The Australian Imputation System and Labor’s Plans to Deny Imputation Credit Refunds
Hi Duncan here from CapitalQ, today I want to talk about what is currently a very controversial topic and one of interest to many Australians and a topic receiving a huge amount of media, and that is the Australian Tax Imputation System. And coupled with that the Federal Opposition Leader, Bill Shorten of the Labor Party’s proposal to remove the ability for unused imputation credits to be refunded to taxpayers.
So before we can talk about Bill’s proposed changes, it’s important to understand what the Imputation System is and how it works …
The Australian Tax Imputation System
As we all know, Companies pay tax on their profits, on their taxable income.
The funds they have left after paying their taxes are then available to be distributed to the owners of the Company, being the Shareholders, as Dividends.
When the Shareholders receive their Dividends, this is also taxable income to them, and so they pay tax on that income received as well.
So in simple terms the one element of taxable income ends up being taxed twice. Once at the Company level and then again at the Shareholder level.
Now the imputation system is basically designed to remove the double taxing of the one element of income.
So lets look at some illustrative examples.
Example 1 – Current System (With Imputation) – Recipient of the Dividend has a High Tax Rate (1.32min)
Lets take a Company that has earned $100 of profits.
It will pay tax on those profits and as with most companies, certainly large companies listed on the stock exchange, will pay tax at the rate of 30%, being $30 in tax.
This leaves $70 of after tax profits which it can pass on to it shareholders, as dividends.
Now under the present imputation system, when a company pays a dividend, that income has attached to it, for tax purposes, credits, known as Imputation Credits, or Franking Credits, the terms are interchangeable for our purposes, and those Credits are generally equal to the tax paid on the income in question.
The attached Imputation Credits, are treated as taxable income to the recipient. So they aren’t a cash item, but they are taxed on them nevertheless.
So you can see if the Shareholder received a Dividend of $70, it generally comes with $30 of imputation credits and that means the Shareholder has to pay tax on $100.
So lets assume the Shareholder in this example is an Individual.
The Individual will include the $70 received in cash their tax return and pay tax on it and they will also be taxed on the $30 of Imputation Credits received.
This means the Individual pays tax on the total of $100. So you can see at this stage, they are paying tax on the same amount of income that the company first paid tax on. That may seem a little strange, but stay with me …
Now lets assume the Individual has quite a bit of other income, so they are on the top margin tax rate which right now is 47%.
So tax on $100 is therefore $47.
But, thanks to the way the Imputation System works, they now get to reduce the amount of tax they pay by the Imputation Credit they received. Yes that means the credit both increases their taxable income and it reduces their tax payable.
So they get to reduce the $47 tax by $30, leaving only $17 that has to be paid to the Tax Man.
Again, that might sound a bit convoluted but it actually makes a lot of sense and works really well.
You see the Tax Man has now received two amounts. They received $30 from the Company, and $17 from the Individual. So in total they received $47.
And you can see that is equal to the tax that would have been paid by the Individual had they earned the $100 themselves in the first place. So if the company structure was never used, never inserted into the equation.
So the whole idea is that the company level is effectively removed from the equation and the ultimate total amount of tax paid is based on the tax rate of the ultimate recipient of the income. And to me, that makes good sense. Companies, while obviously a big part of modern life, are not real things, they are legal silos for money, activity and the like but ultimately everything that goes on in them is for the benefit of the people behind them. And so it makes sense to me that the amount of tax that is ultimately paid is based on those people’s tax rates, as those rates are deemed appropriate by the Government of the day.
So what happens if we don’t have an Imputation System.
Example 2 – As above, but what if there was No Imputation (5.13min)
The Company still pays the $30 tax on its $100 profit.
The $70 is then paid to the Shareholder as a Dividend.
The Shareholder then pays tax on the Dividend received. At their marginal rate of 47%, so that is $32.90.
Now the Tax Man has received a total of $62.90 on just $100 of taxable income!
And of the $100 originally earned, the Shareholder is left with only $37.10.
Doesn’t sound too good does it. Aside from it being unfair at least in my mind, more importantly it is a major disincentive for anyone to go out there and take risks, invest and employ people.
Example 3 – Current System (With Imputation) – Recipient of the Dividend has a Low Tax Rate (6.05min)
So lets go back to the first example, where the Imputation system applies, but this time, instead of the shareholder being an individual with quite a bit of other income and therefore being on the top marginal rate, they have much less other income and instead are on a much lower tax rate of say 19%.
Now everything that occurs at the company level is the same, nothing changes there. The Shareholder receives $70 dividend as before with $30 of Imputation Credits attached to it.
In the first instance they are assessed tax on $100, but as their rate is only 19%, that is only $19 tax payable. Then they get to claim the Imputation Credit against that, which is $30 so what it means is they end up with a refund of $11.
The total tax the Tax man gets is $30 from the company, less $11 refunded to the Individual, so that is $19 in total. Exactly what it would have been if the individual earned the money themselves in the first place. So again the company structure is removed from the equation and the tax is paid at the rate deemed appropriate to the ultimate recipient.
Now the $11 may not always actually be refunded to the Individual, often it is used or offset against the tax they have to pay on other income they have earned. But that doesn’t really matter, the effect is the same in that the income earned via the company is taxed at the rate applicable to the ultimate recipient.
Example 4 – Current System (With Imputation) – Recipient is a Superannuation Fund (7.35min)
So what about if the Shareholder is a Superannuation Fund.
Super Funds generally pay tax at 15%. So as you can see based on an individual with a tax rate of 19%, there will be a refund, or at least an offset that can be made against tax on other income.
It gets a little messy when you consider Super Funds that are in Pension phase, so this means the Member of the Fund is drawing down a regular pension for them to live on (this is generally for people over at least 55, or more likely 65 years of age). Those super funds currently to a large extent have an effective tax rate of 0%. Most of them pay no tax!
That means all of the tax paid by the company would be refunded back to the Super Fund, so that the ultimate tax rate on the income earned remains 0%.
So where is the mischief? (8.30min)
Now that doesn’t mean there is a problem with the Imputation System, it continues to work exactly as intended. It is as if this somewhat artificial construct being the company didn’t exist and it is as if the member, via his super fund, earned the original $100.
So the problem seems to be that the Labor Party (although I suspect not all of the Labor Party) believe the refunding of credits to super funds is unfair, that it only benefits the rich, or otherwise that it is a massive drain on the Government.
Well firstly, there is an argument to make that the tax they received in the first place from the company was never entirely theirs, it was just a form of prepayment of tax, awaiting the final assessment of the tax liability of the ultimate recipient of the income. And in the case of a member in a super fund, the deemed appropriate rate right now is either 15% or 0%, and hence the tax paid by the company didn’t need to have been paid, and it all, or a lot of it, needs to be returned.
Secondly, the 0% rate applies to the very vast majority of people at that age using super to hold their life time accumulated wealth. So whether you have $50k, $500k or $1.5m, it has been deemed your income on that money is to be taxed at 0%. And the imputation system allows this to happen.
For people with more than $1.6m in super, the income on their wealth above the $1.6 is taxed at 15%. So they still get some Imputation credits refunded, but not all. The end result still being that they pay tax at 15% as is presently deemed appropriate for someone in that situation.
So, now what happens if Bill’s idea that the imputation credits can no longer be refunded. Well it means that lots of people start to be taxed on their income earned via a company at the 30%, even though on other income they pay a lower rate, and even though it has been deemed appropriate that they have a lower overall tax rate.
So for me, that doesn’t make a lot of sense.
Changing Imputation is Not the Way to Go About This (10.45min)
If you feel that paying tax at 15% or even at 0% is inappropriate, then that is a different conversation. And there is probably no right or wrong answer, it is just whatever rate deemed most appropriate by the Government of the time driven, to an extent, by public opinion.
But causing income earned via one medium to be taxed differently to another, really doesn’t make a lot of sense to me, and seems like the wrong way to go about attempting to fix a different perceived problem.
I just feel if the Labor Party really thinks people of that age, and in particular with a certain amount of life savings, are not paying enough tax, then they should change the rate applicable to them. But don’t complicate things even more than they already are by messing around with what seems to me to be a perfectly good, perfectly logical and perfectly effective system.
Of course as most will know, Bill Shorten is arguing because of the way the imputation system works, the rich aren’t paying their fair share (they aren’t paying sufficiently more than the less rich as he feels they should).
Now the whole issue of just how much more people who have been financially successful in life should pay over and above what those who have not been as successful should pay is yet another conversation and not one where a consensus is easily reached.
But I will attempt to demonstrate in my blog post that will accompany this video that based on my understanding of his proposal, he is not going to achieve what he thinks he will. And certainly he is not just increasing the tax paid by the supposed rich. It seems to me he is effecting a lot of people who are anything but!