Franking credits in the firing line

Suddenly, without arousing even a murmur of dissent, an active scrutiny of the tax and superannuation system is under way. Spearheaded by the Henry Tax Review (led by Treasury Secretary Ken Henry) this review has the power to upend a superannuation system - especially a DIY super system - that has been an enormous success.

Remarkably, although many powerful lobby groups are clearly getting the ear of the increasingly powerful Treasury Secretary, investors themselves seem absent from the debate.

At stake is the shape of our investment system centred as it is on tax (specifically corporate tax) and investment income (specifically franking credits available on dividends).

It is going to be crucial that individual investors take the time to look at the issues, and put their ideas forward.

After all, franking credits provide a significant benefit to individuals and superannuation funds that invest in shares, ensuring that they are not taxed twice on the profits from the companies that they own.

What's more, franking credits serve the Australian investor extremely well. Without franking credits an Australian investor is taxed three times on the money earned by companies that they own, through:

In the superannuation environment particularly, franking credits provide the ability to significantly reduce the tax burden of a superannuation fund and, when a superannuation fund is paying a pension, those franking credits provide another source of returns for the investor in the form of a tax refund.

Separately, self-directed investors need to be aware of a possible higher superannuation tax rate for high income earners.

In terms of the tax benefits applied to dividends (otherwise known as dividend imputation) Ken Henry, who is in the process of undertaking the Henry Tax Review, has already highlighted the possibility of a cut - or even the scrapping - of franking credits in exchange for a cut to the company tax rate (currently 30%).

What would happen if franking credits were cut? It is a useful exercise to model some of the possible effects of corporate tax rate and franking level changes on investors. At the moment, the average OECD company tax rate is 26.5%. Let's assume that the government will try to target a tax rate slightly below this average: 25% seems plausible. Let's also assume that franking credits are "rolled back" (which sounds much better than cut) by 50%; so only 50% of the value of franking credits are passed on to investors.

The result of this for various tax brackets is that:

• A super fund in pension mode with a 0% tax rate that would currently receive a total benefit (cash and tax refund) of $100 would receive a dividend benefit of only $87.50.
• A super fund in accumulation mode (before it starts paying a pension) currently receives a benefit of $85 for a distribution of $100 of company earnings. Under the proposed changes it would receive $74.38.
• An investor in the 31.5% tax bracket would currently receive $68.50 after tax from a distribution of $100 of company earnings. Under the proposed changes they would receive $59.94 after tax.

The next three tables outline the calculations for: a super fund paying a pension; a super fund in accumulation phase; and for an investor on a tax rate of 31.5% outside the superannuation system.

It is assumed that tax is payable on the "gross" amount of the dividend (the cash amount and the value of franking credits), and that excess franking credits are refunded, as they are now.

nSuper fund in accumulation phase
	Current -15% Superannuation Fund	Proposed - 15% Superannuation Fund
Company Earnings	$100.00	$100.00
Company Tax Paid (currently 100% of company tax paid - proposed 50% of company tax paid)	$30.00	$25.00
Cash Dividend	$70.00	$75.00
Value of Franking Credits	$30.00	$12.50
Tax Payable @ 15%	$15.00	$13.13
Tax Refund (franking credits - tax payable)	$15.00	-$0.63
Total Benefit (Cash dividend = tax refund)	$85.00	$74.38

nInvestor on 31.5% tax rate
	Current - 0% Pension Superannuation Fund	Proposed - 0% Pension Superannuation Fund
Company Earnings	$100.00	$100.00
Company Tax Paid (currently 30%; proposed 25%)	$30.00	$25.00
Cash Dividend	$70.00	$75.00
Value of Franking Credits (currently 100% of company tax paid - proposed 50% of company tax paid)	$30.00	$12.50
Tax Payable @0%	$ -	$ -
Tax Refund (franking credits - tax payable)	$30.00	$12.50
Total Benefit (Cash dividend = tax refund)	$100.00	$87.50
	Current -15% Superannuation Fund	Proposed - 15% Superannuation Fund
Company Earnings	$100.00	$100.00
Company Tax Paid (currently 100% of company tax paid - proposed 50% of company tax paid)	$30.00	$25.00
Cash Dividend	$70.00	$75.00
Value of Franking Credits	$30.00	$12.50
Tax Payable @ 15%	$15.00	$13.13
Tax Refund (franking credits - tax payable)	$15.00	-$0.63
Total Benefit (Cash dividend = tax refund)	$85.00	$74.38

Many Australian investors enjoy the income they receive from investing in shares. This income comes in the form of both the cash received, and the tax benefits of franking credits. To date, even in this global economic downturn, those investors with a well diversified portfolio of shares that looked to their dividends and franking credits for returns have had their financial plan impacted to a far lesser degree than those who relied on capital growth.

Even those investors with large amounts of cash will be somewhat envious of the 6% plus "gross" income yields being provided across the sharemarket at the moment compared to cash income often less than 4%.

At their simplest level, the benefit of franking credits is that it stops the double taxation of company earnings; that is, franking credits give an individual or superannuation fund a "tax credit" for the tax that has already been paid at the company level, which offsets their own personal or superannuation tax.

One (sometimes disputed) benefit of this tax credit is that it encourages companies to pay a reasonable level of dividends to investors. If the franking credits did not exist and investors had to pay the full tax rate on the cash component of their dividends, there is an argument that it would be more effective for companies to not pay out dividends, to re-invest the money in new projects and try to create capital growth for investors - which is concessional taxed for long term (more than 12 months) investments. The US sharemarket, which does not have any franking credits, pays a much lower level of income that the Australian sharemarket.

The question then is why would the roll-back of franking credits even be discussed? The answer mainly lies with the theoretical benefit of attracting foreign investors to the Australian markets, investors who don't derive any benefits from franking credits. A lower tax rate for them means greater earnings from an Australian share, making them more inclined to invest in Australian companies, providing capital for Australian companies and increasing the value of Australian shares.



If you look at these arguments, you can see that there is a tradeoff between the interests of Australian and international investors. Cutting the corporate tax rate makes Australian shares more attractive for international investors, while the cutting franking credits actually makes Australian shares less attractive for Australian investors. The cutting of corporate tax rates may have other theoretical benefits for Australian investors; for example, if Australian shares become more attractive to international investors, those investors would be likely to invest more money into Australian markets, pushing Australian shares higher and making it easier for Australian companies to access global capital.

There have also been a number of general discussions around a possible increase in the superannuation tax rate for the contributions of high income earners, possibly to subsidise the superannuation tax obligations of lower income earners. It is not so long since the superannuation surcharge tax was abolished in 2005-06. This was an additional tax on the superannuation contributions of high income earners - and my experience of it was that it was much despised when it was in place.

We are often warned that for all the benefits of the superannuation system, the one downside is that it will probably be inadequate to provide the amount of capital to fund people's retirement. Any increase in superannuation tax seems to work against this aim. Compulsory superannuation is only a product of the early 1990s. That means people coming toward retirement over the next 10-15 years have not had the benefit of compulsory super throughout of their working life. An extra tax burden won't help them have an adequate super accumulation at retirement, an outcome that benefits the government coffers when people are less dependent on the age pension in retirement.

Conclusion

Franking credits have been a powerful innovation in the Australian tax system, ensuring that investors were only taxed once on the earnings related to the shares that they own. This seems to be both a reasonable situation, and one that allows investors in the Australian market to continue to receive a solid after tax income stream even during uncertain times such as these.

The fact that there is a public discussion around adjustments to the corporate tax rate and levels of franking credits means that individual investors and superannuants should take the time to get involved, to put forward their thoughts on what is in their best interests. After all, every other stakeholder in the system from Treasury to corporate and industry super funds are making their views known in Canberra. If DIY investors don't speak up for themselves, nobody else will.