How to Adapt to the Labor Party’s Reforms to Franking Credits

According to the Sportsbet odds, there is a very good chance that the Australian Labor Party will win the next election, and there are a number of proposed policies that will have a large impact on investors.

Sportsbet odds as of 6 April 2019 have Labor winning the next Australian federal election

I don’t want to focus too much on my personal political views as I feel I should only discuss personal finance here, but personally, even if I benefit economically by voting for the Liberals, there are many other non-economic issues that bother me about the Liberals e.g. it is highly likely that there is a Nazi faction within the Liberal party. This raises the likelihood that the Liberals will engage in Trump-style divisive politics based on racism and sexism. Furthermore, something I care about more than money is the environment, and the Liberals are filled with climate change skeptics.

Back to the topic of personal finance, one proposed Labor policy is banning refundable franking credits. This has mislead many people who think that franking credits will be banned. In order to understand what this policy is, it is important to understand what franking credits are.

Australian companies pay a corporate tax rate of 30% on their profits. A portion of the profits is then distributed to to shareholders as dividends. However, when shareholders receive dividends, they pay tax on their dividends. As a result, there is “double taxation” i.e. the company pays taxes on profits and then the shareholder pays income tax. To fix this problem, when companies pay dividends, they can attach franking credits to it, which allows the tax paid by companies to be refunded back to the shareholder.

Companies pay 30% corporate tax, but shareholders pay income tax, and given that there is progressive taxation is Australia, shareholders may pay anywhere from zero tax to 45% tax depending on their income. The higher your income, the higher your income tax rate. If you are on the highest income tax rate of 45% then the franking credits that refund the 30% corporate tax back to you will not cover all your taxes and you will still need to pay money to the government. However, there are many people who retired who have low income and live off dividends. Because they earn little, they may pay zero income tax, but because dividends have franking credits, they are in a position to receive money from the government. It is these cash refunds that Labor is targeting, not franking credits in general.

How to adapt to the new policy

Franking credits do not apply to all investment income. For example, income from property has no franking credits e.g. REITs. Furthermore, income from outside of Australia e.g. US equity ETFs such as IVV pay dividends with no franking credits.

In order to adapt to the new policy, simply increase the amount of unfranked investment income you receive. Once the amount of unfranked investment income increases, the income tax you pay will rise. Remember you only get a cash refund when your personal income tax is below 30% so if you increase how much unfranked investment income you receive such that your personal tax rate is at or above 30% then any franking credits you receive will simply offset the taxes you pay on the unfranked income you receive, so you don’t need to worry about receiving a cash refund.

As I said, the easiest way to achieve this is to invest not just in Australia but to go overseas and invest outside of Australia. Examples of ETFs that achieve this are VGE (as well as the ethical equivalent VESG) as well as INCM, which is globally focused equity income ETF. Another option is to invest in AREITs e.g. SLF, which invests mostly in Australian commercial property and pay quite high rental yields.

6 thoughts on “How to Adapt to the Labor Party’s Reforms to Franking Credits”

  1. Its an interesting subject and will cost Labor IMO, self funded retirees earning less than 40k should still be allowed to claim franking credits whether they are paying tax or not IMO. A lot of those self funded retiree’s who are at the right age will alter their finances to qualify for the pension and it will end up costing the government more. Those who cant will probably take on higher risk investments like REIT’s as you suggest or higher dividend but more risky small-mid cap stocks. A lot of my friends are already looking at Aus REIT’s like AVN, ARF, CMA etc …
    Fund managers know investors will bail out of certain income/heavily franked stocks and some of the big names like Geoff Wilson have campaigned heavily against Labor’s proposal. I think depending on the make up of the senate that the legislation might have trouble passing anyway and even if it does it will be watered down further.

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  2. Overseas shares, local shares with unfranked income (REIT’s), property, bonds, savings accounts all offer unfranked income sources which can be used to ‘soak up’ the excess franking credits.

    P.S. It is a stupid policy. Imagine if they said “If the tax your employer withholds leads to the ATO owing you, you don’t get a refund”……

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  3. Calvin’

    Please take this in the spirit intended; a calming friendly voice, but;

    you sound like a bit of a nutter making such claims, and it is also demeaning to those who suffered under the Nazis.

    Its just Australian politics, there are supposed to be a range of views!

    Anyway thanks for the blog, I enjoy you work.

    Cheers

    Pete

    >

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    1. Hey that’s cool. I dont want to talk too much politics but I’m just sensitive to these things. I just get this feeling the world is descending into more division, hate, racism, sexism etc. It often depresses me. Thanks for reading.

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  4. It would be a shame to lose those franking credit refunds (which my wife receives), but we shouldn’t be making investment decisions based solely on receiving franking credits (at least those of us not in retirement mode), even though they are a bit of a free kick. Hopefully most people are well enough diversified and not needing to radically altering their investment strategies as a result…

    Liked by 1 person

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