Funds are also impacted by this proposal as their tax rate varies between 0% and 15% depending on whether it's members are in pension or accumulation phase. Interestingly, Industry funds escape this proposal as they will likely have enough accumulation members paying tax on contributions and other income to allow the Fund to fully utilise the franking credits that a Self Managed Fund in full pension phase would not be able to. This is clearly an inequitable result that allows a member in one type of Fund to claim the credit while that same member in another type of Fund would be prevented from claiming the credit.

The good news for self-funded retirees, small businesses and members of Self Managed Super Funds is that it appears unlikely that Labor and the Greens would be able to control the senate between them and would therefore need cross bench support. All current and likely potential cross benchers have announced that they are not in support of the policy. Therefore if Labor and the Greens do not achieve a majority at the election, it is unlikely they will get this policy through parliament in it's current form. There is a chance that a cap may be put on the amount of franking credits you can claim as a refund which would likely protect most taxpayers other than Self managed Super Funds with very large balances.