A system supposedly to avoid double taxation, has become a tax deferral system for the privileged. Company tax has become a withholding tax to be refunded later.
Indications are the forthcoming federal election will see some policy differences between the major parties particularly in the area of taxation.
The Labor Party is proposing changes to dividend imputation. This widely misunderstood system was described by the Parliamentary Budget Office (PBO) which costed the Labor proposal as follows:
“Under the dividend imputation system, Australian resident companies that distribute dividends from after-tax profits have the option of passing on franking credits (also known as imputation credits) to their shareholders, attached to the dividends they receive. This provides shareholders with a credit for the tax that a company has paid on its profits.”
The credits are used to offset against tax otherwise payable. Excess credits are refunded. The PBO estimates about $5 billion worth of credits are claimed each year by individual and superannuation funds, the two classes of taxpayers to which the system applies.
The system heavily favours wealthy taxpayers. They receive most dividend income whether directly or via their super funds. When super funds are in the accumulation phase about half the franking credits are available to be offset or refunded, but in the pension stage almost all are refundable. All pensions paid to retirees are tax free. Despite this they have a much higher tax free threshold than other taxpayers which allows them to receive even more tax free income from non-super sources.
So what’s the problem? Supporters of refundable credits simply say it simply avoids double taxation, once when income is received by companies and again when after tax income is received by shareholders.
That sounds fair?
Most commentary implicitly assumes dividends are from listed companies, CBA and Telstra for example. But it also applies to private companies. Here the imputation system operates as a tax deferral mechanism.
A lot of small businesses operate via a private company or a family trust. It is not uncommon for a trust, which is just a flexible family partnership, to distribute excess income to a family company as an eligible beneficiary. Hence a lot of income ends up being taxed at a company level which results in a large bank of imputation credits. The challenge is to distribute after tax earnings as dividends in a manner and at a time to maximise the refund of franking credits. The accounting profession is only too happy to assist with this task.
Tax deferrals arguably undermines the integrity of the tax system. One principle of a fair tax system is that there should be horizontal equity across all taxpayers in any tax period. Allowing company income to be treated differently violates the equity principle.
There are undoubtedly high-income earners who didn’t have the opportunity to channel income through a company and are about to spend their hard-earned after-tax income, possibly in retirement, who would welcome the chance to have their income reassessed as happens to company income received by shareholders via franked dividends.
A system supposedly to avoid double taxation, has become a tax deferral system for the privileged. Company tax has become a withholding tax to be refunded later. Whether it’s in retirement or when adult children are being supported as students say, there will always be an opportunity to arrange a refund of franking credits.
If a Labor victory becomes more certain we are likely to see public companies offer to buy back shares via a part purchase/part dividend arrangement which will allow franking credits to be refunded to eligible shareholders. Retirees and super funds love these deals.
During the Turnbull government negotiations around last year’s budget measures, the Business Council of Australia argued companies needed a tax cut, so they would have more cash to employ more staff. They may have to overlook their own arguments as they spend cash to buy back their own shares in a way that gives refundable credits to shareholders before Bill Shorten shuts the gate on 1st July 2019. It’s hard to find an argument for a government subsidy for share buybacks which a refundable franking credit system encourages. It sounds awfully like a government sponsored Ponzi scheme?
If the company tax payment and the subsequent dividend payment happened in the same year, the double taxation argument would have more validity. But as it occurs over time, the imputation system becomes a tax deferral system.
Almost all public discussion about tax is based on self-interest. There is little or no attempt to discuss guiding principles. What constitutes a fair and reasonable tax? The debate about Labor’s negative gearing proposals follow that pattern.
Essentially however, negative gearing is another example of tax deferral. The overriding reason negative gearing attracts participants is because it provides the opportunity to defer tax, to offset current year rental losses against other income thereby saving tax, and continuing this until the property is sold, realising a gain that will be taxed at a lower rate. In that regard it violates the principle that horizontal equity should apply to all current earnings from all taxpayers. The Tax Act doesn’t recognise a rental property as a business. That’s fortunate as small business losses can’t be offset against other income if the Tax Act deems them to be non-commercial. Negative gearing is ipso facto a non-commercial activity. Negative gearers aim to be loss makers. The whole point of negative gearing is to defer tax as long as possible.
Tax deferrals may be inequitable but may lead to better outcomes? However, it’s difficult to see dividend recipients more in need of support than Newstarters? And is assistance to negative gearers preferable to say more public infrastructure?
It is hoped the inevitable self-interested claims and counter claims about dividend imputation and negative gearing don’t remove all the oxygen from the public debate. We need to discuss guiding principles for a fair system. Arguably one of those, in the case of a tax on earnings, is the principle of horizontal equity, to treat all taxpayers similarly. Any opportunity to defer tax by one group undermines that principle. The system can ill afford tax haemorrhaging on the present grand scale that mainly benefits an underserving minority.
(Published in The Mercury 24th Jan 2019)