Impact of franking credit – Literature review

FIN921 Managerial Finance

Group Assignment – Literature Review

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Abstract
The study assimilates the impact of franking credit upon the shareholder as well as corporate entities concentrating on the policies of Australia. The study clearly defines the method to accurately estimate the franking credit to be tendered to the shareholder of the company. The benefits are also explained and the methods to tackle any changes in the policy.
Introduction
This essay is focusing on the market value of franking credit and dividends. The tax system of Australia is having a mix of direct and indirect taxes (Cannavan and Gray 2017). This is levied by the state government and Commonwealth. However, it depends on the tax type. Taxation is imposed by the Commonwealth, which is the federal level government. However, Australia is having a franking credit system. This helps in reducing the personal tax which is payable to the Australian Taxation office. However, this credit is not given to everyone. This is entitled to only those people who own share in a company.

Body
Concept of Franking Credit
Franking Credit is also known as imputation credit. This is a tax credit, which is paid by the corporations to their shareholders. This is done along with their dividend payments. There are many countries apart from Australia who is using this franking credit system. It is because the double taxation is eliminated or reduced. There is franking credit for mutual funds, which is holding domestic-based companies. In Australia, there are many blue-chip companies for whom this system is a great method of promoting long-term equity ownership (Marshall 2018). There is an increase in the payouts of dividends to investors. Australia is having this credit system where the investors get paid in a tax bracket of 0% to 30%. This is paid proportionally to the tax rate of the investors. This credit payout decreases when the investor’s rate of tax increases. Hence, the whole system works proportionally. The holding period of franking credit in Australia is 45 days. The entitlement of this system is not provided to everyone. This is only provided to the residents of Australia. It is not given to the foreign owners of some companies in Australia. There is a standard method of calculating the franking credit in the country. It is:
Franking Credit= {Dividend amount/ (1-company tax rate)}-dividend amount

The market value of dividend and Franking Credit
There is a dividend imputation system in Australia. This is a corporate tax system where some of the taxes given by the companies are imputed to the shareholders in the form of a tax credit. This is better than the traditional method because the disadvantages of taxes are reduced. The main objective of this system is reducing the double taxation of company profits. The companies in Australia can now declare the tax paid that is associated with dividends paid. The maximum imputed amount of tax is known as Franked Dividends. Earlier in the year 1987, the excess credits of the franking system were lost over the liability of tax. However, since 2000 the excess credits get refundable. The franking credit level will be determined through its dividends. Before the year 2002, there was a direct flow of the credits so that benefits could be gained. The dividend streaming practice became illegal in 2002. There is quite less difference between fully franked and unfranked. The tax amount paid and the money available in the pocket is the same. However, it might get changed according to the investment strategy. The 45-day rule of holding is seen in Australia. According to (Davis 2016) it is important for a person to hold the shares for a minimum of 45 days. The shares should be purchased before the ex-dividend rate. There are certain rules like the first one is purchase and sales date. This should not be included in the 45 days of the count. Then the next rule is a small shareholder exemption. The 45 days rule is not applied if the taxpayers are individual and the franking credit is below $5,000 for that financial year. The next one is the Last-in First-out Rule (LIFO). If the investor is buying or selling the share in a company in those 45 days then the LIFO rule gets applied. The eligibility for the franking credit is dependent on the recent purchase. There are hardly a few countries that are following the dividend imputation system. Maximum countries are following the classical tax system. The investors are not provided with a special system in Australia. According to (Abraham, Dempsey and Marsden 2015) Australia is appearing to give a higher proportion of the pre-tax profit to the tax resident investors. This is better than the other jurisdiction system. There is a favourable treatment provided to the tax resident investors. There is a valuation methodology to capture the franking credit that is supportable.

Implications of franking credit and dividend
The labour party of Australia is proposing the removal of cash funds that are being provided for the excess franking credit (Guardian.com 2019). There is an understandable worry among the investors due to this reason. They feel that a huge impact will be there if the proposal became law. The industrial-scale has been rorted but the labour fix is not the solution. It is important to note that franking credit refunds are costing more than $5 billion in a single year. This is a superannuation reform, which is making the system fairer. Nobody wants to be on welfare. There is inter-generational fairness in the battle of franking credit refunds. This is a good deal for baby boomers. In the elections of 2019, the labour party wants a ban on the dividend imputation returns. In such circumstances, the excess franking credits may get protected. The people getting the effect by this credit system are many. The burden of this policy is for the self-managed super funds. These earnings are exempted from tax currently if they are in the phase of pension. The super funds are benefiting this credit system. There are around 70% taxpayers over the age of 75 who are receiving franking credit. There is an impact on the large retails and industry. The labour party says that 10% of cash refunds are claimed by the APRA-regulated funds. The tax liabilities are at offset with this credit system. Hence, the returns won’t be affected. There are some individual investors who own 53% of the Commonwealth bank. On the current circumstances, the investors will be facing difficulties receiving the refunds. The main suffering is with smaller balances. The lower balances ones will be losing their large proportion of the earnings. The investors will have to wait before they make an investment if the proposal becomes law in Australia.

Estimation and Method of Franking Credit
The aim of franking credit is to avoid the level of taxation imposed on dividends. Shareholders obtain franking credit as a type of dividend. The methods of calculating franking credits are as elaborated in the procedure below. Hypothetically, if the shareholder of a company receives dollars from a company, which has been incurring 30% of the taxes on the profits, then the franking credit of the shareholder amounts to 30 dollars more. This means the shareholder will be paid a total dividend value of 100 dollars.

Figure 1: Method of franking credit
(Source: Leigh 2018)

The exact formula for the credit calculation as per this Leigh is (Leigh 2018):
Franking Credit = (Value of the dividend / (1- Rate of tax on the profit of the company)) – The value of the dividend.
Following the above formula, the franking credit is estimated as
Credit= ($70/ (1-$30)) – $70 = $30

The above calculation shows that a shareholder other than receiving the dividend amount of $70 also is liable to receive an additional $30 from the company. Thus in totality, the shareholder is set to receive a total amount of $100. However the income of the shareholder and the marginal rate of tax us responsible for determining if the credits will be obtained as a form of tax refunds or whether the shareholder is supposed to pay an additional amount of tax.
While apparently, the franking credits appear to be advantageous for shareholders the ATO devised some conditions, which must be addressed before the shareholder can offset the taxes. The condition requires that shareholders acquaint themselves with the holding period regulations. Taxpayers need to hold their risky shares for a period of at least 45 days excluding the days of sales and purchase. The tax liability of investors is substantially reduced by the franking credit. Marginal tax rates as well as the 45 days risk period needs to be fulfilled for gaining the advantage.

Franking credits tendered by companies
As per the 200 indexes among the 200 largest companies of Australia 180 companies pay the franking credit. Among these companies about half paid fully franked dividends a quarter of the companies paid partially franked shares and around a quarter of them paid dividends which were unfranked. In Australia, 92% of companies have paid dividends with a total yield of around 4.3%. The system of this particular imputation implies that companies pay their profits as a dividend. Companies can also accumulate franking credits in a specific account. As per Murphy, the companies paying the highest amount of franking credits include BHP Billiton, Woolworths and Commonwealth Bank (Murphy 2018). The dividend accepted by the shareholder of the company is the income of the receiving company. However, the dividend is not grossed for franking credit nor is the company receiving is entitled to claim the credit received as a tax credit.

Policies to tackle changes in the imputation
The companies are more likely to assess a return in the capital if there is a particular change in the system of dividend franking. The Labour Party is asking for the elimination of franking credits returns. This would have a deep impact upon the entities, which have a tax rate lesser than 30%. According to Cannavan, this includes super funds, trusts, people with low incomes and SMSFS belonging to the phases of pension. Entities belonging to the lower tax bracket would have to pay 30% taxes on dividends, which are fully franked. There is an exemption proposed known as the Pensioner guarantee. The Pensioners guarantee includes certain entities such as unemployed, parenting payments, carers as well as part and full pensioners. SMSF, which has at least one person exempts must also be exempt.
The franking credit will still exist but any imputation credit or tax credit not used will not be refunded in the form of cash. Thus, the dividend franking under such conditions will be more valuable for entities with a higher rate of marginal tax. In addition, entities with a lower marginal rate of tax may pay taxes on dividends belonging to a higher rate.

Conclusion
The franking credit system is an effective way to eliminate the process of double taxation. Once as corporate taxes as well as on the distribution imparted as dividends to shareholders. The government of Australia has designed a critical condition by ensuring there is a 47 day period of holding. The franking credit is not for traders operating in the short term. However, it must be observed that a company is not liable to attach the franking credits to its respective dividends. Foreign shareholders are not eligible to use franking credits.