Q. Could you please explain what franking credits are and how they work with share dividends? 

A. Dividends paid to shareholders by Australian resident companies are taxed under a system known as imputation. This is where the tax that the company pays is imputed to the shareholders. The tax paid by the company is allocated to shareholders as franking credits attached to the dividends they receive.  A dividend may range from no franking up to a tax credit of 30% depending on the tax paid by the company.

By way of example, if a company declares a fully franked dividend of 70 cents, this amount would be received by the shareholder as a dividend.  As the dividend is declared as “fully franked”, we know the company would have paid 30 cents tax.  Therefore for tax purposes, the shareholder would declare income of $1 incorporating the 70 cent dividend and the 30 cent franking tax credit.  The tax credit can be used to offset income tax payable, or if there are franking credits that cannot be offset, the shareholder can make application for a cash refund of the franking credit to the ATO.

Q. We are retired and rely on income from the age pension, our  Allocated Pensions and our small portfolio of Australian shares.  Given the proposal by Labor to abolish franking credit refunds, what should an investor do?

A. In March 2018, Chris Bowen, the shadow treasurer announced that Federal Labor’s tax reforms would abolish this tax benefit should they be elected to government. The policy announced does not seek to abolish franking credits but rather abolishes the tax refund for those who have franking credits in excess of the tax they offset.

For those who claim franking credits and are still liable to pay tax, there is no change, they will continue to be eligible to use franking credits to offset any tax liability.  Those who will be most impacted will be those paying little or no tax due to low income who have investments generating franked dividends in excess of their tax liability.

Treasury analysis estimates that there are up to approximately 1 million Australians with taxable income of less than $37,000 who may be impacted by this proposal. Retail and Industry Super funds are unlikely to be impacted due to their broader source of income.  However Self-Managed Superannuation funds which traditionally carry a concentration of share investments with franking credits will be disadvantaged.  Others impacted will be investors in Retirement Income streams such as account-based pensions who pay no tax on earnings within the fund. Thankfully charities and “not-for-profits” have been exempted from the proposal.

Dividend franking was introduced by the Hawke/Keating Labor government in 1987.  From 1 July 2000, amendments were made to the policy by the Howard/Costello Liberal Government, enabling taxpayers to claim franking credits as a cash refund from the ATO. For retirees, these franking credit refunds have formed a valuable source of supplementary income to offset the impacts of falling interest rates and reductions in age pension benefits as a result of changes to assets test thresholds.

It is important that investors do not rush to make substantive changes to their investments in anticipation of the law change.  In the first instance, Labor would need to win the election and legislation would need to pass through both the lower house and the senate.   

If this proposal was to become law there are a range of measures that investors should consider; diversify your investment portfolio to include investments that do not wholly rely on franked dividends to generate income.  Include investments that generate partially franked dividends or dividends with no franking credits.  These may include investments that generate income from offshore or international investments.  Examples of these could be managed funds investing offshore, international shares or property trusts with investments held domestically or offshore.

Be careful of Australian listed hybrid, notes and bond investments where the yield is derived or boosted as a result of franking credits.  Most likely if franking credit refunds were abolished, the market would reprice these investments in light of the change. 

Share buy backs incorporating a large proportion of the payment as a franking credit would also become less popular in future with less shareholders being able to benefit from the tax credits.

In assessing where to invest for retirement income, the investment yield must be sustainable regardless of tax policy.  If you are relying on investment or fixed incomes in retirement, focus on lower risk and diversified income sources.  Ultimately look for managed or direct investments that focus on the yield regardless of franking credits.