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Today's quote:

Thursday, December 18, 2014

Be afraid, be very afraid!


When the Murray Financial System Inquiry declares that dividend imputation creates a bias in the system because income from other investments including bank deposits and fixed interest investments do not have the same concession, you should be afraid, very afraid! That people in such high places in finance as Mr Murray could put their name to such ignorance is highly disturbing.

(Of course, Mr Murray, a former Commonwealth Bank chief, wants us to deposit our money into his bank to earn a miserable 2% interest on which we still pay income tax, instead of investing in shares which yield fully-franked dividends of 5% and more, and carry a tax credit of 30%.)

Trish Power, author of "Superannuation for Dummies", the plain English super bible for all Australians, who also publishes a free monthly SuperGuide Newsletter - subscribe here - , explains:

"The reason for that incongruity is simple. If banks paid tax on bank interest before the interest was paid, the depositor would need to take that tax already paid into account before they prepared their own tax return. Unless the tax already paid was a tax credit to the depositor, the interest on the bank deposit would effectively be paid taxed twice; once by the bank and again by the depositor.

This is precisely the situation that applied to dividends from Australian shares before 1987. Dividends are always paid out of after-tax profits. Until 1987, companies paid tax on their profits at the company tax rate, which was then as high as 39% and dividends were then taxed again in the hands of the shareholder at their marginal tax rate which was as high as 60%. With these punitive rates of tax there was little incentive for companies to pay dividends. Many companies preferred to reinvest the after-tax profit into the business and many shareholders preferred to take their investment returns as capital gains which were then lightly taxed. That situation still applies in the US and may explain the greater volatility of the US stock market.

Since 1987 the dividend imputation system has been straight forward. If a company makes $100 in profits and the company tax rate is 30%, then $30 is sent to the ATO and $70 is sent to shareholders as a dividend. The dividend carries a tax credit to the shareholder for the tax already paid. These tax credits are sometimes called franking credits because after a letter goes through a franking machine it comes with postage paid and is said to be “franked”. These tax credits are described as imputation or franking credits and these terms are used interchangeably. In this case franking means “tax paid”.

A PAYG taxpayer has tax withheld from their wages by their employer but their taxable income includes both their take-home pay and the tax already paid by their employer. Similarly, a shareholder’s taxable income includes the dividend and the associated franking credit because this tax has already been paid to the ATO on their behalf. Importantly, the franking credit is a tax credit that can be applied to their tax liability from their dividends and any other income.

Clearly if the company tax was lower, the franking credit would be lower but the dividend, all else being equal, would be higher and the shareholder’s taxable income would be unchanged. Using the previous example of $100 in company profits, if the company tax was 20% only $20 would be sent to the ATO and $80 would be sent to the shareholder. As the shareholder’s taxable income remains unchanged at $100 ($80 plus $20), so their tax liability remains unchanged.

In the extreme case there would be no company tax and all company profits would be taxed in the hands of Australian shareholder at their marginal rate. For Australian shareholders, clearly their taxable income is still unchanged but non-residents, who pay no personal income tax in Australia, would receive their dividends tax-free. Lowering the company tax (and the associated imputation credits) is designed to ease the tax burden on foreign shareholders. Why would an Australian government want to do that?

The purpose and effect of the dividend imputation system is to ensure that Australian shareholders pay tax on their dividends at their marginal rate and no more. It is not a tax concession to shareholders.

Until 2001, imputation credits could be used to offset other tax liabilities only up to the limit of those tax liabilities. Any excess credits were simply lost to the taxpayer. Since 2001 any imputation tax credits in excess of tax liabilities are refunded in cash. Taxpayers whose marginal tax rate is lower than the company tax rate obviously benefit from this tax refund. Taxpayers whose marginal tax rate is higher than the company tax rate clearly need to make up the difference.

The refund of unused imputation credits and the tax-free status of super pension funds together explain the popularity of Australian shares inside SMSFs. Because the marginal tax rate of a super fund paying a pension is zero, the imputation credits are refunded in cash to the fund on completion of the fund’s tax return. Using the example above, if the fund receives a $30 refund in addition to a $70 paid in dividend, the tax refund is more than 40% greater than the dividend itself. Retail and industry super funds paying pensions also receive a refund for their imputation credits but the lack of transparency around their operations means that most members of these funds are unaware of the benefits that Australian shares bring to their retirement savings. That notwithstanding, fund managers most certainly are aware of, and keen to retain, these tax benefits.

In the context of the Murray Inquiry there have been a number of suggestions made, each would have far reaching consequences:

◾ The abolition of imputation credits would simply mean a reversion to the double taxation of dividends that applied before 1987, once at the company level and again in the hands of the shareholder.

Removing imputation credits would adversely affect every Australian shareholder, including those who hold shares directly as well as those who hold superannuation accounts with retail or industry super funds that invest in Australian shares.

◾ Removing imputation credits would decimate those shares which have become popular because they pay high fully-franked dividends. The impact on superannuation funds is incalculable and because the superannuation system is now so large, the impact on the share market would be profound

◾ Allowing dividends to be considered as tax-paid by virtue of the imputation credit but without a cash refund for taxpayers on low marginal tax rates would discriminate between taxpayer as some would benefit from these tax credits and others not at all. This would not be politically popular."