The Franking Credits Refund Issue Explained

So, the Franking Credits Refund Issue...A good fellow who asked to remain nameless put this together. Yes it's long, because it's thorough, very thorough. It spells it out very well.

The Franking Credits Refund Issue



It is a very complicated area.
 By way of an example only….
 Fred Farmer retires at age 65 and after paying off all his debts has enough to buy himself a nice house in Albany, has $500,00 0 in Wesfarmers Shares, and $900,000 in his Self-Managed Super Fund (Being the proceeds he invested over 40 years of farming). He also has $ 25,000 in the bank in his own name.

Because of his assert base he doesn’t qualify for the pension, and being fiercely independent he does not want it either.

Of his Super Fund, he has invested $675,000 in 6 shares that he likes, and $225,000 in Term Deposits with the Bank that supported him all through his farming career.

So his Self-Managed Super Fund (SMSF) has the following profile:

$225,000 in Term Deposits at 2.60% pa = $ 5,850 a year in interest income

$125,000 In Telstra Shares at 4.87% yield Fully Franked

$112,500 In Macquarie Group Shares @ 3.69% yield Fully Franked

$112,500 In Wesfarmers Shares @ 6.92% yield Fully Franked

$112,500 In Woolworths Shares @ 3.16% yield Fully Franked

$112,500 in AGL Shares @ 5.84% yield Fully Franked

$112,500 In Woodside Shares @ 4.30% yield Fully Franked

Therefore his Dividend Income is $ 32,400 a year

His Franking Credits are a further $ 13,837 a year.
 This assumes all the dividends are 100% franked. Some companies are not.
 (That would be the case where a lot of the company income is earned overseas.)


Franking works like this: Let’s say Telstra pays you $700 in dividends.
Telstra has paid 30% tax on that already = $ 300

That is your Franking Credit.


On your tax return you would show income of $1,000 from Telstra being the $700 in cash you got plus the attached $300 Franking Credit.

The franking credit is able to be offset against any tax you have to pay.

So if you had to pay $400 in tax – then you could deduct $300 in respect of the Franking Credit (As Telstra has already paid the tax) So you would only owe $100 in Tax not $400.
If you tax bill was $150, you still deduct $300 and thus get a $150 REFUND of the surplus Franking Credits. (It is this bit Mr. Shorten wants to rip off you!)


This is the same as what would happen if you were on a wage/salary income, and your employer deducted too much tax, or you had lots of deductions that lowered your tax below what your employer had already deducted. In other words. It’s you money you are getting back. Telstra provided you with a tax credit, otherwise you would be taxed twice on the Dividend (Once at Telstra’s end and then on $700 at your end)

So Back to Fred Farmer’s SMSF for the year

His result would look like this:

Interest Income $ 5,850

Dividends $ 32,400

Franking Credits $ 13,837
Total Income $ 52,087
  Operating Costs of the SMSF $ 3,000 (Accounting / Audit Etc.)
Net Income $ 49,087
  If Fred was not yet drawing a Pension from his SMSF (IE it is still in Accumulation mode), then his tax would be 15% of $49,087 or about $ 7,363 but remember he has the Franking Credits up his sleeve totalling $ 13,837 – so he deducts his credits off his tax payable and gets a refund in cash into his SMSF bank account of $ 6,474. (Mr. Shorten wants to keep that bit instead.)

So Fred SMSF would have a net income of $41, 724 now or $ 35,250 if the Labor policy is adopted.

It’s even worse of Fred has converted his SMSF to pension phase.
Pension Phase SMSF’s do not pay tax.

So the Franking Credits of $13,837 would all come back into Fred’s SMSF as a REFUND in Cash.

Mr. Shorten wants to keep all of that.

That’s the bit that is wrong. The Companies have already paid the tax on the shareholder’s behalf. Now Mr. Shorten wants to keep that from being refunded to them.

Bear in mind that tax on Contributions and income of the fund for its life before it was converted to a pension, was 15% on the way in. That is why it is supposed to be tax free on the way out.

So that’s Fred’s SMSF position

In his own right he earns dividends of $34,600 on his $500,000 worth of Wesfarmers Shares and gets a further $14,850 Franking Credit.

His $25,000 of bank deposits (at call) earn his another 1% interest = $ 250.00

So his Taxable personal income is $49,700

Let’s ignore any deductions or discounts he can get, to avoid complicating the example.

His tax position would be:

Taxable Income $ 49,700

Tax on First $18,200 Nil

Tax on next $18,800 $ 3,572

Tax on next $12,700 $4,127

Medicare Levy $ 994 (2% of $49,700)


TOTAL TAX $ 8,693
  But again, he has those franking Credit of $ 14,850 to offset what he owes the Tax Dept, so he gets a refund of $ 6,157 ($ 14,850 less $ 8,693).

Mr. Shorten wants to keep that bit too.

So Fred Farmer who has worked hard all his life to provide for his retirement in comfort, and not be a burden on the taxpayer by drawing a pension, will see his total income (Personal and SMSF) reduced from $ 90,094 (After the tax on his personal income) to $ 70,100 – a difference of $19,994 that Mr. Shorten and his cronies want to trouser for the Government so they can give it to other people who don’t pay tax because they are unemployed or unemployable, but likely to vote for Labor, which they think Fred Farmer doesn’t.
Effectively this is an income reduction for Fred Farmer in the above scenario of 22.19% Interestingly if Fred Farmer does not operate a SMSF and uses a Union Super Fund, the Franking Tax Rip-off does not apply. The Union Super Fund gets to claim the value of the Franking Credits. They use this to offset the amount of tax they have to pay for all their members who are still in the Accumulation Phase. Robbing Peter to Pay Paul.

Also if Fred happened to be on a part pension when Labor decided on this, then Mr. Shorten has given his an "Exemption" because he is a pensioner (and perhaps a Labor voter).

There’s plenty of ways Fred Farmer can address all this if it comes in (And it would have to pass the Senate as well as the lower house – and control of the Senate is not yet certain unless it is a real landslide instead of just the train –wreck it looks like).

He can sell his SMSF shares and replace them with companies that earn the bulk of their income overseas and thus have minimal franking credits, but pay higher dividends. That’s not really what he wants to do, as he has supported the companies he has dealt with for years as a farmer – like Wesfarmers etc. But he will be penalized for that conviction now.

He can cease all his generous donations to all the good causes he has supported for years, thus reducing his tax deductions and using up the franking credits in his personal income. The lost Franking refund is replaced by the donations he no longer makes. All those charities, will then be running to the Federal Government for funding, or shutting down their much needed services. (Good luck with that!)

So that’s the Franking Credits bit explained.

Other parts of the story relate to the proposal Labor has for the Negative Gearing and Capital Gains Tax regimes.
Negative Gearing
 Labor’s proposal is to disallow Negative Gearing on existing properties – only allow it on newly built ones. (To do otherwise would kill the housing industry)

For those who don’t understand what Negative Gearing is – here is a very simplified versions:

Bill and Jill Battler are trying to improve their financial circumstances by investing in real estate.

They buy a house for $500,000 all up including Stamp Duty and Settlement Costs.

It is then rented out for $ 400 a week = $20,800 a year.

It costs about $10,000 a year to run the house (Rates/Insurance/Accounting Fees/ etc) So they make about $ 10,800 a year on their $500,000 outlay or around 2.16% - not even as much as a bank Term Deposit (2.5%), but if the house value goes up they get a Capital Gain. A Term Deposit never gets a capital gain – you get back what you invested – unless the bank goes belly-up and you are not covered by the $250,000 Government Guarantee (Which you wouldn’t be if you invested $500,000).

But back to Bill and Jill Battler. They didn’t have $500,000 up their sleeve – they only had $150,000 that Jill’s mother left them in her will when she died.

So they borrowed $350,000 from a Bank to fund the rest.

Over 25 years at 4% interest their loan payments are $1,847 per month or $ 22,164 per annum.

As their costs are already $10,000 a year, their total outlay is now $ 32,164 per year. But because they can now also claim the interest on the bank loan as a deduction, they get a claim of just under $14,000 in interest in the first year. That reduces their taxable income by $14,000.

As they only have $10,800 left over from the rent after the $10,000 costs, this deduction wipes out all of that $10,800 as being taxable income. In addition they still get a further $3,200 deduction against their other taxable income (Wage and Salary income etc.). If they were on a 32.5% tax bracket (plus 2% Medicare levy), the saved tax on that $14,000 at 34.5% would result in $4,830 less tax payable. And on their existing Wages and Salary extra deduction, that is worth $1,311 in tax refunds from what they have already paid via the PAYG system on their wages.

As you can see it still doesn’t fully cover their annual outlay to keep the house, but their hope is that the value will go up by more than enough to cover this over time.

That’s called Negative Gearing – The costs outweigh the income and result in a tax refund.

Mr. Shorten wants to stop that for existing houses. So Bill and Jill Battler will not be able to claim the $14,000 interest deduction. As you can see that makes the whole thing un-workable and they would not do it.

What are some of the implications of this?
 A sharp drop in investment real estate for existing houses:

o Prices fall

o Rental properties dry up

o Rents go up due to competition for the fewer houses

o Public Housing waiting lists explode (Viz: Hawke/Keating era)
 
Real Estate Agents lose business as investors build instead of buying.

Teachers/Nurses/Police Personnel/Military Personnel/Prison Officers/Bank Clerks etc all lose the ability to chase promotions that entail moving to other locations and temporarily renting out their existing houses until such time as they can return.

o With no interest deductions available on their existing housing loans, their ability to pay rent in their new location as well as meet the payments on their existing loan is severely reduced.

o This makes the proposition of moving to improve their income via promotions etc. much less appealing.

o It will be harder to attract these occupations to rural and regional areas that already have enough difficulty in that area.

 If they do persevere in the hope that they can manage, then find out after three years, that it is too hard, and then sell their existing house, Mr. Shorten has a surprise instore for them on that front as well. He is going to reduce the Capital Gains Tax discount from 50% to 25% when the investment (Property/Share etc.) is held for more than 12 months. So instead of getting a 50% discount on the gain in the value of their property over the three years since they moved, that only get a 25% discount. The capital gain would be taxed on 75% of the gain not 50%.

o Another reason they will not move to rural and regional areas.



Who will these proposed changes impact most?

Self-Funded retirees not drawing a pension (IE: Those who are not presently a burden on the pension system)

Share Investors with a high proportion of franked dividend paying Australian Shares in their portfolios

Share Investors with margin loans (No Negative Gearing will be allowed)

Investors buying existing properties (No Negative Gearing Allowed – Capital Gains reductions halved).

The tenants who might have lived in those properties were they available for rent

People seeking to accept promotions in Rural and Regional areas who will no longer be able to claim the interest on their existing home loans when they rent out their existing house to take up their new role

The same people above, when they go to sell the house because they can no longer afford it, and find their capital gains tax has increased because they can only get a 25% reduction not a 50% reduction as now.

Charitable groups who rely upon donations from retired people – these people will not need tax deductions anymore.

Real Estate Agents who will sell a lot less existing houses to investors

Property owners who are looking to sell their existing house into a market where all the investors are buying blocks of land and building.

The list goes on…

 

All in all very bad public policy on a number of fronts.

Mr. Shorten and Mr. Bowen’s response?

Frankly – We don’t give a damn

Don’t vote for us.