Global tax rate winners and losers

Should we cut Australia’s corporate tax rate to 15% and eliminate dividend imputation? That question arises again now that the G7 countries have agreed, in principal, to a global minimum corporate tax rate of 15%. There would be winners and losers in such a change and the losers have a lot more political influence than the winners, so don’t hold your breath waiting.

Effective corporate tax rate

The key to understanding who would benefit from a trade-off of lower corporate taxes for an end to dividend imputation is to understand the meaning of the effective corporate tax rate faced by different investors. The legal corporate tax rate is 30% for large companies and 25% for smaller companies (in 2021/22). But that is not the effective rate.

Under current tax law, Australian residents who are invested in the shares of companies that pay out all of their net profits as fully franked dividends have an effective corporate tax rate of close to zero. Think, for instance, of Australian investors in the shares of the big banks. Eliminating dividend imputation and cutting corporate tax rates to 15% would increase their effective corporate tax rate from nearly zero to 15%.

In contrast, shareholders who are not Australian residents currently face an effective corporate tax rate of close to 30% because they can’t use their franking credits to reduce personal tax. Their effective rate would fall to 15%. So, you can see that there would be big winners and losers.

Dividend imputation

Before 1987 investments in shares were taxed at both the corporation level (corporate income tax on company earnings), and the shareholder level (personal income tax on dividends). To end this double taxation a system of corporate tax credits called variously dividend imputation credits, franking credits or simply corporate tax credits, was introduced. It is common in finance to have three different names for the same thing (shares, stocks, equities or earnings, profits, net income).

Dividend imputation was intended to make corporate tax effectively zero for Australian tax payers. When a corporation earns a dollar and then pays 30 cents of corporate tax to the ATO, 30 cents of corporate tax credits are recorded in its franking credit ledger.

Later, when the company uses its after-tax earnings to pay a dividend to its shareholders, 30 cents of stored franking credits can be attached to the payment for every 70 cents of dividend. If the whole allowable 30 cents is attached, then the dividend is fully franked.

Tax due

To calculate how much income tax must be paid on the dividend received by a shareholder, the ATO:

  1. Grosses up the dividend to the corresponding amount of pre-tax earnings; then
  2. Calculates the income tax due on that grossed up amount;
  3. Then applies the (franking) credit for corporate tax already paid.

For example: Imagine that BHP pays out 50% of its net profits as dividends in a particular year, and retained the rest to grow the firm. Sonja receives a dividend of $1400 on her BHP shares, with $600 of franking credits attached (it is fully franked).

  • Sonja’s marginal tax rate is 47%, so she owes 2000 x 0.47 = $940 in income tax, but the $600 of franking credits reduces that to $340, which is the amount paid to the ATO.
  • If, alternatively, Sonja’s marginal tax rate is 15%, because the shares are held in her superannuation account (which is in the accumulation phase), then Sonja would only owe 2000 x 0.15 = $300 and the $600 of franking credits would lead to a $300 dollar refund to her super fund from the ATO.

In both cases the corporate tax rate is irrelevant to how much total tax is ultimately paid. If the corporate tax rate was 40% instead of 30%, then Sonja with the 47% and Sonja with the 15% rate would both still receive the same after-tax amount from the original $2000 of pre-tax BHP earnings: $1060 and $1700 respectively.

It doesn’t matter to Sonja whether the corporate tax rate is 20%, 30%, 40% or 0%. All of the corporate tax paid is returned to her by a reduction in her personal income tax due. Even if that requires a refund from the ATO. Only her personal tax rate determines how much tax she pays.

When is the effective corporate tax rate not zero

However, that doesn’t mean that the corporate tax rate of BHP shareholders like Sonja is effectively zero overall. There is the problem of the 50% pay-out ratio. Because BHP only paid out 50% of its net profits as dividends, half of the franking credits for corporate tax paid are trapped inside BHP.

Yes, those credits may be used in the future, but BHP’s franking ledger will grow and grow (I am ignoring the complication of BHP’s dual listing in Sydney and London). The point is that the lower the pay-out ratio of a corporation, then the more franking credits that are trapped inside the corporation, rather than being passed to shareholders, and therefore the higher the effective corporate tax rate.

An even more important issue is that Sonja might not be an Australian resident for tax purposes. Foreigners own a lot of Australian shares (more than 50% of the ASX) and Australians own an even greater value of foreign shares.

In general, non-residents cannot use the franking credits attached to dividends of Australian shares to reduce their personal income tax in their home country. Foreign investors generally use the franking credits to meet the ATO’s 30% withholding tax imposed on the dividend income of foreign investors. In some cases that income tax withheld by the ATO will reduce the non-resident investor’s income taxes in their home country, but in general it will not.

So, there are two big reasons why the effective corporate tax rate is not zero:

  • Non-residents cannot in general use franking credits against their income tax obligation in their home country.
  • A payout ratio of less than 100% traps franking credits inside the corporation.

Corporations (investment companies) that own shares

Another important possibility is that Sonja in our previous example is actually a corporation, Sonja Pty Ltd, which owns shares in BHP as well as other investments.

  • Extending the previous example, Sonja Pty Ltd would owe 2000 x 0.30 = $600 in income, which would be reduced to zero by the franking credits. But note that Sonja Pty Ltd is a corporation, not a person, which pays corporate income tax which in turn creates new franking credits.
  • After all tax is paid, Sonja Pty Ltd will have $1400 in cash and $600 of new franking credits in Sonja’s own franking ledger. It can pass those franking credits to Sonja’s own shareholders by paying a fully franked dividend at some point in the future. But for now, until a fully franked dividend is paid by Sonja, those franking credits are trapped.

Would the shareholders of Sonja Pty Ltd prefer a 15% corporate tax rate with no dividend imputation, or alternatively, a 30% corporate tax rate with full imputation?  Well, that depends on how wealthy they are. If they are a very wealthy family that never intends to drain Sonja Pty Ltd of the stored funds and franking credits, then 15% is much better than 30%, because the dividend imputation credits don’t help them much. They would much prefer $1700 of cash and no franking credits to $1400 of cash and $600 of trapped franking credits that are never used.

A less wealthy family, with a family trust and corporate beneficiary (bucket company) that they intend to drain of cash and franking credits once the children turn 18, is going to prefer a corporate tax rate of 30% with dividend imputation, because the franking credits will be stored and then eventually paid out to the children when they have a low tax rate, resulting in a refund of the corporate tax.

Winners and losers

So, who are the winners and losers if the corporate tax rate goes to 15% and dividend imputation is ended?

Losers (effective tax rate up)

  • Australian resident shareholders in shares that pay most of the profits as fully franked dividends. That is, most households who invest in shares through their super.
  • Australian residents with smaller family trusts and bucket companies that they will drain when children turn 18, or the parents retire.

Winners (effective tax rate down)

  • Foreign investors in Australian shares.
  • Australian residents with large family investment companies that have franking credits permanently trapped in the company.

Conclusion

You don’t need to be a political genius to know how this plays out in the press and the parliament.

In my course for private investors like you, called Finance Education for Investors, I comprehensively explain all the important issues in structuring (family trusts, corporations, super funds, etc.) and tax planning (dividend imputation, negative gearing, super, estate planning, etc.) using straightforward, practical, real world examples. Go to windlestone.com.au for more information.

Dr. Sam Wylie

Dr. Sam Wylie

Director, Windlestone Education
Principal Fellow, Melbourne Business School

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