Labor is proposing radical changes to our imputation system – the problem is that very few people understand how the system works.
Here is a simple explanation.
Long before imputation was introduced, there was double taxation of dividends. Back then if a company made $100,000 profit, it lost $49,000 in tax and had just $51,000 to distribute in dividends.
For a top rate taxpayer who received those dividends the tax then was a further $29,070 leaving just $21,930.
No, I am not making this up: the company made $100,000, the government took 78 per cent of it and the hapless investor was left with just 22 per cent.
The imputation system was designed to protect the taxpayer against double taxation by giving a credit, called a franking credit, to the shareholder to compensate for the tax paid by the company.
Suppose a company made $1000 profit, and paid $300 tax at the 30 per cent company tax rate, leaving $700 to be distributed as a dividend. The franking credit was as good as cash because it could be used to reduce your taxable income, or even refunded if you had a low taxable income.
Labor’s proposed changes to the imputation system are based on false premises, are discriminatory, and will end up hurting the most vulnerable.
Let me show you step-by-step.
The imputation system, which avoids dividend income being taxed twice, will stay in place; what Labor proposes is to abolish the refund of excess franking credits.
The only way you can have an excess franking credit is to have a low income. Therefore, the only possible targets are low income earners and superannuation funds, where the tax rate varies between zero and 15 per cent.
But there will be no tax to be collected from large retail funds and industry funds, as they can spread the imputation credits over all their members: nothing for Labor here.
And they have promised to exempt all age pensioners: nothing for Labor there either.
So who is left?
Self-managed super funds in pension mode with two members holding a total balance of less than $3 .2 million: They could be seen as the prime target, because clearly all their excess franking credits will be lost under Labor’s proposal. But that is simply solved.
One option is to close the SMSF and roll the balance to a large retail fund as mentioned above. The other option is to cash in their entire holding of Australian shares, which can be done tax-free, and roll over the cash now freed up to a second superannuation account with one of the retail funds, choosing Australian shares as their preferred asset class. With this strategy, there is still nothing for Labor: the SMSF trustees can make any investments they choose – avoiding Australian shares – in their self-managed fund, and the retail fund will invest in Australian shares for them, while optimising their mix for the current tax situation.
Self-managed superannuation funds with large balances: This would appear to be an easy target, but the Liberals got there first.
Think about a portfolio of $10 million, which has a fairly standard asset allocation of cash 20 per cent, Australian shares 35 per cent, international shares 25 per cent and property 20 per cent. The annual income would be $390,000, including franked dividends of $140,000, on which franking credits are $48,000. When you gross up the income for the franking credits, the taxable income of the fund becomes $438,000.
Before the Liberals changed the system last July the franking credits of $48,000 would have been refunded. But because the fund is 70 per cent in accumulation now, the tax payable by the fund becomes $46,000. Imputation credits pay all this, leaving just $2000 for Labor. I'm sorry Bill, but Malcolm beat you to it.
Older, wealthy, self-funded retirees: Their situation should remain unchanged. Let's say their main asset is a portfolio of $4 million of Australian shares in joint names paying franked dividends of $90,000 a year to each person plus franking credits of $38,571. The tax on that will be around $38,000 including the Medicare levy, which means they may lose possibly $600 in franking credits – small bikkies in the scheme of things.
So who is left over to pay the tax?
Widows and widowers: Think about a couple who own their own home, have $75,000 in bank deposits, and also hold a share portfolio worth $710,000 returning dividends of $32,000 plus franking credits of $13,700. Their pension is $19 a fortnight combined, so total income – including franking credits and interest – is $47,700 a year.
Unfortunately, the husband died suddenly last week, leaving all his assets to his wife. Her situation will change dramatically. She is now a single pensioner, and the assets she has inherited take her over the Centrelink cut-off point. She will lose her pension, as well as the concession card that goes with it. The good news is that she will keep the franked dividends of $32,000 – the bad news is that under Labor’s proposal she will lose the franking credits of $13,700. Labor’s proposed measures have finally raised some money!
Hopefully anyone potentially in this situation will have taken good estate planning advice to ensure a more effective distribution of assets when one party dies, so the survivor can retain a part pension and all the franking credits.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance – noel@noelwhittaker.com.au
