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Frankly, I don’t give an Imputation!

Key Points:

  • Surplus franking credits are currently refunded to people who pay no tax. The Federal Opposition has proposed limiting the use of franking credits and not paying refunds should they win the next Federal election;

  • The Opposition claim it is a measure targeting only the ‘rich’ but Treasury figures show that this is not true;

  • The extent of savings from disallowing franking credit refunds for the ‘rich’ are dubious given the impact of changes to pensions which took effect from 1st July 2017;

  • Application of the policy would result in widespread inequality in the superannuation system;

  • Portfolios are likely to adjust quickly to reduce excess franking generation with potential impact on different market segments;

  • The Opposition has started to backtrack on how the policy will be applied to low income earners, further complicating the implementation of the proposed policy;

  • Don’t change your strategy just yet – policy is only proposed and is contingent on the Opposition winning the next election.

  • The big issue is not franking credits, it’s policy around longevity. More superannuation reform can be expected to keep the system sustainable.

New policy announced by the Federal Opposition has ignited furious debate. Listening to the rhetoric, you could be forgiven for applying cliché character types to our leading politicians: Bill ‘Robin Hood’ Shorten promising to reform the dividend imputation system with effect from 1 July 2019 should Labor win the next Federal election. He’ll take away a tax lurk from the wicked ‘rich’ and give it to the righteous ‘poor’.

Malcolm ‘defender of the faith’ Turnbull accusing Bill of ripping the cash out of retirees pockets (to reclaim tax they never paid). He’ll protect our wealth from the ravages of Labor policy.

Hang on – what’s really going on? How does it really work and where are the vested interests outside of the emotive language?

How do franking credits work?

Companies pay dividends from their accumulated profits to shareholders. When a company pays a dividend it can also attach a ‘franking’ or ‘imputation’ credit, which represents tax previously paid by the company on profits.

Dividends may be unfranked, partially franked or fully franked. Fully franked means the company has paid the full 30 % company tax of those distributed profits and, along with a cash dividend, a 30% franking credit will be attached.

This franking credit is, in essence, a tax credit that says, “on your share of profit in this company, you have already paid 30% tax”. The reason you receive this tax credit is to acknowledge you have already paid some tax on your gross earnings and to prevent you paying tax twice. Sounds fair, right?

It works like this for a fully franked dividend:

What does Labor’s policy mean?

Quite simply, it means you would not get a refund for reclaiming franking credits beyond tax paid.

In practice, a pension account in a self-managed super fund will lose its franking credits. In the table above, a pension fund will be limited to earning the cash dividend.

Is this fair?

This is a very complicated question and it does depend on who you ask. However, we’ll limit the points to consistent application of the policy.

The primary argument that this is a fair policy is: it doesn’t make sense to get a refund on tax you never paid. Quite compelling at face value but it ignores the concept that company taxation is ultimately assessed against shareholder income.

Arguments that it is unfair include:

1. A pension fund earning a gross dividend of 8% (made up of around 5% cash dividend plus 3% franking credits) will only be able to earn the cash dividend. By contrast, a pension fund with an asset yielding a cash yield of 8% on another type of asset reaps the full benefit of an asset which does not pay tax;

2. Pooled super funds, particularly those with a high proportion of accumulation members are given an unfair advantage. The reason is, pooled funds have both superannuation and pension accounts within the same structure and many if not most of their members are in the accumulation phase. This means that franking credits are earned by the pool and not earned by a discrete pension account i.e. the pool uses franking credits earned to offset taxes payable across the entire pool. This includes tax on earnings as well as tax on contributions. The lower tax paid by the pool is reflected in the returns of the whole fund and so pension members benefit from excess franking credits generated by their account.

Conspiracy theorists have suggested this is a plot cooked up between industry funds (which are pooled) and the Labor party. We’re not in a position to make such a statement but the idea does highlight how political the policy is.

By contrast, funds dominated by pension members and self-managed super funds that may have no member accounts in accumulation phase are heavily discriminated against. One segment of pension members in society has an unfair tax advantage over another segment of pension members.

3. The lowest income earners will be affected. Whilst charities and not-for-profits will be exempted, the Opposition has claimed it will not affect low income earners but the statistics show otherwise. Dr Don Hamson of Plato Investment Management highlights Treasury’s numbers which indicate 610,000 Australians in the lowest tax bracket (earning less than $18,200 pa) would be impacted and a further 360,000 in the next tax bracket ($18,201-$37,000).

4. SMSF’s appear to be the prime target of this policy. ATO statistics from March 2017 indicated that round 67% of SMSF’s had less than $1m (19% had balances between $1m-$2m and around 14% with balances in excess of $2m). With the majority of saving balances under $1m, the policy looks like a headline grabber rather than having any structural merit. If we take a SMSF with $1m in pension phase invested to a balanced profile and assume that 30% is invested in Australian shares paying a 4% dividend full franked (5.7% gross yield), there will be approximately $5,142 in franking credit refunds that would be lost under the proposed policy. If this pension fund is paying out 5% in income to the member ($50,000 pa), the loss of those franking credits represents 10% of their annual income. An income of $50,000 per annum can hardly be a description of ‘the rich’ and to take away 10% of this may well have a material impact on retirement lifestyle.

Anecdotally, a single age pensioner I used to live next to has a small handful of the popular shares many have invested in as they have come to market (think AMP, NRMA, Telstra, CBA). She earns very little being on the full age pension and she looks forward to the franking credit refund in her tax year which helps pay for a holiday – think caravan park up the coast. Hardly flagrant but this will have meaningful impact on her lifestyle.

What outcomes can we expect?

The Opposition has thrown up very big numbers on what they expect to save in tax. The reality is it will not be remotely what they expect. This is for a few reasons:

1. The numbers the Opposition are using to target the few super wealthy SMSF’s (member balances in excess of $1.6m) are historical and are no longer accurate. The reason is that changes took place only with effect from 1 July 2017 limiting pension balances to a maximum of $1.6 million. Any balance over this had to be rolled back to accumulation where earnings are taxed at 15%. Funds could still generate surplus franking credits and a refund for their SMSF but not to the same extent as prior years;

2. Asset allocation will shift. Advisers and active investors are likely to revise their asset allocations to determine, in light of any changes, where they believe they can generate the highest risk/return trade-off. If the ability to generate surplus franking credits is removed, the attractiveness of Australian shares may diminish. Shares will be sold and someone else who may be able to use the franking credit will buy them;

3. Australian shares may experience strong selling by retail investors as portfolios adjust – if this occurs it is more likely going to be felt by those large companies which have the highest dividends i.e. the top 20 on the ASX. Property trusts may regain popularity. That said, if the shares are sold off sufficiently, the cash dividend may become attractive in its own right so these shares will have a floor price;

4. Companies may rethink their dividend policy – payouts may reduce in favour of reinvestment. This is not so much a reason that additional tax won’t be realised but rather a side effect. This would perhaps be a positive side effect of the policy, potentially generating greater overall productivity and wealth;

5. Bank hybrid securities will likely see a shift in ownership. Whilst institutions may invest in hybrids, they are predominantly retail investments. The effective yield will be materially lower if the ability to use franking credits is removed and investors may look to alternative defensive assets. Banks may find these instruments are not as attractive and popular as they have been;

6. More remotely, some companies may review their need to be domiciled in Australia. If corporate tax rates remain high and the value of franking credits is diminished alongside perhaps other company or industry specific concerns, some companies, in light of their own business and strategy, may question remaining corporate citizens of Australia.

7. Corporate Tax Reform – if the Government’s policy to reduce corporate tax comes to pass, there will be less franking credits issued and so less likelihood of excessive refunds being paid.

What about the big picture?

It’s not franking credits.

The big picture is longevity and the impact this is having now and will continue to have on the age pension. Taking away franking credit refunds will not alleviate this but, rather, risk accelerating people drawing down their personal resources more swiftly and ending up receiving age pension benefits sooner.

The broad issue is how we deal with funding longevity. The two primary sources of funding are the Age Pension and superannuation savings. Are these structurally right for the next 10, 20, 30 years?

Australia has one of the largest pools of retirement savings in the world. The purpose of this is to encourage people to sustainably save in a tax advantaged environment for the duration of their employment so that, as retirees, they are as self-funded as possible, thereby reducing the burden on the Age Pension system. This is more important than ever as we are living longer in greater health. The Age Pension is a measure that we value and ought to protect – encouraging greater burden on this system is hardly consistent policy.

The intent of the superannuation system remains right but then the question is, what is a fair and sustainable maximum amount to accumulate in this environment? In the near term this question has been answered – a pension balance of $1.6m per person. But what about any surplus accumulated in super beyond this? This question has been deferred (i.e. you can keep it in super for now and it will only be taxed at 15% on earnings).

There is no doubt there will be more superannuation reform.

If you have concerns or questions, please contact your adviser at Sovereign Wealth Partners on (02) 8216 1777.

Disclosure Statement: This communication has been approved and issued by Sovereign Wealth Partners Pty Ltd ABN 18 607 071 367 Corporate Authorised Representative (No. 001233909) of Bennelong Wealth Partners Pty Ltd ABN 44 164 127 833, AFSL 456235.

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