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Back to basics shows franking credit refunds are fair

Back to basics shows franking credit refunds are fair

By Warren Bird on March 21, 2018

Warren Bird is Executive Director of Uniting Financial Services, a division of the Uniting Church (NSW & ACT). He has 30 years’ experience in fixed income investing. He also serves as an Independent Member of the GESB Investment Committee.

Warren would like to thank John Stroud, who worked on the Campbell Inquiry, for reminding him of the fundamental principle on which this article is based.

 

Federal Opposition Leader Bill Shorten has proposed to change the dividend imputation system so that people or funds who have a zero-tax rate do not receive franking credits. He has presented it as way to make the tax system fairer, by clawing back what is asserted to be an overly-generous provision. However, if implemented, it would make the tax system much less fair.

What is dividend imputation supposed to do?

Let’s start by going back to the fundamental principle behind dividend imputation, which is to ensure that income is taxed once by those who are obliged to pay it.

If people who have a zero-tax obligation do not received franking credit refunds, then they have paid tax on income when they should not have. This results in them paying more tax than someone who earns the same gross income.

To illustrate, consider the following three cases.

  • Person A does a little bit of part-time work that earns them $17,500 a year, just under the income tax threshold. They don’t have to pay any tax.
  • Person B is semi-retired but runs a small sole trader business that brings in a net of $17,500 a year. They also don’t have any tax obligation.
  • Person C is retired and owns shares in a company that earns $17,500 of profit on C’s shares. Being a company with other shareholders, it pays 30% company tax and most of the rest is distributed to shareholders as dividends. Person C receives a dividend of $12,250 (that is, 70% of $17,500). They have effectively paid $5,250 in tax on their income because of the veil that the company structure has created.

Under the current imputation system, Person C receives a franking credit for that amount and a payment of $5,250 from the ATO. This recognises the fact that the full $17,500 earned by the company should belong to Person C, just the same as Person B’s business income or Person A’s part-time salary.

It’s like someone getting a tax refund at the end of the year because their PAYG taxes didn’t take legitimate deductions into account. They overpaid tax and so can get it back. It is their money.

 

Why the current system is fair?

The proposal by the Labor Party will take this away, leaving Person C with a lower income. That is not fair. Why should the presence of other income earners on the share register of the company force low income earner Person C to pay 30% tax?

There was a lengthy discussion of this in the Campbell Inquiry in 1981 (see chapter 14). When he introduced dividend imputation in 1987, Paul Keating moved our tax system in the right direction. However, his system had a flaw in it because Person C in my example was not afforded the same fairness as higher tax rate payers. John Howard (the Treasurer to whom the Campbell Inquiry Report was delivered) and Peter Costello fixed it, so that Person C could get that $5,250 back. Thus, in two steps we ended up with a much better tax system.

 

I understand charities will be exempt from this change. That seems to recognise the very point I am making. Why stop there? All people who have a zero tax rate should be treated the same and people who have a zero tax obligation shouldn’t be forced to pay tax. This is a matter of not discriminating against those who happen to earn their income through shareholdings.

Most of the arguments against zero tax rate individuals receiving franking credits are arguments against the whole dividend imputation system. For if you accept that zero tax payers shouldn’t get a credit, why stop there? Why should any tax payer get franking credits to offset other tax? The answer for all is that the pre-tax earnings of the companies they own, partly via being one shareholder among many, or wholly if it is their own business, belong to them.

The company, for all shareholders irrespective of their tax rate, is simply a pooling structure. It should not pay tax on earnings it pays to the members of the pool. The fact that it does is what creates the errors of perception about the incidence of taxation, about who should pay what, that are now clouding the discussion.

The current dividend imputation system is the second-best way of fixing the error that having a company tax system has created. The best way would be to have a zero-company tax rate and apply withholding tax on retained earnings and foreign shareholder distributions.

From the Budget point of view, both systems would raise the same revenue.

 

The real issue is the zero-rate paid by some taxpayers

Which brings us to the real issue behind Mr Shorten’s proposal. It reflects a view that some taxpayers shouldn’t be in the zero-tax bracket, with SMSFs in pension phase a particular target. In that case, he should just propose a change to their tax rate. Be explicit about who is taxed and why. Don’t hide behind erroneous thinking and bad policy, and don’t muck up a good tax reform.

Understanding imputation in this way also changes the discussion about the company tax rate. The economic and public finance impact is the same as if the company tax rate was already zero. Domestic shareholders pay tax on the earnings that they receive from dividends at their own tax rate. All the tax paid by companies on behalf of local shareholders is effectively repaid via the franking credit system and the individual (or managed fund or SMSF or charity) is assessed for tax on the income. Foreign shareholders pay a rate of 30%, and there’s a 30% tax on retained earnings.

 

If the company tax rate was zero and the government charged 30% withholding tax on all dividend payments to non-residents and on retained earnings, the budget would be in exactly the same position as it is now. There’d be no need for an imputation system. There’d be no franking credits for any income level and shareholders would include dividends (on which no tax had already been paid) in their income tax calculation.

 

The company is simply prepaying tax for its shareholders

Politically, the latter is unlikely to come in. My point is that the discussion about tax policy matters required us to recognise that the individual is always the ultimate payer of any tax and is where the incidence of tax lies. Behind the ‘veil’ of the legal structure, when a company pays tax it is, in effect, prepaying tax for its shareholders.

The point of the imputation system is to adjust how much tax has been collected on the shareholder’s behalf and correct it back to the amount of tax that should have paid in the first place. If that was zero, then a fair and just system would pay a tax refund. We have that system now. It shouldn’t change.

 

The information contained in this publication is of a general nature and as such does not take into account your personal circumstances, needs or objectives and should not be acted upon. Reliance is not to be placed on this without reference to me as your adviser. Before acting on the advice, you must consider the appropriateness of the advice, having regard to your objectives, financial situation and needs; and if the advice relates to the acquisition, or possible acquisition of a particular financial product, you should obtain a Product Disclosure Statement (PDS) relating to the product and consider the Statement before making any decision about whether to acquire the product

 

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