The New Franking Credit Debate

Franking credits were a significant policy issue in the run up to the 2019 federal election, with the opposition Labor Party’s position being to remove the ability for excess franking credits to be refunded. Federal Labor leader Bill Shorten acknowledged after losing the election that he has misread the level of community concern about that policy.

Franking credits have emerged as a policy discussion again – albeit in a different way. The current federal Labor government has provided some explanatory materials on why it is looking to restrict the use of franking credits in certain situations. The document can be found here under the title: Exposure Draft Explanatory Materials: Treasury Laws Amendment (Measures for a later sitting) Bill 2022.

Franking Credits and Dividends

It is worth considering the traditional role of franking credits, which was to stop the double taxation of dividends. By double taxation, it meant that the earnings of a company were taxed as the company earned the income, and then again in the hands of an investor who paid income tax after receiving a dividend.

For example, if a company made $100 in profit, at a 30 per cent company tax rate they would pay $30 in tax with $70 left as the dividend for the investor.

Assuming the investor pays income tax at the rate of 32.5 per cent on the $70 dividend they receive, they paid another $22.75 in tax and ended up with $47.25 from the original $100 in company earnings.

To stop the impact of the ‘double taxation’ of income, the franking credit system saw the $70 dividend include a $30 franking credit. With the franking credit, the investor paid 32.5 per cent income tax on $100, being the value of the $70 cash and the $30 franking credit. They would have to pay $32.50 in tax, which is offset by the $30 franking credit meaning they only have to pay a further $2.50 in tax. They now keep $67.50 after tax, rather than the $47.25 without franking credits.

The New Focus

This brings us to the current ‘draft explanatory materials’, which considers the role of franking credits beyond just paying dividends, including using franking credits as an element in off-market share buybacks.

As an example of an off-market share buyback, let’s consider the Woolworths (ASX: WOW) share buyback in the second half of the 2021 calendar year. At the time, Woolworths shares were trading at around $40. Woolworths was able to buy back 58 million shares, paying $4.31 of capital and a $30.15 fully franked dividend.

Woolworths was effectively buying shares trading on the market at $40 for $34.46 in cash.

Alongside the $30.15 fully franked dividend were franking credits equal to $12.92. This meant a Woolworths investor who sold their shares in the off-market buyback received $4.31 of capital, $30.15 of fully franked dividend plus $12.92 of franking credits. If they were a superannuation investor with a pension fund on the 0% tax rate, they received cash of 4.31 30.15 12.92 (refund of franking credits) = $47.37.

It seems to be a corporate strategy that suited everyone:

• Woolworths pays cash of $34.46 to buy back shares valued at $40, using excess franking credits;
• The 0% tax rate investors who participate receive $47.37 for their $40 shares;
• Other Woolworth investors now have 58 million fewer shares outstanding to share earnings and dividend with.

The question mark that sits with the proposed franking credit changes is the $12.92 per share contribution that the tax refund makes to this situation – is this a reasonable use of franking credits?

Proposed Changes

This leads us to the proposed franking credit changes. The following is directly from the draft explanatory materials, and sets out the situations where a dividend is ‘unfrankable’:

1.12 A distribution by an entity is funded by capital raising if, broadly:
• the distribution is not consistent with an established practice of
the entity of making distributions of that kind on a regular
basis;
• there has been an issue of equity interests in the entity or
another entity; and
• it is reasonable to conclude in the circumstances that either:

– the principal effect of the issue of any of the equity interests was to directly or indirectly fund some or all of the distribution; or

- any entity that issued or facilitated the issue of any of the equity interests did so for a purpose (other than an incidental purpose) of funding the distribution or part of the distribution.

In the commentary around this possible change, there seem to have been two impacts discussed. The first is limiting off-market buybacks that use franking credits as seen in the Woolworths example, and the second is limiting the ability of companies to pay dividends where the money may have been raised by capital raisings (e.g. issuing new shares).

The purpose of this article is not to come to a position on whether this is the correct option or not, but to provide the background information to this new discussion around franking credits.

Dividends as a Signal of Quality

There is a view that a stream of growing dividends, paid from earnings, can be a signal of quality. Restricting franking credits to the core use of being a refund of tax paid by a company means that fully franked dividends can be seen as being paid out of company earnings. When this is a pattern in a company over time, this might be a useful signal of earnings quality for an investor. 

Dividends or Reinvestment?

One of the more important capital management decisions is the use of earnings – to what extent are company earnings used to pay dividends or used to reinvest in new projects? An important question to consider is that if franking credits can only be used to support ongoing dividends, might this influence this decision towards higher dividends and greater franking credit use?

Conclusion

The franking credit system in Australia is clearly a positive for investors and the demonstration of how a franked dividend works to protect an investor from the double taxation of a dividend shows how effective the system is.

The proposals that are now being discussed around the use of franking credits don’t have any impact on the treatment of ‘normal’ franked dividends. Rather, they consider how widely franking credits should be used outside of franked dividends. They remain an interesting discussion for investors to be aware of and to participate in.