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How to be perfectly franked and pay no tax

This article was originally published in Edition 1 of Firstlinks (then Cuffelinks) on 8 February 2013, 10 years ago this week. Firstlinks aspires to offer timeless insights to its readers, with less of the daily noise of other newsletters. It is pleasing to look back on Edition 1 and see most of the articles remain relevant today, including a piece by former PM, Paul Keating.

Similarly, this explanation of franking by Chris remains as accurate and informative today as when it was written.

***

Kerry Francis Bullmore Packer would have loved superannuation and franking credits. In 1991, he was subpoenaed to appear before a Parliamentary Committee enquiring into the print media, and it was wonderful theatre. He bellowed out his responses and left most of the Committee members cowering. But his most memorable response came when asked about his company’s tax minimisation schemes:

"Of course I am minimising my tax. And if anybody in this country doesn't minimise their tax, they want their heads read, because as a government, I can tell you, you're not spending it that well that we should be donating extra!"

You may not feel quite as critical as Mr Packer, since our taxes pay for health, schools and pensions, but the superannuation system has been designed to encourage people to finance their own retirement, so it makes sense to use it. Income in superannuation is taxed at 15% in the accumulation phase, and personal marginal tax rates hit 19% when earnings exceed $18,200, so income in superannuation is tax effective for anyone earning above this amount.

But that’s only half the story. Let’s put franking credits into the mix by understanding how dividend imputation works. Companies pay tax on their profits at a full rate of 30% before dividends are paid to shareholders. In the hands of an investor receiving the dividend, the tax paid is called a franking credit or an imputation credit. For tax purposes, the shareholder receives both a cash dividend plus the imputation credit, and is treated as if they paid tax equal to the imputation credit.

The system operates like this to avoid double taxation of income. In effect, the shareholder receives back the tax that has already been paid by the company and instead pays tax at the investor’s own tax rate. If the owner of the shares is on a tax rate less than the 30% company tax rate, such as superannuation funds, they are entitled to a rebate of the overpaid amount.

Let’s consider a simple example. A company earns a profit of $10,000, and pays tax of $3,000, leaving $7,000. It pays this amount as a franked dividend to its only shareholder, which is a super fund. In its tax return, the super fund adds the tax already paid by the company to the cash dividend received. The 'grossed up dividend' is $10,000, and the super fund pays tax on this at 15%, or $1,500. However, it receives a credit worth $3,000 for the amount of tax already paid by the company, leaving a tax refund of $1,500. Neat!

So it’s a matter of maths to calculate how much fully franked dividends is needed to offset the income tax due on the rest of a super fund’s portfolio, and pay no tax, meaning that no investments need to be sold to fund the tax bill.

Skip the following box if you don’t have a mind for numbers.

So with some current day numbers, this formula can be used with values for D (the dividend yield on the shares) and Y (the yield on the rest of the portfolio) to determine how much of a portfolio needs to be invested in fully franked shares to have a zero tax rate on the entire portfolio.

  • a franked dividend yield on the Australian shares portfolio of 6%
  • an unfranked yield on the remaining portfolio of 4% (bonds or bank bills).

The portfolio would only need to contain 32% of Australian shares paying fully franked dividends to pay a zero tax rate. And without getting into a discussion on portfolio construction, most Australian super funds can justify an allocation to Australian shares of at least one-third.

The calculation ignores the impact of any realised capital gains and expenses from running the portfolio.

The combination of favourable tax rates and dividend imputation shows the power of saving in a superannuation vehicle. Once a fund converts to paying a pension, there is no tax payable by the fund on earnings. In this case, imputation credits are refunded in cash. Furthermore, if the pension recipient is aged over 60, then pension drawdowns are also tax free.

Kerry Packer would have loved it. All that income and no tax. And later, a refund from the government. Kerry probably learned a lot from his father, and maybe it's no coincidence that this powerful process carries the same name as that equally powerful man. Sir Frank.

 

16 Comments
Gerry
February 16, 2023

I buy a share in a company. My company pays 30% tax. So, I'm also paying that tax.
I can't see how I'm paying no tax.

Koen
February 17, 2023

No you're not. Neither are you paying tax on your gross wage if you are an employee. Your company does. You never receive your gross wage.
Same for dividend. You are not getting the pre-tax amount so you pay no tax over the taxable amount the company already paid.
If you did receive the pre-tax (unfranked) amount you wouldn't be better off. The nett amount you are left with is the same. Maybe you feel like you are personally paying all taxes the company you own shares in must pay.
To say that you pay no tax at all is wrong. The tax man always gets their share every time you buy something.
So if you spend your fully franked dividend you pay GST no matter what. Taxes are unavoidable. Minimizing the amount of tax you pay is legal if it is within the tax law.

Barry
February 12, 2023

The idea that you should aim to pay zero tax is silly. This article is focusing on the wrong thing.

The aim of investing is not to pay zero tax. It is to make the best risk-adjusted return you can.

If you can make a better risk-adjusted return even if it means paying more or less tax than you are getting in your situation where are paying zero tax then you should switch to that.

Dudley
February 12, 2023

"The aim of investing is not to pay zero tax. It is to make the best risk-adjusted return you can.":

Receiving the best risk-adjusted return upon which no net tax is paid is possible.

The best risk-adjusted return, without reference to risk 'appetite', is the same for everyone. What is it currently?

Stephen
February 10, 2023

These types of articles always annoyed me. Franking credits are not a way to pay no tax, they are simply a portion of the return that has already been taxed. Holding 32% fully franked shares to 'pay zero tax' does nothing for the ultimate amount of tax paid, just the order in which you pay it. Those franking credits are part of the return or profit of the investment.

Does the wage earner who receives their pay packet after their employer has taken the PAYG tax out and sent it off to the government "pay no tax" just because it is not them physically sending the ATO a cheque?

Jon Kalkman
February 10, 2023

Chris Cuff asks an interesting question: What proportion of the portfolio needs to be in Australian shares with fully franked dividends so that the franking credits generated, cancels out the 15% tax liability on the whole portfolio, so there is no more tax to pay? Answer: 32%.

When the stage 3 tax cuts arrive, the 30% tax rate will apply from $45,000 all the way to $200,000. Anything above $200,000 is taxed at 45% but the bit below $45,000 is taxed at less than 30%. It is interesting because the franking credit represents the prepaid company tax of 30% and franking credits can cancel out the personal tax liability for all taxpayers. If franking credits are not used to pay a tax liability, they are refunded as cash to all taxpayers.

So I have a slightly different question: Assuming I am 100% invested in Australian shares with fully franked dividends, (a dubious assumption, but instructive nonetheless), how large can the portfolio be before the franking credits are insufficient to cover the tax liability, so that I have no more tax to pay.

Answer: If the portfolio generated $185,000 in fully franked dividends, the franking credit would be $79,286 generating a taxable income of $264,286. The tax payable on this income under the new tax scales is $79,303, only $17 tax to pay.

If those dividends were derived from shares earning 5%, the portfolio would need to be $3.7 million to generate $185,000.

Please note that this has nothing to do with retirees or super funds, it is simply the interaction between the new tax rates and franking credits.

Dudley
February 10, 2023

"only $17 tax to pay.":

Only $17 EXTRA to pay; $79,286 had already been paid and available as a tax credit to the shareholder.

If shareholder is senior no super guarantee:
= $165,924 gross dividend income (116,146.80 dividends + 49,777.20 franking credit)
= $49,777.36 personal income tax ( -$0.16; https://paycalculator.com.au/ )
Net EXTRA tax = $0.00.

Dane
February 12, 2023

I think you do need to get into a discussion on portfolio construction. Assuming a portfolio is 100% shares, having 32% in Australia is 16x the weight considered appropriate according to the collective wisdom of the market. ASX is also highly concentrated in a handful of mostly cyclical sectors and stocks and more volatile vs debt world markets. On top of this ASX has been a perrenial underperformer over the last 10+ yrs returning 8.7% pa vs the US (17.5% pa AUD) or a market weight world portfolio (10.4% AUD). My maths could be out here but the uplift in return from imputation credits is not enough to offset this shortfall. Franking credits are nice but theory says tax considerations should not heavily skew investment decisions.

C
February 13, 2023

but over the long run ( since 1900 ) it is said that Australian shares have delivered equal returns to US shares.
So if US shares have outperformed over the past 10 years, it is conceivable that reversion to the mean will see Australian shares outperform over the next 10 years.

Lily
February 09, 2023

Great article, thank you!
I'm wondering if SMSF can invest in private companies?
Thanks
Lily

Old but Sane
February 09, 2023

Yes, they can, but you need to be careful of who owns the private companies as the in-house assets rules apply if related parties are involved. And, given you did not know the answer to the question, perhaps you should become more familiar with the roles and responsibilities as a trustee of an SMSF.

Lily
February 11, 2023

Thanks for your reply! I went to ATO website and found that there's a 5% limit for in-house assets. This doesn't help with the situation when you have after tax profits trapped in your private business. Any solutions to the distribution of these assets?

Lily
February 12, 2023

Yes you are quite right there. My employment income makes the franking credits useless.

Lyn
February 12, 2023

Lily, be very cautious, heed Old but Sane's advice, then find a Cream-of-the-crop accountant.

Old but Sane
February 12, 2023

After tax profits are not “trapped” in your business. You are able to distribute these profits, presumably as franked dividends (as you say they are after tax). Problem you probably have is that your other income means that the franking credits are not adequate to offset all the tax payable in your hands, otherwise you should be distributing the profits as you go. Means you have a choice, pay the extra tax or don’t distribute the profits.

Another problem maybe that the company does not have the cash to pay the dividends, but that is just poor cash management (ie you can’t have your cake and eat it too).

Rob
February 09, 2023

No Chris - Kerry would have loved Pension Mode better, with zero tax and refundable Franking Credits but alas I suspect that may well be under attack! All Pensioners need to again rise up as they did in 2019 re franking!!

 

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