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.