My inbox has been running hot with queries about Bill Shorten’s plan to end the refunding in cash of excess imputation credits. Self-funded retirees and others are seething. This is a naked tax grab, not (as he tried to dress it up) about closing a “tax loophole”. Refunding excess imputation credits means that everyone gets the same benefit. What can be fairer than that? (see my article in Switzer Daily http://www.switzer.com.au/the-experts/paul-rickard/shortens-naked-tax-grab-may-lead-to-more-buybacks20181503/ [1] )
Late last week, he appeared to back track a little from the proposal, saying that “pensioners” would be compensated. He didn’t say how this would be done, and whether it would apply to any person receiving an aged pension, or just those receiving the full aged pension.
The two most common questions I have received are who is impacted, and what effect will it have on the stockmarket?
I will come back to these shortly, but firstly, a brief re-cap on how dividend imputation works.
Aim is to eliminate double taxation
Dividend imputation exists to eliminate the double taxation of company profits. If a company makes a profit, it pays tax on that profit at 30%. If the company then pays a dividend out of its after-tax profit, that dividend is taxed in the hands of the shareholders at their marginal tax rate, which could be as high as 47%. The original profit has been taxed twice – once in the hands of the company, and once in the hands of the shareholders.
Paul Keating recognized that company profits were, through double taxation, effectively being taxed at punitive rates and introduced dividend imputation in 1987. The system effectively rebates, through imputation credits (also called franking credits), the tax that the company has already paid, so the profit is only taxed in the hands of the shareholder.
Critically, the system only recognizes company tax that has been paid to the Australian Taxation Office, so if companies aren’t paying tax in Australia, they can’t frank their dividends. This is why companies such as CSL, which earns more than 90% of its revenue outside Australia and pays tax to foreign governments, can’t frank its dividends. It simply doesn’t pay enough company tax to the ATO.
In 2000, an enhancement to the scheme was made by Peter Costello to refund excess imputation credits in cash. The purpose was simple – to make sure that every shareholder (taxpayer) gets the same benefit. This is what Shorten now proposes to axe.
Let’s take an example to demonstrate the point. Suppose that a company makes a profit of $100, pays tax of $30, and then distributes a dividend of $70 to its shareholders. Because it has paid the full amount of company tax, it can fully frank the dividend. Consider five shareholders – with respective marginal tax rates of 47% (the highest), 30% (potentially another company), 19%, 15% (a super fund in accumulation phase) and 0% (a super fund in pension phase or an individual earning less than $18,200).
Dividend Imputation by Shareholder Tax Rate
Both the cash dividend of $70 and the imputation credits of $30 are included in a shareholder’s taxable income. If their marginal tax rate is 47%, tax of $47 is payable. The imputation credits are then applied for a second time, this time acting as a tax rebate, meaning that the net tax payable is $17. On the profit of $100, the company has paid $30 in tax, and the shareholder $17 (total $47).
In the case of a shareholder paying tax at 30%, such as another company, the gross tax payable on the taxable income of $100 is $30. After deducting the imputation credits, the net tax paid is $0.
For shareholders paying tax at 19% or 15%, the imputation credits more than offset the gross tax payable. The excess imputation credits are then refunded in cash, meaning that the shareholder has, in addition to the dividend, received a cash payment from the ATO. Finally, for a shareholder with the best marginal tax rate of 0%, they pay no tax and get the imputation credits refunded in full.
Effectively, every shareholder’s tax has been reduced by $30 – the tax paid by the company.
Will you be impacted?
Well, if you are a share investor (either directly or through your SMSF) and are receiving a tax refund from the ATO, then the answer is ‘yes’. But circumstances and investment returns change, so it will not always be as obvious as this, particularly if you are a member of super fund in accumulation mode or a fund with members in accumulation and pension phase. Lets’ work through the following examples.
- Non-working spouse, no other income, who owns 10,000 Telstra Shares
- Worker with $180,000 salary income, who owns 10,000 Telstra Shares
- Single member SMSF in accumulation, balanced investment exposure
- Single member SMSF in accumulation, aggressive investment exposure
- Two-member SMSF, accumulation and pension phases, balanced investment exposure
- Single member SMSF, pension phase, conservative investment exposure
- Single member SMSF, pension phase, balanced investment exposure
Example 1: Non-working spouse, no other income, who owns 10,000 Telstra shares
Other Income: $0; Dividend: $2,200 pa ($0.22 per share); Franking (imputation) credits: $942
Impact: $942 worse off
Example 2: Worker with salary income of $180,000, who owns 10,000 Telstra Shares
Other Income: $180,000; Dividend: $2,200 pa; Franking (imputation) credits: $942
Impact: Nil
Example 3: Single member SMSF in accumulation phase; balanced exposure: $1,000,000
In this example, we will assume a balanced investment exposure, with 30% of the portfolio invested in Australian shares (franked to 80%), 30% invested in international shares, and the balance of 40% invested in cash and fixed income securities.
We will further assume that the income returns on Australian shares are 5%, offshore shares 2%, and fixed interest is 3%. There are no realised capital gains.
Investment Mix: 30% Australian Shares ($300,000), 30% Offshore Shares ($300,000), 40% Fixed Interest ($400,000).
Income: Australian Shares $15,000, 80% franked (franking credits of $5,143); Offshore Shares $6,000; Fixed Interest $12,000.
Impact: Nil
Example 4: Single member SMSF in accumulation phase; aggressive exposure; $1,000,000
In this example, we will assume an aggressive exposure, with 50% of the portfolio invested in Australian shares (80% franked), 40% in international shares and the balance of 10% in cash and fixed income securities.
We will further assume that the income returns on Australian shares are 5%, offshore shares 2%, and fixed interest is 3%. There are no realised capital gains.
Investment Mix: 50% Australian Shares ($500,000), 40% Offshore Shares ($400,000), 100% Fixed Interest ($100,000).
Income: Australian Shares $25,000, 80% franked (franking credits of $8,571); Offshore Shares $8,000; pa; Fixed Interest $3,000.
Impact: $1,885 worse off
Example 5: Two-member SMSF, with one member in accumulation phase, other member in pension; balanced exposure; $1,000,000
In this example, we will assume that the fund has two members, with one drawing a pension, and the other still making contributions. Assets are not segregated, with the total balance of $1,000,000 split evenly between the two members. They have a balanced exposure, with 30% of the portfolio invested in Australian shares (franked to 80%), 30% invested in international shares, and the balance of 40% invested in cash and fixed income securities.
We will further assume that the income returns on Australian shares are 5%, offshore shares 2%, and fixed interest is 3%. There are no realised capital gains.
Investment Mix: 30% Australian Shares ($300,000), 30% Offshore Shares ($300,000), 40% Fixed Interest ($400,000).
Accumulation/Pension Mix: 50% (effective tax rate of 7.5%).
Income: Australian Shares $15,000, 80% franked (franking credits of $5,143); Offshore Shares $6,000; Fixed Interest $12,000.
Impact: $2,282 worse off (effectively $1,141 per member)
Example 6: Single member SMSF in pension phase; conservative exposure: $1,000,000
This example looks at an SMSF in pension phase with a conservative investment exposure. We will assume 15% of the portfolio is invested in Australian shares (franked to 80%), 5% invested in international shares, and the balance of 80% invested in cash and fixed income securities.
We will further assume that the income returns on Australian shares are 5%, offshore shares 2%, and fixed interest is 3%.
Investment Mix: 30% Australian Shares ($150,000), 5% Offshore Shares ($50,000), 80% Fixed Interest ($800,000).
Income: Australian Shares $7,500, 80% franked (franking credits of $2,571); Offshore Shares $1,000; Fixed Interest $24,0000.
Impact: $2,571 worse off
Example 7: Single member SMSF in pension phase; balanced exposure: $1,000,000
This example looks at an SMSF in pension phase with a balanced investment exposure. We will assume 30% of the portfolio is invested in Australian shares (franked to 80%), 30% invested in international shares, and the balance of 80% invested in cash and fixed income securities.
We will further assume that the income returns on Australian shares are 5%, offshore shares 2%, and fixed interest is 3%.
Investment Mix: 30% Australian Shares ($300,000), 30% Offshore Shares ($300,000), 40% Fixed Interest ($400,000).
Income: Australian Shares $15,000, 80% franked (franking credits of $5,143); Offshore Shares $6,000; Fixed Interest $12,000.
Impact: $5,143 worse off
Apart from tax rate, the other major factor in determining impact is investment mix – i.e. the proportion of any portfolio invested in Australian franked shares.
Impact on the stockmarket
Because Bill Shorten has a reasonable chance of becoming Australia’s next Prime Minister, the prices on higher yielding Australian franked shares eased. For a SMSF in pension phase purchasing (for example) Telstra shares, the effective yield falls from 9.38% to 6.56%. For an SMSF in accumulation phase that can utilise the excess credits (i.e. receives a cash refund), the effective yield falls from 7.97% to 6.56%. This is why Telstra’s shares fell by around 3% last week.
Bank shares are also potentially impacted, as are other self-funded retiree favourites such as Wesfarmers, Woolworths, BHP, Rio and Woodside. Hybrid securities will also be impacted – as the franking credit return is a key part of the overall investment return. By design with these securities, only 70% of the actual distribution is paid in cash – investors need the franking credits to make up the balance of the income return. While only some investors will be impacted, a small reduction in demand can have quite a big impact on price.
Shorten has announced a start date of 1 July 2019, so that presents a window of opportunity for “switched on” boards to leverage the current system. Of course, if Shorten doesn’t get elected, the policy will be junked, so anything that a company does will need to stack up prudentially.
The most obvious actions are to pay special dividends or conduct off-market buybacks. In the absence of business disposals, the major banks are unlikely to be candidates for either as they have only just got their capital up to the level required by the Australian Prudential Regulation Authority. Wesfarmers, which has a history of paying special dividends, is an obvious candidate, particularly with sale of its Curragh mine and possible closure of the UK Homebase business.
Off-market buybacks are probably the most likely action for companies with strong capital bases and a pool of imputation credits. With an off-market buyback, the company buys its shares back at a discount to the current market price (typically up to 14%), and in return, distributes most of the purchase consideration as a fully franked dividend. Off market buybacks are attractive to 0% rate taxpayers, and horribly unattractive to 47% rate taxpayers. If the franking credits are no longer refundable, off market buybacks will be significantly less attractive to low rate taxpayers.
In the absence of a major acquisition, BHP and Rio are candidates for an off-market buyback.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.