Frankly, fair change is now taxing the coffers

The federal government may be forced to review how it taxes superannuation funds in relation to franking credits in coming years. If measures are not taken the consequences could be billions of dollars lost of tax receipts and a big underinvestment by corporates in their own operations.

The concept of imputation credits was introduced by the Hawke/Keating government in 1987 to avoid the double taxation of company profits. This was a logical move. Until 1987, a company would pay the corporate tax rate on its profit before distributing a dividend to its shareholders who would then pay their full marginal income rate on it. If we applied today's corporate and personal income tax rates, up to 63 per cent in tax could be paid on company profits. Now that imputation credits are in place, the same dividend can only be taxed at the highest marginal tax rate of 45 per cent, which is far more equitable.

The big beneficiaries of the imputation system were those people who paid tax at a rate lower than the company impost of 30 per cent, including superannuation funds, at 15 per cent. These funds received credits that could be used to offset tax generated by other forms of income.

Since then, though, two events have taken place, changing the whole dynamics of franking credits. In 2000, the Howard government decided that low taxpayers such as superannuation funds could receive a cash payment each year for any credits remaining after offsetting tax on all income earned. In other words, a super fund would not only pay no tax but would receive a cash refund from the government.

The second change has been the emergence of the self-managed superannuation fund (SMSF). Of the $1.4 trillion of superannuation money in Australia today, nearly $500 billion sits in SMSFs, which are voracious for franking credits.

A super fund that only invests in domestic companies paying fully franked dividends will have a negative tax rate. It also means the government receives less than 30 per cent from corporate profits, being forced to write out cheques for SMSFs. Just how much less than 30 per cent is hard to work out and the government needs to undertake a study to quantify the amount of tax being lost. For retirees who pay no tax on super earnings this has become a boon and could be viewed as a loophole. These retirees are progressively living off tax refunds while the government is suffering from a lower corporate tax rate.

What is more of a concern for the government is the fact that super funds are forecast to grow from the $1.4 trillion today to between $6 trillion and $7 trillion in 2030, with about $2 trillion of that sitting in SMSFs. This money will drift towards the area that produces the most tax-effective outcome, which under the current system is imputation credits.

It will be tremendously difficult to change this system as hundreds of thousands of Australian retirees who are in their drawdown phase of superannuation have become dependent on fully franked dividends. The recent attempt by the Labor government to alter the system was meet with a cacophony of concern. It was portrayed as a greedy attempt by a desperate government to snare a greater slice of the largest savings pool Australia has ever accumulated. The result was the changes were dramatically watered down not to offend the vast majority of retirees.

Opposition Leader - and probable prime minister from September - Tony Abbott is aware of this situation. He has cleverly attacked the situation by saying he will push out the increase of superannuation contributions from 9 per cent to 12 per cent by two years. He justified this decision by declaring the current timetable too much of an impost on corporate Australia, when the reality is that he also knows it is becoming a major burden on the government.

There are other unintended consequences of the current super tax system. Companies have twigged to the notion that the best bang for their buck is to promise a high fully franked yield to their shareholders. Management pay packets are typically linked to the value of the company's share price, creating a natural inclination to pay out the highest fully franked dividend possible.

There is typically nothing wrong with this because the franking credits do belong to the shareholders and not the company.

The problem arises when companies drain their capital base to pay dividends and neglect spending the requisite capital on their own operations. We may have already seen an example of this with Woodside. The energy group recently paid a special one-off dividend and announced a policy to pay out 80 per cent of its earnings in dividends. A decision not to proceed with the multibillion-dollar Browse development on the North-West Shelf was the catalyst for this decision. Under normal circumstances, a company like Woodside, with its large and lumpy capital requirements, would pay the special dividend but not lock in such a high payout ratio for the future.

I suspect Tony Abbott will not tinker much with super tax. He will be hoping instead that low interest rates will fire up the economy at the same time as he cuts government spending.

matthewjkidman@gmail.com