Heffron | Banning franking credit refunds - is there another way

Banning franking credit refunds - is there another way

With the Federal election looming, the Australian Labor Party’s policy to prevent many taxpayers from receiving a refund for their franking credits has certainly become a dominant issue for many retirees, particularly those with SMSFs.  

While we have no idea how easy it will be to get it passed, it does seem likely to remain firmly on the agenda unless the ALP is defeated.

The logic for this policy is, broadly speaking, “rich people shouldn’t get tax refunds, they should effectively pay more tax” on their personal and SMSF investments.  Importantly, the language supporting the policy is about people paying tax but the proposed changes would implement it via the entities in which their assets are held.

Initially that seems like an esoteric point.  But consider the difference in outcomes between two identical people who have both saved for their retirement through superannuation but are different in only one respect : they belong to different superannuation funds.

Let’s say one of our imaginary people is receiving a superannuation pension from his large industry fund or bank-owned master trust.  Because that fund has other members that are bringing in contributions (income that gets taxed), it is likely that he will receive the full value of the franking credits attached to the shares supporting his pension account. 

How does this happen? 

Smart industry funds, master trusts and wrap accounts already have systems in place to make sure that the tax paid to the ATO is calculated at the fund level, taking into account all the income and costs for the whole fund.  That tax bill is then divided up fairly between all their members. 

They will simply use the same systems to make sure that something like this happens:

  • let’s say the dividends received on assets notionally held for our pensioner included a $5,000 franking credit.
  • there was also income of $100,000 from all the assets notionally held for the other members (which would normally result in a $15,000 tax bill : 15% x $100,000). 
  • the fund would end up paying tax of only $10,000 ($15,000 less $5,000 franking credits).  It hasn’t had a refund of its franking credits but it has been able to use them in full.
  • the fund trustee would then break that down to be fair to the members,
  • it’s likely the trustee would increase the earnings given to the pensioner’s account by $5,000 (to reflect the franking credit) and reduce all the other members’ accounts by (combined) $15,000.  This is fair – the pensioner effectively created the $5,000 tax saving and so should receive the benefit of it.
  • what has really happened is that the fund has not officially received a refund of its franking credits (so is not hurt by the ALP policy) but the member has. 

Overall, the members who are creating the taxable income that is using up the franking credits will receive no benefit from them.  Fancy (but completely fair and in fact common) internal accounting techniques will ensure that all that benefit goes to the member that “owns” them – our imaginary pension recipient.

But now let’s look at a member with precisely the same size and type of superannuation investments in a small fund that doesn’t have enough other taxable income to use the franking credits.  This could be an SMSF but equally it could be a small corporate fund, a fund with most of its members in pension phase or even a small industry fund.  This person will be in a very different position to our “large fund member” above.  They will experience the full force of the change and find they simply lose a valuable tax refund. Their retirement assets will grow more slowly (or shrink more rapidly) and they will be worse off.  This is completely consistent with the intent of the ALP’s policy.

What’s interesting here is that the measure is promoted this as a fairness measure between people and yet the implementation will be precisely the opposite.  It will treat two identical people (same amount of money, held in the same environment – superannuation, and same assets) differently simply because they have made different choices about which superannuation fund should house their retirement assets.  In fact by adding a late adjustment to protect SMSFs that had a person receiving the age pension at a particular (arbitrary) date from this change, the ALP has reinforced the message that this is about people paying the right amount of tax.

So could the ALP achieve their objective some other way?

Absolutely. 

They could apply the refund ban at a member level.  Simply ask the large fund in our example above to work out the franking credit amounts that were created by our hypothetical pension member ($5,000 in this example) and make sure they are only used to reduce tax on his account.  If there is no tax to pay on his assets, set the value of those franking credits to $nil.  This is exactly what would happen under the ALP’s policy if he was the only member of his fund and it received no other income.  The Fund would then pay $15,000 in tax and this would be shared between the other members (it would have no impact on them).

That would put people on a level playing field.

Personally I think this would be foolish but then I think the whole idea of taking away franking credit refunds is misguided.  Franking credit refunds were introduced to ensure that company profits were ultimately taxed at the tax rates of the people who received them via dividends.  Since companies already pay tax at a relatively high rate (30%) and this is taken out of the dividend before it is given to the investor, it makes sense that some of the overpaid tax needs to be given back as a refund.  That’s what we’ve done now for many years.

If Australia must increase its taxes (and that’s entirely possible), then put up the tax rates.  Let’s not artificially introduce a distortion into the tax system to hide what is really happening.

If supporters of the policy are doing so on the basis that some people really should pay more tax, my counter suggestion should be extremely palatable.  It would mean that everyone, no matter who else belongs to their superannuation fund, is treated in exactly the same way.