Q. Could you please explain how franking credits work on share dividends?  We are retired and rely on income from the Age Pension, our  Allocated Pensions and our small portfolio of Australian Shares.  We also rely on tax refunds to supplement our income.  We are concerned about the impact of any change to Franked Dividends as proposed by Bill Shorten last week.

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 tax credit.  The tax credit can be used to offset income tax payable, or in the event of that there are franking credits that cannot be offset, the shareholder can make application for a refund of the franking credit to the ATO.

It is this ability to claim back a franking credit that is causing controversy.  On the 12th March, Chris Bowen, the Shadow treasurer announced that Federal Labor’s tax reforms would abolish this tax benefit. The policy announced does not seek to abolish franking credits but rather abolishes the tax refund for those who have 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.  Those who will be most impacted will be those paying no tax due to low income who have investments generating franked dividends. 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. 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.

Given that these changes have initially been announced as Labor policy proposal, it is important that investors do not rush to make substantive investment changes 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.

Ultimately look for managed or direct investments that focus on the yield regardless of franking credits.  Be careful of Hybrid investments where the yield is derived or boosted as a result of franking credits.

Yield must be sustainable regardless of tax policy, especially in retirement.  If you are relying on investment or fixed incomes in retirement focus on lower risk and diversified income sources.