How franking credits work
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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.
The shortest, simplest version
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.
A step-by-step version
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:
- A company makes a profit of $100 and pays company tax of $30 at the 30% rate.
- The company fully distributes the profit after tax by paying a dividend to shareholders of the remaining $70. It also ‘imputes’ (or ‘allocates’ or ‘assigns’ or ‘credits’) a proportion of the $30 tax already paid to each shareholder as a franking credit.
- When shareholders complete their personal tax returns, they add the $70 of dividend to the $30 of franking to declare the $100 of taxable income. The $100 of company profit is therefore subject to tax in the hands of its shareholders.
- Shareholders pay tax on the $100 at their marginal tax rate and claim the $30 as a tax credit.
- If the shareholder’s marginal tax rate is 45%, the tax is $45 but $30 is a tax credit and the shareholder pays the extra $15 tax.
- If the shareholder’s marginal tax rate is 0% (for example, someone with income below the tax-free threshold of $18,200 or an SMSF in pension mode), the tax is $0 and the $30 is refunded to the shareholder.
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.
Some additional details
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.
Why does this happen?
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.