Tax Policy Political Battleground of 2019 - Imputation Credits

AUTHOR: Carl Valentine

With the Federal Election due to be called within weeks, much has been made of the differing taxation policies of the Coalition and the Opposition.

The Opposition announced its intention in March 2018 to remove the ability, from 1 July 2019, for individuals and superannuation funds to get a tax refund from imputation credits (also known as franking credits).

This has undoubtedly been one of the most emotive fronts of the 2019 Federal Election battleground to date, especially for self-funded retirees. However, if we step back and look at the bigger picture the real policy debate is about how companies are taxed in Australia, as the ability to get a refund of imputation credits is a consequence of how companies and the profits they distribute to shareholders are taxed, as opposed to the issue itself.

As summarised in the following table there are three broad models that Australia’s corporate tax system could follow to prevent corporate profits being taxed twice (once in the company’s hands and again in the shareholder’s hands without provision made for the tax paid by the company).

The summary contrasts the positions for taxpayers in receipt of a fully franked dividend (i.e, a dividend paid out of profits fully taxed in Australia) at either end of the marginal tax rate scale: 47% (an individual on the highest marginal tax rate) and 0% (an individual with taxable income of less than $18,200 [ignore the effect of tax offsets] or an SMSF wholly in pension mode).

Example of a $1,000 fully franked dividend paid by a company on the 30% tax rate ($700 cash and $300 imputation credit)	47% marginal tax rate shareholder	0% marginal tax rate shareholder
Withholding tax model – tax paid by the company is essentially a withholding tax with the final tax paid on fully taxed distributed profits determined by the ultimate shareholder’s marginal rate of tax. This is the current system of full dividend imputation and has applied since 2001. Where a company retains its profits and never distributes them to shareholders, the company tax paid then is in effect a final tax on those profits (total tax paid on undistributed profits is $300).	$170 top up tax paid by shareholder (total tax paid: $470) Shareholder has after tax cash of $530	$300 tax refund due to shareholder (total tax paid: $Nil) Shareholder has after tax cash of $1,000
Minimum withholding tax model – tax paid by the company is the final minimum tax payable on its profits, but with the potential for a higher ultimate level of tax to be paid on distributed company profits where the shareholder’s marginal tax rate is higher than the company’s own tax rate. Shareholders with a marginal rate of tax less than the company’s tax rate get no benefit for the company tax paid but won’t pay any further tax on that income. This model was followed from 1987 to 2001.	$170 top up tax paid by shareholder (total tax paid: $470) Shareholder has after tax cash of $530	No tax paid by shareholder (total tax paid: $300) Shareholder has after tax cash of $700
Final tax model – tax paid by the company is a final tax on their profits, whether profits are distributed or not (total tax paid on all company profits is $300). Under such a system dividend imputation is not required because the shareholders would not then be subject to further tax on those dividends. This model serves to reduce the rate of tax that would otherwise by payable by shareholders whose marginal tax rate is higher than the company’s own tax rate.	No tax paid by shareholder (total tax paid: $300) Shareholder has after tax cash of $700	No tax paid by shareholder (total tax paid: $300) Shareholder has after tax cash of $700

Example of a $1,000 fully franked dividend paid by a company on the 30% tax rate

($700 cash and $300 imputation credit)

47% marginal tax rate shareholder

0% marginal tax rate shareholder

Withholding tax model – tax paid by the company is essentially a withholding tax with the final tax paid on fully taxed distributed profits determined by the ultimate shareholder’s marginal rate of tax. This is the current system of full dividend imputation and has applied since 2001.

Where a company retains its profits and never distributes them to shareholders, the company tax paid then is in effect a final tax on those profits (total tax paid on undistributed profits is $300).

$170 top up tax paid by shareholder (total tax paid: $470)

Shareholder has after tax cash of $530

$300 tax refund due to shareholder (total tax paid: $Nil)

Shareholder has after tax cash of $1,000

Minimum withholding tax model – tax paid by the company is the final minimum tax payable on its profits, but with the potential for a higher ultimate level of tax to be paid on distributed company profits where the shareholder’s marginal tax rate is higher than the company’s own tax rate. Shareholders with a marginal rate of tax less than the company’s tax rate get no benefit for the company tax paid but won’t pay any further tax on that income. This model was followed from 1987 to 2001.

$170 top up tax paid by shareholder (total tax paid: $470)

Shareholder has after tax cash of $530

No tax paid by shareholder (total tax paid: $300)

Shareholder has after tax cash of $700

Final tax model – tax paid by the company is a final tax on their profits, whether profits are distributed or not (total tax paid on all company profits is $300). Under such a system dividend imputation is not required because the shareholders would not then be subject to further tax on those dividends. This model serves to reduce the rate of tax that would otherwise by payable by shareholders whose marginal tax rate is higher than the company’s own tax rate.

No tax paid by shareholder (total tax paid: $300)

Shareholder has after tax cash of $700

No tax paid by shareholder (total tax paid: $300)

Shareholder has after tax cash of $700

In summary, taxpayers on lower marginal tax rates will prefer the withholding tax model as it maximises their after-tax position with the potential for 0% taxpayers to get a full refund of the tax paid by the company. Higher marginal tax rate payers will prefer the final tax model as it caps their tax liability at the company tax rate rather than their own marginal rate.The Opposition’s imputation credit policy reflects the minimum withholding tax model and essentially reinstates the system in place from 1987 (when dividend imputation was first introduced) to 2001 (when full dividend imputation was introduced).

There will be no difference for taxpayers on higher marginal tax rates to the current system – they will still pay the same total tax on dividend income (all other things being equal).

However, taxpayers on lower marginal rates would no longer be able to obtain a refund of any surplus imputation credits. That is, the imputation credits would reduce their tax otherwise payable to nil but won’t then generate any cash refund.

The Opposition has proposed that some taxpayers will continue to enjoy the full refund of surplus imputation credits including:

Recipients of an Australian Government pension or allowance with individual shareholdings (including individuals receiving the Age Pension, Disability Support Pension, Carer Payment, Parenting Payment, Newstart and Sickness Allowance;
SMSFs with at least one member as at 28 March 2018 that is a recipient of an Australian Government pension or allowance (more detail is needed here around both timing of membership and timing of the pension or allowance receipts); and
Tax exempt entities, like charities and not for profit entities (including universities).

In all likelihood, the withholding tax model, the current model in use, results in the lowest overall company tax collections to our Federal Government after allowing for the refund of imputation credits to lower marginal tax rate shareholders. I suspect that the minimum withholding tax model to which the Opposition wants to move results in the highest overall company tax collections, however more research and calculations would be required to confirm that relative to the final tax model.

Only time will tell how the Opposition’s proposed changes will be legislated, and thus only then the full range of potential consequences understood to be properly planned for. Some areas that will need to be considered by affected entities may include:

Reduced after tax rates of returns and cash flows from fully franked dividends for low marginal rate taxpayers (including SMSFs – especially those in pension mode).
Reduced levels of after-tax cash flows could lead to a need to review investment strategies and investment compositions to ensure enough cash flows exist to service minimum pension payments or interest on margin loans (the current tax benefits associated with margin loans may be less pronounced in the future in the absence of refundable imputation credits).
Potential differences in how SMSFs and retail / industry superannuation funds are impacted by the changes (and indeed differing practices between different retail / industry superannuation funds and how they account for and allocate imputation credits between their members) with a risk that retail / industry funds arguably unfairly gain a comparative advantage to SMSFs.
Market valuations for listed companies that have traditionally paid fully franked dividends (with the potential for an after-tax yield-based valuation to be reduced where the after-tax earnings of the shareholder are reduced).
Review of how listed entities raise capital with potential for the mix of equity and debt to change with such entities likely to give further consideration to debt-based securities and the nature of returns paid as a substitute for fully franked dividend-based return on equity.
Relative attractiveness of continuing to fund retirement living as a self-funded retiree as opposed to switching to an aged pension (in whole or in part but recognising its potentially difficult to change retirement income sources in a short space of time).
Appropriateness of holding structures for investments yielding fully franked dividend returns (the Opposition’s proposed changes to negative gearing [which will be the subject of a separate article] will also need to be considered in this context) and what other investment might be held there to ensure maximum utilisation of imputation credits that might otherwise not be utilised.
Dividend policies from smaller companies, most typically privately owned, to family groups may need to be revised to ensure no imputations credits are “wasted” where in the past family members may have benefited from a refund of imputation credits.
Potential for increased compliance costs as these changes will likely increase legislative complexity, especially in dealing with proposed exemptions (such as that put forward by the Opposition in respect of individuals in receipt of an aged pension on 28 March 2018 or an SMSF with such an individual as a member).

More insights into the differing taxation policies of the 2019 Federal Election can be found here Federal Election Taxation Policies

Please note: The Opposition’s taxation policy announcements are relatively low on detail and require legislative change for them to be implemented. The final form of any taxation changes will of course be dependent on the outcome of the May 2019 Federal Election and the composition of both the House of Representatives and the Senate. The above comments are general in nature and do not constitute financial advice in any form. You should consult with your specialist advisor for advice on these matters specific to your circumstances.