Tax with Max: Franking after a tax cut

Company tax changes and franking credits; CGT and bequeathments; super transfers to non-dependants.

Summary: Past cuts to company tax rates have complicated the process for calculating dividend franking credits. With another tax cut on the agenda, will shareholders be left in a franking bind?

Key take out: What's most likely is that the franking rate for dividends received by shareholders will remain at 30 per cent despite company tax being paid at a lesser percentage.

Key beneficiaries: Retirees. Category: Tax. 

Franking changes?

Q. I have accumulated franking credits in my company of $600,000 at the current 30 per cent tax rate. If the company tax rate changes to a lower rate can the franking credits still be applied at the 30 per cent until they are exhausted.

Answer: The franking account system for company tax was introduced in the 1980s by the Hawke/Keating government but has not been a static system and gone through a number of changes. Most of these changes resulted from the different company tax rates that have applied since its introduction. 

In addition to the change in tax rates there was also a change in the way that companies accounted for franking credits. Up until July 1, 2001 a company could have three franking accounts. These were:

  • class A account, reflecting the 39 per cent company tax rate;

  • class B account, reflecting the 33 per cent company tax rate, and;

  • class C account, reflecting the 36 per cent company tax rate.

The different franking accounts showed the value of after-tax profits based on the company tax rate paid. One of the recommendations to come out of the Ralph Report, the review conducted into business taxation, was that a franking account should be based on the actual dollar value of tax paid rather than the value of after-tax profits.

The job of converting the different franking accounts was made harder because, in some cases companies, could have a negative franking account. This meant that the formula for doing the conversions was reasonably complicated.

At the heart of the formula was the conversion of the after-tax profit to an amount of tax that would have been paid had the original profit being taxed at the new 30 per cent rate. You could be forgiven for thinking that any new changes in company tax rates would result in a similar treatment to the franking account system.

I at first thought that the way the franking account system would deal with the change to the general company tax rate that will eventually drop to 25 per cent from July 1, 2026, that has already started with Small Business Entities having a tax rate of 28.5 per cent, was a similar adjustment to franking accounts to reflect the new tax rate.

But the way that it will more than likely operate, according to an explanatory memorandum issued at the time the legislation was passed to give effect to the reduction in the SBE company tax rate, is for the franking rate for dividends received by shareholders to remain at 30 per cent despite company tax being paid at a lesser percentage.

The explanatory memorandum explained this with an example of an SBE company that made a $100,000 profit and paid tax of $28,500. The tax paid of $28,500 would be added to the company’s franking account and any dividend paid would have a franking account credit applied of 30 per cent.

This would result in one of two dividend options for that company. The first would be to declare a fully franked dividend of $66,500 that has attached to it dividend imputation credits of $28,500. The $66,500 dividend represents the after-tax profit that the company would have made had it been taxed at 30 per cent.

The second option will be for the company to declare a dividend based on the full after-tax profit made of $71,500, which would be made up of a fully franked dividend of $66,500, dividend imputation credit of $28,500, and an unfranked dividend of $5000.

Under option one the company can use the undistributed profit of $5000 to invest back in the business, while under option two shareholders will effectively pay a higher rate of tax on the dividend they receive because of the $5000 of unfranked dividend they receive.

In the final analysis the $600,000 of dividend imputation credits currently in your company’s franking account will more than likely result in you still receiving dividends from your company that will still have a 30 per cent imputation franking credit.

CGT considerations

Q. My husband died on April 15, 2015. He bequeathed me a property (house and 150 acres land) which he bought in 1982. It was bought by a company that he was the sole owner, director and shareholder of. It was our principal place of residence at the date of his death. Do I need to get a valuation of the property at the date of his death so as I don't have to pay CGT? Is there anything else I must consider?

Answer: Because the property was purchased by a company the fact that it was your principal place of residence does not affect how it will be treated for capital gains tax purposes. The principal place of residence CGT exemption only applies to individuals and does not apply to companies.

Had the company been formed after September 1985 and purchased the property, and the property was transferred from the company to you, tax would be paid on all of the profit made at the 30 per cent company tax rate.

The company would then be left with a large amount of undistributed profits and a franking account. These profits would need to be distributed to you in the form of dividends and then tax would be paid at your applicable marginal rate, after allowing for the 30 per cent dividend imputation credit.

Because the company and the property are both pre-CGT assets, no tax will be paid if you transfer the property from the company to yourself. This would be done by valuing the property, preparing a contract of sale transferring it to you, calculating the non-assessable gain made on the sale of the property, and then possibly winding up the company.

Because the shares were owned by your husband a value would need to be placed on them at the date of his death that equaled the value of the property. In the liquidation you would then receive a payout from the company that effectively equaled their cost to you, which should result in no capital gains tax payable.

This is a very complicated area of CGT legislation and you should seek professional advice before undertaking any action, and also obtain legal advice to see if there is anything you can do to reduce the stamp duty that would be payable upon the transfer of the property.

Super to non-dependants

Q. In one of your recent articles about death and outcomes I believe that many of your readers could have been left with the impression that all superannuation inherited by non-dependants is taxed at 17 per cent and that includes the Medicare Levy. I thought that this tax rate only applies to taxable superannuation and not to tax-free superannuation.

Answer: I am sorry if I left some of our subscribers confused about the tax treatment of superannuation passing to non-dependants. You are correct that it is only taxable super, as opposed to tax-free super that results from non-concessional contributions and the Small Business Entities capital gains tax superannuation contributions that is taxed at the 17 per cent.

It is interesting to note that when a non-resident receives a taxable super payment as a result of the death of a member, they only pay the 15 per cent income tax and do not have to pay the current 2 per cent Medicare Levy.