There has been a lot written about franking credits over the years, and none more so than on Firstlinks. So please bear with me, as I sort through a perceived franking credits issue that has surfaced since the updated proposal for Division 296 tax legislation was announced by Treasurer, Jim Chalmers in October last year (also known as Better Targeted Superannuation Concessions).
Specifically, a number of industry experts, including auditors, accountants, and the SMSF Association, are concerned that a flaw exists in how franking credits are treated under Div 296, and they use the term “taxing a tax refund” or “tax on tax”.
Their concern is that assessable income for Div 296 tax purposes includes franking credits attached to dividend income. Their argument is that the franking credit reflects company tax paid and therefore shouldn’t be taxed again under Div 296. Hence the “tax on tax” term.
Note that assessable income for the standard super tax calculation (the earnings relating to the portion of super below the $3 million) includes franking credits, which are then deducted from the tax calculation in arriving at the assessed tax liability. It can result in a tax refund to the SMSF.
The concerns are borne out of a failure to separate company tax paid on profits, and the SMSF’s tax obligation on dividend income. In effect, a franking credit serves a dual function. In the eyes of a company, it represents corporate tax paid, while from the recipient of the dividend’s perspective, it is assessable income and a tax offset used to finalise the fund’s tax liability. And what brings those who claim Div 296 is a “tax on tax” unstuck, is the thinking that the franking credit is tax already paid, rather than SMSF income.
This is better understood with some numbers.
Imagine an SMSF with a Total Superannuation Balance (TSB) of $5 million in accumulation phase. It will be subject to Div 296 tax at a rate of 15% x ($5m - $3m) / $5m = 6% on earned income. The fund’s effective tax rate on earnings is therefore 15% + 6% = 21%.
Assume the fund’s only income is a fully franked $70 dividend (see footnote for an unfranked dividend example). The economic outcomes are:
Company
- Earns pre-tax profit: $100
- Pays company tax to ATO: $30
- Pays dividend to SMSF: $70, ($30 franking credit attached)
- Net cashflow: $0
SMSF
- Receives dividend: $70 (assessable income is $70 dividend + $30 franking credit = $100)
- Ordinary fund tax: 15% x $100 = $15
- Less franking credit: $15 refund
- Div 296 tax: 6% x $100 = $6 (note, applies to franked dividend plus franking credit)
- Consolidated tax position: $6 - $15 = refund of $9
- Net cash received: $70 + $9 = $79
ATO
- Receives company tax: $30
- Pays refund to SMSF: $9
- Net tax received: $21
Economically:
- Total tax paid on $100 company profit = $21.
- Tax paid matches SMSF effective tax rate.
- Company is cashflow neutral.
In fact, it wouldn’t matter what the effective SMSF tax rate was, the company would remain cashflow neutral, and the total tax paid would match the SMSF tax rate. It’s as if therefore, the tax transaction has occurred between the SMSF and the ATO, with the company acting as an intermediary.
That is, under imputation, company tax on distributed profits functions as a prepayment of shareholder’s tax, not as a final tax borne by the company. The company’s role is mechanical, with final tax incidence lying between the shareholder (in this case an SMSF) and the ATO. The company does not bear the tax economically, the shareholder does. Acknowledging this makes it clear that ordinary fund taxation (the less than $3 million portion), and Div 296, apply to SMSF income, not to company tax. And it is why the “tax on tax” argument fails.
When company profits are distributed as dividends, the grossed-up amount including franking credits, becomes assessable income in the hands of the recipient. In essence, the company is effectively a conduit between the SMSF and the ATO, rather than a taxpayer itself in an economic sense.
To further illustrate, consider how the taxation of a non-dividend income source compares, and why the imputation system exists.
Consider again the SMSF with a TSB of $5 million. As before, the effective tax rate on earnings is 21%. This time assume the SMSF’s only income is $100 bank interest. The following unfolds:
Bank
- Earns pre-tax profit: $100
- Pays interest to SMSF pre-tax: $100
- Pays 30% tax on profit less expenses: $0
(interest paid is a deductible expense, net tax paid = $0)
SMSF
- Receives interest: $100
- Ordinary fund tax: 15% x $100 = $15
- Div 296 tax: 6% x $100 = $6
- Consolidated tax position: $6 + $15 = $21 payable
- Net cash received: $100 - $21 = $79
Whether receiving bank interest or fully franked dividends, the SMSF’s net cash outcome is identical after tax. This demonstrates tax neutrality, where different income sources arrive at the same tax outcome. Excluding franking credits from income for Div 296 purposes would break that neutrality and favour dividend income over earnings from other sources.
In both cases, the SMSF’s outcome is determined entirely by gross income and the SMSF tax rate. The company tax rate is irrelevant to the SMSF. This example also shows that Div 296 simply raises the effective tax rate on SMSF earnings, and it does not tax company tax, no matter the source of income.
The fact that Div 296, with the franked dividend included in earnings equalises outcomes across different income types, demonstrates that the “tax on tax” claim does not hold for dividend income.
And why the imputation system? Because dividends are fundamentally different to interest. Dividends are paid out of after-tax profit, and imputation ensures they are not taxed again in the hands of the recipient. Interest, however, is tax deductible to the bank so no company tax is paid on that slice of profits. The interest can only ever be taxed once (in the SMSF), so no imputation is required.
And finally, even though the Div 296 is an overlay on the 15% tax on earnings relating to the portion of super below the $3 million, an ‘all in’ rate without added Div 296 would yield the same tax outcome.
To illustrate, in the above example with a TSB of $5 million, the overlay tax was 40% x 15% = 6%. So that the effective tax rate with Div 296 uplift is 15% + 6% = 21%.
If the tax rate on earnings was 21% instead of 15%, with no overlay Div 296 tax, then the tax on the $70 fully franked dividend would be 21% x the grossed-up dividend, being 21% x ($70 + $30) = $21. Less the $30 franking credit yields a $9 refund, exactly as above.
So under an overlay system such as Div 296, franking credits should remain in the earnings calculation, just as they are under a system with a single tax rate. The tax base does not change simply because Div 296 increases the effective tax rate on earnings. Franking credits form part of gross assessable income, are taxed only once, and then applied as a tax offset against the resulting tax liability just once.
In summary, franking credits are assessable to the recipient, including for Div 296 purposes. From the SMSF’s perspective, they are not tax paid by another entity, but gross income against which tax offsets are applied. This is why the “tax on tax” argument breaks down. There is no flaw. Rather it is the imputation system operating exactly as intended, ensuring that all income is taxed only once, at the relevant tax rate.
Footnote
As per the $5 million TSB example above, except the $70 dividend paid is unfranked. The fund’s effective tax rate remains 15% + 6% = 21%.
The economic outcomes:
Company
- Earns pre-tax profit: $100
- Pays company tax to ATO: $30
- Pays dividend to SMSF: $70, ($0 franking credit attached)
- Net cashflow: $0
SMSF
- Receives dividend: $70 (assessable income is $70)
- Ordinary fund tax: 15% x $70 = $10.50
- Div 296 tax: 6% x $70 = $4.20
- Consolidated tax position: $14.70 payable
- Net cash received: $55.30
ATO
- Receives company tax: $30
- Receives SMSF tax: $14.70
- Net tax received: $44.70
Economically:
- Company remains cashflow neutral.
- Total tax paid on $100 company profit = $44.70.
- Tax paid matches SMSF effective tax rate on after-tax company profits plus company tax rate = 21% x (1 – 30%) + 30% = 44.7%
Rearranging, the additional tax relative to the fully-franked case, 30% x (1 – 21%) = 23.7%, reflects stranded company tax net of the tax that would otherwise have been paid on the unfranked $30, now not counted as earnings, as appropriate.
This outcome is entirely consistent with the imputation system. With full franking, company tax is credited to the recipient (the SMSF) and effectively unwound. With no franking, company tax is not credited and therefore remains part of the total tax burden. Div 296 continues to apply only to the SMSF’s earnings, not to company tax paid. And it does not change the tax base, it only increases the SMSF’s effective tax rate.
Therefore, the unfranked dividend is taxed more heavily not because of Div 296 or any “tax on tax”, but because company tax is no longer credited to the SMSF under the imputation system.
Tony Dillon is a freelance writer and former actuary. This article is general information and does not consider the circumstances of any investor.