Don’t fiddle with franking credits

With friends like David Murray’s Financial System Inquiry concluding that the case for retaining dividend imputation is less clear than in the past, small and large business as well as self-funded retirees hardly need enemies.

While acknowledging that removal of the double taxation of dividends has reduced the cost of equity and contributed to a general decline in leverage, the FSI criticises imputation as affecting the development of the domestic corporate bond market and creating a bias for individual investors and institutions including superannuation funds to invest in domestic equities.

The FSI also suggests that the benefits of imputation, particularly in lowering the cost of capital, may have declined due to a more open economy. In the context of a country with a long history of balance of payments deficits and a banking system reliant on overseas borrowings, these arguments are at best simplistic and naive observations. 

The imputation credit system is not the reason corporate bond markets are struggling. The key reason is historically low interest rates. Does the FSI want a return to the pre-1987 days of investing offshore and domestically in trust structures and other entities to avoid the double taxation of dividends? (See Dixon and Vann, An Examination of the Imputation System in the Context of the Erosion of the Company Tax Base, (1987) Australian Tax Forum, pp63-93). Just ask any small or medium-size business about the additional flexibility provided by the imputation credit system.

It is no longer essential to operate in unincorporated structures or via heavily geared companies merely to avoid the double taxation of dividends. Denying imputation credits to non-residents ensures that the benefits of imputation are confined to Australian residents. The fact that some investors including charities and superannuation funds may end up receiving a full or partial refund of the company tax paid is not a valid reason to change the imputation system.

The logical solution to this problem, if it is considered a problem at all, is to change the income taxation arrangements for the entities receiving the refund, for example by levying an income tax on charities and pension funds. This was demonstrated most clearly in the one year that the government denied access to imputation credits to super funds because they were tax-free entities.

Market arbitrage in that short period helped tax-free investors to restructure their portfolios to replace dividend paying shares by assets including convertible notes and property assets. Therein lies the origin of the introduction of the 15 per cent income tax on superannuation funds in 1988 in order to finance access to imputation credits by super funds. Since 1988, the value of imputation credits has been capitalised into share prices and any future government removing or significantly reducing the value of imputation credits would create mayhem in the sharemarket.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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