The great franking credits rip-off

Have we seen the first step towards the government abolishing franking credits, as occurred in the UK in the 1990s? If so, this is a major problem for Australian investors, particularly those with superannuation. Which is almost everyone.

Abolishing franking credits could halve retirement incomes.

The budget and franking credits: What happened?

Australian investors will suffer a $1.4 billion reduction in their dividends due to a 7% loss of franking credits in the federal budget. The cause of the reduction in franking credits is the decision that the new 1.5% company tax for paid parental leave (PPL) will not have franking credits.

Two income tax changes affect companies from July 1, 2015. Company income tax is reduced by 1.5% (from 30% to 28.5%), with a compensating fall in franking credits. This has no effect on shareholders as the tax reduction and fall in franking credits offset each other.

Companies earning more than $5 million are hit with the new 1.5% PPL tax. It will apply to all but the smallest dividend-paying companies listed on the Australian stockmarket (ASX).

The net effect is that these companies pay the same 30% tax as they do now. But franking credits will only apply to the 28.5% tax, down from the current 30%. The final result is a 2.1% reduction in total dividends (cash plus franking credits) for the shareholders of these companies.

The effect on Australian shareholders

ASX-listed companies paid about $60 billion in cash dividends in 2013-14, with an additional $20 billion in franking credits. The new unfranked PPL tax will reduce franking credits by $1.4 billion to $18.6 billion, assuming cash dividends are unchanged. The lost franking credits are expected to grow to $1.6 billion in 2015-16, the first year of the reduced franking.

Almost every Australian will suffer some loss. Everyone with a superannuation account, as well as individual investors, will get reduced earnings.

Current dividends with 30% franking credits

Currently, an investor who receives $700 in fully-franked cash dividends gets $300 in franking credits, for total dividends of $1,000. Their tax is calculated on the $1,000, but they receive credit for the $300 franking credits. They get a refund if the tax on their dividends is less than $300, and pay extra tax if the tax on the dividend tax is above $300.

A shareholder with a 0% tax rate gets a $300 refund. This includes many pensioners, charities, and the superannuation fund investments for retired members.

A superannuation fund paying 15% tax on the dividend income of working members gets a $150 refund. A taxpayer on the middle tax rate of 34% pays $40 extra tax. A taxpayer on the top rate of 46.5% pays $165 extra tax.

Future dividends with 28.5% franking credits

From July 2015 all but the smallest ASX-listed companies will pay the same 30% tax rate as now, so their cash dividends will not be affected by the tax changes.

An investor who receives $700 in fully-franked cash dividends will get $279 in franking credits, producing total dividends of $979.

Total dividends are lower by $21, or 2.1%. Franking credits have fallen by $21, or 7.0%.

Their tax is calculated on the $979, but they receive credit for the $279 franking credits.

The shareholder with a 0% tax rate will get a reduced refund of $279, instead of $300. A 7% reduction for the pensioners, charities, and superannuation fund investments for retired members.

The superannuation fund paying 15% tax on dividend income of working members will get a refund of $132 (down from $150). A taxpayer on the middle tax rate of 34% will pay $54 extra tax (instead of $40). A taxpayer on the top rate of 46.5% will pay $176 extra tax (up from $165).

[An increase in the Medicare Levy and the new debt tax increase some of these amounts, but to compare just the effects of the ‘no franking credit’ decision current tax rates have been used].

Reduction in superannuation retirement income

The long-term effect on superannuation is bad news. The lower franking credits results in a reduction in superannuation retirement incomes, even after the increased superannuation contributions which start in July 2014.

The increase in compulsory contributions from 9.25% to 9.5% of salary and wages is almost entirely eroded by the reduction in franking credits. If franking credits remained equal to the total company tax, the 2.7% increase in annual contributions would have increased the balance of superannuation accounts at retirement by 2.7%, with annual income after retirement also up by 2.7%.

The reduced franking credits results in the higher superannuation contributions producing balances which will be just 0.4% higher after 30 years, but annual income after retirement will be 1.7% lower due to reduced franking credits. More contributions for reduced income.

Threat to future franking credits

There is a real danger that this is the first step towards the total elimination of franking credits.

What if we followed UK tax history? Dividend tax credits, similar to Australia’s dividend imputation, operated in the UK for several decades. In 1993 the UK government made a small reduction in the value of dividend tax credits.

Four years later, in 1997, they eliminated dividend tax credit refunds (except for charities). The biggest losers were pension funds (similar to our superannuation funds). In 1999 dividend tax credits were totally abolished, and full double taxation of dividends was reintroduced.

Starting with a small reduction, the UK government eliminated dividend tax credits from retirement savings just four years later, then everyone else lost their relief from double taxation just two years later.

Repeating this in Australia would have a much bigger effect on superannuation funds than would a tax on the super funds themselves.

The 2010 report by Ken Henry, the former Federal Treasury Secretary, recommended that consideration be given to abolishing dividend imputation, in the long term.

Abolition is on the agenda in Australia. Following the same timeline as the UK would have franking credits disappear by 2021, which is the long term for a 2010 report. The threat cannot be taken lightly.

The effect of no franking credits

With no franking credits, superannuation balances will be 26.4% lower after 30 years compared to maintaining full franking. Annual income after retirement will be 48.5% lower.

These results are due to the compounding effect of all dividend income being 30% lower every year in a ‘no franking credit’ future, instead of dividends still being fully franked. 

For example, a person currently earning $100,000 can expect after 30 years to have annual superannuation income of $45,000 in today’s dollars (after adjusting for inflation), and not need a government pension. This would not be a lavish lifestyle. Abolition of franking credits would reduce this annual income to $23,000 (in today’s dollars), and a government pension would still be needed.

This is the result for a person earning well above the average income. An average income earner would be in a worse position. Imagine contributing significant amounts to superannuation for 30 years, and ending up below the poverty level when your investments have achieved the expected results. How would you feel if it was you, your partner, your children or grandchildren?

All because of the abolition of franking credits, which significantly reduces the investment returns for all Australians.

Compulsory superannuation contributions would have to be doubled to 18.5% of salaries and wages, to make up for the lost franking credits. Such an additional cost on employers would severely reduce the competitiveness of Australian businesses.

Stop the franking credit destruction

The damage is done whenever franking credits do not equal company tax. If company tax changes are matched with franking credit changes there is no effect on shareholder returns. This is why there is no negative effect on the shareholders of small companies where the company tax falls by 1.5% and franking credits also fall by 1.5%.

I make no comment about the PPL tax. That is a different issue, on which I express no opinion.

This is about the lack of franking credits related to the 1.5% PPL tax on company profits. It is not the PPL tax which will cause the loss to Australian investors, but the lack of franking credits related to the PPL tax. This is a return of double taxation on company profits in Australia after an absence of almost 30 years.

The abolition of double taxation by the introduction of franking credits in the mid-1980s was a major economic reform which has contributed to Australia’s strong economic growth of the past two decades.

The time to stop the new double taxation is now, before the first step is taken.

This is an edited version of an article which first appeared in The Dividend Man, John King’s blog at thedividendman.blogspot.com.au. John King is a director of AJK Consulting. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.