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The franking credit imputation system has been a feature of Australian taxation for almost 30 years. A potential change proposed by the Federal Labor Party has thrust franking credits into the headlines, yet most Australians do not fully understand how franking (imputation) works.
This article seeks to explain franking as simply as possible without taking any side in the political debate.
Here is how imputation works in a simple explanation.
To avoid taxing company profits twice, tax must be paid at either the company or individual level but not both. If it were paid only at the company level at a rate of 30%, high income people on a marginal tax rate of 47% would benefit and low income people taxed at 0% would suffer. So the imputation system taxes company profits at the individuals’ marginal tax rate in personal tax returns. To avoid double taxation, tax already paid by the company is refunded to the individual.
At its core, that’s it.
Let’s look at exactly what happens to make it even clearer.
Remember, shareholders pay tax on franked dividends at their personal marginal tax rates and receive a credit for the tax on profits paid by the company. For example:
That is the current system.
Initially the franking credit system allowed only for offsets on tax paid. In 2001, this system was amended by the Howard Government to allow for the cash refund of excess credits to those whose tax liabilities were less than the refunded credits. Prior to 2001, this $30 would have been retained by the ATO as tax payable on the company’s income.
Under the Labor proposal, the franking credit can be used to pay tax on other taxable income but there will be no refund for shareholders who cannot use the full $30 credit (with some exceptions, such as for pensioners).
The debate on the policy proposal results from Labor’s intention not to refund the excess franking credits.
It is understandable that many people miss a crucial point about our taxation system, because it sounds unusual. That is, our company tax system operates on the proposition that company profits are taxed at shareholder level.
If we want a system that taxes company profits once as a measure of equity, simplicity and fairness, we could simply tax companies at 30% with no further taxation of shareholders. However, there would be a significant loss of government revenue because most company profits are taxed in the hands of shareholders in higher tax brackets, up to 47%. It would also be unjust on people in the lower tax brackets of 0% and 19%.
Following a tax review 30 years ago, we settled on the imputation system, which is similar to way normal PAYG salaries are taxed. Companies withhold tax from pay packets and there is an end-of-year adjustment (refund or payment) after each person lodges their personal tax return.
In other words, under imputation, the 30% tax is paid by the company but it is then refunded to the individual as a credit against their other income taxes.
Graham Hand is Managing Editor of the financial newsletter, Cuffelinks. As nabtrade is a sponsor of Cuffelinks, subscription will always be free to nabtrade clients. Please note that at the time this article was published, Labor’s policy on the imputation system was still in proposal stage. We strongly recommend that investors consider the risks of making investment decisions based on policy in the absence of draft legislation.