Fairfax Media Limited (ASX: FXJ) is reporting that Labor plan to remove franking credit refunds from the tax system.
Most readers are probably aware that franking credits are 'attached' to most Australian dividend payments. Franking credits are generated when a company pays tax and helps avoid company profits being taxed twice – which is the case in a lot of other countries around the world.
The franking credit is a refundable tax credit. This means the franking credits reduce taxes owed or generates a refund if the franking credit total is more than the tax charged.
Labor are proposing that if the tax result is a refund then the individual doesn't receive the refund. However, franking credits will still reduce taxes owed.
Bill Shorten emphasised that people will not be paying more tax, "these people will no longer receive a cash refund – but they will not be paying any additional tax."
Labor say that reforming the system will save the budget $11.4 billion over the final two years of the current forward estimates and $59 billion over the medium-term.
This will affect every retiree in slightly different ways, depending on how their assets are structured, their income and franking credit position.
I'm not an expert, but my understanding is that this will hurt the wealth of the middle class more than the super wealthy. Self-managed super funds are affected as well, but that's different too.
With the way franking credits and the tax free threshold work, an individual's only taxable income could be from a (non-SMSF) portfolio worth $100,000 invested in bank stocks like Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC) and that person will lose all of their franking credit refund.
It's a similar franking credit refund complete loss for a person's portfolio worth $200,000.
When a person's portfolio is worth more than around say $300,000 they may start being charged tax because their income is now above the tax-free threshold, assuming that their portfolio is their sole source of income. Of course, it completely depends on the dividend yield and the make up of the portfolio. But, the point is that the individual could start being charged tax. For example, the tax charged could be $1,000 which reduces the refund by $1,000. The individual tax rate at 19% (excluding Medicare) is still less than the 30% franking credit refund rate. This person is affected less, but still loses their refund.
The situation repeats itself for bigger portfolios, as the tax charged becomes bigger and the refund becomes smaller. The bigger the portfolio, the less they lose out on a refund.
Finally, with a portfolio worth somewhere between $1 million to $2 million (depending on the portfolio's overall yield), the tax charge is so much that it's more than the franking credit total and the individual is in a tax payable position. Therefore, they aren't affected by this at all.
Someone with a $4 million portfolio might not be affected by this at all, whereas someone with a $100,000 portfolio or $500,000 portfolio loses out.
The situation is more complicated with the SMSF $1.6 million cap, so if you get franking credits from your SMSF portfolio it's worth asking your accountant how you would be affected.
Foolish takeaway
At this stage, it is only a planned move by Labor and it would require Bill Shorten to win the next election. As a share man I would have preferred Labor focus on negative gearing or reducing the capital gain discount.
