Withdrawal of refundability of franking credits | KPMG | AU
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Labor Policy announcement: withdrawal of refundability of franking credits

Withdrawal of refundability of franking credits

Grant Wardell-Johnson provides a broader context to Australia's imputation system.


Lead Tax Partner, KPMG Economics & Tax Centre

KPMG Australia


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On 13 March 2018, the Leader of the Opposition, Bill Shorten, and the Shadow Treasurer, Chris Bowen, announced that, if elected, from 1 July 2019 they would change our imputation system to ensure that franking credits are not refundable for individuals and superannuation funds. Charities and not for profit organisations, by way of contrast, would be exempt from the measures.

We need to have a debate about imputation. Refundable imputation fits into a broader context of whether we have our policy settings right for the taxation of company profits.

Australia introduced an imputation system in 1987. In 1998, Treasurer Peter Costello released a document called A New Tax System. That document amongst many other things proposed that the Government would consult on treating trusts like companies with a simplified imputation system and the refund of excess imputation credits for resident individuals and complying superannuation funds.

Whilst the proposed tax treatment of trusts as companies was subsequently dropped, from the 2001 year the system was changed such that imputation credits in excess of a person’s tax liability would not be lost but would be refundable. This refundability provided a benefit to superfunds, charities and not-for-profits and individuals with a tax rate below the company tax rate of 30 percent.

The logic of this was to effectively tax distributed company profits at a recipient’s tax rate having regard to tax paid at the company level. In an odd way, refundable imputation asks the question how much tax would be paid if the company tax system did not exist separately and a shareholder made the investment directly. In this sense refundable imputation ‘undoes’ company tax.

At the time of the change in the early 2000s it was expected that the cost of refunding franking credits would be $550 million per year which is $825 million in today’s dollars. However, refundable imputation is now many times more expensive than this with estimates of around $5.6 billion and growing.

Australia is the only country in the world with refundable franking credits. In the 1990s the UK had a refundable imputation system, but replaced it with a non-refundable partial imputation system just before we went the other way.

Indeed the history of the last two decades is one of countries moving away from full imputation system for partial ones. There are now only three other countries in the world with full imputation: New Zealand, Mexico and Chile. In these countries a credit is provided at the shareholder level for actual corporate tax paid at the company level. Canada meanwhile provides a credit at the shareholder level on a notional basis whether or not corporate tax at the company level has actually been paid.

Other countries provide for partial relief of double taxation. This may arise because dividends are taxed at preferential rates at the shareholder level. This treatment is adopted by the United States, Japan, and Spain amongst many others.

As the United Kingdom, France, Germany and Italy all moved to partial imputation systems in the late 1990s and early 2000s, they notably all cut corporate income tax rates at the same time.

There was concern that the European Court of Justice would rule that dividend imputation was discriminatory against foreign investors. For the most part the movement away from full imputation arose because in an environment where the cost of capital was determined by the marginal foreign investor, imputation ends up being a subsidy to the domestic investor.

When economists compare taxes, they often use the language of “excess burdens” which dates from Adam Smith’s time in the 1770s. An average excess burden shows the cost to consumers of a tax relative to its contribution to revenue raised. A marginal excess burden shows the cost on the last dollar of revenue raised.

Tax changes, for an economist, should seek to lower taxes with high marginal excess burdens and to raise taxes where there is a low marginal excess burden. Doing this raises overall consumer welfare.

Chris Murphy from the Tax and Transfer Policy Institute has very recently modelled the reduction in franking credits at a marginal excess burden of 13 percent, whereas corporate tax between 25 percent and 30 percent has a marginal excess burden of 104 percent. This presents a strong case for funding a company tax reduction with a reduction in franking credits.

There is a broader picture in relation to imputation. It creates a tax bias in favour of domestic investment and against Australian companies investing overseas because they do not get franking credits for foreign taxes paid. This is seen by some as a good thing. But it, in the long term, it has a significant cost. It makes us inward looking.

As a country, we are facing a critical period where we will need to increasingly look to Asia. We need strong Australian-headquartered multinational corporations with significant Asian investments. We have to ask whether our current imputation system presents the right tax settings to achieve this.

Ultimately, we need a lower company tax rate. This lowers both the cost of capital for foreign investors and imputation benefits, thereby reducing a tax bias that effectively inhibits us from looking out to the world. Reducing the refundability of franking credits goes part of the way. 

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